The future is uncertain – what’s the problem?
The International Valuation Standards (IVSs), and other standards based on them such as the RICS Red Book, require the disclosure of any material uncertainty that affects the reported valuation. Despite the guidance that exists on what constitutes material uncertainty in this context, many valuers misunderstand the purpose of this requirement and produce sometimes convoluted and often unnecessary commentaries in their reports.
Recent proposals announced by the UK Financial Conduct Authority* to introduce measures to require funds invested in illiquid assets such as commercial property to suspend trading if an independent valuer expresses uncertainty about the values reported, adds emphasis to the need for valuers to understand when an appropriate caveat is required, and the consequences that can flow from inappropriate declarations of uncertainty.
Like other “mots du jour” that journalists have beaten to death over the years, such as “unprecedented” or “literally”, nowadays one cannot read or hear any commentary on the economy without a very liberal sprinkling of the “U word”. It is as though not knowing what is going to happen in the future has suddenly become a new phenomenon. I suspect this has grown out of the trend for news organisations to spend far more time speculating on what might happen rather than reporting what has actually happened, with consequence that journalists are literally working themselves into an unprecedented state of excitement about the fact that they cannot predict the future, because it is… uncertain!
I am sure that this over use of the adjective “uncertainty” combined with the standards requirement is why I see too many valuation reports containing ill considered expositions on how the valuation is plagued by the problem. Too often factors which are a feature of the market on the valuation date are muddled with factors which make estimating a reliable price difficult to impossible. As a result, the valuer risks undermining their own opinion and giving a false impression to those relying on the valuation, neither of which is a good idea.
The IVSs require a suitable disclosure of material (or significant) valuation uncertainty when reporting. The guidance in the IVSC’s 2014 TIP 4** defines valuation uncertainty as:
The possibility that the estimated value may differ from the price that could be obtained in a transfer of the subject asset or liability taking place on the valuation date on the same terms and in the same market.
Valuation uncertainty in this context is therefore only concerned with matters that affect the reliability of the valuation estimate on the date it is made. Examples are then given in the guidance. It, quite emphatically, is not concerned with market risk, ie the risk that the value may be different at a different time under different market conditions.
The fact that values change over time is undeniable and something that is implicit in current prices. Buyers and sellers do not agree prices looking only at known facts from the past. They also take a view, or if you prefer, speculate, on what will happen in the future. Some valuation models will explicitly seek to measure the risk that a predicted income or capital gain may not accrue in the future, for example by adjusting the discount rate used or probability weighting future inputs. But the principle applies equally even where sophisticated models are not being used. Even the gourd seller haggling in the souk will be making a calculation as to whether he will get a better price from the next tourist that passes through. Whatever the asset, prices reflect the combined view of market participants as to what will happen in the future.
The danger of bolting an uncertainty caveat which refers to the unknown consequences of a known or anticipated future event onto every valuation is that it suggests that the valuer has ignored the market perception of the risks involved in holding the asset in question. For any valuation that is supposed to reflect a market price, such as Market Value as defined in the IVSs, this would clearly be wrong.
To take a topical example, many real estate valuers in the UK have been putting a caveat in their reports saying their valuation is subject to uncertainty because of “Brexit” ever since the referendum result in mid 2016. While it is probably fair to say that the result was unexpected at the time, more than two years later the range of possible outcomes has been considered by market participants and is reflected in current prices. To suggest that the valuation given may be incorrect because the outcome of a future event is unknown is bordering on the disingenuous. It implies the valuer knows better than buyers and sellers in the market.
At any given time there are multiple, often interrelated, events that affect the market’s perception of risk. The most recent report on “Risk and Vulnerabilities in the EU Financial System” issued jointly by the EU supervisory bodies for banking, insurance and the financial markets identifies risks arising from rapidly increasing spreads for sovereign bonds, monetary policy normalisation, the effect of trade sanctions and tariffs as well as the possible impact of the UK withdrawal from the EU as matters of concern. A vast industry exists in researching and analysing these economic risks, and comment on them fills the media. Under the Market Value hypothesis, buyers and sellers are deemed to be “knowledgeable” so are assumed to be aware of likely trends in their market. While many individual prognoses may be wrong, in the short term leading to mispricing and arbitrage opportunities, if asked to provide a Market Value, the valuer’s job is to establish the market consensus on the relevant date, not to speculate that this may be wrong.
This is not to say that valuers should not advise on future trends and the likely direction of values. On the contrary, for some purposes, eg advising a lender on the value of an asset held as security, it is both expected and necessary. However, such advice must clearly be distinguished from the value on the specified valuation date which will reflect the market’s current view on the impact of future events.
So when is a specific disclosure of uncertainty required to comply with the standards? Basically, only under two scenarios. The first is in the immediate aftermath of an unexpected event, or market shock. The second is if the asset is highly illiquid due to an inherent feature, such as its design or location.
Under the first scenario, because the event had not been anticipated all price data from before the event is unreliable and there will be a period before sufficient post event transaction data becomes available to measure its impact. Any valuation on a date during that lacuna is subject to “material uncertainty” and therefore should be accompanied by a caveat effectively saying that while the valuer has done their best to reflect the impact of the event on value, the absence of post event data means that the valuation is materially uncertain. The time it will take for markets to become active after such an event will vary, but in most cases will be measured in days or weeks. So, to the extent that the result of the Brexit referendum was unexpected, an uncertainty caveat would have been appropriate for real estate valuations for a few weeks but not beyond the point when sufficient post referendum transactions had taken place to measure the impact, if any, on prices.
In contrast, in the case of an inherently illiquid asset the problem of uncertainty is enduring. An example would be a highly specialised building for which there would always be limited demand, or a more conventional building in a location for which there would always be limited or no demand. The valuer would probably have no data which was directly applicable and therefore would be obliged to extrapolate data from different assets or markets and make adjustments, which inevitably involves a greater degree of subjectivity than is ideal. This affects the reliability of the valuation estimate provided and therefore an appropriate uncertainty disclosure is required to alert users to this.
Valuers must therefore distinguish between discussion of the uncertainty attaching to the outcome of expected future events, which should be reflected in market data and therefore in their valuation, and uncertainty that arises from the lack of relevant data to input into their valuation. The standards only require a specific caveat in the latter case. Including one under other circumstances only serves to unnecessarily undermine the credibility of the valuation, and by extension, the valuer.
* CP 18/27: Consultation on illiquid assets and open-ended funds and feedback to Discussion Paper 8 October 2018
** See also RICS Valuation – Global Standards 2017 – VPGA 10