Silvia Cappelli and Konstantinos Pallis Chair and Member of the TEGoVA AQR 2.0 Working Group

1. TEGoVA’s Proposal to the ECB for a Revised AQR Manual Chapter 5 “Collateral and Real Estate Valuation” Silvia Cappelli and Konstantinos Pallis Chair and Member of the TEGoVA AQR 2.0 Working Group Members of the Board of TEGoVA TEGoVA Conference“European Valuation Standards in an Ever Closer Union” Brussels, 13 May 2016

2. Background The Financial Crisis caused a shift in banking supervision power from the national level to the EU and in particular to the Eurozone and European Central Bank. In order to know which banks needed to be saved or shut down, and also to avoid future systemic crisis, the ECB needed to know the quality of the banks’ assets. This led to the Asset Quality Review of 2014 an important part of which concerned “Collateral and Real Estate Valuation” .

3. The AQR – A flawed exercise Though Real Estate Valuation was recognized as key, it did not fit well with the strong ‘accounting principles culture’ that permeated the Manual. Even though the Manual provides for possible involvement of other asset appraisal specialists, the guidance for the national competent authority (NCA) bank teams was drafted by auditors, not property valuers. The Manual suffers from this structural flaw, creating a dangerous methodological conflict between the Manual’s instructions and commonly accepted valuation practice, a conflict that unless resolved can lead to misunderstandings and incorrect use of the Manual.

4. From TEGoVA’s meeting with the ECB in Frankfurt, we knew that the Bank was conscious of these flaws and was considering a second AQR exercise At that meeting, TEGoVA pointed out some important methodological improvements that would greatly enhance the end value of the AQR exercise … … and promised to provide this guidance for the ECB to have at its disposal in the event that they would decide upon the need for a second AQR.

5. This led to the Board’s decision to set up of the TEGoVA AQR 2.0 Working Group WG Silvia Cappelli (Chair) (ASSOVIB) Mike Morris (Adviser to TEGoVA) Konstantinos Pallis (AVAG) Adrian Vascu (ANEVAR) WG Secretariat: Michael MacBrien Supervision: Krzysztof Grzesik (PFVA) Roger Messenger (IRRV)

6. Format of the TEGoVA Guidance The Working Group decided that the guidance would be in the form of a Manual re-write with justifications as this seemed the most reader-friendly way of proceeding.

7. Examples of methodological conflict between the Manual’s instructions and commonly accepted valuation practice By describing ‘Hope Value’ as applying where there is planning consent, the Manual gave it a meaning that contradicts established valuation practice. The valuation approach proposed for leasehold properties is not in line with those generally adopted by valuers and is likely to give results that are out of line with market values. Yield:It is necessary to add a number of points that valuers would take into account in determining the correct yield to be used.

8. Methodological Conflict cntd. The Manual’s reference to valuing land with planning permission for development by means of a DCF approach is a method that valuers would not always use to value such properties. The provisions on “Valuation without comparables” including instructions to apply the notion of “closest available comparable” introduce levels of subjectivity into the valuation process that lead to substantially different results for valuations of the same property.

9. The Yield para. on page 153 of the ECB AQR manual was re-written as follows: Yield  The yield should be determined based on similar transactions in the market reflecting the specifics of the asset including: Risks associated with the rental agreement – in particular credit quality of the tenant, length of the remaining lease term (up to lease end, or the next tenant’s break opportunity) and repairing and other responsibilities of the parties; Characteristics of the surrounding area including the transport infrastructure, and the availability of communications and facilities which affect value; Characteristics of the property, including the layout and quality of the accommodation, dimensions and areas of the land and buildings; Construction of any buildings and their approximate age;The quality of construction of any buildings and their apparent age; Uses of the land and buildings and their appropriateness to the macro and micro location of the asset; The apparent state of repair and condition; Environmental factors, such as abnormal ground conditions, historic mining or quarrying, coastal erosion, flood risks, proximity of high-voltage electrical equipment; Contamination, e.g. potentially hazardous or harmful substances in the ground or structures on it; Hazardous materials, such as potentially harmful material present in a building or on land; The existence of any unusual legal restrictions on the use of the property (such as third party rights of way); and Any physical restrictions on further development, if appropriate. Manual re-write examples

10. Yield ranges anticipated to be used in analysis will be provided by the NCAs to the ECB during early March. The actual yield ranges applied for the sample will be returned by the NCA’s to the ECB together with the interim and final submissions of template T5 (i.e. the collateral valuation template). The level of detail required for yield ranges is shown below. (Please do not delete lines, even if no values are reported for those lines). Justification a. We have added a number of additional points that valuers would take into account if determining the correct yield to be used. b. In the table we have removed reference to the valuation of land with planning permission for development by a capitalisation approach, as valuers would not use that method to value such properties. We propose replacing “Other land (no planning permission)” with “Other land (not for development)” to avoid the reader thinking that land held for development but that which does not yet have planning permission should be valued in this way. Manual re-writeexamplecntd.

11. 5.6.1.2 5.7.4.2 COMPARABLE BASED VALUATION BASED ON UNIT OF AREA For vacant properties or properties with short term rental agreements that are out of line with market rents, the asset will be valued based on comparable transactions normalised for area. The valuation based on unit area relies on two key parameters: The area of property The valuation unit of area The valuation is then simply the valuation per unit area multiplied by the area. The comparative method estimates market value by analysing prices obtained from sales of properties similar to the subject property and adjusting the unit values to take account of differences between the comparables and the subject property. The prices from the comparable transactions are usually related to one or more points of comparison, such as the size of the property. Depending on property type and the data available, different units of comparison are used. It is important that the units of comparison be defined and measured in the same way for all the properties in a particular class. For mixed properties, the valuation may be done on the basis of a ‘sum of the parts’ reflecting the difference in the valuation per unit area of different parts of the property. For leasehold properties, the valuation must be adjusted to reflect the value of the Freehold (i.e. the value of the freehold must be deducted to arrive at the value of the leasehold property). Only the property size with potential value is aimed – therefore, property size can be assimilated to the usable size. methodology should follow that used for the same type of property in the local market. Where there are sufficient market comparisons of sales of similar leaseholds, the property can be valued on the basis of comparison with those transactions. In some countries the value of leasehold properties may be determined by determining the value of the same property if it were held freehold, rather than leasehold, then deducting the value of the freeholder’s interest, given the existence of the lease. For investment properties, or in the absence of sales evidence of leaseholds, the value will generally be determined by capitalising or discounting the net effective rent over the remaining unexpired length of the lease (see 5.7.4.1,above). Manual re-writeexamplecntd.

12. The valuation per unit area should be determined based on similar transactions reflecting the specifics of the asset including similar factors to those described in 5.7.4.1 in the section on Yield. As before, anticipated assumptions should be provided in March 2014 to ECB by NCAs and actual assumptions together with the interim and final submissions of template T5 (i.e. the collateral valuation template). Justification The comparable based valuation in the current Manual is lacking accuracy in its description focusing only on normalisation of the transaction price for area only. The purpose of this amendment is to introduce an internationally accepted methodology of normalisation of unit prices considering the multiple factors that affect an asset price – and not only size. Furthermore, regarding leasehold properties, we propose introduction of the comparison method for markets with sufficient data as an alternatively accepted method in use in some countries. "Sufficient data" means (as written in the text) sufficient market comparisons of sales of similar leaseholds. In the current version of the Manual there is only provision to adjust the leasehold value to reflect the freehold value, so markets working with leasehold values are forced to adapt to freehold value... Manual re-writeexamplecntd.

13. 5.6.1.4 VALUATION WITHOUT COMPARABLES Given the scope of the exercise, it is not perceived feasible to produce valuations on the basis of depreciated replacement cost at a reasonable level of accuracy and conservatism. As a result, if a property has no immediate comparables and no net income can be attributed to the property (i.e. a situation where a going concern cash flow based provisioning would be appropriate) then the appraiser is asked to apply the closest available comparable with an additional discount of 20% reflecting the inherent illiquidity of the property. The 20% are a benchmark to be used unless there is a strong reason for a higher discount. Justification We propose exclusion of this sub-chapter, since application of the provisions raises a significantly high degree of subjectivity which cannot be reasonably explained or justified. If the market approach is not applicable, no market information is available in relation to transactions of comparable properties. Hence, no market information is available to justify the adjustments applied under this approach. Furthermore, the level of 20% discount cannot be documented and although it employs a certain level of prudence, it also interferes with the judgment and work of the valuer. Also, this sub-chapter comprises the notion of “closest available comparable”, which implies a high degree of subjectivity as well. It is difficult to provide a coherent definition of the concept, ensuring coherent application in each member state. Generally, two properties may or may not be comparable. Partial comparability raises the subjectivity threshold and allows for a circumstance under which two valuations of the same property, under the same terms of reference may lead to substantially different results. This outcome is not acceptable, since the results should be similar, regardless of the valuer. This objective should be met by applying AQR, since many European banks present large exposures in several member states, and similar approaches to valuations are expected from one country to another, in order to facilitate consolidated reporting. Under these circumstances, the ‘tools’ available to valuers should avoid deviations from the valuation standards, such as the provision proposed for exclusion. Manual re-writeexamplecntd.

14. Other Sticking Points Independence and qualification of valuers:This is so fundamental to producing objective and high quality reports that we believe the Manual should be more prescriptive. TEGoVA AQR 2.0 demonstrates how this can be done. Valuations carried out in phase of origination:The Manual underestimated the importance of analyzing the type of valuations carried out in the phase of origination. We explain why and propose a new sampling procedure to determine in a cost-effective way the quality of valuations performed at origination.

15. Sticking Points cntdInformation required for valuation: The short timeframe for carrying out the original AQR made it difficult for banks to gather the minimum information. The value of 0 attributed to collateral items for which the bank is unable to provide the minimum information could result in heavy impairment for banks. We believe the experience of the first AQR informed banks about the minimum information that has to be archived in their files. We specified the minimum information required to carry out a valuation, so that it is easier for banks to identify the data that they must extract from their files and make available to valuers.

16. Sticking Points cntdValuation Approach: We believed it would be prudent to reinstate the tried and tested hierarchy of valuation approaches (comparisonincome-basedcost) and suggested it should be made clear that this hierarchy should be respected in estimates of value for AQR purposes.

17. Guiding Principles for the WG’s Work Propose correct methodology replacing what in the original document was incorrect and Describe the review of valuation appraisals as a process that should be carried out by valuers, not audit firms. Make clear that if a bank followed the valuation process properly at the time of mortgage origination and then updated the value according to EU law, nothing else is necessary during the AQR so as to guarantee that no new appraisals have to be commissioned without reasonable cause.

18. Guiding Principles cntd. Make the Manual shorter deleting some detail – for example in the methodological section – that was left from the original Manual and that we found not necessary. Incorporate TEGoVA's definition of Market Value Country-specific valuation methods are accepted (as long as the local approach is conservative) without being changed, amended or reinterpreted.

19. A Spin-off from TEGoVA’s AQR Exercise … Methodology A spin-off from the AQR WG deliverable was the TEGoVA Board’s realisation  that it is now time to start work on Methodology  that will refer to Europe-wide accepted methodologies for the valuation of any kind of real property for any kind of purpose. The intention of this work is not to set out rules to be rigidly followed or to attempt to provide a valuation textbook, but rather to express principles   to be adhered to in a context of evolving market practice and analytical techniques. It will set out the generally accepted methodologies applied throughout Europe. This has inspired the planned establishment of a European Valuation Practice and Methodology Board (EVPMB).

20. Going Forward … At TEGoVA, we were honoured by the ECB’s accordance of primacy to EVS over all other standards. But being singled out in that way also brings responsibilities, and we have made it our business to offer our expertise in all areas of EU policy focusing on valuation. We knew that the Asset Quality Review might not be repeated and even today we have no idea whether and when this might happen…

21. Our obligation … but we felt obligated to ensure that if ever the exercise is envisaged again, the ECB will have the capacity to adapt the AQR Manual to best valuation practice. This is what we have achieved. The ECB has acknowledged and analysed our work. What follows is out of our hands but the ECB knows who to turn to if need be.