Definition of Value:

Market Value and Stabilized Values

CRN & AEI Conference

Reengineering the Appraisal: A Return to Market Fundamentals

Wolfgang Kälberer

Head of EU-Affairs

Association of German Pfandbrief Banks,

Brussels

Reiner Lux

Managing Director

Hypzert GmbH, Berlin

2

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.

3

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

4 4

u

The Basel capital allocation formula

Total regulatory capital

------------------------------ = 8%

Risk weighted assets

Basel

III

Basel

II

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

Standardized Approach: risk weights provided by law (Basel framework)

Internal Ratings Based Approach: risk weights based on EAD, PD, LGD, M

Basel I

1. Real estate finance under the Basel Accord

5

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.)

Internal Ratings based Approach (IRBA):

• 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%

6

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

arm‘s-length buyer on the date of valuation

Monitoring and revaluation:

• 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.

7

Liability side:

Funding of the mortgage portfolio

(Covered Bond)

Asset side

Capital allocation to the

mortgage portfolio

Risk Management

Risk-sensitive property valuation

The Value-at-Risk Approach

2. The value at risk approach:

the stabilized value

8

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

Capital Markets and Property Valuation:

Mortgage funding through Covered Bonds (Pfandbrief): the business model

9

Covered Bond vs. MBS (Mortgage Backed Security)

Covered Bond (Pfandbrief) ABS/MBS

issuer of bonds licensed credit institution

bank debt collateralized by registered

cover assets

Special purpose vehicle

only exposure against collateral and

its cash-flows

key features • cover assets remain on balance,

• product is standardized by law

highly homogenous, simple and

transparent

• assets sold off balance,

• individual product on a contractual

basis heterogeneous and complex

eligibility

criteria

strict legal requirements (asset class

restrictions, LTV limits, conservative

valuation)

driven by ratings

regulation of issuers and

issues

general and special supervision by national

supervisory authorities (GER: BaFin and

Bundesbank)

no public supervision

liquidity of

bonds

provided by market making system and

issuers

no institutionalized provision of liquidity

access to

funds

rate product

reliable access

to funds at low cost

credit product

funding subject to more volatile

market conditions

10

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. Qualification requirements for valuers:

• 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.

Mortgage

lending value

methodology

Hypzert

Certification

of valuers ISO

17024

11

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

total load

(annuity) Interest portion

redemption

interest and redemption … of the first year … of the last year

A stabilized value: why

12

Mortgage Lending Value vs. Market Value

Mortgage Lending Value

Value

Duration

60 % LTV limit for the preferential risk weight and for Covered Bond funding

Market Value

• 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

Conservative valuation of real estate

13

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.

Operational cost:

• 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.

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.

14

Market Value Mortgage Lending Value

Valuation

Procedure:

Investment Method or

Cost Approach or

Comparison Method

Approved Method

„Two Columns“

Investment

Method:

Rental Income on Valuation Date Rental Income sustainable for along

period of time

Input

Parameters:

Overrent in calculation Overrent not considered

Adequate maintenance Typical maintenance costs for the

property type; Minimum 15 %

Modernization risk to be considered

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: Recent Land value Land value sustainable achievable

Input

Parameters:

Recent value of the building Recent value of the building ./. 10 %

security haircut

Sustainable Valuation

15

Source: EUROHYPO

Sustainable Rent ?

0

50

100

150

1986 Q

4

1987 Q

4

1988 Q

4

1989 Q

4

1990 Q

4

1991 Q

4

1992 Q

4

1993 Q

4

1994 Q

4

1995 Q

4

1996 Q

4

1997 Q

4

1998 Q

4

1999 Q

4

2000 Q

4

2001 Q

4

2002 Q

4

2003 Q

4

2004 Q

4

2005 Q

4

2006 Q

4

2007 Q

4

2008 Q

4

2009 Q

4

2010 Q

4

2011 Q

4

2012 Q

4

2013 Q

4

2014 Q

4

2015 Q

4

0

5

10

15

Prime Rent (GBP/sqft/pa) Vacancy Rate (%)

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

16

Mortgage Lending Value vs. Market Value

a comparative calculation – Multi-family home (1) 10 €/m² market value

9 €/m² MLV

17

Mortgage Lending Value vs. Market Value:

a comparative calculation – Multi-family home (2) 9 €/m² market value

9 €/m² MLV

18

Mortgage Lending Value vs. Market Value:

a comparative calculation – Office(1) 20 €/m² market value

17 €/m² MLV

19

Mortgage Lending Value vs. Market Value:

a comparative calculation – Office(2) 17 €/m² market value

17 €/m² MLV

20

Market Value vs. Mortgage Lending Value

Rental Income Annual Gross Income based on the incoming rent

1,779 sq.ft. x $18.50 per sq.ft. x 12 months = 1,779 sq.ft. x $17.00 per sq.ft. x 12 months =

$394,938 $362,916

Less operating costs (individual evidence)

Equivalent Yield 7.00% 1.0%

Multiplier 14.29 PV factor into perpetuity 3.0%

394,938 x 14.3 = 5.0%

5,643,664 9.0%

15.0%

Less: additional purchase costs @ 5.75% 324,511 Less: Ttl. Exp. based on minimum estimate 54,437

5,319,153 Total annual net income 308,479

$5,320,000 Less: income attributable to the land

950,000 x 6.50% =

Net income attributable to the land only 61,750

Building income 246,729

Present Value of Building calculation

60 years

6.50%

15.03

Present Value of Building 3,709,063

Plus Land Value 950,000

Total Property Value 4,659,063

Less: additional purchase costs @ 5.75% 267,896

4,391,166

$4,390,000

Income Value Method - Mortgage Lending Value

Total

Minimum estimate

Remaining Economic Life

Property capitalization rate

Multiplier (PV factor)

Mortgage Lending Value (rounded)

rental income per year

Income Value

Market Value (rounded)

Income Value Method - Market Value

rental income per year

Administration

Rick of rent loss

Maintenance / Revitalization

21

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 valuer’s are crucial prerequisites for

the reliability of the appraisal system

22

vdp Price Index for Houses in Germany

Source: vdpResearch

3. How fixed rate mortgages and prudent property

valuation shape the German property market

23

vdp Price Index for Apartments in Germany

99.7

98.7

100.6100.9

100.1100.4

101.3101.1

105.1 105.2

103.5

104.9

103.7

104.2

105.7

104.2

103.4103.8

104.5

105.4 105.4

104.8

101.7

102.9

104.4

105.6105.8

107.3

105.6

105.0

105.5

107.7

109.1

110.6

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

90

95

100

105

110

115

Ind

ex,

20

03

=1

00

99.7

98.7

100.6100.9

100.1100.4

101.3101.1

105.1 105.2

103.5

104.9

103.7

104.2

105.7

104.2

103.4103.8

104.5

105.4 105.4

104.8

101.7

102.9

104.4

105.6105.8

107.3

105.6

105.0

105.5

107.7

109.1

110.6

vdp Price Index (Flats)

3-quarter moving average

Source: vdpResearch

24

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

1. H

J 20

10

80

100

120

140

160

180

200

220

240

260

H

ausp

reis

e (2

000

= 10

0)

Spain

Australia

France

UK

Ireland

USA

Netherlands

Germany

Sources: vdpResearch, national statistics, BIS

Ho

use

pric

es

(20

00

=10

0)

House and apartment prices – selected countries (2000 = 100)

25

Owner Occupied Housing – Germany vs. U.S.

2003Q1-2011Q3

U.S.: – 2.75 %

Germany: + 10.45 %

26

Rent development and capital values for office real estate in Germany and the US 2

00

3

20

04

20

05

20

06

20

07

20

08

20

09

20

10

20

11

:II

80

100

120

140

160

180

Mie

ten

un

d K

ap

tita

lwe

rte

(In

de

x,

20

03

= 1

00

)

Mietindex

Wertindex

Germany

Source: vdpResearch

20

03

20

04

20

05

20

06

20

07

20

08

20

09

20

10

20

11

:II

80

100

120

140

160

180

Mie

t- u

nd

Ka

pita

lwe

rte

(In

de

x,

20

03

= 1

00

)

Mietindex USA

Wertindex USA

USA

Source: TW – CBRE EA; RCA

Rent index Germany

Value index Germany

Ren

ts a

nd

cap

ital

val

ues

(Ind

ex,

20

03

= 1

00

)

Ren

ts a

nd

cap

ital

val

ues

(Ind

ex,

20

03

= 1

00

)

Rent index USA

Value index USA

27

1. Commercial properties 2. Residential properties

Year First mortgage loss rates in

%

Total loss rates in % Year First mortgage loss rates in

%

Total loss rates in %

1988 0.030 0.076 1988 0.042 0.115

1989 0.044 0.108 1989 0.028 0.080

1990 0.029 0.074 1990 0.020 0.053

1991 0.022 0.055 1991 0.013 0.035

1992 0.019 0.045 1992 0.014 0.036

1993 0.021 0.053 1993 0.013 0.035

1994 0.032 0.075 1994 0.009 0.024

1995 0.030 0.093 1995 0.010 0.037

1996 0.032 0.105 1996 0.017 0.056

1997 0.022 0.087 1997 0.022 0.054

1998 0.040 0.117 1998 0.028 0.074

1999 0.068 0.393 1999 0.022 0.099

2000 0.083 0.424 2000 0.029 0.189

2001 0.066 0.437 2001 0.034 0.216

2002 0.033 0.345 2002 0.038 0.267

2003 0.064 0.443 2003 0.042 0.288

2004 0.071 0.427 2004 0.054 0.327

2005 0.095 0.432 2005 0.069 0.359

2006 0.141 0.409 2006 0.072 0.210

2007 0.054 0.168 2007 0.044 0.155

2008 0.099 0.234 2008 0.050 0.151

Loss rates of residential & commercial mortgage lending from 1988 to 2008 in

Germany – all banks

Source: vdp

28

4. ISO 17024 certification by HypZert

Federal Association of German „Volksbanken und

Raiffeisenbanken“ Co-operative Banks

Saving Banks Finance Group

Association of Private Building Societies

The Association of German Public Banks

Federal Association of German Banks

The Association of German Pfandbrief Banks

29

Application/Mentoring

Application processing, decision

about admittance to examination

Written Exam

Oral Exam

Granting of certification

(valid for 5 years)

Monitoring of certification holder

(during validity)

Re-Certification

(before end of validity)

!

!

“Lifelong

Learning” Professional

Ethics

ISO 17014 certification process

30

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

31

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

Structure and Process of Exams - CIS HypZert (F)

32

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

33

• 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

Cooperation

Agreement

Cooperation with the Appraisal Institute

34

TEGoVA: Recognised European Valuer