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Public Report

Valuation of investment property

Finanstilsynet's observations and assessments
Translation as of Sept. 2011 Norwegian report published 20.12.2010

Valuation of investment property

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Implementation and scope

The Financial Supervisory Authority of Norway (Finanstilsynet) has reviewed property valuations in periodic reports filed by a number of listed entities; see section 15-1 subsection (3) of the Securities Trading Act. The periodic reports reviewed were dated 31 December 2007, 31 December 2008 and 30 June 2009. Finanstilsynets review focuses on investment in office property. Segments such as retail property, hotels and residential property have not been part of the review. Neither have investment in property shares and property funds. As part of the review, the entities submitted information related to valuation of commercial property in general and to the valuation of two or three selected properties centrally located in Oslo. Further, meetings were held with the entities. In order to gain a better understanding of the market and the valuation methodology employed, meetings were also held with other market participants. This report presents Finanstilsynets observations and assessments and will be relevant for all entities that measure investment property at fair value in accordance with IAS 40 Investment Property.


Accounting for investment property is regulated by IAS 40 Investment Property. IAS 40.5 defines investment property as property (land or a building or part of a building or both) held (by the owner or by the lessee under a finance lease) to earn rentals or for capital appreciation or both. IAS 40.30 permits entities to choose either of two accounting models when valuing investment property: a fair value model a cost model

The entity shall apply the method chosen as its accounting policy to all of its investment property. This report comments only on the application of the fair value model. The fair value model entails measuring investment property at fair value (IAS 40.33). IAS 40.35 requires gains or losses arising from changes in the fair value of investment property to be included in profit or loss for the period in which they arise. Fair value is defined as the amount for which a property could be exchanged between knowledgeable, willing parties in an arm's length transaction (IAS 40.5 and IAS 40.36). Under this definition both buyer and seller are reasonably informed about the nature and

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characteristics of the investment property, its actual and potential uses, and market conditions on the balance sheet date (IAS 40.42). Further, a willing buyer and a willing seller are motivated, but not compelled, to buy or sell. The fair value of investment property reflect market conditions on the balance sheet date (IAS 40.38). IAS 40.32 encourages, but does not require, entities to determine the fair value of investment property on the basis of a valuation prepared by a duly qualified, independent valuation expert. The best evidence of fair value is given by current prices in an active market for similar property in the same location and condition and subject to similar lease and other contracts (IAS 40.45). The term active market is not explicitly defined by the above standard or in its basis for conclusions. It is however defined in IAS 36 Impairment of Assets, IAS 38 Intangible Assets and IAS 41 Agriculture. 1 An active market is a market where the following conditions exist: (a) the items traded within the market are homogeneous; (b) willing buyers and sellers can normally be found at any time; and (c) prices are available to the public. The Norwegian market for commercial property has limited liquidity and transparency. Identifying similar property in the same location and condition and subject to similar lease and other contracts is unlikely. The Norwegian market therefore does not meet the requirements for an active market. In the absence of current prices in an active market, other sources of information as described in IAS 40.46 may be considered. Sources mentioned include: 1. current prices in an active market for properties of a different nature, condition or location, adjusted to reflect those differences; 2. recent prices of similar properties in less active markets, adjusted to reflect any changes in economic conditions since the date of the transactions that occurred at those prices; and 3. discounted cash flow projections based on reliable estimates of future cash flows, supported by the terms of any existing lease and other contracts and (when possible) by external evidence such as current market rents for similar properties in the same location and condition, and using discount rates that reflect current market assessments of the uncertainty in the amount and timing of the cash flows. Finanstilsynet points out that relevant guidance with regard to fair value measurement may be available in other IFRS standards, in general valuation theory and in industry standards for property valuation.

IAS 39 Financial Instruments Recognition and Measurement AG 71 defines an active market for financial instruments. This definition differs somewhat.

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Observations and assessments

3.1 Discounted cash flows

Finanstilsynets observation is that market participants primarily use discounted cash flows, supported by available market information. Finanstilsynet has not considered other alternative investment property valuation methods. IAS 40 contains no specific rules with regard to the unit of account, although other standards address the topic. The general starting point appears to be that assets that are used separately and have separate cash flows are accounted for separately. This is the case for investment property. Investment properties are used and function separately, have separate cash flows and can be disposed of separately. In Finanstilsynets view, the unit of account is a particular investment property, and assumptions should therefore be determined on a property-byproperty basis. According to IAS 40, discounted cash flow projections should be based on estimates of future cash flows and discount rates that reflect current market assessments and are supported, where possible, by market information. Hence, where market information is not available or is incomplete, valuations based on discounted cash flows may not fully reflect market values. Finanstilsynet observes that entities apply models differently in terms of the length of the projection period and method for determining the value at the end of the projection period, the terminal value. Moreover, the timing of receipts and payments in cash flows is taken into account with a differing level of precision. Practices also differ in terms of whether assumptions are incorporated in the models on a lessee-by-lessee basis or based on an average of all lessees. Entities make simplifications to a greater or lesser degree in their models. Finanstilsynet accepts simplifications provided they do not have a material impact on amounts recorded in the financial statements. However, an entity must be able to justify that the effect of simplifications is not material. Entities apply models that take into account actual contract rents, future market rents, vacancy rates, owner costs and costs of leasehold improvements. Entities calculate cash flows based on the terms of any existing contracts in the contract period and then incorporate the market rent expected after the contract period. Another approach is to measure the value of the asset and contract separately, as seen in the valuation of ships and rigs, etc. For property, value can be measured on the assumption that the building has no lease or other contracts, the resulting figure subsequently being adjusted for the favourable or unfavourable rent in existing contracts. This approach makes it easier to compare the value of different buildings. Key figures such as yield 2, price per square metre etc., then represent the value of vacant buildings and do not include the favourable or unfavourable value of existing leases or other contracts. Entities assess value measurements against available market information such as relevant transactions, leases recently entered into, external valuations and other market participant analyses and forecasts for the property market, as well as general macroeconomic prospects. In Finanstilsynets view, the challenge facing market participants is to establish internal

Yield is the required real rate of return on the first years cash flow.

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procedures and methodological approaches that combine, systematise and document a broad selection of information. Assumptions should be determined in a consistent and verifiable manner that as far as possible reflects market conditions on the balance sheet date.

3.2 Cash flow

Discounted cash flow projections should be based on reliable estimates of future cash flows, supported by the terms of any existing lease and other contracts and (when possible) by external evidence (IAS 40.46(c)). Key assumptions included in the estimation of future cash flows are expected future rental income upon the expiry of current leases and expected owner costs. Entities determine expected future rental income by estimating future market rents and expected vacancy rates. IAS 40 contains no provisions with regard to accounting for risk. According to general valuation theory, risk may be taken into account either in cash flows or in the discount rate, as also indicated in IAS 36 Impairment of Assets A15. The discount rate should not reflect risks that have already been taken into account in adjusting the estimated cash flows. Otherwise, the effect of some assumptions will be taken into account twice.

Market rent
According to IAS 40.40 the fair value of investment property should reflect reasonable and supportable assumptions that represent what knowledgeable, willing parties would assume about rental income from future leases in the light of current market conditions. In the Norwegian market for commercial property, Eiendomsverdi Nring 3 and Dagens Nringsliv index 4, among others, gather and process data on rent level per square metre in various geographical areas. According to available historical data, market rents have followed a cyclical path from 1986 until today. In some geographical segments market rents have shown even greater volatility. Hence the actual future market rent may diverge widely from the current level, even in the short term. There are significant differences in rent level between geographical areas, and the quality of the data depends on the number of new leases registered in the period. One property will often have several leases of varying duration. Hence contracts are renegotiated, or new contracts are entered into, at different times, reflecting current market conditions at the time. The actual rental income for a building with a number of contracts entered into at different times with different market conditions may therefore vary less than the observed market rent. Finanstilsynet observes the use of several approaches to estimating future market rent. Approaches in use are mechanical projections of rental history, use of current market rent as a proxy for future market rent and use of current market rent adjusted by professional judgement.

Eiendomsverdi Nring monitors and registers activity and developments in the Norwegian property market. The companys published reports give an overview of the office rental market in Oslo, including rental prices, terms, contract volumes and contract sizes. 4 A panel of experts with representatives from OPAK, DnB NOR Nringsmegling AS, Akershus Eiendom AS and DTZ Realkapital AS prepares an index for Dagens Nringsliv. It specifies the assumed market rent per square metre for office property in various defined areas (segments) in Oslo. The index is prepared twice yearly and was first published in 1986.

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Current market rent does not necessarily reflect the best estimate of future market rent. Future market rent should in Finanstilsynet's view reflect the market's cyclical nature and should also take into account the fact that leases are entered into at different times and reflect different market conditions. Determination of expected future market rent will involve substantial exercise of judgement and will reflect the market participant's view of the market. Finanstilsynet points out that entities must apply a systematic approach when determining future market rent to ensure that assessments are verifiable and consistent across different properties and over time.

Vacancy rate
An element in the estimation of future rental income in the cash flow is the vacancy rate assumption. Properties may not be fully occupied at all times and the available space is termed general vacancy. In addition, when leases expire, space may remain vacant pending new contracts. According to available statistics, 5 the general vacancy rate for office properties in Oslo, Asker and Brum was as an example never lower than 4.6 per cent in the period 2002 to the first half of 2010, although vacancy levels may vary widely within this area. To Finanstilsynet's knowledge there are no segmental vacancy statistics for Oslo, and data that are relevant to a particular property may be difficult to find. Hence the vacancy rate factor employed should be considered against the observed vacancy rate in the relevant segment as well as the propertys vacancy history.

Owner costs
Owner costs include costs of exterior maintenance, insurance, tax, technical replacements and property management costs. Owner costs should be considered against budgets and historical costs for the particular property. In Finanstilsynet's view it is not sufficient to apply cost estimates based on statistics, such as OPAKs key figures for commercial property. Such a simplification could have a skewed impact for individual properties.

3.3 Discount rate

According to IAS 40.46(c) discounted cash flows should be based on using discount rates that reflect current market assessments of the uncertainty in the amount and timing of the cash flows. The required rate of return for an investment is the return that is required over time to attract capital to the business. The required rate of return is the cost of capital offered by the capital market on investments carrying the same risk as the investment under consideration. 6 The estimated required rate of return is the discount rate used when estimating the present value of cash flows. Finanstilsynet points out that cash flows and discount rate must be consistent in terms of how tax and debt finance are taken into account.
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DnB NOR Nringsmeglings Market Report for the first half of 2010. Gjesdal, F. and Johnsen, T., Kravsetting, lnnsomhetsmling og verdivurdering, 1999

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Yield is often mentioned in connection with property valuation. Finanstilsynet has not reviewed the application of the term. Yield is a required real rate of return on one year's cash flow and is therefore not directly applicable to discounting cash flows over a longer period. The term is defined and applied in differing ways: for example as direct yield, prime yield, contract yield or market yield. Yield is a relatively uncertain measure of the expected actual return. Yield may vary as a result of, for example, differing contract rent, and observed yield for a property cannot be applied to another property in the same segment uncritically. The different approaches to estimating property-specific factors and how these are taken into account in the assumptions applied vary widely. Some include risk in estimating the cash flows while others do so by adjusting the discount rate. Differing practice makes comparing different valuations of the same property at the same point in time very difficult. A specific case observed by Finanstilsynet concerns two valuations of the same property at the same point in time where the respective market rents differed by 50 per cent and the discount rates by 2.5 percentage points. The valuations are nonetheless within a 10 per cent interval. A more uniform application of methodology would be beneficial. Finanstilsynet is not aware of a suitable methodology for adjusting the discount rate to capture property-specific risk and considers it most appropriate for property-specific factors to be taken into account in estimating the cash flows. Property is in general an asset class with limited liquidity. It normally takes several months to invest and to realise direct investments in property, and carrying out a transaction involves significant costs. The liquidity of the investment is also likely to vary from one property to the next. Limited liquidity may involve a risk of not being able to sell the property or of being forced to sell at a substantial discount. It is reasonable to assume that a significant part of the excess return over risk-free interest rate that can be achieved by investing directly in property represents compensation for the limited liquidity. The discount rates used by the entities are the risk-free nominal interest rate, comprising expected real interest and an inflation expectation, and a risk premium. None of the entities has provided a satisfactory explanation for the discount rate chosen. All entities apply a discount rate that is higher than the risk-free interest rate. They point out that the discount rate has been determined using professional judgement, but are not explicit in their assessments of the respective components. Finanstilsynet remarks that this particularly applies to their choice of risk premium, including which risk is to be reflected and what part of the premium covers the individual risk. In Finanstilsynets assessment a more robust methodology is needed to determine discount rates in order to combine, systematise and document the data underlying the exercise of judgement. This will enable discount rates to be determined in a consistent and verifiable manner in accordance with market conditions on the balance sheet date. Finanstilsynet considers that such a methodology should have a theoretical foundation. There are examples of financial theory being applied to determine the discount rate when valuing investment property. 7 The methods presented pose a challenge since they require sufficient data, including data on historical excess return, for the Norwegian property market. Finanstilsynet none the less believes that a development in that direction would be beneficial.

Damodaran, A., Investment valuation, Second edition 2002

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3.4 Documenting exercise of judgement

The absence or incompleteness of market data means that market participants often need to exercise judgement when valuing investment property. Minor changes in assumptions can have a substantial effect on the measured value. The review revealed that the exercise of judgement and internal assessment of assumptions performed by the entities are insufficiently documented. In Finanstilsynets view, exercise of judgement needs to be systematised to assure consistent assessments over time and between properties. Judgements should be documented to ensure other parties, both internal and external, an understanding of management's market view underlying the valuation, and to assure verifiability. See also section 11 of the Bookkeeping Act and chapter 6 of the Bookkeeping Regulations. According to section 6-4 of the Bookkeeping Regulations, documentation of items valued by professional judgement should at minimum contain information about the method of measurement used and about the assumptions on which the measurement is based. In Finanstilsynets view it is not sufficient to quantify the assumptions employed; the basis for the assumptions applied must be substantiated.

3.5 Financial statement disclosures

IAS 40 contains comprehensive requirements for note disclosures related to fair value measurement. IAS 40.75 requires entities to disclose the methods and significant assumptions applied in determining the fair value of investment property. A general description of the factors taken into account in a valuation is not sufficient to meet these note disclosure requirements. It is Finanstilsynets assessment that specific information must be provided both about the model and the assumptions applied. Expected future market rent is a significant assumption for the valuations, and as a result extensive information about the entitys market view should be provided in notes to the accounts. Information about discount rates utilised can be provided by group of property, for example by site, shopping centre, office building and location. Entities should disclose whether the determination of fair value is supported by market evidence or is more heavily based on other factors because of the nature of the property and lack of comparable market data (IAS 40.75(d)). Entities should also disclose whether the fair value of investment property is based on a valuation by an independent valuer who holds a recognised and relevant professional qualification. If there has been no such valuation, that fact shall be disclosed (IAS 40.75(e)). The amounts recognised in profit or loss from various income and expense elements, including rental income and operating expenses, should also be disclosed (IAS 40.76(f)). IAS 40.76 requires disclosure of a reconciliation between the carrying amounts of investment property at the beginning and end of the period showing net gains or losses from fair value adjustments (IAS 40.76(d)). In addition to the requirements of IAS 40, data may also be required under the general provisions of IAS 1. IAS 1.125 requires an entity to disclose information about its key assumptions concerning the future, and other key sources of estimation uncertainty that have a significant risk of causing a material adjustment to the carrying amounts of assets and

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liabilities. The information should be given in a manner that helps the user to understand managements assessments; it may for example be relevant to disclose information about the carrying values sensitivity to choice of methods and assumptions (IAS 1.129).

3.6 Concluding comments

Finanstilsynet acknowledges that valuation of investment property is challenging. The market for commercial property in Norway has limited liquidity and transparency. Moreover, current legislation provides little guidance on property valuation, and valuation practice among market participants is far from uniform. Where discounted cash flows are used, the determination of assumptions may have significant impact on the estimated property values. It is Finanstilsynet's assessment that market participants should establish internal procedures and systematic approaches that ensure consistent and verifiable determination of property values. Improved market transparency may help to ensure that valuations made on the basis of discounted cash flows to a greater degree reflect market conditions on the balance sheet date. Systematic retrieval and publication of market data, including transaction data, would be a major contribution to increased market transparency. More uniform application of methodology and an increased focus on the application of finance theory models to estimate discount rates would also be favourable. In Finanstilsynet's view such a development should be driven by market participants.

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