The Valuation of Distressed Assets

Jon Faust of Johns Hopkins University writes on the distinction between current market values and long-term ‘fundamental’ values: you can read it here.

11 replies on “The Valuation of Distressed Assets”

What persistently concerns me in the mark to market debate in the US and elsewhere is that no-one seems willing or able to apply a CAPM rule to pricing property assets on balance sheets.

Instead, the preferred method for arriving at fundamental value seems to be a kind of “educated guess” at the “long-term market value” of an asset. However, guesswork is likely to be not only less accurate than market values, but also much more open to manipulation.

Let me clarify what I mean and why I mean it: The problem with using market values in certain markets is that prices are too sticky. This combines with endogeneity to form asset bubbles big enough to pop the entire financial system.

So the solution, I think, is to price the assets based on the imputed or real stream of income they generate. For housing assets, this is rent. Rental markets have the advantage of being much less sticky than sales markets.

So, if you want to know what BoI is worth – go back to the balance sheet and take every loan. Calculate the NPV for the performing stream of income, then subtract from this the “fundamental value” of the underlying security multiplied by risk of default. This “fundamental value”, in turn is the NPV of the net rental income of the asset.

This should be the accounting standard for the bank and for NAMA.

Deviation of price from value? No such distinction exists in contemporary economics. So the pricing of ‘distressed assets’ will be determined politically, by those who have sufficient power to impose a price favourable to their interests.

I wrote a piece for yesterday’s Sindo discussing this issue in relation to NAMA. Would be interested in any comments.

I can’t find the link unfortunately, so here is a copy and pasted version:

Financial commentary since the proposed establishment of a National Asset Management Agency has focused on the degree to which NAMA will overpay for assets from the banks, or, specifically, how it can avoid overpaying without relieving banks of their capital reserves.

The idea that NAMA can overpay relies, in the first instance, on knowing what the price of an asset is. This is tacit acceptance of efficient markets, the belief that the market always reflects all available information and that a unique value, set by the interaction of supply and demand, exists for every asset. But what if a unique value does not actually exist?

At present, the market for development loans, and indeed the land provided as security on these loans, is inactive. In markets such as this, where assets are highly illiquid and demand is very low, transactions are only likely to occur at deeply discounted prices.

Therefore, if one considers this depressed market price as the true value, NAMA will almost certainly overpay (relative to the current market valuation).

However, what if there is another, “hold-to-maturity”, valuation of these development loans, which reflects cash flows and other returns over their lives? If one can calculate an inherent valuation that reflects total expected returns and embedded value over the life of the asset, it is conceivable NAMA will pay fair value for these assets, or possibly even underpay in some cases.

Therefore, while NAMA is likely to overpay relative to current market prices, it is also conceivable that it will pay fair value, or perhaps underpay, relative to some fundamental valuation.

With regard to the linked to article, the question of current versus “fundamental” value of the assets is made somewhat irrelevant by the sentence: ‘Treasury reminded the panel that part of the value to the taxpayer was to come in “ensuring the stability of the financial system,” a factor that plays no role in market valuations.”‘

Obviously on this basis simple handing over the cash to the banks with no assets in return could constitute “fair value”. But nobody honest would buy that, hence the need for more complicated TARP-style deals.

What concerns me about applying this here is the implicit assumption that the fundamental value of property in Ireland exceeds current prices. I think it is quite possible that the opposite is true.

Market prices are sticky downwards, and, while they are falling quite rapidly, I don’t see any signs that they are approaching market clearing levels. It seems clear to me that the market will bottom out at a price level significantly lower than what we see at the present. The ultimately realisable value of property will be somewhere above this bottom, but may still turn out to be much lower than current prices.

Issues of unemployment and property oversupply will hopefully dissipate over time. Presumably the idea of realising the fundamental value of the property is about pacing its release to match returning demand.

1) The net present value of substantial expected future price rises seems to have made a significant contribution to market prices in the past, and this component of price is unlikely to reappear. A significant part of the fall in prices to date probably just reflects this.
2) More rational lending practices will reduce what people can pay for residential property over the long term. This will probably be compounded by a lasting correction on pay levels, which will further reduce what people are able to pay for residential property, and which has probably not yet been factored adequately into residential prices.
3) Margins on domestically traded services should be much lower than in the boom years, which should ensure that commercial rents stabilise at a much lower level than in recent years. Again, this may not yet have been factored properly into commercial property prices.
4) It seems likely that a non-trivial volume of property is so poorly located that it will never be occupied, or at least will never be saleable or lettable for a reasonable commercial price. The costs of management (and in some cases eventual site clearance) will give it a very low or even negative realisable value, even over the long term.

Aside from all these issues, it seems inevitable to me that political pressures will emerge to keep NAMA-owned properties off the market as a form of construction industry “intervention”, like we used to have for beef and butter. If successful, these pressures could scupper NAMA’s economics, ensuring that much of its portfolio might never be sold.

Excellent discussion path. The concepts of ‘market price’ and ‘fair value’ need to be discussed, along with current value and fundamental long term values. We have to accept the market didn’t work in the upswing, nor will it in the downward spiral. We can only hope we have better advice on the downside. It’s brilliant that you people are willing and brave enough to put yourselves in the spotlight and allow us to share your insights.

Is the problem that there is no market, or is it that no one likes the valuations the market throws up? The valuations for development land are going to tend toward zero for some time to come for all the reasons that have been stated. This is not a freak of the market, it’s just that there isn’t much demand.

It might make some sense to talk about analysing the NPV of developed land, even if it is vacant. But for development land it makes no sense at all. When there is no market for new developments, development land is worth what you can sell it for, and no more.

The assets most be priced above market value otherwise the banks collapse and that is not in the best interests of the country..

I believe nationalisation is not the solution to this problem

Yes obviously when we say “there’s no market” what we mean is that the holders of the assets are unwiling to sell at current market value. This may have something to do with the fact that if they were to do so they would have to admit (finally!) that they had run the banks (not ot mention the country) into the ground.

The alternative (excluding government action) is presumably for them to recapitalise over a decade through operating profits (the zombie solution).

Meanwhile on Q & A last night Dick Roche seemed to be mainly concerned at the possibility of NAMA underpaying for the assets. I wasn’t aware of the phenomenon of a buyer worrying that the price is too low…

Determining a price for distressed assets is easy, but won’t be allowed to happen.

Creating a valuation model is difficult. I used to favour rental yields, though these only prove useful as a rough benchmark. Rent and vacancy rates are variable. For example, German banks determine a ‘lending value’ rather than market price when granting a mortgage. In theory, this produces a sustainable value. In practice, (in my experience) it doesn’t work. One observation is that if people couldn’t make a living in a particular location, the properties had little or no value. I guess that creates a lower bound 😉

The way I see Irish property prices, both residential and commercial, is that they’re a credit adjusted price. To calculate a ‘fair value’ for an asset, is it reasonable that the price be dependent on credit? I.E. should a ‘fair value’ require credit to support it?

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