NCREIF Valuation Committee FAS 157: Fair Value Measurements - Revisited July 12, *connectedthinking

Transcription

1 NCREIF Valuation Committee FAS 157: Fair Value Measurements - Revisited July 12, 2012 *connectedthinking p w c

2 Agenda Basic Principles of FAS 157/ASC 820 Application of the Framework to Real Estate Investments Special Considerations for Liabilities Disclosure Requirements Implications to Real Estate Fund Investors Q&A PricewaterhouseCoopers Slide 2

3 Crying out on the Use of Fair Value Financial crisis raised questions about the use of fair value Proposals surfaced advocating the suspension of mark to market accounting Challenges concerning reliability of valuation estimates Clarifications on FV measurements provided by the SEC and FASB Pros & Cons expressed on the use of mark to market accounting PricewaterhouseCoopers Slide 3

4 Which of the following statements best describes your views on mark to market accounting? a. The requirement to use fair value measurements produces inaccurate results in the unusual market conditions recently experienced b. Earnings volatility introduced by fair value accounting unfairly influences investors views about long term value c. Fair value reporting increases the transparency of the impact of market forces on financial information d. Fair value, while not perfect, is the best method to reflect market conditions when accompanied by appropriate disclosure PricewaterhouseCoopers Slide 4

5 Basic Principles - Reasons for Issuing FAS 157 GAAP guidance for measuring FV dispersed and inconsistent Various myths & beliefs existed re: FV principles 157/820 provides single overarching definition of FV Establishes a framework for measuring FV Enhances disclosures about FV measures Improves reporting related to quality of earnings PricewaterhouseCoopers Slide 5

6 Basic Principles Definition of Fair Value in FAS 157/820 Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Exit price not an entry price Orderly transaction not a forced liquidation Market participants willing to transact, but not forced to transact PricewaterhouseCoopers Slide 6

7 Basic Principles Valuation Techniques FAS 157/820 provides guidance on valuation techniques to be used for initial and subsequent measurement and describes three techniques: - Market Approach - Income Approach, and - Cost Approach PricewaterhouseCoopers Slide 7

8 Basic Principles Market Participants FAS 157/820 emphasizes that fair value measurements should be based on the assumptions of market participants. Market participants are buyers or sellers in the principal (or most advantageous) market for the asset or liability, that are: Independent of the reporting entity; Knowledgeable; Able to transact for the asset or liability; Willing to transact for the asset or liability; and May be hypothetical. PricewaterhouseCoopers Slide 8

9 Basic Principles Highest and Best vs. Intended Use Fair value measures are determined based on the use of the asset by a market participant, even if the intended use of the asset by the reporting entity may be different. Accordingly, gy, management s intent may be irrelevant unless is indicative of market participants assumptions. Fair value is a common measure intended to provide information to investors about the price assets could be sold or liabilities transferred at the measurement date. It is not intended to provide information about the expected internal rate of return or future results that existing investors are expected to realize. PricewaterhouseCoopers Slide 9

10 Basic Principles Transaction Costs FAS 157/820 clarifies that the reporting entity s acquisition and/or disposition costs relating to an asset are NOT included in the asset s fair value estimate. Such costs are incremental to purchase or sell an asset and therefore are not an attribute of the asset. A standard DCF model is prepared from the perspective of the buyer and properly includes the buyer s disposition costs in the final year reversion amount as it is relevant in estimating what the buyer would be willing to pay for the asset. PricewaterhouseCoopers Slide 10

11 Basic Principles Pension Plan Investments FAS 157 amended FAS 35 to clarify that, if significant, the fair value of an investment that is recognized in the financial statements of a defined benefit pension plan shall be reduced by brokerage commissions and other costs that are normally incurred in a sale. PricewaterhouseCoopers Slide 11

12 Fair Value Framework 1. Identify Exit Market Principal or Most Advantageous Market 2. Identify Valuation Premise (Highest and Best Use) Identify Market Participants In-Use or In-Exchange 3. Determine Market Participant Assumptions 4. Apply Inputs into Valuation Techniques 5. Exit Price/Fair Value PricewaterhouseCoopers Slide 12

13 Fair Value Framework - Unit of Account Represents what is being measured at FV Is dependent on GAAP accounting policies Diversity in industry accounting practices for real estate funds causing notable differences in the unit of account determination PricewaterhouseCoopers Slide 13

14 Fair Value Framework Identify Market Participants - Identify exit market (principal / most advantageous market) - Consider valuation premise (highest h & best use, in-use /i inexchange) - Profile market participants - Determine market participant assumptions PricewaterhouseCoopers Slide 14

15 Fair Value Framework Valuation Techniques - Apply inputs into valuation techniques - Use techniques that are appropriate in the circumstances and for which sufficient data is available - In some cases, one valuation technique may provide best indication of FV, while in others multiple valuation techniques may be appropriate - Where multiple techniques are used, the reporting entity will need to evaluate and weigh the results PricewaterhouseCoopers Slide 15

16 Fair Value Framework Attributes of the asset or liability - FV of assets and liabilities are not affected by entity-specific ifi attributes - Only attributes of the underlying asset or liability should be considered - Valuation of assets contained in open end vs. closed end funds would not be impacted by entity-specific attributes PricewaterhouseCoopers Slide 16

17 Fair Value Framework - Restrictions A restriction that impacts fair value must be specific to the asset or liability, not to the reporting entity holding the investment. Examples include: - Easements, Leasehold interests, Ground Leases - Zoning (An effort to rezone land contains an element of uncertainty related to whether the proposed rezoning obtains approval. Therefore, the fair value of the land should also consider this uncertainty.) y) - A contractual restriction on the use of donated land imposed on a not-for-profit organization would not impact the fair value of the land if the restriction would not legally transfer to market participants if the land were to be sold. PricewaterhouseCoopers Slide 17

18 Hot topics concerning valuation of real estate investments Compliance with Fair Value Principles and Standards Eliminate logic flaws in valuation conclusions, in the written valuation analysis and in the firm s policies & procedures Provide affirmative evidence that the key concepts inherent in the fair value standards have been addressed Exit price, market participant, i t transaction ti costs, not held at cost, highest and best use Expected IRR vs. discount rate, expected hold vs. market hold PricewaterhouseCoopers Slide 18

19 Hot topics concerning valuation of real estate investments Joint Venture Investments If from the perspective of a market participant, the hypothetical liquidation of the venture net assets via JV waterfall is market then HLFV approach may be appropriate Investment level restrictions may exist to sell interest or sell underlying assets consider for possible discount PricewaterhouseCoopers Slide 19

20 Hot topics concerning valuation of real estate investments Developmental Assets Outdated approach of holding at cost until construction is substantially complete Requirement to monitor exit price valuation Development profit or loss should be recognized at each reporting period rather than at end of construction ti completion Project cash flows incorporating estimated costs to complete as well as other milestones PricewaterhouseCoopers Slide 20

21 Hot topics concerning valuation of real estate investments Mezzanine Debt Valuation Outdated approach includes consideration of whether mezz debt position is covered by collateral value Others rejecting the logic of reporting unrealized losses when there is a reasonable expectation to receive all amounts due under the terms of the loan. Need to consider collateral valuation as well as current position in the capital structure Valuation should include of analysis of spreads appropriate for comparable position in the capital structure in addition to consideration of underlying credit risk PricewaterhouseCoopers Slide 21

22 Valuation of Liabilities used to Finance Real Estate Investments Unit of Account Gross approach Net approach Diversity stems from a lack of applicable US GAAP guidance PricewaterhouseCoopers Slide 22

23 Special Considerations for Liabilities When considered from the perspective of a liability unit of account - FAS 157/820 clarifies that the fair value of a liability is the price that would be paid to transfer the liability at the reporting date It assumes the obligation will continue to exist following the transfer, even if there is a contractual lack of ability to transfer the loan by the borrower Fair value of a liability should reflect market conditions as well as the reporting entity's non performance risk (i.e. credit risk, delivery risk, etc) Does this mean non-transferable debt should be valued as though it can be transferred to another borrower? PricewaterhouseCoopers Slide 23

24 Special Considerations for Liabilities Consider all attributes of the loan that would be significant to a market participant In addition to prevailing interest rates and the state of financing markets, the loan s LTV, term, size, covenants, and any restrictions should be considered - Market participants may not place significant value on loans with LTV and term which is inconsistent with their needs PricewaterhouseCoopers Slide 24

25 Substantially all open end real estate funds carry liabilities at fair value but many closed end real estate funds do not why not? a. Don t believe its relevant to fund performance? b. Lack of reliability & consistency in valuing such liabilities? c. Incremental cost associated with valuation efforts? d. Disagreement with FAS 157/820 valuation principles? e. Introduction of unnecessary volatility in earnings? f. Investor confusion over related gains & losses? PricewaterhouseCoopers Slide 25

26 Special Considerations for Liabilities - Underwater Assets Example of why FV accounting for debt may be appropriate for all Real Estate Funds Underwater nonrecourse debt would reflect deficit NAV Many consider ways to work around because reporting does not make sense Policy is not to report debt at fair value unless underwater? PricewaterhouseCoopers Slide 26

27 Special Considerations for Liabilities Views on US accounting guidance for liabilities at fair value a. The guidance for the measurement of liabilities at fair value is clear and results in an appropriate fair value measurement. b. The variance in fair value measurements for a debt unit of account vs. an equity unity of account in the underwater asset example illustrates a flaw in the valuation principles contained in current US accounting standards. d c. For real estate funds, this guidance has increased the level of diversity and inconsistency resulting from differing accounting methods to unacceptable level. d. It s difficult to understand why US accounting standards prohibit the consideration of restrictions on transfer when measuring liabilities at fair value. PricewaterhouseCoopers Slide 27

28 Disclosure Requirements Fair Value Hierarchy prioritizes the inputs to valuation techniques used to measure fair value into three broad levels: Level 1 Inputs Level 2 Inputs Level 3 Inputs The significance of an input to the measurement of fair value determines the level in which a fair value estimate is categorized. This hierarchy primarily drives financial statement disclosures. PricewaterhouseCoopers Slide 28

29 Disclosure Requirements - Fair Value Hierarchy Level 1 Inputs Level 1 inputs are observable inputs that reflect quoted prices for identical assets or liabilities in active markets. The reporting entity must have the ability to access at the measurement date. Level 2 Inputs Quoted prices for similar assets. Quoted prices for identical assets in illiquid markets. Level 3 Inputs Unobservable market inputs that reflect the reporting entity's own assumptions about market participant assumptions used in pricing an asset. PricewaterhouseCoopers Slide 29

30 More Disclosure Requirements For assets and liabilities measured at fair value on a recurring basis: - The fair value measurement at the reporting date. - The level within the hierarchy in which they fall. - A roll-forward of Level 3 measurements. - Total unrealized gains or losses in the Level 3 roll-forward that were included in earnings due to assets and liabilities held at the reporting date. - Disclosure of valuation techniques and a discussion of changes to techniques PricewaterhouseCoopers Slide 30

31 New Disclosure Requirements In May 2011, the FASB issued ASU guidance regarding updated fair value measurements and disclosure requirements. The guidance was effective for interim and annual periods beginning g after December 15, 2011 for public companies and for annual periods beginning after December 15, 2011 for nonpublic entities. It requires, among other things, a qualitative description of the valuation process in place for Level 3 fair value measurements and a qualitative discussion about the sensitivity of the unobservable inputs and description of the interrelatedness between and among the inputs PricewaterhouseCoopers Slide 31

32 Implications to Real Estate Fund Investors AICPA issued audit interpretation as well as practice aid for auditing alternative investments - describes investor management's responsibility as follows: - "management of the investor entity is responsible for the valuation of alternative investment amounts as presented in the investor entity's financial statements" - "this responsibility cannot, under any circumstances, be outsourced or assigned to a party outside of the investor entity's management Requires investor to have sufficient understanding of underlying investments, assets and liabilities as well as methods and assumptions used by fund management to value underlying investments, assets and liabilities PricewaterhouseCoopers Slide 32

33 Implications to Real Estate Fund Investors Fund manager's valuation policies and process appropriate in circumstances and in compliance with 157/820? Practical expedient permits (does not require) use of NAV if underlying fund determined NAV in accordance with Investment Company Accounting Certain underlying funds may or may not value certain assets and liabilities based on accounting policy decisions Management should consider the specific attributes of their fund interests and ensure sound professional judgment is applied in all material valuation matters PricewaterhouseCoopers Slide 33

34 Questions? PricewaterhouseCoopers Slide 34

35 Thank You! p w c