Debt valuation applications and best practices—borrower's perspective

Table of contents

• Timing of market conclusions
• Materiality thresholds
• Fund-level debt

Timing of market conclusions

Written May 2019 (updated January 2021)

For a variety of reasons, fund managers may differ in their practices when valuation conclusions are derived during the quarter. Given the illiquid nature of real estate, this does not often pose problems for the valuation of real estate assets; however, information regarding debt is more readily available. Consequently, the timing of when market information is drawn for the purpose of valuing debt can meaningfully impact valuation conclusions in comparison to another fund manager, with the same debt profile, who finalized market information at another point during the quarter.

Best practice

Finalize quarterly market data on the 10^th business day of the last month of the quarter.

Frequently asked questions

Q: What does it mean to finalize market data?

A: Market conclusions, such as market interest rates, are derived using the latest available market information on the 10^th business day of the last month of the quarter.

Q: Are adjustments made to market conclusions between the 10^th business day and the end of the quarter?

A: Adjustments may be made for factual changes such as the incorporation of an updated property value, principal balance or other property or loan modifications. Changes in market data such as treasury yields or coupon rates are subject to materiality thresholds (see Materiality Thresholds).

Q: How does this impact draft valuations?

A: If draft quarter-end valuations are disseminated prior to the 10th business day of the last month of the quarter, market conclusions as of the date of the draft valuations should be used. Final valuations will then be refreshed using market data as of the 10th business day of the last month of the quarter and disseminated as specified in client engagements.

January 2021 update

The recommended best practice for the timing of finalizing market data was changed from the 15th of the last month of the quarter to the 10th business day of the last month of the quarter to be consistent with prevailing valuation deadlines for open-ended funds.

Materiality thresholds

Written May 2019

Changes in benchmark rates such as the US Treasury Yield impact lending rates for commercial real estate. However, short term market volatility does not always result in meaningful changes to lending rates. Lenders may adjust credit spreads, apply coupon floors or take other measures to offset volatility. When there is a meaningful shift in the markets, it takes time for commercial real estate lenders to reset return requirements and spread pricing, making it difficult to support changes to market rate conclusions for the purpose of valuation.

Best practice

For the purpose of quarterly valuations, final market assumptions should not be refreshed once market data is finalized unless there is a movement of more than 20 basis points in the 10-day average of the 10-year US treasury yield or the equivalent national benchmark rate for international investments.

Frequently asked questions

Q: Why use a 10-day average?

A: Lenders often look for sustained movements in benchmark rates before reevaluating yield or resetting spreads. For material movements in the market, this can take two weeks or more. A 10-day average incrementally recognizes significant movements in the market as it becomes sustained.

Q: How was a 20 basis point threshold selected?

A: Various thresholds were considered for defining materiality including 15, 20 and 25 basis points. Using those thresholds, thirteen quarters from Q1 2016 through Q1 2019 were back tested to identify when each hypothetical threshold was triggered and if there was enough information or momentum in the market to warrant a change in lending rates within a two-week period. As expected, a 15-basis point threshold was breached most frequently—six times in 2016, once in 2017, three times in 2018 and once in Q1 2019. A threshold of 25 basis points was breached only once in the last three years. While 20 basis points was only exceeded twice, in both cases the markets had clearly moved in a short time period. Based on anecdotal feedback, markets that resulted in movements below 20 basis points did not generate enough momentum to justify immediate changes in lending rates.

Q: What is the process for refreshing market data if the materiality threshold is exceeded?

A: If the materiality threshold is breached between when market data is finalized and the end of the quarter, market research is performed to understand changes in both the benchmark rate as well as any changes in spreads for each loan. Therefore, while exceeding the materiality threshold will trigger new valuations, changes to the market rate conclusions will often not necessarily equal changes in the benchmark rates. Market interest rate conclusions will be made consistent with Chatham debt valuation methodologies as described in the most recent version of Chatham’s white paper: Debt valuation methodologies for real estate investments.

Fund-level debt

Written October 2019

Fund-level debt has become a more popular financing strategy with private real estate fund managers over the last several years. This type of financing includes revolving lines of credit, unsecured term loans, and private placements. The use of financing instruments such as private placements provide a borrower with an extended maturity schedule and attractively priced capital that reduces the long-term cost of borrowing. Additionally, fund-level debt allows managers to buy and sell investments without prepayment penalties often associated with property-level debt.

While the characteristics of fund-level debt can be attractive for a borrower, marking these instruments to market can be challenging. Additionally, changes in fair value can be meaningful to a fund’s performance returns due to the relatively large principal balances creating a heightened awareness on defining appropriate and consistent valuation methodologies.

In an effort to minimize differences in debt valuation conclusions due to policy nuances, we engaged in discussions with a variety of investors and fund managers to determine if the existing methodology for valuing fund-level debt was appropriate or if changes needed to be explored. Two primary themes emerged from these conversations. First, when it comes to financing strategies, investors are primarily concerned with duration and the average cost of debt. In other words, a fund’s decision to use fund-level debt as opposed to property-level debt has little impact on an investor’s assessment of a fund if weighted average maturity and cost of debt are the same.

Second, because fund-level debt is not tied to an individual property, and given the typically onerous prepayment penalties, there is a very high likelihood that fund managers hold fund-level debt until maturity; at which time they exit the debt at par. While there is not a market for transferring fund-level debt from one borrower to another, if an entire fund were to change ownership, the buyer or incoming fund manager would consider both the average cost of debt relative to the current market as well as the high likelihood that fund-level debt would continue to be held until maturity. The current method for valuing fund-level debt does not fully consider these characteristics. Therefore, we have determined that a change is needed to align fund and property-level debt valuation methodologies in a way that appropriately reflects the assumptions that another fund manager would consider when pricing the impact of the debt on the fund, including assumptions about risk.

Best practice

Apply methodology consistent with property-level debt including the consideration of par in a reconciled conclusion.

Frequently asked questions

Q: Should fund-level debt be marked to market?

A: Fair value continues to be an important measurement in financial reporting. For real estate equity fund managers, marking debt to market is an exercise that adjusts net asset value for the impact of above or below market financing on equity cash flows. For example, if Fund A has been able to obtain favorable long-term financing relative to the market, the impact is accretive to the equity cash flows and the fund is more valuable to an investor relative to another fund who has a higher average cost of debt. Like property-level debt, fund-level debt should also be marked to market.

Q: How is transferability considered?

A: Exit price is an important concept in fair value accounting. ASC 820 defines fair value as “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.”¹

The first and most common method for borrowers to exit a debt position is to settle the debt (e.g., pay back the liability to the lender including all costs associated with the early payment). However, accounting standards are clear that the fair value of debt assumes that “a liability would remain outstanding and the market participant transferee would be required to fulfill the obligation. The liability would not be settled with the counterparty or otherwise extinguished on the measurement date.”² Further, accounting standards require the assumption that the fair value measurement assumes “market participants act in their economic best interest.”³ Prepayment penalties in both property and fund-level, long-term, fixed-rate debt are typically significant enough that it is not practical to assume a market participant would prepay the loan when there is meaningful term remaining. For these reasons, it is uncommon to conclude that the payoff value of a debt instrument represents fair value.

For property-level debt, a second method for a borrower to exit a liability is to reassign the loan to another borrower as part of a real estate transaction. However, such a market does not exist for fund-level debt. Nonetheless, and as previously stated, for the purpose of measuring fair value of the loan, it must be assumed that the loan remains outstanding.⁴

Q: If there is not an exit market for fund-level debt, should it be marked to par?

A: The accounting standards do not allow for debt to be marked to par due only to transfer restrictions. ASC 820-10-35-18B states “When measuring the fair value of a liability, or an instrument classified in a reporting entity’s shareholders’ equity, a reporting entity shall not include a separate input or an adjustment to other inputs relating to the existence of a restriction that prevents the transfer of the item.” Further, marking a loan to par due to transferability restrictions does not appropriately adjust net asset value for the impact of above or below market debt. Therefore, fund-level debt should not be marked to par simply due to the non-existence of an exit market.

Q: How has fund-level debt historically been valued?

A: Chatham has historically valued revolving lines of credit at par and non-revolving fund-level debt using the Equity Method within the confines of an Income Approach by discounting the difference between contract and market debt service payments at an implied equity discount rate. Support for this method can be found in various sections of our white paper.⁵ The difference between methodologies for calculating property and fund-level debt is the consideration of par as a reasonable conclusion in property-level debt conclusions.

Because property-level debt has been known to transfer as part of real estate transactions, there is data to support the notion that the present value of debt service payments at a market rate infrequently equates to the actual impact of the debt on real estate. This can be supported with real estate transactions when debt is assumed and is corroborated by anecdotal commentary from buyers and sellers who generally agree there is some sharing between parties of the impact of existing debt on a real estate transaction. Further, there is a corresponding argument to be made that debt often has no impact on the price a buyer is willing to pay for a net investment. As a result, when Chatham values property-level debt, par is considered a reasonable consideration and, when appropriate, debt valuation conclusions use an equal-weighted reconciliation between par and the Equity Method. Similar empirical data however is not available for fund-level debt, which is not transferred with real estate transactions.

Q: Should property-level and fund-level debt have different valuation methodologies?

A: Conversations with investors revealed the notion that they are primarily concerned with duration and the average cost of debt and less concerned about the type of financing used. For example, if there are two identical funds except Fund A uses fund-level debt and Fund B uses property-level debt, the impact of the debt on returns reflected in debt valuation conclusions should be similar. In other words, if both funds exhibit the same average cost of debt, prepayment terms and weighted average maturity, investors would not expect a material price difference between the two as a result of capital strategy. Differences in methodologies may result in material differences in valuation conclusions between funds who have otherwise similar duration and average cost of debt. Therefore, the valuation methodologies should also be similar, considering the risk characteristics and nuances of each debt instrument.

Q: Is par a reasonable consideration for fund-level debt?

A: There are several reasons why par should be considered in the valuation of fund-level debt. First, these loans are intended to be held to maturity; at which time the value of the debt will be the remaining principal balance. Any volatility between the valuation measurement date and maturity is therefore hypothetical. While it is still important to reflect the impact of above or below market debt in a fair value measurement, understanding future exit value is helpful when considering “the assumptions that market participants would use when pricing the asset or liability, including assumptions about risk.”⁶

For instance, if a fund were to be transferred in its entirety to another equity investor (borrower), not only would there likely be a negotiation on the impact of the debt on the purchase price, but the purchaser will also likely intend on holding the fund-level debt until maturity and would take that into consideration when pricing the impact of the debt. In other words, both the price of the debt relative to market and the likelihood that it is held to maturity would be considered.

Given the characteristics of fund-level debt and in keeping with the principles of fair value, par is an appropriate value to consider. Revolving lines of credit should continue to be marked to par due to the unpredictable nature of their cash flows. For non-revolving fund-level debt, which most frequently includes term loans and private placements, applying an equal weighted reconciliation of the equity method and par appropriately accounts for above or below market debt and aligns property and fund-level debt valuation methodologies.

¹ ASC 820-10-35-2

² ASC 820-10-35-16

³ ASC 820-10-35-9

⁴ See also ASC 820-10-35-18B

⁵ Reference white paper

⁶ ASC 820-10-05-1B