Investment property valuations – the wrong way

A European example of a non-compliant approach to measuring fair value

Here’s another of the issues arising from extracts of enforcement decisions issued in the past by the European Securities and Markets Authority (ESMA) (for more background see here); this is from their 11th edition:

  • “The issuer is a real estate company specialized in industrial property. The investment properties (including those held for sale) constitute more than 95% of the total assets.
  • The issuer measures its investment property using the fair value method, in application of IAS 40, paragraph 30. In its annual and half-yearly financial statements, the issuer stated that “for determining the fair value of the real estate, the latter is measured using the ‘new-build value less obsolescence’ and not the return based expected rent value.”
  • Valuations are conducted by an independent real estate appraiser. The appraiser determined the value of both the land and the construction. The appraiser stated that the new-build value was determined by means of a detailed measurement and calculation, from which obsolescence was then deducted. In order to determine the deduction, the appraiser took account of the age of the property and the nature of its use, e.g. assembly versus heavy industry. According to the appraiser, this method of calculation is complex but gives a very precise result.
  • The issuer argued that the fair value is based on the price at which the property could be exchanged, on the date of the valuation, between knowledgeable, willing parties in an arm’s length transaction, as required by IAS 40, paragraph 36.
  • According to the issuer, the most important sellers and buyers of industrial property are the owner-operators of industrial property. Owners who rent out industrial property, such as the issuer, constitute a very small market and transactions in industrial property between owner-lessors are limited. Even more than for logistics or semi-industrial property, users of industrial property take a strategic decision regarding personnel and investment in installations. Users of industrial property thus have a limited choice between renting, buying or erecting a building that meets their specific requirements (the “Rent-buy-make” decision). This “Rent-buy-make” decision is taken on the basis of the cost-benefit analysis between, on the one hand, the new-build value of a new structure and, on the other hand, the new-build value less obsolescence of an existing building versus the rental income charged for it. For this reason, according to the issuer, the new-build value less obsolescence was, in this case, a suitable method for determining fair value.”

The enforcer (as ESMA likes to term it) disagreed with this method. IAS 40.40 emphasizes that the fair value of investment property reflects, among other things, rental income from current leases and other assumptions that market participants would use when pricing investment property under current market conditions” (NB the wording of the standard has changed somewhat since the ESMA report was issued, to reflect the issuance of IFRS 13, but the basic content remains the same). The new-build value method doesn’t do any of this.

From the account provided, it sounds like the enforcer had a pretty strong case, as far as compliance with IAS 40 goes. It would be interesting to know a few more things though. One wonders among other things if the appraiser’s assertion about the new-build value method being “very precise” in these circumstances was in any way supported by the issuer’s transaction history; whether the method was used by comparable entities (if any existed); whether the appraiser thought he or she was using a methodology consistent with IAS 40, or had just gone about things in ignorance of what would actually be required for financial reporting purposes; whether the issuer’s accounting policy disclosure and the notes to its statements gave a reasonable description of the method used and its potential limitations; whether the issuer had any knowledge of what users thought of its existing accounting policy; and what the auditors thought of all this.

None of these things, on the face of it, would dilute the enforcer’s finding of non-compliance with IAS 40. But many of us might think they reduced the importance of that non-compliance. The most effective regulatory cases act on two fronts, stamping out a practice that was harmful in its own specific circumstances, while also sending a broader message to market participants about acceptable conduct. It’s not really clear here that either was accomplished: in the issuer’s own case, we can’t tell, for the reasons I listed above; in the world beyond, it sounds plausible that no one would care. That is (again, based on the information we have), most issuers with investment property wouldn’t want to use the new-build value method anyway, and/or wouldn’t have any basis for claiming it made sense. Of course, the intended message might be broader – to argue against any material deviation from the requirements of IAS 40 (and IFRS in general), not just this particular one. But such messages are surely best sent from the teeming centre of poor practice, not from some obscure spot located out on the sidelines. Put another way, stories of misplaced good intentions (if regarded as such) need to be told in a different way from stories of self-serving manipulation. That’s not just a point about IFRS, but one about any system of rules and principles; about society itself…

Perhaps my reaction seems like an overly complacent response to the situation. But ultimately, IFRS and regulators and the rest of the infrastructure only matter insofar as they contribute to risk-appropriate capital allocation decisions, and it’s hard to tell whether such decisions were being significantly hindered here….

The opinions expressed are solely those of the author

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