Loan Security Valuation - Level 3 Flashcards
What is the normal valuation basis for lending instructions?
o Market Value
o Where the circumstances are different to this, the valuer and client should agree on a special assumption.
What 5 broad areas does VPGA 2 cover?
- Conflict of interest
- Taking instructions
- Use MV basis
- Assumptions and special assumptions
- Reporting and disclosures
What does VPGA 2 state re. dealing with conflicts of interests for lending instructions?
- Valuer has had no previous involvement with the borrower or asset to be valued with a transaction for which the lending is required.
Outline some typical examples of ‘previous involvement’ under VPGA 2.
- Long-standing professional relationship with the borrower or owner of the property or asset
- Has a financial interest in the asset or in the borrower
Under VPGA 2, what should you do if you are instructed by a borrower who does not disclose the lender?
o make a statement to the effect of the valuation may not be acceptable to a lender
What 2 main pieces of info does VPGA 2 advise the valuer to request off the lender?
o if there has been a recent transaction or provisionally agreed price
o details of the terms of the lending facility being contemplated by the lender.
Under VPGA 2, what must you state if you have made a special assumption?
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.
What does VPGA 2 advise you to include in your report re. the way you valued a property?
- The valuation method adopted
- supported with the calculation used
What does VPGA 2 advise you to include in your report re. a property’s security for a loan?
- 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
What does VPGA 2 advise you to include in your report re. any factors that could affect the price?
- Any circumstances of which the valuer is aware that could affect the price
What does VPGA 2 advise you to include in your report re. any other factors that may conflict with the agreed basis of value?
- 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
What does VPGA 2 advise you to include in your report re. the property use in relation to market conditions?
Potential and demand for alternative uses, or any foreseeable changes in the current mode or category of occupation
What does VPGA 2 advise you to include in your report re. the market conditions in relation to the property and the loan?
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
What does VPGA 2 advise you to include in your report re. property condition and environmental/planning issues?
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
What does VPGA 2 advise you to include in your report re. the comparable evidence used?
Details of any significant comparable transactions relied upon and their relevance to the valuation
What emerging factor (VPGA 2 reporting) should you make a comment on?
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.
Under VPGA 2 reporting requirements, what additional 5 areas should you report/comment on (think leases, rent, occupiers, the loan and property potential)?
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)
Why should a valuer disclose any potential circumstances that could be considered a conflict to a lender?
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.
What 2 main things does UK VPGA 10 advise valuers to agree to limit their liability and how must it be documented?
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.
What should a valuer consider when instructed under a panel agreement, and what action may therefore need to be taken?
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.
What does UK VPGA 10 recommend re. who the LSV report is addressed to?
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.
By what 2 measures should you decide upon a liability cap?
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.
What does UK VPGA 10 recommend re. the default liability limitation position, and what if other beneficiaries are to be included?
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.
Under UK VPGA 10, how should a valuer approach a lenders requirement for an opinion of asset quality?
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.
Under UK VPGA 10, who is responsible for the loan decision, and therefore how should the valuers comments be limited?
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.
Under UK VPGA 10, what requirements must be met if forward looking advice is provided to the lender?
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.
In contact law, what is ‘implied’?
• 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.
How is ‘tort’ different to a breach of contact, and what standard of care is a valuer held to?
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.
What question will a Court ask when considering a valuer’s negligence, and what additional consideration will they take into account?
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.
What is the SAAMCO Cap, and why should a valuer consider the advice they are giving to a client?
- 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.
Who can sue a valuer for a breach of contract/tort, and why should you be careful with you consent reliance to?
- 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.
- 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
Why does RICS recommend you state re. the purpose of a loan security valuation?
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.’
Why is it important to include a clause in the valuer’s terms of engagement excluding all personal liability?
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.
How is the limitation period for breach of contract different to a tort claim, and why (2 potential circumstances)?
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.
Explain the importance of ‘claims made’ basis provision of PII, and why RICS recommends ‘run-off’ cover.
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.
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’?
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.
Explain the difference between a liability cap and a firm’s professional indemnity insurance limit.
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.
What 4 factors will the Court consider when deciding if a liability cap is reasonable?
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
What is the common basis to negotiate a liability cap on for LSV purposes?
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).
What approach does RICS advise if you are asked to allow a borrower to merely see the valuation report?
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.
If you do permit 3rd party reliance, what 3 things should you ensure takes place?
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.
If there is a panel agreement in place, what 3 things must you always consider in your agreement (from a risk perspective), and why?
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.
Why is it important to minimise negligence claims, even if you are not found to be negligent?
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
What is a bilateral loan, and why is it the least risk area of LSV?
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.
What is the English law principle re. assigning a contract to a 3rd party, and therefore what should you include in your engagement contract?
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.
What are syndicated loans, and what should a valuer consider if instructed in this manner?
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
What risks do crowdfunding and peer to peer lending agreements entail, and what therefore should a valuer ensure to do?
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.
What did Titan v Colliers CA 2015 establish re. whom the duty of care was owed in a securitised investment?
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.
What did Scullion v Bank of Scotland Plc establish re. a valuers duty of care to a borrower?
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.
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?
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.
Why do lenders often require particular special assumptions as part of an instruction?
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).
How does a valuer’s approach to a property differ from a lender’s decision making process?
- 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.
What are the 2 overall risks a lender typically focus on as part of their risk analysis?
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.
How is risk defined/what does it measure from a lender’s perspective, and how does uncertainty therefore arise?
• 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.
What 2 things will a lender seek to identify in their (explicit cash flow) risk analysis?
- 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).
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?
- 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.
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)
• 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.
What is the typical commercial LTV % range, interest rate range (and dependent on what)?
- 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%.
What are interest rates typically lower for larger loans?
• 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
What is the BOE base rate at the time of writing, and what relationship does this have to lenders proposed interest rates?
• 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).
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?
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.
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?
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.
