Questions Auditors Ask
All real estate borrowers face scrutiny over debt valuation.
Debt valuation is affected not only by
fluctuating market rates, but also by the methods used to perform the valuations.
While the volatile rate environment of the financial crisis has dissipated, the
heightened scrutiny auditors now apply to the methods companies use to
determine these values has not. Whether you mark your debt to market or
disclose its fair value in your GAAP-compliant filings, the approach should
consider three factors: the market interest rate environment, the projected
cash flows, and the spread, or credit charge, above a selected market index at
which you could replace the existing loan.
Before getting started, let’s review the
basics of discounted cash flow methodologies and how they relate to debt
valuation. DCF is a common technique whereby a stream of future cash flows is discounted
at the cost of capital in order to obtain the present value of each payment. In
the context of debt valuation, the future cash flows are simply the loans’
contractual cash payments to the lender.
cost of capital is comprised of two components: market interest rates and
adjustments based on credit, also called credit spreads. Determining these two components
isn’t always straightforward, and that ambiguity can yield different results,
some more defensible than others.
real estate borrowers face various degrees of scrutiny from their auditors and
investors regarding the debt valuation approaches they use. Acceptable
approaches range from rudimentary to sophisticated, but they all must be characterized
as reasonable and consistent. The best are also well-documented. To validate
debt valuation methodologies, auditors ask the following three key questions
related to the above factors.
you using the right market interest rates?
There are a
variety of sources from which you can obtain market rates. These rates should
be as of the date your valuations are effective, typically month- or
quarter-end. They should include Treasury and swap rates spanning the term of
your portfolio’s maturity dates that allow you to interpolate for each loan’s
In theory (using fixed-income mathematics), it
doesn’t matter whether you discount the cash flows using a yield curve or a
specific discount rate: These approaches are economically equivalent. In
practice, the resulting values will differ if the specific discount rate
doesn’t make specific adjustments for the loan’s precise day count convention,
payment frequency, and -- most importantly -- the degree of amortization.
Generally speaking, the yield curve produces
more defensible discount rates and greater accuracy, but the differences are usually
only 5 to 20 basis points (assuming only slight amortization). Within reason,
borrowers (or auditors) decide if the greater precision is necessary.
are the cash flows projected?
flows for fixed-rate loans is a straightforward process, but that is less true
for floating-rate loans that have uncertain future cash flows. In the past,
when borrower credit spreads were more stable, many borrowers were able to
assume that their floating-rate debt was valued at the face value of the loan,
or par. However, this assumption implies that the underlying credit spread
remains equal to the contractual borrowing spread. When these two spreads
diverge, the fair value of the debt is no longer at par. In that case, what market
rates should be used to project future variable rate debt payments?
Using the current index setting, for example,
the LIBOR or prime rate, isn’t a best practice as we can be fairly certain that
the floating rate will move over the remaining term of the loan. Luckily, the
market’s anticipation of these forward rates is inferred through the swap rates,
which are available from a variety of sources.
Accordingly, borrowers can approximate the
expected forward cash flows of a floating-rate loan by using the interpolated swap
rate of the underlying index plus the loan’s borrowing spread. As with fixed-rate
debt, any amortization will further complicate the selection of an interpolated
rate, adding more complexity to the valuation.
Depending on your sourcing, however, the
selected swap rate may have payment frequency and day count convention
assumptions that differ from those in your loan portfolio. Any mismatch will
lead to a difference in the ultimate valuation, and the magnitude of the effect
is similar to that described in the preceding section.
is the rationale for the credit spreads you apply to each loan?
earlier, typical valuation methods discount contractual cash flows at the
market (or benchmark) rate plus a replacement credit spread. That credit spread
is the loan spread you currently could
obtain if you sought to replace your loan under the same conditions and
maturity. There are a variety of sources from which you can obtain credit
spreads including your lender, a third-party provider, or yourself.
Whatever the source, the credit spreads should
take into account the key characteristics of the debt instrument, the quality of
the underlying collateral asset, and the changes in overall market conditions. Finally,
the approach should be consistent across your portfolio and from period to period.
most solid foundation for understanding your portfolio’s debt valuation is
achieved by understanding basic DCF techniques. Armed with this knowledge,
borrowers who understand how they approach each of the above three questions are
prepared for most of the debt valuation conversations they encounter with
Kjellberg is a member of Chatham’s Financial Management System team, advising
clients with managing and valuing their debt portfolios. Contact him at firstname.lastname@example.org. Chatham’s Debt
Valuation Methodology White Paper provides additional information on this