Loan Security Valuation

Question 1

In addition to the min. valuation report requirements, what must also be reported for loan security valuations THAT IS OR WILL BE SUBJECT OF DEVELOPMENT (5)?

Answer 1

• Comment on costs
• Implication of cost overruns
• Comment on viability
• Sensitivity analysis for residual valuations
• Comment on development timelines

Question 2

What are typical special assumptions for loan security valuations THAT IS OR WILL BE SUBJECT OF DEVELOPMENT (2, extra 1 subject to particular special assumption)?

Answer 2

• Works complete
• Completed development let or sold
• Where a valuation is required on the special assumption that the work had been completed as of a current valuation date, the value reported should be based on current market conditions. If a valuation is required on the special assumption that the work has been completed as of a future date and the valuation date is as of that future date, the valuer is reminded of the requirements for developing and reporting the opinion of value.

Question 3

When might a property not be suitable for secured lending (tenure, environmental, lease)?

Answer 3

Short leasehold interest, high flood risk, tenant break option very soon (cannot guarantee income for any period of time)

Question 4

What is the normal valuation basis for lending instructions, and what should you do if that won’t be applicable for the instruction?

Answer 4

o Market Value is the basis for LSV and is defined in IVS 104 (MV definition as normal)
o Where the circumstances are different to this, the valuer and client should agree on a special assumption.

Question 5

What 5 broad areas does RB VPGA 2 cover?

Answer 5

	Conflict of interest checks – within 24 months
	Taking instructions
	Use MV basis
	Assumptions and special assumptions
	Reporting and disclosures

Question 6

What does VPGA 2 state re. dealing with conflicts of interests for lending instructions?

Answer 6

o Valuer has had no previous, current or anticipated involvement with the borrower or prospective borrower, the asset to be valued or any other party connected with a transaction for which the lending is required.
o ‘Previous involvement’ would normally be anything within the period of 24 months preceding the date of the instruction or date of agreement of the TOE (whichever is earlier) Also should consider the level of fees earned from any connected party as a proportion of total fee income.

Question 7

Outline some typical examples (5) of ‘previous involvement’ under RB VPGA 2.

Answer 7

 Long-standing professional relationship with the borrower or owner of the property or asset
 Introducing transaction to lender or the borrower, for which a fee is payable to the valuer or firm
 Has a financial interest in the asset or in the borrower
 Is acting for the owner of the property or asset in a related transaction.
 Is acting (or has acted) for the borrower on the purchase of the property or asset

Question 8

Under RB VPGA 2, what should you do if you are instructed by a borrower who does not disclose the lender?

Answer 8

o If the borrower approaches you for a report, but does not disclose the lender, you should make a statement to the effect of the valuation may not be acceptable to a lender (some lenders see borrower procured reports as insuffuciently independent, or have additional requirements)

Question 9

What 2 main pieces of info does VPGA 2 advice the valuer to request off the lender?

Answer 9

o The valuer should enquire if there has been a recent transaction or provisionally agreed price, and further enquiries e.g. marketing, effect of any incentives, whether best price obtainable
o The valuer should request details of the terms of the lending facility being contemplated by the lender.

Question 10

What is MLV, how does VPGA 2 advice it should be reported, and why?

Answer 10

 Sometimes described as a ‘mark to model’ valuation approach to distinguish it from a ‘mark to market’ approach, the (‘mortgage lending value’) valuation output must only be used for the particular purpose for which it is provided. This is because often the bases forms part of a risk assessment tool, the risk being viewed primarily from the lenders perspective across an extended period of time.

Question 11

Under VPGA 2, what must you state if you have made a special assumption?

Answer 11

o Any valuation for secured lending purposes arrived at by making a special assumption must be accompanied by a comment on any material difference between the reported value with and without that special assumption.

Question 12

What does VPGA 2 advise you to include in your report re. the way you valued a property?

Answer 12

 The valuation method adopted, supported (where appropriate or requested) with the calculation used (note that in some jurisdictions, the method or methodology itself will be prescribed in some degree).

Question 13

What does VPGA 2 advise you to include in your report re. proposed agreed prices (or in the absence of being provided with one)?

Answer 13

 Where a recent transaction on the property has occurred or a provisionally agreed price has been disclosed, the extent to which that information has been accepted as evidence of value. This should be accompanied by a request that if such information (or further information) comes to light before the loan is finalised, the matter must be referred back to the valuer for further consideration

Question 14

What does VPGA 2 advise you to include in your report re. a property’s security for a loan?

Answer 14

 Comment on the suitability of the property as security for mortgage purposes, bearing in mind the length and terms of the loan being contemplated. Where the terms are not known, the comment should be restricted to the general marketability of the property

Question 15

What does VPGA 2 advise you to include in your report re. any factors that could affect the price?

Answer 15

 Any circumstances of which the valuer is aware that could affect the price (these must also be drawn to the attention of the lender, and an indication of their effect must be provided)

Question 16

What does VPGA 2 advise you to include in your report re. any other factors that may conflict with the agreed basis of value?

Answer 16

 Any other factor that potentially conflicts with the definition of the basis of value or its underlying assumptions must be noted and its effect explained

Question 17

What does VPGA 2 advise you to include in your report re. the property use in relation to market conditions?

Answer 17

 Potential and demand for alternative uses, or any foreseeable changes in the current mode or category of occupation

Question 18

What does VPGA 2 advise you to include in your report re. the market conditions in relation to the property and the loan?

Answer 18

 The potential occupational demand for the property
 Past, current and future trends, and any volatility in the local market and/or demand for the category of property
 The current marketability of the interest and whether it is likely to be sustainable over the life of the loan

Question 19

What does VPGA 2 advise you to include in your report re. property condition and environmental/planning issues?

Answer 19

 Disrepair, or whether any deleterious or harmful materials have been noted
 Comment on any environmental or economic designation
 Comment on environmental issues, such as flood risk potential, historic contamination or non-conforming uses

Question 20

What does VPGA 2 advise you to include in your report re. the comparable evidence used?

Answer 20

 Details of any significant comparable transactions relied upon and their relevance to the valuation

Question 21

What emerging factor (VPGA 2 reporting) should you make a comment on?

Answer 21

 Sustainability factors (see VPGA 8) are becoming a more significant market influence and valuations for secured lending should always have appropriate regard to their relevance to the particular assignment.

Question 22

Under VPGA 2 reporting requirements, what additional 5 areas should you report/comment on (think leases, rent, occupiers, the loan and property potential)?

Answer 22

 a summary of occupational leases, indicating whether the leases have been read or not, and the source of any information relied on
 a statement of, and commentary on, current rental income, and comparison with current market rental value. Where the property comprises a number of different units that can be let individually, separate information should be provided on each
 an assumption as to covenant strength where there is no information readily available, or comment on the market’s view of the quality, suitability and strength of the tenant’s covenant
 comment on maintainability of income over the life of the loan (and any risks to the maintainability of income), with particular reference to lease breaks or determinations and anticipated market trends – this may well need to be considered in a broader sustainability context and
 comment on any potential for redevelopment or refurbishment at the end of the occupational lease(s)

Question 23

Why are there a more diverse range of lenders now, and what is the overriding objective for the valuer?

Answer 23

As the ‘mainstream’ established lenders are subject to enhanced regulatory and capital requirements, a range of alternative lenders have emerged who may operate on different business models.
o The overriding objective is that the valuer should understand the lender’s requirements and the lender should understand the advice that is given

Question 24

Why should a valuer disclose any potential circumstances that could be considered a conflict to a lender?

Answer 24

o Lenders usually have distinct internal risk and compliance policies, which are supplementary to the satisfaction of regulatory requirements. In this context, a valuer’s opinion of what circumstances could give rise to a conflict may differ from the perspective held by a lender.

Question 25

What term does UK VPGA 10 advise is the minimum ‘conflict position’ you must be in to undertake a secured lending valuation?

Answer 25

o The valuer providing the opinion of value on which the lending decision will ultimately be made will – at a minimum – be expected to be an ‘external valuer’ as defined in the Global Standards Glossary.

Question 26

What does UK VPGA 10 advise valuers to do to ensure they meet the lenders conflict of interest policy?

Answer 26

o As there is no universally recognised definition of this or other similar terms, it is essential that the valuer ensures the instructing client has defined the term or terms employed in writing, so the criteria for independence being applied are crystal clear. It follows that the valuer must meet those criteria before agreeing to act.

Question 27

What 2 main things does UK VPGA 10 advise valuers to agree to limit their liability and how must it be documented?

Answer 27

o Prior to accepting any instruction, valuers may or will need to discuss with clients the principle of liability caps and the reliance that will be placed on the valuation. The resultant agreement must be unambiguously documented in both the terms of engagement and the valuation report.

Question 28

What should a valuer consider when instructed under a panel agreement, and what action may therefore need to be taken?

Answer 28

o Great care must be exercised to ensure that where panel agreements are in place, they are and remain appropriate in relation to individual valuation assignments. This is of as much importance to the lender as to the valuer. The great diversity of circumstances relating to property assets that may be considered for secured lending means that members should be alert to instances where, for specific and identified reasons, standardised terms of engagement may not be appropriate.

Question 29

What does UK VPGA 10 recommend re. who the LSV report is addressed to?

Answer 29

o For valuations undertaken in the UK, it is strongly recommended that any loan security report is addressed only to the named lender, and not to a broker or potential borrower.

Question 30

By what 2 measures should you decide upon a liability cap?

Answer 30

o Both parties should have regard to the requirement that any cap in liability should be reasonable and proportionate to the nature of the instruction and their respective exposures to risk. Particular care is required, both to understand the potential extent of liability and to understand its management.

Question 31

What does UK VPGA 10 recommend re. the default liability limitation position, and what if other beneficiaries are to be included?

Answer 31

o As a default position, the terms of engagement should limit reliance only to the addressee, who should be the named lender. They should also state as default that any third-party reliance is specifically excluded. However, if any other beneficiaries are to be included, as appropriate to the nature of the instruction, these should be specifically named.

Question 32

Under UK VPGA 10, how should a valuer approach a lenders requirement for an opinion of asset quality?

Answer 32

o A lender may request the valuer to provide an opinion of asset quality in accordance with categories established by regulatory authorities. In these instances, the valuer should confine their response to a direct answer to the questions. Any limitations on the valuer’s ability to complete these questions accurately should be noted.

Question 33

Under UK VPGA 10, who is responsible for the loan decision, and therefore how should the valuers comments be limited?

Answer 33

o It is wholly the responsibility of the lender to assess and take the final decision on the suitability of the asset for loan security, as this will involve factors other than the property being taken as collateral. Any comments by the valuer should be limited to those property or market factors that could or may have an impact on cash flow, value or liquidity.

Question 34

Under UK VPGA 10, what requirements must be met if forward looking advice is provided to the lender?

Answer 34

o The valuer is only expected to provide an opinion based on information that is readily available in the market and/or is reasonably foreseeable. Where forward looking advice is provided to the lender, it must meet the requirements of VPS 3 section 2 paragraph 2(e) subparagraph 3 and VPS 4 section 11.

Question 35

In contact law, what is ‘implied’?

Answer 35

• Whether its terms say it or not, a contract for professional services is usually considered to be subject to an ‘implied term’ that the services to be provided by the professional will not fall below the standards of skill and care expected from a reasonable body of the professional’s peers. In effect, this means that the professional undertakes not to act negligently.

Question 36

How is ‘tort’ different to a breach of contact, and what standard of care is a valuer held to?

Answer 36

A ‘tort’ is an umbrella term for all civil wrongs recognised by the law, other than breach of contract. When we refer to claims against valuers in tort, we usually mean claims for the tort of negligence. In practice, a tort claim holds a valuer to the same standard of care as the implied contractual term not to act negligently.

Question 37

What question will a Court ask when considering a valuer’s negligence, and what additional consideration will they take into account?

Answer 37

o The usual question the courts ask is what are the maximum and minimum valuations that could be given by a reasonable valuer in the actual valuer’s position (assessed by a valuer’s peers).
o To be found negligent, the actual valuation must generally have fallen outside that ‘bracket’ of hypothetical reasonable valuations.
o The courts may sometimes also consider whether there were any specific errors made by the valuer in the course of the valuation. If there were, that could increase the chances of the valuation being held to be outside the bracket. This means that a valuer cannot focus purely on the end figure; the process followed by the valuer and the text of a valuation report are also important.

Question 38

What is the SAAMCO Cap, and why should a valuer consider the advice they are giving to a client?

Answer 38

o The SAAMCO Cap: usually restricts the damages to the difference between the valuer’s valuation figure and the figure the court decides was the actual value of the property at the date of the valuation. Therefore, valuers are not generally liable for additional losses suffered by their clients by market depreciation in the property between the date of the valuation and the date of the claim.
o It is important to note that the SAAMCO Cap is based on the principle that providing a valuation is only, in legal terms, providing ‘information’. The cap does not apply if a valuer goes beyond the provision of information and advises a client whether to proceed with a transaction.

Question 39

Who can sue a valuer for a breach of contract/tort, and why should you be careful with you consent reliance to?

Answer 39

o A claim for breach of contract (or tort) can usually only be brought by a party to the contract, i.e. the client. A valuer can be sued in negligence by those third parties (i.e. those who are not party to the valuation contract) to whom the valuer expressly accepts a duty of care, or those to whom the court says the valuer has assumed a duty of care.
o If the valuer does consent to reliance by a particular third party, they will probably be considered to owe that third party a duty of care. This may enable that party to have the same rights as a client, whilst not being bound by the terms of the valuer’s engagement, including any liability cap

Question 40

Why does RICS recommend you state re. the purpose of a loan security valuation?

Answer 40

o RICS recommends that, where possible, members should be more specific than saying only that a valuation is provided, for example, ‘for secured lending purposes’. Although a member may not have full visibility of what a client hopes or intends to use the valuation for, they should record what they consent to it being used for. They should consider including wording along the following lines (again, secured lending is used as an example):
 ‘we consent to its use only in a single secured lending decision.’

Question 41

Why is it important to include a clause in the valuer’s terms of engagement excluding all personal liability?

Answer 41

o Occasionally, claimants try to bring claims against individual partners, or individual employed valuers, even if the services are provided by an LLP. This means that it is prudent to include a clause in the valuer’s terms of engagement excluding all personal liability.

Question 42

How is the limitation period for breach of contract different to a tort claim, and why (2 potential circumstances)?

Answer 42

o Generally speaking, the limitation period for bringing a claim against a valuer will be six years from the date of the valuation (breach of contract).
o This period can be longer, particularly where the claim is brought as one for the tort of negligence.
 The six-year period for bringing a professional negligence claim does not begin until the claimant incurs loss, which may not be the date when the negligent professional services were provided i.e. starts from the date on which the borrower draws down the loan.
 In addition, in 1986 the Limitation Act 1980 gave the claimant three years to bring a claim, from when the claimant learned about his or her entitlement to claim. This three-year period is subject to a ‘long-stop’ period of 15 years from the date of the negligent act, which in a valuation context will usually mean 15 years from the date of the valuation report.

Question 43

Explain the importance of ‘claims made’ basis provision of PII, and why RICS recommends ‘run-off’ cover.

Answer 43

o PII is provided to firms of valuers on a ‘claims made’ basis. This means that in order for there to be insurance for a claim, there must be an insurance policy in place when the claim is made. For example, for valuations conducted in 2017, the firm should continue buying insurance every year until at least 2023. There is still a risk of a firm or its partners being sued if it ceases practice during that intervening period, which is why RICS requires firms to buy ‘run-off’ PII to cover the period after ceasing practice.

Question 44

What is a liability cap,
what purpose does it serve,
how must they be drafted to be enforceable,
and why should you perhaps not consider using one when dealing with a ‘consumer’?

Answer 44

o A liability cap is a contractual agreement that a client can only claim damages up to the amount agreed, even if the law would otherwise award a greater sum in damages (applies even where a valuer has conducted a valuation negligently).
o A way to ensure that there is a fair allocation of risk and reward between members and their clients.
o Legally, liability caps are enforceable as long as they are properly incorporated into the contract, and they are at a ‘reasonable’ level.
o Any contract between a business and a consumer will fall within the jurisdiction of the Competition and Markets Authority, which has wide powers to challenge the conduct of any business that is seeking to impose terms that cause unfair detriment to consumers.

Question 45

Explain the difference between a liability cap and a firm’s professional indemnity insurance limit.

Answer 45

 The insurance limit is set out in the firm’s insurance policy and is fixed on the annual PII renewal; it is the maximum amount insurers will pay in any particular claim.
 A liability cap is an agreement between a member and their client, fixed when they enter into a valuation engagement.

Question 46

What 4 factors will the Court consider when deciding if a liability cap is reasonable?

Answer 46

 The level of risk in the engagement.
 The level of fees - there is no reason for the liability risk to be disproportionate to the reward.
 The degree of sophistication and the relative bargaining position of the parties to the contract (i.e. lender = enforceable, consumer = not)
 How effectively the cap is brought to the client’s attention – Terms of Engagement or Confirmation of Instructions is suitable, should not be ‘buried away’ in fine print

Question 47

What is the common basis to negotiate a liability cap on for LSV purposes?

Answer 47

o The level of the liability cap can be negotiated on different bases - a percentage of the amount intended to be loaned (in the case of valuations for loan security purposes).

Question 48

What approach does RICS advise if you are asked to allow a borrower to merely see the valuation report?

Answer 48

o Permitting third party reliance is different from merely permitting a third party to ‘see’ or to have ‘disclosed’ to them the valuation report as it does not automatically give rise to a legal duty to the third party. However, members should still take care even in allowing this, because there is a risk this might be construed as the same thing as permitting reliance. If members do agree, make it clear, in writing, that this is being permitted without assumption of any legal liability to that third party.

Question 49

If you do permit 3rd party reliance, what 3 things should you ensure takes place?

Answer 49

 the third party is bound by the terms and conditions of the firm’s contract with its client (including the liability cap)
 the third party understands and acknowledges (if it is the case) that the firm has not conducted a fresh valuation and the effective date has not changed simply by the act of permitting third party reliance and
 the purpose for which the valuation has been provided has not altered simply by permitting third party reliance.

Question 50

If there is a panel agreement in place, what 3 things must you always consider in your agreement (from a risk perspective), and why?

Answer 50

 1 The scope of the work
 2 The fee
 3 The liability cap

o Frequently, claims against valuers arise because of a mismatch between the work the valuer intended to do to prepare the valuation, and the work the client anticipated the valuer would do. The engagement letter is the valuer’s opportunity to ensure that the client’s expectations match those of the valuer as to what the valuer is going to do and, just as importantly, what the valuer is not going to do.

Question 51

Why is it important to minimise negligence claims, even if you are not found to be negligent?

Answer 51

o Claims on a firm’s PII directly affect the cost and terms of insurance in the future. In practice, that means it is in the interests of the firm’s partners and senior staff to maintain an active involvement in risk management, so as to minimise claims under the policy. PII costs vastly more for LSV – liability caps significantly reduce your PII – litigious

Question 52

What 3 things increase the liability risk when undertaking a commercial mortgage instruction?

Answer 52

 more parties are permitted to rely on the valuation
 the level of debt increases (particularly when the loan to value ratio increases) and
 investment instruments such as bonds are issued and secured on the debt, particularly if those instruments are issued in public markets.

Question 53

What is a bilateral loan, and why is it the least risk area of LSV?

Answer 53

 A bilateral loan is the simple situation where one lender lends 100 per cent of a loan amount to one borrower. From a structural perspective, these are the least high risk secured lending valuation engagements for valuers. As there is only intended to be one lender client and the engagement is a relatively simple one, the instruction will in many cases be covered by an umbrella Service Agreement or other standardised documentation.

Question 54

What is the English law principle re. assigning a contract to a 3rd party, and therefore what should you include in your engagement contract?

Answer 54

 In general, as a matter of English law, the benefit to a client of the contract can be assigned by the client to a ‘third party’ (i.e. someone who is not already party to the contract), unless the contract expressly prohibits assignment.
 However, this will not be possible if members include a clause in their terms of engagement by which they prohibit assignment of their engagement contract without their consent.

Question 55

What are syndicated loans, and what should a valuer consider if instructed in this manner?

Answer 55

 Syndicated loans are loans where there is a group or syndicate of lenders. This structure is usually used for higher value loans than bilateral loans (see above).
 If providing a valuation for a syndicated loan, members should think about how to make sure all of the lenders are bound in to the terms of their engagement contract

Question 56

When is mezzanine finance typically used,
Where does it get its name,
Why does it pose a higher liability risk to a valuer
And therefore what does the RICS recommend you do in such situations?

Answer 56

 Mezzanine finance is used in situations where a higher Loan to Value (LTV) is required by the borrower or, for example, where the value of the project is expected to grow quickly such as development and refurbishment situations.
 It gets its name because it is the middle layer of debt, falling between the secured ‘senior’ debt of a conventional lender, and the equity of the project owner.
 Mezzanine finance is often provided quickly, with relatively little due diligence on the part of the lender. For a valuer, it is important to understand that:
• a mezzanine lender is usually the first lender to be exposed in the event that a project fails or a borrower defaults and
• a mezzanine lender lends against the security of the highest tranche of equity in the property that forms the security.
 These factors mean that the liability risk for a valuer in advising mezzanine lenders about the value of a property is high. Members should ensure that their fee and liability cap reflect this level of risk.

Question 57

What risks do crowdfunding and peer to peer lending agreements entail, and what therefore should a valuer ensure to do?

Answer 57

 The risks can be similar to those for public offerings, because the valuer may not know who the investors are who wish to rely upon the valuation, and is unlikely to be able to agree contractual terms with each of them.
 The arranger of the crowdfunding or peer to peer lending may be content for the valuation report to be provided to potential investors for their information only, on a ‘non-reliance’ basis, which will reduce the risk for the valuer.
 If so, members should ensure that both their engagement letters and valuation reports make this basis clear.

Question 58

What did Titan v Colliers CA 2015 establish re. whom the duty of care was owed in a securitised investment?

Answer 58

 Significant: first English Court analysis of duty of care in a securitised investment.
 Titan, as the issuer of the notes, brought a claim against Colliers for negligently over-valuing the property.
 Commercial Court found that the issuer could bring the claim, that the valuer had indeed been negligent, and awarded damages to the issuer.
 The Court of Appeal has now overturned that decision on the facts (within ‘the bracket’), but has confirmed the principle that an issuer (but not the noteholders i.e. by proxy ‘borrower’) may bring a claim in negligence against the valuer in the context of a CMBS structure.

Question 59

What did Scullion v Bank of Scotland Plc establish re. a valuers duty of care to a borrower?

Answer 59

 The claimant ‘S’ sought finance from a bank that engaged the defendant surveyors (Colleys) to provide the lender with a valuation and a prediction of the monthly rental income. S did not himself instruct an independent valuer. The rental prospects had been overstated and S was forced to sell the property, unable to meet the mortgage repayments. S sued the surveyor.
 The case established the current legal position that a valuer appointed by a lender in a buy-to-let transaction will not owe a duty of care to the borrower, unless the valuer is appointed directly by the borrower or expressly permits the borrower to rely on the valuation.

Question 60

Why do lender’s require a valuation report,
What will the valuation report be used for, and therefore what is the utility of the valuer’s role, and what 2 primary factors is the lender concerned with when measuring uncertainty?

Answer 60

o Lenders often do not have a detailed understanding of a particular property market or investment. The valuation report will normally be used to support work of internal underwriting teams, who conduct a very subjective process of risk analysis using detailed mathematical models. As measurement of this type of uncertainty is not conducive to a standardised approach, lenders do not usually seek third party advice.
o Valuers have a useful role to play in identification of investment uncertainties and provision of relevant data that lenders can use to measure and assess those uncertainties in their own way. A SWOT analysis is popular, as it is a relatively simple way to set out uncertainties in the context of both positive and negative investment factors.
o Emphasis is placed on uncertainties that will have biggest impact upon forecast cash flow and the borrower’s ability to service interest and capital payments on the loan.

Question 61

Why do lenders often require particular special assumptions as part of an instruction?

Answer 61

o Cash flow analysis also has the advantage of allowing lenders to model possible ‘residual’ (or ‘exit’) value scenarios at the date of loan maturity, in order to assess probability of repayment of the outstanding loan balance (i.e. Vacant Possession value, or subject to 6 months marketing period).

Question 62

How does a valuer’s approach to a property differ from a lender’s decision making process?

Answer 62

• Use of the ‘all risks’ yield (and this term may include the initial yield, the equivalent yield or the reversionary yield) is widely accepted for the purposes of analysing transaction evidence, but it may serve to mask some of the fundamental assumptions that lenders are making about properties.
• Income and capital growth assumptions, and their relationship with perceived levels of risk, are central to the lender’s decision-making process.
• All investment properties can be seen to carry an additional risk premium (compared to government bonds) because of their illiquid nature (i.e. the time and cost of individual transactions), which the lender will look to measure.

Question 63

What are the 2 overall risks a lender typically focus on as part of their risk analysis?

Answer 63

o risk of the cash flow being insufficient to cover the interest payments; and
o risk of the residual value of the investment (at the maturity of the loan) being insufficient to be able to repay the outstanding balance of the loan.

Question 64

How is risk defined/what does it measure from a lender’s perspective, and how does uncertainty therefore arise?

Answer 64

• Risk may be defined as the probability that an expected cash flow (or target rate of return) is not realised. In other words, risk is a measurement of the uncertainty in a cash flow and uncertainty arises from a lack of knowledge and information.

Question 65

What 2 things will a lender seek to identify in their (explicit cash flow) risk analysis?

Answer 65

• Most lenders will develop specific risk management plans which are designed to remove, or at least mitigate, as many of these uncertainties as possible.
• The fundamental starting point is identification of these uncertainties and their parameters (i.e. by how much they can vary, attaching probabilities to these outcomes and protecting position through either funding a proportion of costs or careful drafting of loan agreement terms, for instance additional interest payments in year 2 (a ‘cash sweep’) if a tenant may not renew).

Question 66

From a lender’s perspective, if a tenant was to vacate at lease expiry (within the loan term), what 2 figures/measures may be breached in the loan agreement,
and what 3 things will the lender look to measure the probability of?

Answer 66

• If the National Corporate tenant vacates the property at lease expiry, the interest cover ratio on the loan will fall to 1.25 in year 3, which will breach terms of the loan agreement. Moreover, it is likely (all other things being equal) that the Market Value of the property would fall to such an extent that the loan to value ratio would rise above 75%, possibly triggering a second breach of the loan agreement.
• The uncertainty of length of vacancy period, the extent of necessary refurbishment costs and probability of finding a good quality tenant at the anticipated rent and lease terms, are all issues that both investor and lender will try to measure.

Question 67

What is the measurement of uncertainty also called, when is it conducted, and explain the uncertainties a lender would consider for the following areas-
Economic, financial and political uncertainty (2)
Legal and regulatory uncertainty (4)
Physical uncertainty (4)
Occupation uncertainty (2 really)
Leasing uncertainty (what 5 lease areas will lender consider)
Market uncertainty (i.e. economic growth/recession issues)
Valuation uncertainty (what does a lender use the valuation figure for, and what consequence could it have if wrong)

Answer 67

• The measurement of uncertainty (risk analysis) is conducted at a fixed point in time (the present), even though the uncertainties themselves are to be found in the future. Uncertainties include:

o Economic, financial and political uncertainty –
 Economic uncertainty will always exist to some extent, drives fluctuations in occupational demand.
 Political uncertainty – potential changes to government policy.

o Legal and regulatory uncertainty –
 e.g. statute, case law, health and safety, planning policy.

o Physical uncertainty –
 physical building obsolescence (outdated accommodation),
 economic building obsolescence (e.g. where the production process at a specialised industrial property is relocated in order to take advantage of cheaper labour costs elsewhere),
 and environmental uncertainties –
• land contamination/subsidence (readily measurable) and
• non-fluvial flooding etc. (highly unpredictable, almost absolute uncertainty)

o Occupational uncertainty –
 A major uncertainty in the cash flow analysis, particularly in older multi-let properties.
 Lenders will look carefully at probability of each tenant exercising a break option or not renewing at lease expiry, or even going into administration or liquidation (with reference to covenant strength analysis).
 Surveyors are well-placed to advise on tenant’s operational requirements/general market occupational requirements.

o Leasing uncertainty –
 Exists where there is anticipated/actual vacancy, lender will consider variations in levels of:
• occupational demand,
• marketing/letting period length,
• new tenant covenants,
• precise lease terms (length, RR, FRI etc.),
• rent + any incentives.

o Market uncertainty –
 Extent to which future market movements can be accurately predicted.
 Easier to predict how strong economic growth will increase occupational demand (dependent on property type supply etc.), more difficult in economic contraction (lack of data, difficult to work out how much things could get worse).

o Valuation uncertainty –
 Vital part of the process, lenders will use it largely as a benchmark for drafting loan agreement terms.
 Any variation in accuracy of valuation could have an impact upon future investment performance. If used for pricing purposes (i.e. in the explicit lenders cash flow model), may therefore be regarded as an uncertainty in its own right. RICS recognises this through the use of uncertainty clauses.

Question 68

What is the typical commercial LTV % range, interest rate range (and dependent on what)?

Answer 68

• Commercial LTV is usually 60-70% (deposits should be at least 30%).
• Interest rates on commercial mortgage products around 6-8% depending on risk. The average interest rate varies heavily throughout the year, can increase/decrease based on economic factors such as Brexit, recession, surge/fall in property demand – in 2020 rates have fluctuated between 2.75% and 7.5%.

Question 69

What are interest rates typically lower for larger loans?

Answer 69

• Lower interest rates for larger loans. This is because of the costs of running the mortgage account, a higher interest rate may be required on a small facility in order to cover the costs involved and for the lender to make a profit

Question 70

What is the BOE base rate at the time of writing, and what relationship does this have to lenders proposed interest rates?

Answer 70

• BOE base rate 0.75% at time of writing. Lenders obviously have to add their ‘risk premium’ for the lending decision on to the BOE base rate (i.e. if they offered 3%, they are offering a 2.25% interest rate, or return, for the lending agreement).

Question 71

Differences between senior and junior debt:
Who funds senior debt/why/and why is it lower risk?
What is subordinated/junior debt, and why is it higher risk?
What are the two lowest priority financing methods in a capital stack?

Answer 71

o Banks typically fund senior debt. Banks assume lower risk senior status in the repayment order because they can afford to accept a lower rate given their low-cost sources of funding from deposit and savings accounts. In addition, regulators advocate for banks to maintain a lower risk loan portfolio.
o Subordinated debt is any debt that falls under, or behind, senior debt. If a company has both subordinated debt and senior debt and has to file for bankruptcy or face liquidation, the senior debt is paid back before the subordinated debt. Once the senior debt is completely paid back, the company then repays the subordinated debt.
o However, subordinated debt does have priority over preferred and common equity. Examples of subordinated debt include mezzanine debt, which is debt that also includes an investment.

Question 72

Who are commercial mortgages available to, what % will lenders typically fund up to and for what term length?
How will they secure the mortgage, and how will they assess affordability?
What happens if the value falls below the agreed LTV %, and what two methods are typically used to finance in this scenario/why are interest rates typically higher in these scenarios?

Answer 72

o Commercial mortgages are available to a range of businesses, from sole traders to limited companies. Lenders will normally fund up to 75% of purchase costs with terms of up to 30 years. Typically they will secure the mortgage against a first charge and affordability is based on the profitability of a business, and its ability to make the monthly payments.
o This means that the lender must see a 25% fall in value before they are ‘out of the money’ and the borrower is in ‘negative equity’.
o This 25% equity can also be financed by using ‘mezzanine debt’ or ‘bridging finance’ – these methods charge a higher interest rate due to them not holding a first charge over the asset. Mezzanine or bridge lenders would only get paid out in the event of a default if the value of the asset on being sold was at or above the value when the finance was taken out.

Question 73

What benefit can lending provide to an investor, and therefore what risk are they considering in their cash flow analysis?

Answer 73

o Borrowing also provides the exposure to leverage, which is the strategy of using borrowed capital to increase the potential return of an investment.
o When using the IRR as a performance measure (i.e. to compare ‘like for like’ against other investments), positive value addition along with leverage creates a higher return % than that of all equity. This is due to the investor being able to access positive returns with less of their own capital i.e. making more money with putting less in.
o The counter to this is when negative values are experienced the downside is also amplified and further capital may be required to avoid foreclosure from the lender.

Question 74

What is the difference between an unsecured and secured loan?

Answer 74

o Unsecured loans: a loan that is issued and supported only by the borrower’s creditworthiness, rather than being secured against an asset or company.
o Secured debt: uses collateral (e.g. house, car etc.)

Question 75

What are the typical characteristics of property development finance/when used/typical LTV maximum/term length, and why are interest rates typically higher?

Answer 75

o Usually in the form of a short-term loan that’s used for the development of a new building project, or refurbishment of an existing property. Lenders will look to advance up to 70% of the gross development value, and terms can be up to 24 months. Interest rates typically higher than mortgage (risk).

Question 76

What is portfolio finance, and what criteria will the lender consider with re. loan serviceability?

Answer 76

o A long-term business loan that’s offered to property investors who have a number of rental properties. The lender offers the ability to consolidate borrowing into one loan. Serviceability of this loan is based on rental income

Question 77

Who/why is bridging finance used, and how does it work?

Answer 77

o Bridging finance is a short-term finance solution often favoured by property developers and investors, which provides a quick way to finance the purchase of a property. The lender will take a first charge on the property and will seek an exit once the loan has come to term.

Question 78

Who/why is bridging finance used, and how does it work?

Answer 78

o Auction finance is designed for experienced property developers and landlords. It’s a way of arranging funding in advance of an auction, so bidders know the property value and type they can finance before they bid.

Question 79

What type of finance/how does mezzanine finance work, and what use can it provide to property developers?

Answer 79

o A little more complex, this is a hybrid type of finance that combines elements of debt financing and equity investment – and is secured against the property. Mezzanine finance often helps property developers reduce their cash flow requirement, enabling them to finance projects which would normally require a larger capital share.

Question 80

What type of property investment is regulated, by whom, and is regulated investment a significant part of the lending market?

Answer 80

o Direct investment in real property is not a regulated activity pursuant to the UK’s financial services regulatory system.
o Indirect investment in property through the purchase of units in a collective investment fund or shares in a corporate vehicle are likely to fall within the scope of the Financial Services and Markets Act 2000 (FSMA), and becomes regulated activity under the Financial Conduct Authority (FCA). Investment into property via fund structures is a significant proportion of the overall market with a diverse range of investors taking part.

Question 81

What 3 things do all mortgages have in common?

Answer 81

• A mortgage is a loan that uses a property as security for the lender. Different lenders offer different rates and types of mortgage, but all mortgages have a few things in common:
o Borrowers are charged interest on the money you borrow.
o The higher the mortgage rate, the more money borrowers pay in interest.
o The quicker borrowers pay off a mortgage, the less interest you pay.

Question 82

How long do borrowers typically aim to repay their mortgage, and can this be different?

Answer 82

• Most borrowers aim to repay their mortgage over 25 years, but it’s also possible to take out a mortgage for a shorter or longer period.

Question 83

Why are UK banks now accounting for a smaller proportion of new lending (and what 3 investor types are now making up a bigger proportion)?

Answer 83

• Banks are accounting for less new lending (other foreign banks, insurance companies and non-bank lenders now make up a significant proportion). The main driver of this change was increase regulation and risk management required by banks to lend on property. In certain cases it has become punitive for banks to lend on certain property due to the risk profile of certain properties

Question 84

Which is riskier for a lender – owner occupation or buy-to-let? And how do they assess affordability differently for each?

Answer 84

o If owner occupation (rather than investment) mortgage, the lender will assess how much you can afford to borrow based on your company’s turnover and performance.
o Commercial buy-to-let mortgages are often riskier (no tenant, no rent), therefore typically attract a higher interest rate. Assessed on the projected rental coverage, and some lenders stipulate that the rental coverage reaches 190% for a commercial investment property.

Question 85

What is the due diligence process for loan underwriting, what does it allow a lender to do, and what are the 3 main categories of due diligence?

Answer 85

 Due diligence is an important process of factual and legal investigation, research, analysis and discovery into the relevant borrower, asset, sponsor and other principle parties.
 It allows the lender to make an informed decision as to whether it should lend money to the borrower and, if so, on what terms.

 3 main categories of due diligence (legal, financial and asset) are likely to be followed. Each will have their own focus for investigation and requirements to be met.

• Legal: focus on the legal title and ownership structure.
• Financial: focus on the risk profile of the borrower to pay back the loan. It will look at their track record, credit profile and rent payment security.
• Asset: focus more on the physical risk profile of the specific asset. Risks such as age, structure, condition and location are prevalent in this area.

Question 86

What is a loan agreement, and what will it contain?

Answer 86

o Loan agreements: control the making of loan terms from one party to another. The loan agreement must contain a right of enforcement (including detailed provisions re. when/how a lender can enforce its security). Ideally enforcement provisions should be tailored to reflect the asset nature.

Question 87

What is a letter of undertaking?

Answer 87

o Letters of undertaking: agreement or contract given by the sellers solicitors that they hold the completion monies for the buyer that will automatically be released from the undertaking when completion takes place.

Question 88

What is a lien, what are the 3 types, and what is the most common example of a lien?

Answer 88

o Liens: 3 types (consensual, statutory and judgement) – a lien is a legal claim on a tract of real estate granting the holder a specified amount of money on the sale of the property. They are used to ensure the payment of a debt, with the property acting as collateral against the amount owed. A commercial mortgage is the best example of a property lien.

Question 89

What is a mortgage deed?

Answer 89

o Mortgage deed: the legal document that gives a lender a lien or security interest in a piece of mortgaged property.

Question 90

What are step-in rights?

Answer 90

o Step-in rights: allows 1 party to take the place of another, such as a lender stepping into the borrower’s shoes to take control of the property.

Question 91

What are guarantees and indemnities, and when are they generally used?

Answer 91

o Guarantees and indemnities: in the loan agreement, a way the lender protects themselves from the debt default risk. Generally used when there are doubts about a borrower’s ability to fulfil its obligations under the loan agreement.

Question 92

What is redemption?

Answer 92

o Redemption: the return of the capital borrowed in the loan.

Question 93

What is a deed of release?

Answer 93

o Deed of release: letter agreement in the form of a deed that released the borrower for debt obligations.

Question 94

Where are mortgage charges typically registered, what power does this grant the charge owner, and what should a purchaser therefore ensure?

Answer 94

o Typically for commercial mortgages a legal charge is registered on the Land Registry record for security. The owner of legal charge has a power of sale should the loan payments not be maintained. Anyone buying a property subject to a charge must ensure the seller pays off the mortgage on completion otherwise the buyer will be subject to the lender’s power of sale

Question 95

What are the 2 types of loan agreement covenants, what do they require of the borrower, and what are the 2 covenants banks always include?

Answer 95

restrictive or financial – within the loan agreement – requires borrower to fulfil certain conditions or restricts certain actions/activities. Reporting and disclosure covenants set a minimum standard of communication with your bank.

Question 96

What are the 2 parts of a mortgage?

Answer 96

o A mortgage has two parts. The original amount borrowed to buy the property, sometimes known as the capital, and the additional amount the lender charges for lending you the capital, otherwise known as the interest. Arrangements to repay the capital can vary.

Question 97

What is a repayment mortgage?

Answer 97

o With a repayment mortgage (sometimes called ‘capital and interest’) the mortgage payment covers the interest and also helps to reduce the amount owed (‘the capital’).

Question 98

What is an interest only mortgage, and why is this a higher risk arrangement than a repayment mortgage?

Answer 98

o With an interest only mortgage the mortgage payment only covers the interest on what is owed. At the end of the mortgage the amount borrowed (the capital) is paid off using savings or investments built up during the mortgage period. This is a higher risk financial product for the lender.

Question 99

What is loan refinancing, in what 2 situations can it take place, what does a borrower need to consider if they are thinking of refinancing, and why is this the case?

Answer 99

o When loan comes to end, or can be undertaken during the life of the loan.
o Replacement of an existing debt obligation with another under different terms.
o If occurs during existing loan life, likely to be redemption penalties in the event of early repayment (therefore need to consider the economic benefits of doing so).
o A fixed commercial mortgage has terms that allow the borrower to repay a lower interest rate for a set period of time (often between 2-5 years). Once this period is over, the borrower will begin to pay a higher interest rate on the lender’s standard variable rate.

Question 100

3 reasons why a borrower may want to refinance a loan?

Answer 100

 Desire for increased flexibility
 Reduction in restrictive covenants
 A cheaper loan may be available

Question 101

What 4 factors will affect a lender’s strategy, and what risk appetite do lender’s typically have?

Answer 101

o	They will vary according to:
	Their experience
	Distressed loans
	Case law
	Risk appetite

o A general rule for a standard mortgage product is lenders will be fairly risk averse.

Question 102

What does zero-value refer to?

Answer 102

o Zero value: this refers to the practice of recommending that a property is not suitable for lending because of a risk factor in line with the lender’s policy. For example, Japanese Knotweed. This does not mean that there is no value, just that the lender is not prepared to lend. A cash buyer can still get a bargain, as unmortgageable does not mean no value.

Question 103

Although a longer mortgage term means lower monthly payments, why does it cost more overall?

Answer 103

o Whilst a longer term will mean much lower monthly payments, it will also mean actually paying off that mortgage costs considerably more overall. This is because interest is charged against the debt for a longer period, however it can be useful to manage affordability for some borrowers.

Question 104

What are AVMs/when are they used, how do they come to a figure, and why could they be unreliable?

Answer 104

• They used one or more mathematical software models to estimate the value of a property, a series of properties or a mass appraisal of millions of properties.
• AVMs are not significantly different from any other tool used by valuers to undertake their analyses and arrive at supportable estimates of value.
• Most AVMs perform the same function through complex software as a comparable table. The algorithms express the weighting in number.
• AVMs vary in quality depending on the data they use and their design. Generally they are reliable, but valuer oversight is essential especially for anything out of the ordinary or where information is incomplete or unreliable.

Question 105

What types of loans are regulated, by whom, and when could a potentially unregulated loan become regulated?

Answer 105

• Entities making commercial loans, being loans to businesses, do not require regulatory authorisations to do so.
• A loan becomes ‘regulated’ when the loan is secured against a property that is currently occupied, or will be occupied in the future, by the borrower or any member of their immediate family. Such a loan would then be regulated by the Financial Conduct Authority under the residential mortgage rules.
• Commercial finance can become subject to regulation when the business is provided with a secured loan against property, and the property is owned by an individual or occupied by persons related to the borrower as their home.

Question 106

What may provide protection to an investor with an unregulated loan?

Answer 106

• There is a high standard of self-regulation in the commercial mortgage industry with lenders generally only accepting introductions from members of the National Association of Commercial Finance Brokers – the NACFB. The NACFB has a strict code of conduct and allows the borrower to make a formal complaint.

Question 107

Why does commercial finance remain unregulated, and what risk does this create?

Answer 107

• The lack of regulation means that commercial finance can allow for parties to come to commercial finance solutions. However, it also means that there is little to no protection for new or fledgling businesses who may be unfamiliar with commercial finance and the operation of secured lending and business funding.

Question 108

How have tighter regulations changed the CRE lending market, and why were they introduced?

Answer 108

• Tighter rules set by central banks and other regulators, forcing banks and other lenders to increase their capital reserves for CRE loans, have improved financial stability, and have been the key driver of greater diversification in the UK CRE lending market. Primarily, new regulations have been triggered to avoid future bank failures, government bailouts and takeovers, such as occurred during the GFC, being partly caused by losses on CRE loan books.
• There is a direct impact from regulations on the ability of each lender type to take risk and price loans. Regulation including the slotting, Basel III and IV and Solvency II rules alongside changing lender business models have changed the segmentation across the risk-return spectrum as well as loan type and size. Regulation directly impacts lenders’ loan pricing and risk appetite, and UK banks have been forced to become more conservative in their CRE lending activities.

Question 109

Why are German banks now a larger segment of the CRE lending market, what rules are insurers and German banks subject to that makes their lending behaviour similar, and why are pension/debt funds different/with what outcome?

Answer 109

• Due to favourable regulatory treatment, German covered bond-funded banks and insurers have been able to offer the lowest margins in the UK market.
• Insurers and insurer-funded senior debt funds CRE loan pricing is driven by the capital requirements under the Solvency II rules. Insurers are also restricted to lower risk/lower margin loans by Solvency II, leading to both insurers and German banks focusing on the same segment of the CRE lending market.
• Pension funds and debt funds are able to pursue a broader range of risk-return strategies in real estate lending. This means they are in a position to also fund higher risk/higher margin loans.

Question 110

How and why has the lending market changed since the financial crisis, and what 2 lending platforms have started to develop/how do they work/what are they currently used for?

Answer 110

• Since the financial crises there was a significant change from high street and mainstream lenders to alternative lenders such as insurance companies and debt funds. This was driven by the increased capital requirement that banks had to adhere to as part of increased regulation and risk management under Basel II. This created the opportunity for non-core lenders to enter the market and be competitive.
• More recently there has been a move towards crowd funding and peer-to-peer platforms that have been developed where individuals with cash can pool it via a platform and lend it to a borrower. This market is currently being used for short-term development finance with longer term finance likely to follow.

Question 111

What does crowdfunding allow an investor to do, what is the typical duration range (months) , returns (% p.a.), and investment value range (£ - £)?

Answer 111

• Crowdfunding in property allows investors to buy securities (small pieces):
o Investment duration is 18-36 months.
o Typical returns are 12-20% p.a.
o It’s what investors do when they are desperate (get senior debt from banks, then possibly mezzanine finance, then crowdfunding as last resort, sometimes equity, sometimes loan, the group of people putting money in may get a much higher return, but it’s equally very risky).
o Investments are around £20,000 - £100,000

Question 112

How does private equity crowdfunding work, how are profits typically split, and how is the investment secured?

Answer 112

 Private Equity: investors collectively take an equity stake in a property development project through a Joint Venture Agreement with the developer, receiving a proportion of the profits on exit (typically in a 50/50 split). The investment is secured against the title deeds of the property and a personal guarantee from the developer.

Question 113

How does mezzanine debt crowdfunding work, on what basis is the investment return, and how is the investment secured?

Answer 113

 Mezzanine Debt: investors collectively provide their funding in the form of a Mezzanine loan to the developer. Investment returns on the project take the form of interest. The investment is typically secured with a second charge against a property, alongside a personal guarantee from the developer

Question 114

What are the 4 drawbacks (for an investor) of crowdfunding?

Answer 114

 Risk of loss of capital.
 Herd behaviour (fear of missing out)
 Over optimism
 Lack of FCA protection

Question 115

What happened to London Capital and Financial, what ‘lesson’ has been learnt, and what enquiry has subsequently been created as a result of the scandal?

Answer 115

• The disgraced investment firm (London Capital & Finance) sold £237m ($292m, €270m) worth of mini-bonds to over 11,600 individuals, which prompted the Financial Conduct Authority to place a temporary ban on the promotion of these speculative products to retail investors.
• The firm issued “misleading” mini-bonds and Isas on a non-advised basis, promising 8% returns to clients.
• Mini-bonds allow investors to lend money directly to businesses and are, in effect, IOUs that the companies sell to investors.
• London Capital & Finance entered administration, with Smith and Williamson as the named representatives.
• Investors received bad news that same day, with the Financial Services Compensation Scheme (FSCS) confirming that “the sale of mini-bonds […] is not a regulated activity under the Regulated Activities Order and, therefore, is not FSCS-protected”.
• “For this reason, while the firm is insolvent, we’re not accepting claims against the firm.”
• Investors who got caught up in the mis-selling scandal of London Capital & Finance (LCF) are raising money to pay for a legal fight against the Financial Services Compensation Scheme (FSCS). “Currently, only 150 or so investors out of 11,500 have had their compensation payments made. The case, if successful, would benefit approximately half of the LCF bondholders.”
• The aim of the judicial review is to achieve compensation for any bondholder involved, regardless of whether their investments were through regulated products.

Question 116

Why is loan security valuation ripe for money laundering?

Answer 116

• Purchasing property in the UK and overseas is a common method used by serious organised criminals to launder the proceeds of criminal activity.
• Property has the advantage of being able to move large amounts of funds to be ‘cleaned’ in a single transaction.

Question 117

What types of false information might a borrower give to a lender when committing mortgage fraud (8)?

Answer 117

• People may commit mortgage fraud by giving false information to lenders to get a larger mortgage than they’re entitled to. This can include misrepresenting:
o their identity
o their income
o their employment
o their debts
o sources of funds other than the mortgage
o the value of the property
o the price to be paid
o whether any payments have been or will be made directly between the seller and purchaser

Question 118

Who do you make a disclosure to if you know of or suspect money laundering, and what must you submit/to whom?

Answer 118

• If you know or suspect a money laundering offence is taking place, you must make a disclosure to your firm’s Money Laundering Reporting Officer (MLRO). In my role I would alert a senior colleague.
• If you are the MLRO and you know or suspect a money laundering offence, you must submit a suspicious activity report (SAR) to the National Crime Agency.

Question 119

What are the 3 potential consequences of ignoring possible money laundering?

Answer 119

If you do not take appropriate action, you may create problems for the future, not lease a claim against your PII, bad publicity, and potentially criminal prosecution.

Question 120

What 4 steps/considerations should you take/take into account as part of your money laundering risk management process?

Answer 120

o Verify accuracy of information or documents provided to you, using comparables and information/records available in the public domain e.g. filed accounts at Companies House or planning records at the local authority.
o Seek prior approval for special assumptions – are they realistic or appropriate?
o Qualify your assumptions and invite further investigation by the lender.
o Do not ignore the obvious! If something does not make sense, ask questions – e.g. if an empty property appears to have tenants, raise this with the borrower/lender

Question 121

What is the primary type of mortgage fraud that a valuer could succumb to?

Answer 121

o Over-valuation: defines itself – predominantly due to succumbing to pressure from clients re. evidence or yields etc.

Question 122

What is purchaser fraud?

Answer 122

o Purchaser fraud: use of a fictitious or nominal person to procure the mortgage, who has no beneficial interest in the property. Loan is advanced in full and then the nominated purchased disappears.

Question 123

What is identity fraud?

Answer 123

o Identity fraud: stolen identity used to procure loan or a fake transaction between related parties. The loan is advanced and then the purchase or remortgage never completes. The lender may have no registered enforceable security.

Question 124

What is income fraud?

Answer 124

o Income fraud: borrower overstates or fabricates income to procure a higher loan

Question 125

What is back-to-back fraud?

Answer 125

o Back-to-back fraud: flipping a property basically

Question 126

What is cash-back/incentives fraud, and what consequence does this have if you are provided with reported purchase price information?

Answer 126

o Cash-back/incentives fraud: borrower and seller and/or agent intentionally mislead the lender as to the true price of the property and fail to disclose cashback or cash incentives agreed between the parties. It is therefore important to take the reported purchase price as one factor in deciding value, but to support your opinion with other comparables and to understand whether there are any incentives in place that might be relevant to the lender.

Question 127

What is planning permission fraud?

Answer 127

o Planning permission fraud: valuers supplied with fictitious planning permission documents in order to procure a higher valuation.

Question 128

What are the 4 (1 with 6 sub-indicators) main potential indicators of mortgage fraud/money laundering?

Answer 128

o Out-of-area valuations: why has it come to you?

o Unusual instructions/information:
 requests for divergence from RB,
 discrepencies in borrower/property details,
 instruction does not disclose lender identity,
 no evidence of property marketing,
 indications that not arms-length (connected parties, family relationship, same contact details etc.),
 inflated estimates of value provided by borrower.

o Short-term ownership: if owned under 6 months, why is it being sold/re-mortgaged now, with a different lender and for a higher purchase price?

o Unrealistic deadlines.

Question 129

What is an external wall system?

Answer 129

o The external wall system is made up of the outside wall of a residential building, including cladding, insulation, fire break systems, etc.

Question 130

What was an EWS 1 form originally designed to ensure (for what buildings), how did this change in Jan 2020, and what approach should the valuer take?

Answer 130

o Originally designed following Government advice to ensure 18m+ residential buildings could be assessed for safety to allow lenders to offer mortgages on buildings with an external wall cladding system of uncertain make up (safety implications and potential remediation value implications).
o Jan 2020 Government advice brought all residential buildings potentially within scope, although not every building will require an EWS1 form and valuers should follow the lenders instructions.

Question 131

What is the process for obtaining an EWS 1 form, and how long is it valid?

Answer 131

o Involves a “qualified professional” conducting a fire-risk assessment on the external wall system, considering
 the height of the building,
 the type and amount of cladding
 and additional criteria relating to balconies and combustible material

o before signing an EWS1 form, which is valid for the entire building for five years.

Question 132

When does RICS Guidance Note - Valuing Residential Buildings with Combustible Cladding apply from,
What is the aim, and what ‘gap’ is it seeking to address?
What 2 things will the guidance help valuers to understand?
And what statements/documentation does it advise a valuer to make?

Answer 132

o Applies from 5 April 2021.
o Aims to assist valuers when valuing multi-storey, multi-occupancy residential buildings (i.e. blocks of flats) with cladding, particularly for secured lending (mortgage) purposes. Previously, there has been a lack of specific criteria about when remediation work to cladding or balconies may materially affect value. RICS address this in the Guidance Note by setting out criteria when an EWS1 form is required and resultant remediation works to the cladding or balconies may materially affect value.
o The guidance will help valuers to understand the EWS1 form process and when one will be required due to visible cladding being present.
o Valuers need to ensure that their valuation reports are clear and transparent in relation to the liabilities they assume. RICS provide recommended wording in the Guidance Note (section 3), which valuers should use in their reports to reflect various scenarios, e.g. EWS1 form requested or not requested.

Question 133

Provide some example of a senior debt provider?

Answer 133

This is bank funding, usually from Banks such as HSBC and RBS.

Question 134

What are the main forms of finance available to developers? How do these vary in respect of the funding sources available to investors?

Answer 134

Senior Debt and Mezzanine Finance. Depends on specifics of the case and risk management of the lender.

Question 135

Have you had any experience in respect of arranging mezzanine finance?

Answer 135

No, although this is where the level of senior debt does not provide what the investor needs. Mezzanine
tops up the finance to say from 65% LTV to the remaining 35%. This is very risky

Question 136

What is the role of a surveyor in the funding process?

Answer 136

I value for loan security which contributes toward the amount to which the Bank may lend on the property.
This provides them with the understanding of the property, its current value and a worst case value.

Question 137

How do you check the covenant of a proposed borrower?

Answer 137

Undertake the following: credit report, analyse audited trading accounts for a three year period and review a
business plan.

Question 138

What is a facility loan? How does this different to a loan agreement?

Answer 138

A long term loan taken out to a company to assist its growth. Used often in development schemes which
require projected finance.

Question 139

What is a sub-prime market? Why is this topical?

Answer 139

Subprime market is where credit is provided to parties with poor credit history or standing. Often it has high
interest rate. The risk of default is strong. Topical as this was a contributing factor to the market crash.

Question 140

Mortgage valuation market:
What do larger clients typically have?
What are valuations ‘put out to panel’?
What do lenders and larger valuation firms typically put in place, and why?

Answer 140

o Some larger clients, like Nationwide, have an in-house team of values to support their mortgage products and lending decisions.
o Many valuations are ‘put out to panel’. A panel is a group of appropriate surveyors, usually smaller firms, that can provide a valuation in line with the clients instructions.
o Direct contracts are sometimes set up between the lender client and the larger valuation firms, this is a closer relationship that makes audit easier and helps to maintain policy consistency.

Question 141

What does RICS Residential panel managers Protocol, 1st edition, May 2016 set out,
who set up
and what processes does it advise panel managers have in place (valuer checks, standards, tracking, PVQ, peer review, audits)?

Answer 141

• Sets out professional standards for the industry and, as a model for best practice, aims to improve protection for all parties to the residential mortgage valuation process. This protocol is similar to many in house processes.
• Jointly set up and endorsed by an industry wide group.
• Firms (panel managers) should have a robust allocation/case management processes in place, which should include:

 Checks that panel valuers have the necessary qualifications and hold PII cover in line with lender client requirements
 Processes to monitor that work is completed to agreed SLA standards.
 Tracking process that ensure cases are pursued in a timely manner and the lender client is updated on case progress.
 PVQ process that incorporates a chasing/tracking queries record and an audit trail system accessible for the entire site note and report retention period.
 A robust peer review process is advised for higher value or higher risk valuation scenarios.
 Valuers subject to regular audit checks, with outcomes/follow up actions recorded and available for client/lender inspection.

Question 142

What is private equity?

Answer 142

Direct investment in real estate projects (bricks and mortars)

Question 143

What is private debt?

Answer 143

A loan for the purchase of already built real estate or the development thereof.

Question 144

What is public equity?

Answer 144

A very liquid and volatile way to access real estate investments through the purchase of Real Estate Investment Trusts (REITs) and Property Companies (PropCos) stocks.

Question 145

What is public debt?

Answer 145

Investments in debt instruments which are traded on stock exchanges – as such it has high liquidity and higher volatility than private debt. Income generated from interest payments that the borrower makes, which have priority over any payment to the stockholders.

Question 146

Why is subordination important to a lender?

Answer 146

• Investors must know how the pay-out is subordinated to one another I.e. senior is sub’d to operational expenses of the company, then junior, then mezzanine, then equity.

Question 147

When is mezzanine debt paid, and why is it more risky than junior debt?

Answer 147

 Paid once interest and amortisation are paid to senior and junior lender.
 The surplus from the real estate net operating income then used to pay the mezzanine.
 Similar to junior debt, however, not secured by a mortgage, but secured by the investors equity in the property i.e. in default, rather than normal foreclosure, mezzanine lender gets an equity interest in property.

Question 148

What is junior debt/risk v senior debt?

Answer 148

 ‘the second mortgage’, bridges gap between property price and senior debt, typically short term and carries higher interest rate because of additional risk.

Question 149

Why is leverage risky/helpful?

Answer 149

• The use of debt can increase the return on equity during periods of economic growth or stability. However, leverage can exacerbate negative returns in a falling market. Therefore, leverage will increase the risk of real estate investments.

Question 150

What is the interest coverage ratio (ICR) formula/what indicates?

Answer 150

o Net Operating Income (or Triple Net Rent) / Interest Expenses (or NOA/Interest)
o Indicates whether borrower will be able to pay interest – greater the value, the lower the lender risk.

Question 151

What is the Debt Service Coverage Ratio (DSCR) formula/what indicates?

Answer 151

o Triple Net Rent / Interest Expenses & Capital Repayment (or NOA / (Interest + Capital)
o Indicates whether borrower can pay both interest and required capital amortisation.

Question 152

What does LTV represent?

Answer 152

o Represents leverage level, and the greater this value the higher the risk to the lender.

Question 153

How do commercial banks operate/market position?

Answer 153

 Take deposits from public, use this to make loans

 Remain largest provider of CRE debt.

Question 154

How do insurance companies operate/market position?

Answer 154

Life insurers need to make payouts in case of a policyholder’s death.
 Natural alignment (long term liability profile and long-term real estate investment).
 Insurance companies provide both equity and debt to real estate projects.

Question 155

How do pension funds operate/market position?

Answer 155

 Similar to life insurance companies, property rental income a natural hedge to pension fund liability profile, annuities need to be paid out in a somewhat predicted and stable basis.

Question 156

How do debt funds operate/market position?

Answer 156

Mutual funds that make loans. Target specific debt tranches.

Question 157

How do Commercial mortgage backed securities (CMBS) operate/market position?

Answer 157

 Loans raised for a CMBS purpose will then be repackaged, tranches and sold in the public markets.
 Each tranche has a different rank for pre-payment, and the interest, or coupon, payable to the bond holders corresponds to the risk of their investment.
 These securities can be easily traded on a secondary market, providing portfolio management benefits.

Question 158

What are origination fees?

Answer 158

Charged when loan is made or closed, to cover lenders expenses.

Question 159

What is the difference between recourse v non recourse debt?

Answer 159

For non recourse lender will not hold borrower personally liable in the event of default, can only bring an action to force property sale serving as security for the loan.

Question 160

What 2 things do lenders look at when underwriting loan?

Answer 160

o Lender looks at capital market for contractural interest rate they would need to charge (market yield) and the risks inherent to the specific property (risk analysis).
o Market yield – interest rate charged for similar loan in capital markets i.e. say 10 year US Treasury Bond currently yielding 5% and the RE mortgage market spreads are running at 200 b.p., starting point for interest charge 7%.

Question 161

What is the main objective of the Basel Framework, what requirement, and what consequence?

Answer 161

o Main objective: keep financial system, mainly banks, a safe environment for depositors, without the public funding bailouts. Basis is to set a minimum capital requirement for banks, reducing risk if depositors wanted to withdraw their money.
o Basel regulations mainly require banks to calculate their risk weights based on asset type and leverage and assess their capital adequacy requirements.
o The regulations have generally made the banking sector more conservative in its lending, reducing LTVs from 90% pre-crash to 50-70% post-crash.

Question 162

How is the Solvency Framework different to Basel, what does it require, and what consequences has this had?

Answer 162

o Key difference (to Basel): under Solvency, insurers may develop their own risk model.
o It requires insurers to demonstrate that they have adequate financial resources in place to meet all its liabilities, gives preference i.e. lower capital allocation requirements, to less volatile assets, in which market prices vary less.
o As such, equity investment is less preferable due to a higher capital requirement, whereas direct real estate, especially debt to real estate, is more attractive.
o The Solvency framework means that insurers are mainly focused on low risk and low margin loans.

Question 163

How have the finance regulations affected lender diversification?

Answer 163

o As private equity funds are not regulated and driven by investor return requirements, they can lend to higher risk real estate projects and they can also receive capitals from pensions.
o Therefore private equity and pension funds have become main players in the real estate debt market worldwide.

Question 164

What are the Standards of Lending Practice?

Answer 164

Voluntary set benchmark for good lending practice in UK, outlining the way registered firms are expected to deal with their customers throughout the entire product life cycle.

Question 165

What happened in Hart v Large 2020, and what is the resultant advice for surveyors?

Answer 165

o Homebuyer report provided by Richard Large, a surveyor, for a redeveloped Devon dwelling.
o Property valued for proposed purchaser at £1.2m, with several defects identified relating to drainage, pipes and gutters.
o Client subsequently identified significant water ingress and damp issues post sale, requiring substantial remedial works that were not identified in the original report, resulting in negligence claim.
o As a result of this case, surveyors should ensure that the appropriate level of survey is advised for the type and nature of property in question (e.g. Building Survey (L3) rather than Homebuyer (L2)). Surveyors should also be mindful to recommend a professional consultant’s certificate if appropriate and to record any limitations on inspection in writing.