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Valuation of Properties in Real Estate Finance

In the finance world, property valuation is needed to perform a great many different tasks that are anchored in various legal frameworks. This article sets out to systemize these tasks and, from there, to derive the resultant demands made on property valuation. Further, it will show the interrelationships between definitions of value, valuation occasions and valuation processes, offer approaches to solutions and point out present and future challenges in this field. Raymond Trotz, Dr. Dieter Brwald | Bayerische Hypo- und Vereinsbank AG

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Statutory Requirements New and more stringent demands on property valuation, valuers and property valuation processes result from the changed statutory framework governing the valuation of collateral, refinancing and capital relief. Examples of the changes of the statutory framework are: the Pfandbrief Act (PfandBG), which entered into force on July 19, 2005, the Regulation on the Determination of the Mortgage Lending Value (BelWertV), in force since August 1, 2006, the Solvency Regulation (SolvV) scheduled for 2007, under which the provisions of Basel II and the EU Capital Requirements Directive (CRD) will be implemented into German law and the amendments to the German Banking Act (KWG) and to the Regulation governing Large Exposures and Loans of 1.5 million or more (GroMiKV), both scheduled for 2007.

Thus, Pfandbrief banks need property valuation not only to assess risks and opportunities with regard to the valuation of collateral as part of the loan decision process and for classical Pfandbrief business but also to measure equity backing under Basel II/SolvV. Two alternatives are available for calculating the minimum capital required for loans: the standardized approach and the internal ratings based (IRB) approach. In the IRB approach, credit institutions may choose between two variants, the foundation and the advanced IRB approach. In this context, it may be said that the higher the demands made on the measurement of capital and on the valuation of collateral, the lower the requirements in terms of equity backing. The three approaches: a comparison

Standardized approach

Foundation IRB approach

Advanced IRB approach

Demands rise

Equity backing decreases

Chart based on information of KfW


Valuation of Properties in Real Estate Finance

Valuation Occasions As a result of the Minimum Requirements for Lending Operations (MaRisk) issued by the Federal Financial Supervisory Authority (BaFin) (Circular 18/2005), the demands made above all on the processes in lending have implications for the quality and quantity of property valuation. Thus, property valuation has become an indispensable part of the process of loan processing (loan extension and further loan processing), loan processing control, intensive workout, problem loan processing and risk provisioning.

The procedures of reviewing, administration and realization of furnished collateral are implemented within these processes. Besides the borrowers capacity to meet principal repayments, the credit institution must analyze the factors of importance to assessing the risk while paying particular attention to the property/project in question, and review the valuableness and the legal existence of collateral before granting the loan. In this context, the credit institutions must stipulate the types of collateral accepted and the methods for valuing this collateral. In further loan processing the MaRisk require that the valuableness and the legal existence of collateral be reviewed at appropriate intervals. When handling problem loans and in the event of a loan workout, specialists with the requisite expertise are to be involved in the realization of collateral. Whereas in the past the property was usually valued for a specific occasion, a regular review/monitoring of the value is called for today. The following provides an overview of the property valuation processes at the credit institutions that the new statutory regulations necessitate.


Property Valuation Process to Meet the Requirements of the Pfandbrief Act and the New Regulation on the Determination of the Mortgage Lending Value

Essentially, the mortgage lending value (MLV) is a long-term, sustainable value. The protection of the Pfandbrief creditor against the volatility of the markets is guaranteed by the methodology for determining the mortgage lending value and by the mortgage lending limit. If it is found that current market values are below the determined mortgage lending limits due to market fluctuations, checks of value and/or changes in features of the properties, the mortgage lending values/mortgage lending limits are to be modified accordingly. The mortgage lending value is defined in connection with section 16 PfandBG and section 3 BelWertV. This definition essentially corresponds to the international definitions concerning the mortgage lending value in accordance with the IVS, EVS, CRD and EMF. The PfandBG and the new BelWertV differentiate between assessing or determining and setting the mortgage lending value. Details on the methodology for and the form of the determination of the MLV as well as the minimum requirements as regards the valuers qualifications and his involvement in processes at the credit institutions are set down in the BelWertV. The procedures for determining the mortgage lending value are described in depth in the BelWertV and are based on the classical investment method, contractors method and compara-

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tive method while taking the two-pillar principle into consideration. Regulatory intervention with regard to the selection and the approach of individual valuation parameters including the reasons for same as well as with regard to the derivation of the overall result takes into consideration the particularity of the MLV as a value sustainable in the long term. The mortgage lending value is to be determined within the scope of a prudent valuation based on the future marketability of the property and taking into consideration the features of the property, the regional market situation and possible alternative uses. The mortgage lending value is the quantitative valuation result. To determine the qualitative valuation result, i.e. to estimate the marketability of the property, reference may be made in this connection to the market and property rating (see Trotz, Immobilien-Markt- und Objektrating, R. Mller Verlag, Cologne 2004, and vdp, Property and Market Rating, Berlin 2005), which has already proven itself in practice. Besides the determination and setting of the mortgage lending value, the BelWertV also contains rules on reviewing the basis of the determination of the mortgage lending value. This duty to review refers, on the one hand, to the general price level of the respective regional property markets and, on the other unless non owner-occupied residential properties are concerned , to the claim covered by the property serving as collateral (substantial payment arrears of at least 90 days).


Property Valuation Process within the Scope of Basel II

In the standardized approach, property valuations are necessary if the bank assigns preferential risk weights for residential and commercial properties. Where residential properties are concerned, neither a precisely defined value nor a special valuation procedure is called for. With regard to the preferential risk weight of 35 %, however, it must be ensured that the value, determined according to precisely defined rules, of the collateral substantially exceeds the loan. With commercial properties, the market value and MLV must be determined if the preferential risk weight of 50 % is assigned. Property valuation in the IRB approach is based on the determination of the market value. The market value constitutes the upper limit for the value within the scope of collateral valuation. Market valuation The determination of the market value in accordance with the acknowledged rules and regulations is the basis for further valuation processes within the scope of Basel II. In this context, the property is to be valued at most at the market value as defined in section 16 (2) sent. 2 PfandBG. This definition of the market value is equivalent, among others, to the market value definitions of the IVSC, TEGoVA and the Federal Building Code (BauGB). In addition to the determination of the market value for individual properties, market value determination is increasingly gaining in importance for portfolios. Transactions involving residential and commercial property portfolios and the financing of same, as well as the securitization and the strategic portfolio management in property asset management, often necessitate the valuation of hundreds or even thousands of properties. Valuation tasks of such magnitude can only be performed using a sophisticated valuation system in connection with the market and property rating, which allows a clustering of portfolios with regard not only to property types or value amounts but also to qualitative property features (see also VDH Real Estate Banking 2004, p. 28 et seq.)


Valuation of Properties in Real Estate Finance

In all, Basel II covers the valuation processes shown in the following table:
Process determination Outcome market value Basel II requirement measurement of capital valuation of collateral revaluation measurement of capital

of the market value determination of the mortgage lending value extrapolation of the market value market value forecast determination of market value default monitoring current market value (market value current) market value forecast as at time of realization (market value time of realization) estimated realization proceeds identification of relevant value fluctuations and needs for revaluation mortgage lending value

LGD estimate monitoring of value LGD estimate

LGD estimate

monitoring of value

Market value extrapolation and forecast, market value default The object of market value determination is to establish the current, market-oriented value of the property. However, the value of the collateral in the event of realization is of central importance in determining the loss given default (LGD) called for under Basel II in the IRB approach. The LGD is measured as the percent loss divided by the exposure at default (EAD): loss exposure proceeds + costs LGD = = EAD exposure at default The (realization) proceeds may be derived from the market value as follows: In the absence of a current determination of the market value, the market value determined in the past is extrapolated to the present point in time using a specific index. market value current = market value x market price index The market value time of realization is forecast as at the estimated time of realization using a specific duration of realization empirically derived from the past and using a specific index market value time of realization = market value present x market price forecast index as at the estimated time of realization

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On the basis of the market value time of realization, the expected proceeds in the event of realization (market value default) are estimated using a specific recovery rate empirically determined from the past. market value default = market value time of realization x recovery rate The statistical procedures that may be used for this valuation method can usually take their bearings from the current market situation and the property-specific write-down. However, a further differentiation is desirable in these methods in order, for example, to represent location and property features in a transparent manner and bring them into the determination of the indices. The market and property rating is such a procedure. Our practical experience has shown that when using the market and property rating to extrapolate/forecast the market value, not only market changes but also the specific quality of location, property and cash flow can be reflected in the extrapolation and forecast result, thereby heightening the accuracy of the results. Monitoring Basel II necessitates that the value of the real estate collateral be monitored regularly, at least annually. The purpose of such monitoring is to identify relevant losses in value and needs for a revaluation. Such monitoring may be based on the regularly determined, property-related extrapolation results in that these are compared periodically. Here, too, it is advisable to use the market and property rating. Using the rating result it is possible to establish to a more differentiated degree whether the specific property is developing in its respective market better or worse than the market average on account of its location-, property- and cash flow-related attributes. Values within the scope of the IRB approach


Forecast market value as at the time of realization (market value time of realization) Extrapolated market value (market value present) Market value

Estimated proceeds in event of realization (market value default)

Time e. g. 1995 (effective date of valuation)

(own chart)


e. g. 2008


Valuation of Properties in Real Estate Finance


Property Valuation Process within the Scope of the Requirements Specified in the Capital Requirements Directive (CRD)

Compared with Basel II, the CRD contains less stringent requirements for residential properties in respect of the regular monitoring required as a general principle for all properties serving as collateral. Monitoring must be conducted every three years, not annually. Moreover, Basel II and the CRD differ in two key points: Review of the property value The CRD stipulates: For loans exceeding 3 million or 5 % of the own funds of the credit institution, the property valuation shall be reviewed by an independent valuer at least every three years. Basel II contains no such requirement. On the other hand, no mention is made in this connection of a credit event such as, for example, a default on a loan, which under Basel II necessitates a valuation by a qualified expert. Importance of the mortgage lending value Besides the market value, the importance of the MLV the concept of which plays an important role in the banking industry of a number of European states is greater under the CRD. In EU states whose legal and administrative provisions set strict requirements for the measurement of the mortgage lending value, there exists for the valuation of real estate collateral with all three approaches the possibility to choose, on an equal basis, between the market value and the mortgage lending value. Basel II, by contrast, refers only to the market value for the valuation of real estate collateral in the IRB approach. Under the CRD, the upper limits for the preferential risk weight of 50 % for commercial properties in the standardized approach as well as loss rates in the foundation and advanced IRB approach are based on the market value and also, if need be, on the mortgage lending value. With Basel II, the preferential risk weight may be used for commercial properties in the standardized approach in exceptional cases only.


Property Valuation Process within the Scope of the Requirements Specified in the (Draft) Solvency Regulation

At present, it is the responsibility of the individual EU member states to implement the CRD into national law. It is being implemented into national law in England, for example, in the BIPRU (Prudential Sourcebook for Banks, Building Societies and Investment Firms), a part of the FSA handbook. The implementation of the CRD into German financial regulatory law is to enter into force as at January 1, 2007, and comprises the amendment of the German Banking Act (KWG), the issuance of a Solvency Regulation (SolvV) on establishing regulatory statutes concerning the capital requirements as well as the redraft of the Regulation governing Large Exposures and Loans of 1.5 million or more (GroMiKV). With regard to the standardized approach and the IRB approach, in connection with property valuation the SolvV refers to section 20a of the draft KWG (as at February 15, 2006). In addition to the legal enforceability, it is required here that the property is valued by an independent valuer at most at the market value in accordance with section 16 (2) sent. 4 PfandBG

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or, instead, at the mortgage lending value in accordance with section 16 (2) sent. 1-3 PfandBG. There exists a duty to document and the duty to perform a regular monitoring and review of the value. Thus, the draft of section 20a of the KWG requires: a regular monitoring of the value at least annually in the case of commercial properties, at least every 3 years in the case of residential properties, more often if strong fluctuations in value are identified a regular review of the valuation every 3 years if the basis of assessment of the loan and the value of the encumbered property exceeds the lower of 3 million or 5 percent of the credit institutions liable capital as defined in section 10, par. 2 sent. 2 KWG.

Implications for the Demands Made on the Property Valuation Depending on their purpose, the various statutory regulations require the derivation of different values for use in banking. It is therefore necessary to define the main definitions of value and to clearly set them apart from one other in how they are treated. Section 16 PfandBG defines and distinguishes between market and mortgage lending value for use in finance, whereas this is not the case with the market values to be extrapolated and forecast in the Basel II process. Since the forecast and extrapolation of the market value is based on statistical procedures, market value present and market value time of realization will not be able to represent the current value of a property in all cases. This point must be observed when these values are used at credit institutions. A further particularity of the determination of value for credit institutions concerns the treatment of rights under section II of the land register. These rights may be roughly divided into three categories: a) rights which directly influence individual valuation parameters and consequently the value of a property such as, for example, pipeline wayleave rights and rights to walk or drive over a property etc., b) rights that are take into consideration by determining capital values such as life annuities or annuities certain, c) rights which, in the case of a transfer of ownership, are duly dealt with by a notary together with the parties involved, for example, entry of the conveyance agreement in the land register, note of expropriation, insolvency note, preemption rights in respect of a property etc. The way in which the rights relevant to section II as stated under b) are treated differs where the market value and the mortgage lending value are concerned. Whereas these rights, true to their definition, flow into the determination of the market value a separate requirement exists for the determination of the mortgage lending value. The rights are shown separately in this case and are not elements of the mortgage lending value. These section II rights are considered when determining the mortgage lending limit according to the rank of the credit institutions real estate lien in the land register.


Valuation of Properties in Real Estate Finance

As a result of the difference in how these rights are treated in the market and mortgage lending value, a comparison between market and mortgage lending value as is required under section 16 PfandBG can only be made if both values are determined independently of each other but applying the same method. It is therefore appropriate to state in assessments, in addition to the market value as defined, a market value that does not consider the rights stated under b) as an interim result for the purpose of this comparison. These special requirements in respect of the determination of the market value in connection with the above topic ought to be worded uniformly for credit institutions. The results should flow into best practice standards for property valuers who work in banking. Despite the separate determination of market and mortgage lending value as a result of the different purpose they serve, cross-comparisons between the two values are also necessary, as the above example shows. This is especially true in light of the market value extrapolation and forecast within the meaning of Basel II and the required monitoring. For example, the derivation of requirements to review values or conduct revaluations under Basel II or under section 26 BelWertV can necessitate an adjustment of the different values, giving consideration to their purpose. The increase in portfolio valuations using methods suitable for determining the market value (such as mass, desktop, cluster or aggregated individual valuation) calls for debate on the determination of the MLV for portfolios. The new BelWertV deals with this topic only with regard to the purchase of a large number of loan claims of other credit institutions.

Implications for Demands Made on the Valuer Closely linked with the rising methodological requirements in terms of the separate yet simultaneous determination of the market and mortgage lending value for use at the credit institutions, the demands made on valuers qualifications are also rising. They must understand the philosophy behind both definitions of value, know the different purpose they serve at the credit institutions and be able to duly perform the determinations of value for both values in line with their respective definition. Section 6 of the new BelWertV stipulates the demands with regard to the valuers qualifications, in particular his knowledge of and experience in the property market and the type of property to be valued. HypZert GmbH, an initiative of the German finance sector, has taken this development into account. Since 1996 it has, as an accredited body, certified valuers in accordance with European Standard EN ISO/IEC 17024. The content of the certification examinations satisfies legal requirements as regards the determination of market and mortgage lending values for use in finance. Together with the professional practices such as those prescribed by HypZert, for example, they also meet in all points the internationally harmonized requirements governing the activity of a valuer.

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Implications for Property Valuation Methods The more stringent demands made on property valuation and, related thereto, the additional time and effort involved also necessitate process-related consequences at the credit institutions in order to take account of the growing complexity and meet the stricter regulatory requirements due to Basel II and the PfandBG/BelWertV with as little additional effort as possible, render more efficient the property valuation processes that are aimed at accelerating workflows and minimizing valuation costs, strengthen risk controlling and further improve the quality and the transparency of valuation results. In the property valuation process, the aim is to perform high-quality valuations efficiently by making use of process-supporting measures. HypoVereinsbank has developed the EDP-supported expert system Wertweiser to value standard properties (such as single-family/double-family houses, semi-detached/terraced houses, condominiums suitable and not suitable for self-use). The system supplies, via an Internet portal, quality-assured valuation parameters for determining the market and mortgage lending value. This process support may be procured by other credit institutions. Besides process support for the individual determination of market and mortgage lending value, Wertweiser also offers the possibility, while at the same time monitoring, to extrapolate and forecast market values. The legal duty to monitor/review the property values and the basis of the value determination places higher demands on credit institutions risk controlling operations than was previously the case. The extrapolation of market values and the possible consequences for the mortgage lending value and the review of same could well give rise to a need for discussion. The new BelWertV also regulates the demands made on the determination of the MLV of residential properties in the small loans sector. However, clarification is still needed with regard to the determination of the market value in small loans before a uniform, efficient valuation process can be installed at the credit institutions. Whereas a simplified procedure is possible with regard to the MLV within the limit for small loans, the statutory regulations currently in place do not yet permit this in the case of the market value. This would result, in an extreme case, to the consequence of the same property being valued twice, once for the mortgage lending value and once for the market value. Against this background, a harmonization of the requirements governing the determination of the market value and the mortgage lending value in small loans would appear both appropriate and necessary.


Valuation of Properties in Real Estate Finance

Summary Whilst in the past, properties were mostly valued for a loan decision or were triggered by a valuation occasion in loan processing, real estate collateral is today subject to regular monitoring. For property valuation, this means that market values need to be adjusted and the basis on which mortgage lending values are determined must be reviewed. In addition to the enhanced transparency, it is now necessary to define more clearly for the banking sector the different purpose of the individual property values and the details of how they are determined. It is also up to the parties responsible for valuing properties to find adequate answers to the increasingly complex requirements being made of risk management with regard to the real estate collateral of the credit institutions. More sophisticated procedures need not necessarily mean greater time and effort. Property valuation products and their processes ought to be put under close scrutiny. Examples with as yet unanswered questions and first proposals for a solution are mentioned in this article: definition of the purpose of individual definitions of value and wording of specific demands made on the determination of the market value for use in the finance sector, harmonization of the competences for the determination of the market and mortgage lending value in small loans, concretization of the duty to review in respect of the basis of the determination of the mortgage lending value, examination of the possibilities of determining the mortgage lending value for portfolios, inclusion of the market and property rating in the extrapolation and forecasting of market values, monitoring and in the use of recovery rates, use of process-supporting measures for the automatic valuation of standard residential properties and adjustment and use of the vdps market fluctuation concept for institutions that use the standardized or foundation IRB approach. The new demand to be met by property valuation from the financing viewpoint is to master the new challenges described here through highly qualified valuers and efficient processes with the help of intelligent, EDP-supported valuation systems that are able to determine at low cost not only market and mortgage lending values but also opportunity and risk profiles for properties. One of the main tasks facing property valuation now and in the years ahead is to find for the finance sector the right answers to the questions that have been raised. Transparent products and networked, efficient processes are indispensable in this respect. All of these points are the subject of ongoing debate at the vdp, in particular the Valuation Committee, which is gradually working its way through these issues with a view to bringing the results into the finance sector as best practice standards.