Real Estate fund matters - Alfi

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ALFI WG Real Estate Investment Funds Sub-Committee - January 2009 Frequently Asked Questions - Luxembourg Real Estate Investment Funds (“REIFs”) FAQ 1s Financial framework / Valuation of Properties / NAV / Financial Reporting 6 0BUVALUATION UNCERTAINTY 6.1 1BUWhat is valuation uncertainty? 6.1.1 7BRecent financial and property market conditions, including the “credit crunch”, have reduced property transaction volumes significantly, in all global property markets. This market instability has increased uncertainty around any reported investment property fair value. 6.1.2 8BPractically all regulated real estate funds in Luxembourg rely on independent valuation reports to determine the reported fair value of their investment property portfolio at their year-end and interim reporting dates. 6.1.3 9BThe vast majority of Luxembourg Real Estate Investment Funds (“REIFs”) commission valuations according to the International Valuation Standards Council (“IVSC”) Best Practice guidelines and/or the Royal Institution of Chartered Surveyors (“RICS”) Appraisal and Valuation Standards (“the Red Book”). 6.1.4 10BMaterial valuation uncertainty may arise from a variety of factors associated with a particular property, including but not limited to location, unusual characteristics, lack of current information available about the 1 property, development status, ongoing legal issues and market instability. Under RICS guidanceF F, valuation uncertainty paragraphs, if included, should not cause the management of the fund or its auditor to question the validity of the valuation, and should not amount to standard caveats or general disclaimers. 6.1.5 11BDespite the RICS guidance, it is conceivable that valuation reports may contain emphasis of matter paragraphs making reference to specific circumstances relating to individual properties. It is also possible that valuation reports contain a qualification of the valuation or only provide a range of possible values. 6.1.6 12BDue to significant uncertainties as described above, particularly market instability, valuers have recently and are indicating that they may continue to include ‘valuation uncertainty’ paragraphs in some valuation reports. Most of the uncertainty paragraphs seen to date do not caveat the valuation opinion provided. However, they do typically draw the reader’s attention to the financial backdrop against which the valuations have been assessed. 6.2 2BUWhat actions regarding financial reporting should be taken by the management of the fund relating to the increased uncertainty in the valuation of real estate? 6.2.1 13BManagement should review all the valuation reports received from independent valuers in order to understand the methods and assumptions used by the independent valuers to estimate fair value of the properties. This review should include an assessment whether the valuation reports contain only standard uncertainty paragraphs or whether the valuer has put a caveat on their valuations in any way. In addition management should check whether the conclusions reached by the independent valuer are not materially inconsistent with its own assessment and understanding of a particular market and with comparator market transactions. 6.2.2 14BIn order to appropriately draw the reader’s attention to increased uncertainty cited in the valuers’ report (if any is stated), management should consider enhancing disclosures in the financial statements in the following areas: • the investment property note, which typically already includes disclosures on the valuers used by the company, which could be extended to describe special assumptions used in the valuation reports and any other relevant information highlighting the increased uncertainty of the real estate valuation as stipulated; • the accounting policy ‘valuation method’ note, if the valuation method used by the client or valuer has changed; • the critical accounting estimates and judgments disclosures, to highlight increased uncertainty surrounding real estate fair value estimates; • the disclosures around market risk and the impact on financial instruments that rely on covenant compliance. 6.2.3 15BThese additional disclosures could include reference to some or all of the following topics depending on the particular situation: 1 See RICS Red Book Guidance Note 5, and the ‘Valuation Uncertainty and Market Instability’ bulletin issued by RICS on 26 November 2008. (http://www.rics.org/Practiceareas/Property/Valuation/val_uncertainty_f_271108.html) 2 / 4
ALFI WG Real Estate Investment Funds Sub-Committee - January 2009 Frequently Asked Questions - Luxembourg Real Estate Investment Funds (“REIFs”) FAQ 1s Financial framework / Valuation of Properties / NAV / Financial Reporting • a sensitivity analysis on property yields or an indication of the range of potential valuation outcomes to the extent that the valuer is willing to provide this information within their valuation reports; and • a reproduction of the additional ‘valuation uncertainty’ wording included in the valuation report by the valuers if the report is not reproduced within the financial statements, or a suitable cross reference if it is. 6.3 3BUHow recent should a valuation be to be relevant in current market conditions? 6.3.1 16BLuxembourg REIF regulations indicate that a minimum frequency of annual property valuations is acceptable. Many REIFs have previously organized themselves on an annual valuation cycle, which has meant that real estate valuations that were used for financial reporting purposes were often commissioned several months or quarters before the reporting date. Due to the current volatility in the real estate market and the potential for significant change in values over time, excessively aged independent valuations do not seem any longer to be a prudent basis for financial reporting. 6.3.2 17BIndependent valuation reports should be updated on a regular basis for reporting purposes. It is desirable to have independent valuations performed on the reporting date, e.g. 31 December 2008, or close to this date. What is to be considered close enough to a reporting date will depend on individual circumstances and a decision needs to be taken on a case by case basis. Where formal valuation reports have been issued at a significantly earlier date, management should consider requesting updates from the independent valuers. 6.4 4BUWhat other considerations should management take into account in current market conditions? 6.4.1 18BA key example of this scenario is to consider the impact on the ‘going concern’ assumption. Management may find themselves in a position where the going concern basis is clearly threatened by a property valuation outcome that is within the potential variability of the valuation figure. This would typically arise through lower valuation levels breaching loan-to-value covenants within a Group’s loan portfolio and therefore triggering repayments of the loan or at least additional cash deposit requirements with the relevant banks. Where this is the case, it is appropriate to conclude that the consequence of the valuation uncertainty on the presentation of the financial statements is significant, and therefore an emphasis of matter is required as a minimum in the audit report, and possibly consideration of adopting the break-up basis in extreme circumstances. 6.4.2 19BManagement should review its funding in order to ensure that enough liquidity is available to the fund to continue as a going concern. Special attention should be paid to maturing credit facilities and lines of credit available from banks which themselves may have liquidity issues. Given the current economic climate management should also consider whether committed but uncalled capital is still available to the fund to overcome liquidity issues. 6.4.3 20BA review of any commitments or contingent liabilities the fund might have, e.g. from sales of properties in prior years, which might trigger cash payments due to the current downturn in the economy, should be carried out. 6.4.4 21BAny issued identified from the above should be considered in the preparation of the reporting of the fund. 6.5 5BUHow may this impact the audit of financial statements of Luxembourg real estate funds? 6.5.1 22BIn general, auditors will have to perform more work with respect to the uncertain elements of the valuation as described above such as the valuation of properties and the going concern assumption. Auditors will have to review and assess the appropriateness of the assumptions made by management and the reliability of the supporting documentation gathered to support their conclusions. 6.5.2 23BAuditors may also consider modifications to their audit report in certain circumstances, including where in their judgement: • Assumptions and judgments made by management in valuing the properties are inaccurate or inappropriate; • Insufficient evidence exists, or has been considered, to reasonably value the properties; • Disclosures with respect to the uncertainty of the valuation of underlying funds are inadequate; • The valuer has qualified the valuation of the properties 3 / 4
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