Definition of Value: Market Value and Stabilized Values

CRN & AEI Conference Reengineering the Appraisal: A Return to Market Fundamentals

Wolfgang Klberer Head of EU-Affairs Association of German Pfandbrief Banks, Brussels

Reiner Lux Managing Director Hypzert GmbH, Berlin

THESE MATERIALS ARE PROVIDED FOR INFORMATION PURPOSES ONLY AND DO NOT CONSTITUTE, OR FORM PART OF, ANY OFFER OR INVITATION TO UNDERWRITE, SUBSCRIBE FOR OR OTHERWISE ACQUIRE OR DISPOSE OF, OR ANY SOLICITATION OF ANY OFFER TO UNDERWRITE, SUBSCRIBE FOR OR OTHERWISE ACQUIRE OR DISPOSE OF, ANY SECURITIES AND ARE NOT INTENDED TO PROVIDE THE BASIS FOR ANY CREDIT OR ANY OTHER THIRD PARTY EVALUATION OF SECURITIES. IF ANY SUCH OFFER OR INVITATION IS MADE, IT WILL BE DONE SO PURSUANT TO SEPARATE AND DISTINCT DOCUMENTATION IN THE FORM OF A PROSPECTUS, OFFERING CIRCULAR OR OTHER EQUIVALENT DOCUMENT (A "PROSPECTUS") AND ANY DECISION TO PURCHASE OR SUBSCRIBE FOR ANY SECURITIES PURSUANT TO SUCH OFFER OR INVITATION SHOULD BE MADE SOLELY ON THE BASIS OF SUCH PROSPECTUS AND NOT THESE MATERIALS. THESE MATERIALS SHOULD NOT BE CONSIDERED AS A RECOMMENDATION THAT ANY INVESTOR SHOULD SUBSCRIBE FOR OR PURCHASE ANY SECURITIES. ANY PERSON WHO SUBSEQUENTLY ACQUIRES SECURITIES MUST RELY SOLELY ON A PROSPECTUS IN CONNECTION WITH SUCH SECURITIES, ON THE BASIS OF WHICH ALONE PURCHASES OF OR SUBSCRIPTION FOR SUCH SECURITIES SHOULD BE MADE. IN PARTICULAR, INVESTORS SHOULD PAY SPECIAL ATTENTION TO ANY SECTIONS OF SUCH PROSPECTUS DESCRIBING ANY RISK FACTORS. THE MERITS OR SUITABILITY OF ANY SECURITIES OR ANY TRANSACTION DESCRIBED IN THESE MATERIALS TO A PARTICULAR PERSON'S SITUATION SHOULD BE INDEPENDENTLY DETERMINED BY SUCH PERSON. ANY SUCH DETERMINATION SHOULD INVOLVE, INTER ALIA, AN ASSESSMENT OF THE LEGAL, TAX, ACCOUNTING, REGULATORY, FINANCIAL, CREDIT AND OTHER RELATED ASPECTS OF THE SECURITIES OR SUCH TRANSACTION. THESE MATERIALS ARE CONFIDENTIAL, ARE BEING MADE AVAILABLE TO SELECTED RECIPIENTS ONLY AND ARE SOLELY FOR THE INFORMATION OF SUCH RECIPIENTS. THESE MATERIALS MUST NOT BE REPRODUCED, REDISTRIBUTED OR PASSED ON TO ANY OTHER PERSON OR PUBLISHED, IN WHOLE OR IN PART, FOR ANY PURPOSE WITHOUT THE PRIOR WRITTEN CONSENT OF THE VERBAND DEUTSCHER PFANDBRIEFBANKEN.

Content
1. Real estate finance under the Basel Accord 2. The value at risk approach: the stabilized value

3. German property market characteristcs

4. ISO 45012 certification of valuers by Hypzert

1. Real estate finance under the Basel Accord

The Basel capital allocation formula Basel III Basel II

Total regulatory capital ------------------------------ = 8% Risk weighted assets

Basel I

Corporate Loan: 1 M $ Regulatory capital: 80.000 $ --------------------------------- = 8% 100% risk weight

Residential Mortgage Loan: 1 M $

Regulatory capital 28.000 $ ------------------------------------- = 8% 35% risk weight

u Standardized Approach: risk weights provided by law (Basel framework) Internal Ratings Based Approach: risk weights based on EAD, PD, LGD, M
4 4

Basel II: mortgage collateral recognized as credit risk mitigation tool

Standardized Approach:
Claims secured by residential property: 35% (instead of 75%) risk weight based on strict prudential criteria: the value of the property exceeds the claim by a substantial margin strict valuation rules Claims secured by commercial real estate: 100% risk weight in principle Exceptionally: 50% risk weight for the tranche of the loan that does not exceed 50% of the market value or 60% of the mortgage lending value of the property & additional circumstances (stable markets, low loss rates etc.) Real estate is eligible for recognition as collateral if a certain number of requirements are met, thereof the assessment of the objective market value of the collateral Recognition of real estate collateral through lower LGDs: 35% (instead of 45%) Advanced IRBA: banks own LGD measurement offer another significant leverage driving LGDs down to approx. 20%
5

Internal Ratings based Approach (IRBA):

Basel II provisions on property valuation

Objective market value of the property:

the property must be valued at or less than the current fair value under which the property could be sold under private contract between a willing seller and an arms-length buyer on the date of valuation the bank is expected to monitor the value of the collateral on a frequent basis and at a minimum once every year. More frequent monitoring is suggested where the market is subject to significant changes in conditions (statistical methods, e.g. house price indices may be used). A qualified professional must evaluate the property when information indicates that the value of the collateral may have declined materially relative to general market prices or when a credit event, such as default, occurs.

Monitoring and revaluation:

2. The value at risk approach: the stabilized value

The Value-at-Risk Approach

Risk Management

Asset side Capital allocation to the mortgage portfolio

Liability side: Funding of the mortgage portfolio (Covered Bond)

Risk-sensitive property valuation

Capital Markets and Property Valuation: Mortgage funding through Covered Bonds (Pfandbrief): the business model

Pfandbrief is a bank debenture, cover assets remain on balance Pfandbrief is collateralized by cover assets subject to strict eligibility criteria: regional restrictions LTV limits (only tranches up to 60% of mortgage lending value are eligible for cover) conservative property valuation rules apply (mortgage lending value) upon deterioration of cover asset quality: credit check, potential revision or substitution Insolvency remoteness: cover asset separation in the case of insolvency of the Pfandbriefbank All standards enforced by banking supervision
8

Covered Bond vs. MBS (Mortgage Backed Security)

Covered Bond (Pfandbrief) issuer of bonds licensed credit institution bank debt collateralized by registered cover assets cover assets remain on balance, product is standardized by law highly homogenous, simple and transparent strict legal requirements (asset class restrictions, LTV limits, conservative valuation) general and special supervision by national supervisory authorities (GER: BaFin and Bundesbank) ABS/MBS Special purpose vehicle only exposure against collateral and its cash-flows assets sold off balance, individual product on a contractual basis heterogeneous and complex driven by ratings

key features

eligibility criteria regulation of issuers and issues

no public supervision

liquidity of bonds
access to funds

provided by market making system and issuers

rate product reliable access to funds at low cost

no institutionalized provision of liquidity

credit product funding subject to more volatile market conditions 9

Transposition of Basel II into European Law Value-at-risk concerns motivated the European legislator to introduce in addition to market value a mortgage lending value based approach:
Mortgage lending value means the value of the property as determined by a prudent assessment of the future marketability of the property taking into account long-term sustainable aspects of the property, the normal and local market conditions, the current use and alternative appropriate uses of the property. Speculative elements shall not be taken into account in the assessment of the mortgage lending value. The mortgage lending value shall be documented in a transparent and clear manner. Valuers must be independent. This means a person who possesses the necessary qualifications, ability and experience to execute a valuation and who is independent from the credit decision process.
10

Mortgage lending value methodology

Qualification requirements for valuers:

Hypzert Certification of valuers ISO 17024

A stabilized value: why

Assuming a redemption of 1-2% per annum, the term of a loan usually runs for 25 up to more than 30 years. The value to be determined therefore must be valid for this whole period. The market value, however, is a value related to an appointed due date
term of the loan redemption

total load
(annuity)

Interest portion

of the first year

interest and redemption

of the last year

11

Mortgage Lending Value vs. Market Value

Value

Market Value Mortgage Lending Value 60 % LTV limit for the preferential risk weight and for Covered Bond funding

Duration

Conservative valuation of real estate Properties must be inspected Speculative elements to be excluded Mortgage Lending Value must not be higher than Market value at the time of valuation Strict Valuation criteria Property to be fit for third-party utilization (use/user) Objective and comprehensible market data Transparency of valuation Independence of the valuer
12

Basic principles of the Mortgage Lending Value methodology Net rental income:
The income stream of the property should be no more than the sustainable net rental income that the type of property usually produces over time in the specific local market on the basis of a judgment of past and current long-term market trends, excluding any actual over-rent and other extraordinary cash flows.
Deduction from the net rental income of all operational and administrative cost, allowances for obsolescence, reinvestment, annual maintenance, vacancy risk, tenant default risk and further risks to the rent.

Operational cost:

Capitalization rate:
The application of the capitalization rate must reflect long term market trends and exclude all short term expectations regarding the return on investment of the property. The assessment shall include the sustainably income producing capacity of the property, multi-purpose or appropriate alternative uses as well as the future marketability of the property.
13

Sustainable Valuation
Market Value Valuation Procedure:
Investment Method: Input Parameters:

Mortgage Lending Value Approved Method

Two Columns Rental Income sustainable for along period of time Overrent not considered Typical maintenance costs for the property type; Minimum 15 % Modernization risk to be considered

Investment Method or Cost Approach or Comparison Method

Rental Income on Valuation Date Overrent in calculation Adequate maintenance

Recent property yield for the specific property

Sustainable yield derived from long term market development Minimum 5 % or 6 % Regulated bonds for remaining useful life (10 to 80 years)

Cost Approach: Input Parameters:

Recent Land value Recent value of the building

Land value sustainable achievable Recent value of the building ./. 10 % security haircut 14

100

150

50

1986 Q4 1987 Q4 1988 Q4 1989 Q4 1990 Q4 1991 Q4 1992 Q4 1993 Q4 1994 Q4 1995 Q4 1996 Q4 1997 Q4 1998 Q4 1999 Q4 2000 Q4 2001 Q4 2002 Q4 2003 Q4 2004 Q4 2005 Q4 2006 Q4 2007 Q4 2008 Q4 2009 Q4 2010 Q4 2011 Q4 2012 Q4 2013 Q4 2014 Q4 2015 Q4
0 5 10 15

Prime Rent (GBP/sqft/pa)

Source: EUROHYPO

Sustainable Rent ?
Vacancy Rate (%)

Sustainable rent maximum on market rent level depends on cycle situation, history and future perspective

15

10 /m market value

Mortgage Lending Value vs. Market Value a comparative calculation Multi-family home (1)

9 /m MLV

16

9 /m market value

Mortgage Lending Value vs. Market Value: a comparative calculation Multi-family home (2)

9 /m MLV

17

20 /m market value

Mortgage Lending Value vs. Market Value: a comparative calculation Office(1)

17 /m MLV

18

17 /m market value

Mortgage Lending Value vs. Market Value: a comparative calculation Office(2)

17 /m MLV

19

Market Value vs. Mortgage Lending Value

Income Value Method - Market Value Rental Income 1,779 sq.ft. x $18.50 per sq.ft. x 12 months = rental income per year Equivalent Yield Multiplier $394,938 Income Value Method - Mortgage Lending Value Annual Gross Income based on the incoming rent 1,779 sq.ft. x $17.00 per sq.ft. x 12 months = rental income per year Less operating costs (individual evidence) Administration 1.0% Rick of rent loss 3.0% Maintenance / Revitalization 5.0% Total 9.0% Minimum estimate 15.0% Less: Ttl. Exp. based on minimum estimate Total annual net income Less: income attributable to the land 950,000 x 6.50% Net income attributable to the land only Building income $362,916

7.00% 14.29 PV factor into perpetuity 394,938 x 14.3 = Income Value 5,643,664 324,511 5,319,153 $5,320,000

Less: additional purchase costs @ 5.75%

54,437 308,479

Market Value (rounded)

= 61,750 246,729

Present Value of Building calculation Remaining Economic Life 60 years Property capitalization rate 6.50% Multiplier (PV factor) 15.03 Present Value of Building Plus Land Value Total Property Value Less: additional purchase costs @ 5.75% Mortgage Lending Value (rounded)

3,709,063 950,000 4,659,063 267,896 4,391,166 $4,390,000

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Summary Value-at-risk aspects of property valuation progressively materialized with the Basel rules since late 1990ies and this applies to both asset & liability sides of banks balance sheets:
lower risk weights: under the Basel framework, property valuation is now a
prerequisite for mortgage lenders to get access to lower risk weights: no mortgage collateral recognition without prior valuation ! lower funding costs: investor protection requires legislators to introduce

solid and prudent valuation rules when the safety of the funding instrument
is based on the value of the underlying properties

Property valuation is more and more recognized as an important risk management tool for the measurement of the risk sensitivity of real estate finance Independence and education of valuers are crucial prerequisites for the reliability of the appraisal system
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3. How fixed rate mortgages and prudent property valuation shape the German property market

vdp Price Index for Houses in Germany

Source: vdpResearch

22

vdp Price Index for Apartments in Germany

115

vdp Price Index (Flats) 3-quarter moving average

110.6

110
109.1

107.7 107.3

105.7

Index, 2003=100

105

105.1 105.2

105.4 105.4 104.2 103.8 103.4 102.9 101.7 104.5 104.8 104.4

105.6

105.8

105.6 105.0

105.5

104.9 104.2 103.5 103.7

101.3 100.6 100.9 100.1 99.7 98.7 100.4

101.1

100

95

Source: vdpResearch
90

2003:1

2003:2

2003:3

2003:4

2004:1

2004:2

2004:3

2004:4

2005:1

2005:2

2005:3

2005:4

2006:1

2006:2

2006:3

2006:4

2007:1

2007:2

2007:3

2007:4

2008:1

2008:2

2008:3

2008:4

2009:1

2009:2

2009:3

2009:4

2010:1

2010:2

2010:3

2010:4

2011:1

2011:2

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House and apartment prices selected countries (2000 = 100)

260
Australia

240

220

Hauspreise (2000 = 100) House prices (2000=100)

Spain

200

180
UK USA France

160

140
Netherlands

120
Ireland Germany

100

80

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

Sources: vdpResearch, national statistics, BIS

1. HJ 2010

24

Owner Occupied Housing Germany vs. U.S.

2003Q1-2011Q3 U.S.: 2.75 % Germany: + 10.45 %

25

Rent development and capital values for office real estate in Germany and the US
180

Germany
Mietindex Rent index Germany Value index Germany Wertindex

180

USA
Mietindex USA Rent index USA Value index USA Wertindex USA

160

160

Rents and capital values Mieten und Kaptitalwerte = 100) 2003 (Index, (Index, 2003 = 100)

140

Rentsund and capital values MietKapitalwerte 100) = 2003 (Index, (Index, 2003 = 100)
2011:II 2003 2004 2005 2006 2007 2008 2009 2010

140

120

120

100

100

80

80
2011:II 2003 2004 2005 2006 2007 2008 2009 2010

Source: vdpResearch

Source: TW CBRE EA; RCA

26

Loss rates of residential & commercial mortgage lending from 1988 to 2008 in Germany all banks
1. Commercial properties
Year First mortgage loss rates in % Total loss rates in %

2. Residential properties
Year First mortgage loss rates in % Total loss rates in %

1988
1989 1990 1991 1992 1993

0.030
0.044 0.029 0.022 0.019 0.021

0.076
0.108 0.074 0.055 0.045 0.053

1988
1989 1990 1991 1992 1993

0.042
0.028 0.020 0.013 0.014 0.013

0.115
0.080 0.053 0.035 0.036 0.035

1994
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008
Source: vdp

0.032
0.030 0.032 0.022 0.040 0.068 0.083 0.066 0.033 0.064 0.071 0.095 0.141 0.054 0.099

0.075
0.093 0.105 0.087 0.117 0.393 0.424 0.437 0.345 0.443 0.427 0.432 0.409 0.168 0.234

1994
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

0.009
0.010 0.017 0.022 0.028 0.022 0.029 0.034 0.038 0.042 0.054 0.069 0.072 0.044 0.050

0.024
0.037 0.056 0.054 0.074 0.099 0.189 0.216 0.267 0.288 0.327 0.359 0.210 0.155 0.151

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4. ISO 17024 certification by HypZert

Federal Association of German Volksbanken und Raiffeisenbanken Co-operative Banks Federal Association of German Banks

The Association of German Public Banks Saving Banks Finance Group The Association of German Pfandbrief Banks

Association of Private Building Societies

28

ISO 17014 certification process

Application/Mentoring
Application processing, decision about admittance to examination Written Exam Oral Exam Granting of certification (valid for 5 years)

! Professional Ethics !
29

Lifelong Learning

Monitoring of certification holder (during validity) Re-Certification (before end of validity)

Admission Requirements for CIS HypZert (F)

University graduates

Completed studies at university, e.g.: architecture, law, economics, business administration, etc.
At least 5 years of professional practice in real estate business

At least 3 years of professional practice in real estate valuation

Practitioners

At least 8 years of professional practice in real estate business

At least 5 years of professional practice in real estate valuation

30

Structure and Process of Exams - CIS HypZert (F)

I. Written Exam
Part I: Drafting of two valuations, one market value and one mortgage lending value appraisal duration of exam: 2 hours 15 minutes Part II: Plausibility check of an incorrect mortgage lending value appraisal with high degree of difficulty duration of exam: 1 hour Part III: Answering questions on various topics from the examination list duration of exam: 2 hours

II. Oral Exam

After written exam is passed, an oral exam with questions from the examination list takes place
duration: 30 min. per candidate

31

Re-certification

every 5 years precondition for participation: positive assessment of the certificate holder during the ongoing monitoring process expert interview: 30 minutes, including a short presentation of one the appraisals submitted during the ongoing monitoring process

32

Cooperation with the Appraisal Institute

Cooperation Agreement
Cross approval Appraisal Institute and HypZert Seminars and lectures in the other partner country to the property market in the U.S. or in Germany Exchange of information, data and results of the research Creation of international standards and cooperation with organizations such as WAVO, IVSC and TEGoVA Examination of MAI in Germany by HypZert
33

TEGoVA: Recognised European Valuer

34