The equity side of the Commercial Real Estate (CRE) market experienced a slowdown in 2016 that has continued into 2017. NCREIF ODCE’s gross total return for 1Q 2017 was 1.77%, a sharp decrease from its gross total return in 1Q 2016 of 2.18% and gross total return in 1Q 2015 of 3.39%. Additionally, according to Real Capital Analytics, transaction volume fell year over year from 1Q 2015 to 1Q 2016 by 16.59% and fell again from 1Q 2016 to 1Q 2017 by 18.33%.
With total returns for commercial real estate declining from their unsustainably high returns since the run-up from the bottom of the financial crisis, some investors seeking both CRE exposure and acceptable risk-adjusted returns are now looking at investing in CRE debt. Many investors gain exposure to CRE debt by investing in CRE debt funds,which have different strategies and are offered by a variety of managers via a number of different structures.
Investors in these CRE debt funds are increasingly pushing for fair-value reporting on their CRE debt positions from third-party firms, realizing the importance of increased independence and transparency in the reporting of fund net asset value (NAV). Throughout the remainder of this article, we will explore why investor-driven demand for external valuations on CRE debt positions may be increasing and considerations that related stakeholders have regarding debt valuation.
Why Are Investors Pushing for Increased Transparency and for Third-Party Valuations on Their CRE Debt Positions?
One of the biggest reasons is those same investors sustained losses on their investments in private closed-end funds — it isn’t that investors didn’t believe a loss was warranted (quite the opposite), but rather the duration it took to recognize such a loss if it was not marked by a third-party firm (i.e. funds still reporting losses when the CRE market was improving and returns were strong). Due to the illiquidity of private closed-end CRE funds and the losses many investors incurred on their investments in them, many investors want to invest in funds that offer both a transparent value reporting process consistent with valuation best practices and some degree of liquidity (i.e. private open-end CRE fund offering quarterly liquidity as a percentage of NAV).
Second, CRE debt funds with investment strategies that originate and/or purchase subordinated and transitional CRE loans are attractive to many investors in today’s investment environment because of their CRE exposure and risk-adjusted returns. While these CRE loans are attractive to many investors, they also can carry considerably more risk than senior mortgage investments. With the increased risk involved with investing in subordinated and transitional loans, there is a greater need for closer monitoring of the collateral and business plans (for transitional loans). In addition to the obvious benefits associated with third-party valuations, many other benefits come from portfolio aggregation of data (analytics, consulting, etc.) and enhanced risk management as a result of regularly recognizing and reporting on the investment positions.
Lastly, it has become clear that investors want a way to gauge the performance of their CRE debt positions versus simply valuing them at par if they are to be held to maturity and are not impaired. While there are no widely available benchmarks for subordinated or transitional private CRE loans, by having a third party who has access to reliable, robust data provide fair-value estimates, investors can get a sense of value for their positions given current market lending rates, and whether their positions were originated at rates above or below what was common in the market at their time of origination.
Third-Party Debt Valuation Stakeholders – Considerations
As investors are increasingly demanding greater transparency, one way they can better track and understand the performance of illiquid investments such as CRE loans is through third-party valuations, which are independent, objective and consistent with valuation best practices. Investors have sustained large losses in the past on some illiquid investments in private closed-end CRE funds and want today more than ever policies that adhere to valuation best practices and protect them and provide them with unprecedented levels of transparency — it certainly doesn’t prevent losses from occurring, but it does provide an improvement in fund governance, transparency and timely recognition of losses (and gains).
Investment / Fund Managers
In today’s competitive investment environment, it has become apparent that it is more difficult to raise capital for new CRE debt funds. With investors requesting increasingly greater independence and transparency, hiring a third-party valuation advisor for these funds is moving toward being a necessary component of the reporting process. It is also important to note the significant benefits associated with hiring a third-party valuation advisor, which in addition to the items previously noted (independence, transparency) ensures there is a market expert opining on value and reduces the cost and/or asset management’s time associated with administering the process internally.
As outlined herein, the need for third-party debt valuations is increasing as investors require more transparency and look for best practices to be implemented in fund policies. While the changes being witnessed are largely driven by adverse experiences investors may have had with illiquid investments in the past, the new-age products that offer greater liquidity (open-end vehicles) and tolerance toward investments further out on the risk spectrum (subordinated loans, transitional loans, etc.) are also contributing to the need for third-party debt valuations.
Situs RERC has 15+ years of experience providing debt valuation services on over $60 billion (1,500+ positions) in CRE debt annually, with approximately $6 billion being subordinated or transitional CRE debt. Situs RERC understands the concerns and considerations related to third-party debt valuation in today’s market and is able to not only provide fair-value estimates and consulting services on debt positions but also advise on best practices, policies and procedures regarding debt valuation.