Fair valuation of investment property in uncertain times

in Audit, Financial Services, Regulatory/Compliance, 08.03.2021

It’s no secret that measuring a fair value of investment property has always been a challenging task…and, needless to say, the current pandemic has not made it any easier.

The valuation of investment property following the principles of IFRS 13 is usually dependent on several assumptions and unobservable inputs. The current market situation may very likely result in significant uncertainties impacting those assumptions and inputs as transaction volume on the market could be declining, and lease contracts are being renegotiated or even cancelled – especially by industries or individuals that have been severely impacted by COVID-19.

To reflect uncertainties and risks stemming from the current market situation, unobservable inputs used in valuations will need to be adjusted.

A closer look at valuation approaches

Two approaches are typically used for investment property valuation:

  1. Market approach
  2. Income approach (which uses either the yield method or the discounted cash flow (DCF) method)

The general principle of IFRS 13 is to use the valuation method that is appropriate in the circumstances (and where sufficient data is available), while maximizing the use of relevant observable inputs and minimizing the use of unobservable inputs.

When it comes to the market approach, the use of comparable data is key. Naturally, issues arise when comparable sales transactions become less frequent and the prices do not necessarily reflect the current market situation.

Similarly, the yield method under the income approach becomes less reliable when the transaction volume is reduced, when there is a lack of comparable properties, or if there is a change in future income flows in comparison to comparable properties or vice versa.

Income approach valuations currently pose a greater challenge since they rely on income projections which could become very unpredictable and volatile. The DCF method also becomes less reliable as the projection of future lease payments to be received will require significantly greater estimates. These estimates will be impacted by the uncertainty of contractual rent collection, the probability of their future continuation, as well as future rent levels.

If the creditworthiness of tenants deteriorates substantially, it could severely impact long-term agreements in particular. What’s more, projection for void and rent-free periods might not be representative if based on the current unstable market conditions.

In general, valuation uncertainty will most probably increase because the valuation inputs may still relate to the market before the COVID-19 impact due to lack or volatility of market data.  Also, appropriate rental income may not be reliably estimated since the current levels are not likely to be representative of future conditions. This means the valuations might require significant risk adjustments related to those uncertainties if the market participant would include such risk in the pricing.

Let’s not forget that (as stated in IFRS 13.65) a change in valuation technique or its application is appropriate if it results in a fair value measurement that is equally or more representative of fair value in the circumstances. Changes in market conditions may be an example.

Disclosures

IFRS 13 requires investment properties falling under level 3 fair value measurement to describe the valuation techniques used, how decisions are made in relation to valuation procedures and a narrative description of the sensitivity of the fair value measurements to changes in unobservable inputs, resulting in a significantly higher or lower fair value measurement. It is important to remember that any information about the significant unobservable inputs used for level 3 measurements must be quantitative.

What should be considered more carefully under the current circumstances is the increase in uncertainty and its impact on the assumptions and estimates used in the valuations. Entities may need to exercise significant judgment which could result in a risk of increased subjectivity.

Regulators have indicated that it is essential to consider carefully the IAS 1.125 and 129 disclosure requirements and disclose the assumptions about the future, and other major sources of estimation uncertainty that have a significant risk of resulting in a material adjustment to the carrying amounts of assets and liabilities within the next financial year. This includes the sensitivity of carrying amounts to the methods, assumptions and estimates underlying their calculations. In this case, considering the requirements of the standard as well as regulators’ expectations, I believe a quantitative sensitivity analysis should be disclosed.

In addition, careful attention should be given to an appropriate disaggregation of the asset classes for the purpose of the disclosures of valuation techniques and the inputs used for level 2 and 3 measurements, taking into account nature, characteristics and risks of the investment property. Such disaggregation may need to be more detailed given the current market conditions.

For a deeper dive, check out our KPMG Covid-19 supplement or get in touch with our team of experts!