In the UK, the Prudential Regulation Authority (PRA) has recently consulted on possible changes to its Capital Requirement Regulations (CRR), which would align with the Basel Accord 3.1 for prudently conservative valuation of commercial and residential real estate.
Regulators in the EU, meanwhile, are also close to finalising amendments to banking regulations to reflect the revised accords.
Until a framework for valuation for commercial and residential lending is agreed and implemented, however, RICS members are advised to inform clients requesting prudent value in their instructions of the situation, and to continue to provide market values for their banking or lending clients.
In the meantime, RICS is engaging with UK and EU decision-makers to clarify the meaning and impact of these criteria for markets, valuers and banks.
Accords updated to support financial stability
The Basel Committee on Banking Supervision (BCBS) is the primary global standard-setter for prudential regulation of banks, and provides a forum for cooperation. Its mandate is to strengthen the regulation, supervision and practices of banks worldwide to enhance financial stability.
The BCBS currently has 45 members from 28 jurisdictions around the world, including central banks and organisations with direct authority to supervise banking. Members are committed to implement and apply BCBS standards in their national jurisdictions.
RICS is involved in implementing Basel 3.1 through its long-standing encouragement of independent research focusing on approaches for prudent property valuation, its cooperation with the majority of real estate organisations and institutions across Europe, as well as ongoing regular discussions with the European Central Bank and the Bank of England.
Basel 3.1 aims to enhance the resilience of banks throughout the economic cycle. Real estate lending was identified as a major factor contributing to the global financial crisis of 2008, and in turn, valuation was identified as a significant part of originating and monitoring loans.
Leading institutions and other bodies in the real-estate sector, as well as leading academics, broadly agree with the need for the provision of countercyclical advice to investors and lenders to avert any repeat of the excessive lending that occurred in 2005–07. The concept of prudent valuation plays an important role in such advice.
Alternatives to market value researched
RICS' discussions with financial market regulators indicate that many no longer believe that providing market value in isolation is sufficient for secure lending purposes, because it represents a point in time, is pro- rather than countercyclical, and as a valuation basis is considered to encourage overlending in boom periods and restricted lending in the period following a downturn.
Before BCBS finalised the Basel 3.1 framework in late 2017, RICS worked closely with a number of leading UK commercial real-estate bodies, including the Bank of England's financial stability section, to understand the role that valuation could play in helping lenders better manage risks associated with the property cycle.
Subsequent research led to the publication of reports on how that might best be done, such as the Investment Property Forum (IPF) Long-term value methodologies in commercial real estate lending of July 2020, or its latest March 2023 research report with the Property Research Trust (PRT) – The Implementation of Long-term Prudent Valuation Models Across the UK and Mainland Europe for Financial Regulation Purposes.
The findings of all past and current research are guiding the RICS in its approach. In addition, RICS hosted a prudent value roundtable with UK property sector representatives at its London head office on 7 March, producing a factsheet on this issue, and held a webinar to brief members and other stakeholders on 15 March.
This underpinned the RICS response to the Bank of England Prudential Regulation Authority CRR consultation at the end of March, which included proposals to adopt prudent valuation criteria. Its submission is summarised below.
EU situation depends on outcome of discussion
As part of its implementation of Basel 3.1, the EU is in the process of updating its own CRR. Subject to final approval by the EU institutions – with continuing negotiations between the European Council, European Parliament and European Commission – the proposal is to include the new Basel 3.1 criteria for the prudently conservative valuation of real estate collateral in the revised regulations, including:
- the value excludes expectations on price increases
- the value is adjusted to take into account the potential for the current market price to be significantly above the value that would be sustainable over the life of the loan
- the value is not higher than a market value for the immovable property where the latter can be determined.
At present, it is not known whether the European Commission or European Banking Authority will provide further guidance, or whether the interpretation of these requirements will be up to the real-estate sector and national authorities.
RICS has set up an EU working group that will follow the developments closely and, in cooperation with the RICS public affairs and standards teams, will feed back to regulators and provide our members with further information and guidance.
It should be noted that the research undertaken so far on prudent value, identified above, specifically addressed the implementation of prudently conservative valuation criteria in Europe.
Members or interested parties in other jurisdictions covered by the BCBS with information on the implementation of the criteria there should therefore contact the RICS valuation team and we will work together towards consistent and feasible implementation.
'RICS has set up an EU working group that will follow the developments closely, feed back to regulators and provide our members with further information and guidance'
RICS recommends consistent approach
The research programme has already identified a potential inconsistency of approach and lack of evidence as creating the conditions for significant variations in outcomes if individual property prudent valuations are provided based on undefined or arbitrary adjustments to market value.
There are also significant professional indemnity issues in some jurisdictions if this approach is adopted.
Our current view, therefore, is that the optimum approach for implementing prudent valuation criteria would be to adopt a single, consistent, market-wide market value adjustment factor, rather than seeking to alter the way individual property assets are valued.
We recommend that a process for assessing the market value to prudent value adjustment factor should be defined and its application be obligatory, in consultation with RICS and other relevant actors in the valuation and banking sectors.
The approach could produce regular periodic market value adjustment rates at an agreed frequency – for instance, quarterly – working with relevant data providers at an appropriate level of disaggregation across property type and locality. The relevant adjustment could then be applied consistently.
We believe that this approach would provide an optimum balance of cost-effectiveness and ease of implementation, while ensuring a transparent and consistent approach and thus defending the public interest.
Our recommended approach would also avoid the risks associated with the introduction of an entirely new valuation concept into the sector.
We will continue to monitor political developments, discuss the issue with our member working groups and collaborate with relevant stakeholders in valuation and banking to ensure effective and consistent implementation of Basel 3.1, and provide our members with information and advice.
It is expected that jurisdictions will have implemented the Basel 3.1 requirements by 1 January 2025. From this point, a valuation based on prudently conservative valuation criteria will be required at each individual loan origination – and any subsequent monitoring valuations – across the implementing jurisdictions.
'A process for assessing the market value to prudent value adjustment factor should be defined and its application be obligatory'
Related competencies include: Valuation, Valuation of businesses and intangible assets
Prudent value should be based on market analysis
There appears little doubt that EU and UK regulators alike will follow through on their proposals to implement a prudent valuation regime; but it is also clear that they have little idea of the detail of what that means.
The exception is the commercial property group in the financial stability section of the Bank of England, which has been working on this since around 2011 with UK commercial real estate practitioners and academics after UK global financial crisis post-mortems identified overlending secured on commercial property as a major issue in the crisis.
Under the generic heading of long-term value, the UK real-estate sector and the Bank of England have been exploring how an alternative valuation regime might be implemented.
The IPF research programme has taken the lead in funding this research and development programme, with more recent help from the PRT, formerly the RICS Research Trust. The work has the support of both RICS and the International Valuation Standards Council – see previous references.
Following the EU's decision to implement the Basel 3.1 prudent value criteria, the UK research programme has expanded into how to implement this across Europe, including the difficulties of doing so in the less data-rich countries of Eastern Europe.
The conclusion, which is shared by most stakeholders across Europe, is that the issue concerns market cyclicality and is not an individual asset valuation problem.
Most financial stability issues stem from loans originated in the last two years of a market up-turn. The role of the long-term value therefore is to highlight when property prices, and thus exchange price-based market valuations, are above – or below – what is sustainable in the long term.
The research on long-term value has proved beyond any doubt that both the 1990 and 2007 UK commercial property downturns were entirely predictable using long-term market analysis models, even though one downturn was on account of occupier markets and the other a capital market correction.
As early as 1988 and 2005, two years before the downturn, it was clear that the only question was when the downturn would occur, not whether it would occur.
It follows that the solution should be market-based, and research has shown that normal market analysis can be used to identify mispricing across various market segments.
The market valuation of the individual asset remains integral to the lending process, but it must now be coupled with an assessment of whether longer-term values in a particular market segment are lower than the market value, and whether an adjustment should be applied to that value.
If long-term value is higher than market value, the Basel 3.1 criteria suggest that prudent value cannot be higher; in this case, market value equals prudent value.
It is inconceivable that we can leave the adjustment to individual valuers undertaking particular asset valuations. Inconsistency would be rife, and the banks and regulators wouldn't get the information they need to subdue lending amounts in that crucial period of the up-cycle.
There would be professional negligence implications in some jurisdictions, with valuers who had made prudent value adjustments well before a major downturn being used as evidence of what competent valuers should have done.
At its core, calculating prudent value is not a valuation task. It is a market analysis, and should be undertaken independently of the individual valuer with the full support of the property sector and the regulators.
There is plenty of detail to be worked out in the market analysis modelling process, which will need to be done urgently before the planned implementation of Basel 3.1 criteria at the beginning of 2025.
However, the difficulty of doing so will be nothing like that caused by the inconsistency if valuers are charged with the task and left to get on with it.
Professor Neil Crosby MRICS is professor emeritus, University of Reading, and lead author for the new RICS practice information on DCF valuations
Contact Neil: Email
Property Journal
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