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XYZ (“Fund”) is a fund that owns commercial real estate assets that are leveraged with property-level mortgage debt. The Fund recently hired Situs RERC to complete its debt valuation process, whereby Situs RERC executes via the three different methods used to fair value loan payables: the Cash Equivalency Method, the Modified Cash Equivalency Method, and the Leveraged Equity Method. While Situs RERC was completing its debt valuations for the Fund, the recent refinancing completed on a self-storage asset resulted in a large disparity in the fair value conclusions between the Cash Equivalency and Leveraged Equity Methods, which is further outlined below.
Under normal circumstances, the above methodologies should create a reasonable reconciliation of the debt value, but as will be demonstrated, the fair value conclusions under each of the three methods don’t always reconcile, which may signify a disconnect between the equity and debt markets – does the equity rate of return for an investor to acquire a property and receive its cash flows reasonably align with the interest rate a lender would underwrite on a loan collateralized by the same property?
Through a comparison of the three methodologies on the Fund’s self-storage asset’s debt financing, Situs RERC demonstrated that the leveraged equity method can help identify mismatches (where the cash equivalency method did not) in the debt and equity markets and potential future movements in values (identifying opportunities and risks for future investment). In fact, it is often that the debt markets move faster than equity markets, in both good times and bad times, and that the leveraged equity analysis can effectively tie the pieces together and allow for early identification in market trends and pricing expectations.
TRANSACTION ILLUSTRATION – 2011 SELF-STORAGE FINANCING (4/1/2011)
The Fund refinanced a loan on a self-storage portfolio in April of 2011 for $100MM. The Fund has requested that Situs RERC provide fair values for their loan payable position beginning on July 1, 2011. The details of the analysis are outlined below:
LOAN DETAILS (REFINANCE):
PROPERTY DETAILS AND RATIOS (as of July 1, 2011):
SELF-STORAGE DEBT VALUATION (7/1/2011)
CASH EQUIVALENCY METHOD
Discounts the expected future cash flows of the loan back to present value at a market equivalent rate to conclude to a fair value for the debt. While this method is highly prevalent in valuing mortgage payable positions, it is not consistent with the way payable positions transact (it is reflective of how receivable positions transact).
Under the cash equivalency method, the fair value for the loan payable was concluded to be $98,900,000 a 1.10% discount from par. Given the recent origination of the loan and the assumption that it originated at market, the loan being fair valued close to par aligns with general market expectations.
MODIFIED CASH EQUIVALENCY METHOD
The modified cash equivalency method follows the same procedures as the cash equivalency method previously, but instead discounts the variance between the payments at the “Contract Rate” and “Market Rate” at the investment’s leveraged equity rate of return, with the present value of the variance added to the par value of the loan in order to reach a fair value of the loan. The modified cash equivalency approach is only applicable to valuing the loan payable position (borrower), and takes into consideration that the borrower’s targeted rate of return (yield-to-maturity) is not the market equivalent interest rate (debt financing rate), but instead a return on equity.
The modified cash equivalency method indicated a fair value conclusion for the in-place debt of $99,100,000, a 0.90% discount from par. The higher fair value, relative to the fair value concluded using the cash equivalency method, is entirely attributable to the variance between the loan’s cash flows at the contract rate and market equivalent rate being discounted back at a higher rate – the borrower’s “market derived” leveraged equity rate of return – versus the market equivalent rate.
LEVERAGED EQUITY METHOD
Discounts the after debt service cash flows of the asset at a market derived leveraged equity rate of return, and the difference between the unleveraged (asset) value and the leveraged equity value is the fair value of the debt. While this is not highly prevalent in valuing mortgage payable positions, this is consistent with how the payable position would transact (with consideration to the asset cash flows, under the consideration that the loan is assumable).
The leveraged equity method concluded to a fair value of $84,400,000, a 15.60% discount from par (implying greater equity in this self-storage investment). The leveraged equity method conclusion is $14,500,000 lower than the fair value conclusion under the cash equivalency method; additionally, the leveraged equity method’s fair value conclusion is $14,700,000 lower than the fair value conclusion under the modified cash equivalency method. The equity rate of return in the leveraged equity analysis is 13.1%, and the implied equity rate of return in the cash equivalency method is 11.06%, which is deemed to be well in excess of investor expectations.
As shown in the table below, the cash equivalency and modified cash equivalency methods when compared to the leveraged equity method yield very different fair value conclusions. The fair value conclusions under the cash equivalency methods are reasonable given the recent origination of the loan and the support provided by market rates and spreads; additionally, neither the DSCR or LTV ratio indicate that the debt originated at a rate that was significantly different than market. However, the fair value conclusion under the leveraged equity method cannot be simply written off due to approximately 17% of total equity being attributed to the in-place debt despite there being no major changes in the market or with the collateral in the time since the loan was originated to the date of value. The fair value conclusion under the leveraged equity method indicates that there may be a mismatch in pricing between the debt and equity markets, and as it is reasonable to assume that the debt on the property is valued close to par, Situs RERC concludes that the value of the property (market pricing of the equity investment) should appreciate such that the pricing between debt and equity markets is in closer agreement. As such, it was Situs RERC’s opinion that the property (real estate) is undervalued and there is a disconnect between the rate of return that an equity investor would require to invest in the property and be entitled to its cash flows and the interest rate that a lender would underwrite a loan on the same property at given its in-place cash flows.
PROPERTY DETAILS AND RATIOS (as of July 1, 2011):
PROPERTY DETAILS AND RATIOS (July 1, 2014):
Three years after the refinancing of the self-storage portfolio, Situs RERC’s conclusion that the value of the property should improve such that the pricing between the debt and equity markets is in closer agreement was validated by significant decreases in rates of return (expected based on the noted disconnect between equity pricing and debt financing) and substantial appreciation returns in this specific investment. While average cap rates declined anywhere from 70 bps (retail) to 30 bps (apartment) among the four core property types from 2Q 2011 to 2Q 2014, average cap rates for self-storage declined roughly 150 bps over that same time period. This self-storage portfolio that is part of this case study experienced a significant increase in value to $259 million (as of 7/1/2014) from $178 million three years before, an increase of approximately 50%, when the portfolio was refinanced.
The leveraged equity method when the self-storage portfolio was refinanced indicated that 17% of the equity contribution was attributable to the mark-to-market debt valuation; however, after the property saw significant appreciation over the three years following the refinancing of the portfolio, as Situs RERC predicted, the mark-to-market debt valuation contributed just over 2% of the equity contribution. This is consistent with the in-place debt being accretive, Situs RERC’s observation that the debt markets move faster than the equity markets and can serve as a leading indicator for them and Situs RERC’s prediction that the value of the property would increase such that the pricing between the debt and equity markets is in closer agreement.
In conclusion, while the leveraged equity method is not as commonly used to value CRE debt payable positions as the cash equivalency method, it should still be considered and can provide insight where the cash equivalency and modified cash equivalency methods may not. As demonstrated, the leveraged equity method can identify potential pricing mismatches between the debt and equity markets and serve as leading indicator for the equity markets.
While the fair value conclusions increased under all three methodologies from the date of value in 2011 to the date of value three years later in 2014, the increases can be attributed to different reasons. First, the fair value conclusions under the cash equivalency and modified cash equivalency methods increased over the aforementioned time period primarily due to decreases in market interest rates. This is different from the fair value conclusion under the leveraged equity method, which does not explicitly take into account changes in market rates in its methodology. And second, the fair value conclusions under the leveraged equity method increased primarily due to an increase in the value of the underlying collateral (discount and terminal rates compressed and cash flows increased). The tightening of the discount and terminal rates is consistent with Situs RERC’s prediction that the collateral would appreciate due to a mismatch in the pricing between the debt and equity markets.
The appreciation of the collateral, as predicted by Situs RERC’s analysis of the leveraged equity method’s fair value conclusion on July 1, 2011, happened over three years and was equal to approximately 50% of the collateral’s value at the first date of value (July 1, 2011).
In conclusion, while the leveraged equity method is not as commonly used to value CRE debt payable positions as the cash equivalency method, it should still be considered and can provide insight where the cash equivalency and modified cash equivalency methods may not. As demonstrated, the leveraged equity method can identify potential pricing mismatches between the debt and equity markets.
For more information, please contact Ken Riggs.