Debt valuation methodologies for financial reporting—summary

Key concepts

Market participant behavior establishes fair value

Fair value is a market-based measurement. As such, it is measured using the assumptions that market participants would use when pricing the asset or liability, including assumptions about risk.

Market participants include similar investors

When valuing debt instruments, market participants include similar investors in the relevant market for the same position.

The best indication of fair value occurs at origination

At origination, a considerable amount of due diligence is completed by market participants to evaluate and price the risks of a loan within the context of the capital markets. As a result, par is the best indication of fair value at that time. After initial recognition, observable market data should be used to determine changes to both market-level and collateral-level risks since origination.

Valuation conclusions should consider all relevant exit scenarios

The objective of a fair value measurement is to estimate an exit price from the perspective of a market participant that holds the asset or owes the liability. Therefore, understanding future exit value is helpful when considering the assumptions that market participants would use when pricing the asset or liability, including assumptions about risk.

Fair value measurement requires judgement

A fair value measurement should consider all relevant calculations and scenarios that a market participant would consider in evaluating the financial instrument. In many cases, a thoughtful reconciliation of multiple calculations or scenarios may be the most appropriate fair value conclusion.

Valuation methodology—borrower's perspective

The following summarizes a typical application of the principles outlined in the white paper when valuing financial liabilities. Please note that methodologies may vary depending on individual loan economics and the corresponding assumptions that market participants may use when pricing similar instruments.

Summary

Under the premise that par is a reasonable valuation consideration from the borrower's perspective, fair value is often calculated by equally weighting par and the equity method. The equity method discounts the difference between the remaining contractual and market debt service payments at an equity discount rate.

Typical methodology

1. Remaining contractual debt service: Remaining debt service cash flow as of the date of value (e.g., September 30) is calculated based on the contractual economics stated in the loan agreement.
2. Market interest rate: The market interest rate reflects a best estimate for how a lender would price an equivalent loan based on the origination term (e.g., if a 10-year loan has 6 years remaining, the market interest rate reflects a 10-year rate).
3. Remaining market debt service: Calculate remaining debt service cash flow using the market interest rate.
4. Equity discount rate: The equity discount rate is calculated using a weighted average cost of capital (WACC) formula using LTV, market cost of debt and the unlevered property discount rate to derived an implied equity rate of return.
5. Fair value conclusion: The fair value of most loans is calculated by equally weighting par and the equity method conclusion. Loans with a fair value conclusion above par, but open to prepay are marked to par.

Valuation methodology—lender's perspective

The following summarizes a typical application of the principles outlined in the white paper when valuing financial assets. Please note that methodologies may vary depending on individual loan economics and the corresponding assumptions that market participants may use when pricing similar instruments.

Summary

In the valuation of loans from the lender's perspective, the most frequently applicable methodology is the yield method which discounts remaining contractual debt service payments at a market interest rate.

Typical methodology

1. Remaining contractual debt service: Remaining debt service cash flow as of the date of value (e.g., September 30) is calculated based on the contractual economics stated in the loan agreement.
2. Market interest rate: The market interest rate should reflect a rate of return appropriate for the risks inherent in the cash flows. Considerations in determining a market interest rate include the origination rate, changes in both property-level and market-level risk and recent market observations for loans with a similar risk profile.
3. Fair value conclusion: The fair value of most loans is equal to the result of the yield method. There may be cases however, were it is appropriate to consider additional calculations or approaches particularly for mezzanine, preferred equity, transitional, non-performing or atypical loan structures.