Citation
Crosby, N. (2024), "Editorial: Basel 3 prudently conservative value for loan origination and monitoring", Journal of Property Investment & Finance, Vol. 42 No. 4, pp. 321-322. https://doi.org/10.1108/JPIF-07-2024-229
Publisher
:Emerald Publishing Limited
Copyright © 2024, Emerald Publishing Limited
This will be my last contribution to this journal, having served on the editorial board since the inception of the journal in 1982 before standing down. The Journal of Valuation provided the first academic outlet for those of us working in that field outside the USA, and it has continued to provide an important vehicle for communicating advances in our discipline ever since. Property valuation research is often a practice problem-solving activity, and therefore, I see an impact on users as a vital activity for real estate academics. I personally have never understood why some academics see publication of their work as the goal; for me, it will always be taking the work on, disseminating to users, with the goal of seeking adoption by the users.
Prudent value is one such opportunity. In 2017, the Bank for International Settlements Basel Committee, which provides guidance on financial regulation internationally, proposed a new definition or framework for real estate valuation using prudently conservative criteria. The Basel Committee produces guidance, and many jurisdictions are committed to following it wherever possible. The framework relates to valuations for lending purposes at both loan origination and for monitoring purposes.
The European Commission is the first jurisdiction to declare its intention to adopt this new valuation framework within its Capital Requirements Regulations (CRR). The UK Prudential Regulation Authority (PRA), part of the Bank of England, looks likely to follow. It remains to be seen what other global jurisdictions do, but there is a prospect that prudently conservative valuation criteria (prudent value) may dominate the lending valuation environment in the years to come.
Alternatively, it may go the way of a number of other initiatives by the lending community to impose a “better” valuation regime. Older UK readers may remember the ill-fated “estimated realisation price (ERP)” definition of value invented by lenders. The UK valuation profession “allowed” it to become part of the valuation standards landscape (before consigning it to the rubbish bin a few years later).
However, that framework or definition was fundamentally flawed, while the concept of prudent value is not. The driving force for change in valuation bases and frameworks is the losses sustained by banks in fallen markets. Given that market value (MV) is the main basis for many loan origination transactions and monitoring, it comes under scrutiny every time there is a major property market downturn. Most research indicates that MV (without any major loan-to-value adjustments) is pro-cyclical, with a spiral of increased lending helping to drive asset values upwards, driving more lending and increasing the subsequent losses when the “bubble” bursts.
How does prudent valuer differ from MV? The Basel III definition is:
Value of the property: the valuation must be appraised independently using prudently conservative valuation criteria. To ensure that the value of the property is appraised in a prudently conservative manner, the valuation must exclude expectations of price increases and must be adjusted to take into account the potential for the current market price to be significantly above the value that would be sustainable over the life of the loan. National supervisors should provide guidance, setting out prudent valuation criteria where such guidance does not already exist under national law. If a market value can be determined, the valuation should not be higher than the market value … (BCBS, 2017)
The elements that make it different from MV are that “the valuation must exclude expectations of price increases” and “must be adjusted to take into account the potential for the current market price to be significantly above the value that would be sustainable over the life of the loan”. There is also a requirement for national supervisors to provide guidance on the criteria where none exists and, importantly, for prudent value not to exceed MV. This means that a market valuation is still required.
The role of the national supervisors is obviously crucial, and given their appalling record in consulting with the real estate community on technical valuation matters, it is quite possible that the EU and the UK may come up with some bizarre implementation rules. However, the valuation professional institutions of IVS, RICS and TEGOVA are well aware of these dangers and are trying to engage with other European and UK real estate finance organisations such as the European Mortgage Federation (EMF), the Commercial Real Estate Finance Council (Europe) and UK Finance and supporting research into the implementation of prudent value.
The consensus, with one important exception, is that a prudent value is not a valuation that should be undertaken at the individual property level, as it is a market analysis process rather than a valuation process. Prudent value is lower than market value or long-term value. The individual property valuation remains the market value but is then adjusted to prudent value by a market- or segment-based adjustment factor.
A longer-term value can be found by an attempt to smooth the cyclical movements within markets and derive a MV adjustment factor when markets are assessed to be priced above those long-term economic and property market indicators. UK property market research funded by the Investment Property Forum and undertaken by a team from the Universities of Cambridge and Reading tested a number of models, from basic trend analysis to econometric modelling (IPF Long-term Value Methodologies in Commercial Real Estate Lending (July 2020) Full Report). They all identified overpricing across all three major segments of the UK market at least two years before the major property market downturns of 1990 and 2007.
With the exception of TEGOVA, who seem to currently believe individual valuers are equipped to deliver an individual property prudent valuation, the other professional institutions and organisations have embraced a market level rather than an individual property-based approach. They are working on how that might be delivered across both mature data-rich and data-poor immature markets across the EU and UK, with the EMF taking the lead in Europe and the RICS in the UK. With luck, they may come up with a properly thought-out solution, underpinned by their combined expert knowledge of real estate markets, supported by the real estate academic research community.
Whether financial regulators are listening is another matter. Given that the UK Bank of England PRA didn’t even seem to be aware that the Bank of England Financial Stability section supported the development and then used the IPF long-term value models in their work assessing CRE financial stability, a practical and realistic solution to the prudent value question, there is not much hope of that.
However, if they do listen, the implementation regime will need the further support of researchers working in both academe and practice to succeed – a perfect example of a research-based solution to a very practical problem. Without significant, very time-consuming engagement between academe and practice over a very long period, academic research would not even have been in a position to influence the outcome.