The Value of Mortgaged Assets

The Moscow Times
29 September 2009
By Olga Kochetova
Head of Valuation, Knight Frank Russia and CIS

Banks looking for additional security from borrowers are facing various difficulties in valuing properties and are taking different approaches to cope with them.

In autumn 2008 Russian and Western banks that were financing development projects in Russia encountered difficulties for the first time in valuing mortgage assets, that had been provided as security for previously issued loans. The market value of most commercial property under construction using borrowed capital was falling in light of the financial crisis and overall negative trends on the property markets. For example, the downward correction of rental rates for office, retail and warehousing premises in Moscow was about 30 to 40 percent throughout the year, supply exceeded demand, and now vacancy rates are continuing to increase.

In most cases, the servicing of bank loans relied on rental income, but in this changed environment revenues are impossible to forecast, and income from property leasing has been significantly curtailed. This situation means that very few real estate owners are able to repay borrowings and carry out further refinancing of their projects.

The major decline in prices for property, in most cases mortgaged property, has made banks demand additional loan security, and for several borrowers, such as PIK and Mirax Group, payment difficulties have forced them to start negotiations on restructuring the credit that they had obtained.

What do banks value?

From a bank’s point of view the most important feature of any property is its liquidity, and only assets that can be sold within a reasonable period of time — on average 6 to 18 months — are acceptable as security from borrowers. Normally banks avoid reducing their working capital through accumulating non-core assets such as real estate on their balance sheets.

However, in the current situation it is difficult for banks to estimate both liquidity and the market value of an asset, since investors are now much less active. The most liquid property, which banks are still ready to consider as security, is well-located, up-and-running commercial real estate that provides steady rental income, with a well-designed concept and high-quality construction and fit-out. Dependable tenants — generally defined as large, financially secure companies with a good reputation — and long-term rental agreements are also key. High-quality properties that are still under construction may be considered, if they are over 80 percent complete and meet the rest of the above criteria.

When considering the suitability of real estate as loan security, banks are now likely to pay more attention to ownership structures, the existence of any encumbrance or easement, and its history. If the property is a building, it is important to consider what ownership rights have been drawn up for the land on which it is located, and the zoning of the district in which it is located. It is also key to check whether the property is affected by any third-party rights — transit rights for neighbors, the creation of public roads across the site and obligations to provide neighbors with utilities. Such factors were of little concern before the crisis because favorable market conditions inspired confidence and fostered an attitude that virtually any real estate could be sold.

Other factors banks are now taking into account are the reliability of the borrowing company, its reputation and credit history, and the professionalism of the management company — for an up-and-running property — or of project specialists — for a property still under construction. Western banks will more readily accept a property as loan security if its construction or operation is in the hands of a professional company, meaning architects and designers of international renown, developers with a good reputation, consultancy services provided by recognized market participants, and legal support from specialized firms. In this way banks are trying to obtain additional guarantees of borrower solvency in the current environment, and it has become particularly important for developers to maintain returns at market levels.

Different views

Western banks often use the services of independent appraisers and consultants when making loan decisions. This approach is long established on developed markets, since it provides a professional and unbiased assessment of the value of the pledged property, based on the extensive experience and knowledge of the local market that the independent consultancy has at its disposal. The approach used by Russian banks is somewhat different: they usually carry out valuations themselves internally, and loan decisions are based on the opinion of specialists in the bank’s own pledge department. Russian banks sometimes use the services of their own appraisal experts in property valuation. The process of obtaining credit is more labor-intensive for Russian banks: they need 12 months for due diligence, compared to the 6 months Western banks require. Local banks often make it a condition of granting a loan that the applicant should start to use other services provided by the bank.

In the current environment nearly all Western banks have suspended project financing, while Russian banks are mainly financing projects that have government support. The regular scheme for project financing has changed, so that the balance between loans and resources owned by the developer is now 60 percent to 40 percent, where previously it was 70 percent to 30 percent. Nearly all Russian bank loans are short-term, not more than one year and usually less than six months, with interest rates two to three times higher than before the crisis. It should be noted that Russian banks decide on the size of a loan using a bigger discount to market value than Western banks. This reflects specifics of local business practice.

Banks have started to insert a clause on additional loan security when they draw up loan and property mortgage agreements. If the borrower is unable to offer items of real estate as additional loan security, shares in the borrower’s company may be offered. In this way the bank obtains control over the borrower’s business operations.

In the current conditions banks are also tightening their requirements for selecting not only appraisers but also mortgage assets. The bank needs to know the value of a property that is offered as security and to make an accurate assessment of credit risk in the transaction. An owner’s estimates of the market value of a mortgage asset may be exaggerated. An independent appraiser’s definition of a property’s real market value helps to set a fair ratio between the value of the mortgage and the size of the loan, as well as avoid disagreements between the parties that may arise if foreclosure on the property becomes necessary.

When the collateral used to secure financing for a project is the project itself, its market valuation depends on how near it is to completion, as well as specific bank requirements. In most cases only a property with registered ownership rights is acceptable to banks as security, this means that if borrowers offer an uncompleted property as security, they must register ownership rights to that property. In such instances a cost approach and discounted cash flow method in the framework of a revenue-based model are most usually applied in order to estimate market value.

If construction work has not yet begun when the loan agreement is made, the land may be mortgaged. This can be valued using a comparison of sales and a residual approach. Valuation of a property with financial commitments will require a study of the nature of the encumbrances and the potential for removing them. In this case, if different valuation results are obtained using different methods, it will be reasonable to give the largest weight to results from a revenue approach.

Solutions

In order to minimize the risks in obtaining financing, borrowers should observe a strict procedure in working with the bank: when selecting a creditor they should ascertain that creditor’s list of accredited valuation companies; borrowers should decide what the mortgaged property will be and they should be ready to subscribe to a tripartite agreement, between themselves the bank and the valuer. Borrowers also need to have a precise plan of action and should not attempt to apply pressure on the valuer or to influence the valuation results.

A developer who is looking to borrow should also try to diversify the company’s cash flows. In the current environment many developers are reviewing their project development concepts. This is particularly the case for cottage settlements and warehouse complexes. For example, before the crisis a developer may have proposed the construction of cottage settlements from brick and laminated timber in three stages, targeting a single group of potential customers. But now the company may decide to diversify its risk by implementing a different project in each of the three stages. So the first stage might be positioned as business class, selling plots of land with a contract for the construction of cottages, while the second stage might be the same but without a construction contract, and the third stage might be for completed townhouses.

If there are no alternative sources of financing, borrowers should be prepared to restructure their payables by transfering ownership rights for a part of the property to the creditor as settlement of the debt or part of the debt.

The rules of the game on the credit market have changed significantly. Most market participants have proved unprepared for such a dramatic worsening of the environment. In order to overcome the new difficulties with minimal losses, the old model of cooperation has to be adapted to the new conditions. All parties can do a lot to speed up this adaptation by making the best use of transparency, trust and professionalism.