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.

DCF Methods

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.

The 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.

All 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.

Are 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 maturity date.

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.

How are the cash flows projected?

Discounting cash 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.

What is the rationale for the credit spreads you apply to each loan?

As mentioned 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.

The 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 auditors.

Rick Kjellberg is a member of Chatham’s Financial Management System team, advising clients with managing and valuing their debt portfolios. Contact him at Chatham’s Debt Valuation Methodology White Paper provides additional information on this topic.


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