44 MADISON MARQUETTE

Property Valuation:Addressing Transparency

RICHARD WINCOTTPricewaterhouseCoopers

DON DORCHESTERCushman & Wakefi eld

Q&A

The accounting, appraisal and financial report-ing worlds have come under scrutiny this year

as property values fall, sales slow and accounting methodologies shift. As cap rates continue to rise and underlying property fundamentals continue to erode, these pressures will only intensify.

Marius Andreasen, Director & Financial Reporting Practice Leader of Cushman & Wakefi eld described the current state of the industry by saying, “We’re leaving a period in which there was virtually no risk premium priced into commercial real estate relative to alterna-tive, fi xed income investments. While the increased availability of data over the past decade may have somewhat mitigated risk by reducing some informa-tion asymmetries, as a by-product of this ‘credit crisis’ we will likely be moving back to a period of risk premi-ums which appropriately price the risk associated with commercial real estate.”

Adding to the confusion and volatility is the imple-mentation last year of a new accounting standard, FAS 157, which establishes a framework for measur-ing fair value and expands disclosures about fair value measurements. Th e standard impacts companies that

are required or permitted to apply fair value measure-ments. Th e new rule has been criticized by those who say it is forcing fi nancial and other institutions to price investments, such as mortgage-backed securities, in frozen markets. In response, regulators have recently made changes to the standard.

To get a better appreciation for how the appraisal com-munity is reacting to changes in the industry, we spoke to Cushman & Wakefi eld’s Senior Director of Dispute Analysis & Litigation Support, Don Dorchester.

Q: Have the new account rules under FAS 157 had an impact on your appraisal process or in the information you provide to clients?

DD: The appraisal process has not changed, but there is greater emphasis on three key areas: market

participant information, use of price and other market information, and the development of a highest and best use opinion.

We are conducting primary market research that involves not only known buyers and sellers, but owners of competing properties or other real estate in the vicinity of properties we appraise. Th is information is used to better understand market participant perspectives and behavior, identify methods they use to decide whether to sell/buy or not, develop information about attempted transactions that were not formalized or completed, and the like. We try to identify who the market participants of relevance are and something about them.

Th e primary market research is used along with interviews with buyers and sellers to better un-derstand diff erences between “price” and “market value” so that fair value determinations can be made. Sometimes not fully apparent from other sources is the existence and level of duress, or the absence thereof, in transactions reported from secondary data sources.

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FEATURE

We’ve found that owner models are a good starting point, if they exist, but to adapt them to market participant expectations, or for an owner to have the inputs for Level 3 determinations.

Q: How is the absence of trading volume impacting your valuation process?

DD: While transactions can be very important, and should be understood in any stage of market conditions, transactions can also be misleading if not fully researched and understood. It is reason-able to believe that distressed transactions will occur when distressed economic conditions are prevalent. This does not mean that all transac-tions are bad indicators, but that in any type of market cycle they must be fully researched and understood.

Today, non-transactional market participant information is especially important, particularly for real estate which normally has a dramatically longer expected marketing period than organized securities markets. Th e volume of sales which is abnormally low usually signals potential for duress and/or diff erences between sales prices subject to duress and those that would occur in keeping with the fair value defi nition. Th e same can be true on the other end of economic cycles when abnormally high volumes of sales occur. Th e key in any market, as the Financial Account-ing Standards Board (FASB) has pointed out and is deeply rooted in generally accepted valuation principles (GAVP), is to understand the behavior and pricing of relevant market participants and apply market information, not judgment, guesses, or inferences from secondary data.

Q: What recommendations do you have to improve the quality of your source information in commercial real estate?

DD: As implied, if not said, above it is necessary to go behind the numbers of market transactions. The numbers reflecting the price of a transac-tion under GAVP are important only after, and not until, the facts, circumstances, motivations, duress or absence thereof, terms and conditions, and other elements consistent with market value or fair value have been fully developed, analyzed, and understood. For competent real estate ap-praisers, FAS 157 is mostly business as usual. So the source information should be focused on the market participant information developed by independent, competent real estate valuers.

Q: What tips do you have for ways in which clients can better interact with you?

DD: It’s actually a two way street. Open and frank discussions and disclosure by clients need not violate the independence of professional valuers. Transparency in financial reporting means that everyone must deal with factual information. The appraiser should be considered one of the legs of a three-legged stool: one is the client, one is the appraiser, and the other is the auditor. By open communication among the parties, concerns

about time and cost can be mitigated while the services and eventual goals are enhanced.

Q: What are the biggest changes in the industry you have witnessed over your career?

DD: With nearly 60 years under the belt, this is a tough one. But I’d say that one of the biggest is that the notion of real estate as an investment form being completely different from securi-ties markets has succumbed to transformational effects. CMBS is hardly a small house in rural Kentucky these days when the mortgage is owned by people across the globe. However, what mar-kets still do not understand is the time disinter-mediation (my term) between marketing periods for securities and those for most real estate. Thus, risk adjusted discount rates, IRR calculations, prices vs. market/fair value, and other areas of potential comparison fail to recognize the relative illiquidity of real estate compared with the more usual liquidity of securities.

Q: What other issues are you seeing as a result of FAS 157?

DD: During FASB’s deliberations and study regard-ing fair value leading to FAS 157 there were a number of questions raised about what appraisers call “limited market” or “non market” properties. These are often confused with “special purpose” properties which are defined as those defined for a specific use, and which may or may not have limited marketability. A property which is normally marketable within a time frame that is understood by the market may be sold in an overheated market in record time, sometimes without even being exposed for sale. Conversely, as is sometimes true today, the marketing time becomes much longer than typically expected, and sometimes there is little if any cohesive view of market participants about when reasonable marketability will return. This is an area in which key participants from the real estate valuation community can assist FASB, other regulators, Congress, and the nation in today’s economy.

To further understand how FAS 157 is impacting fi nancial reporting and valuation issues, we spoke to PricewaterhouseCoopers’ real estate expert Richard Wincott.

Q: What is the primary impact of FAS 157 on retail real estate? Is there signifi cant impact outside of CMBS-related issues?

RW: Real estate investment funds have been required to report the fair value of property holdings for many years. The FAS 157 definition of fair value is generally consistent with definitions used for valuation purposes and adopted by appraisers. Determining the fair value of publicly traded CMBS assets has been problematic due to the il-

liquid nature of the market and the requirements of FAS 157 to use market quoted prices. A recent amendment to FAS 157 is intended to address this issue.

Q: What are the signifi cant differences in valuation techniques under FAS 157 than under the traditional appraisal process?

RW: Appraisers have typically used the market, income or cost approach to determine fair value of com-mercial real estate and FAS 157 does not depart from this established practice. FAS 157 does not prescribe which technique is most appropriate, however, the method chosen should maximize the use of “observable” inputs into the valuation process.

Q: Are you seeing substantial changes in the reporting of real estate asset values as a result of FAS 157?

RW: Since real estate investment funds already reported fair values, overall, the adoption of FAS 157 is unlikely to have had a significant impact on values. However, managers have had to review methodologies and make changes as appropri-ate which may impact some asset valuations. For example, some managers may have adopted a pure discounted cash flow approach assuming current use, but FAS 157 requires consideration of a highest and best use concept which may be different to current or intended use. Also, the definition of “fair value” under FAS 157 assumes disposition in the principle market for the asset of the owner or in the absence of a principle market, the most advantageous market for the asset. Apart from the difficulty some firms may have in iden-tifying “principle market” this concept may not have been considered in prior estimations and my impact the fair value estimated under FAS 157.

Q: Are there changes that you would recommend be made to FAS 157 that would make it better suited to commercial real estate?

RW: The issue of debt valuation as a liability appears to be the most discussed and controversial. Hope-fully this will get resolved in the near future.

Q: In general, how well is the commercial real estate industry doing in their transition to FAS 157?

RW: For those firms impacted by FAS 157, the transi-tion has been relatively smooth, primarily because fair values have been adopted for many years. The real challenge for real estate funds going forward will be the potential adoption of International Financial Reporting Standards. P