Thursday, 1 October 2009

Guest post by Brendan Williams: Switching market principles on/off in NAMA

Brendan Williams: The recently announced legislation on Nama, by allowing for the potential payment of a future market recovery price for assets, departs from accepted international market value standards. The government appears likely to be successful in passing its current banking proposals, including the marking up of NAMA valuations to the newly defined long term economic value. In a declining property market this presents an obvious risk for the taxpayer. Among the many concerns about these proposals, the critical issue of price to be paid raises questions as to whether this approach is appropriate and equitable.

The rationale for the proposals relating to the question of asset valuation suggest that we have a non existant or distressed market. In fact, we have a market going through a significant downward shift which many interests are reluctant to accept. Such corrections have occurred periodically through previous cycles, with upward and downwards shifts a feature of any analysis of property markets, and indeed may be expected to occur again in the future.

Proposals departing from market valuations to arranged and legislation-based prices may be an exercise in expediency and hope, rather than an exercise in market reality. Admittedly, the property market is less efficient than other markets, and the cyclical nature of its operations can be argued to both overvalue and undervalue assets at various points in the cycle.

However, the previous conventional wisdom was that attempts to manage or control property market price arrangements by legislation (such as that announced) can produce unintended or perverse results and distort markets. This occurs if the natural market process, change or correction is stalled. Then a clearance of existing stock may not occur as vendors and lessors will not accept market prices, and eventual real recovery is delayed. A functioning market, by comparison, involves participants accepting the consequences of both the upward and downward shifts in the property cycle. Being willing to take the profits, or accept the consequences when a trade decision is proved mistimed by later trends, should be a normal expectation of market participation.

Market price or value implies that a vendor is willing to take a property to the market and accept the best current price available from a willing purchaser which represents both the existing use and future ‘hope’ value. In a buoyant or upward market, there is a body of comparative evidence which is the basis for the valuation of such assets. Thus, in the recent past, we effectively had a pattern of valuations following the transactions upwards. Purchasers of housing and rental occupiers from 2000-2006 may not have agreed with this process, but effectively had no option except to follow the upward only market price trends.

When the market turned and the trend moved sharply downwards in terms of both volumes of transactions and prices achieved, there was been a considerable reluctance by vendors, lessors, financial and market interests to accept the consequences of a declining market on price levels. A period of lower or declining prices is to be expected as the property cycle sees excess supply in the new housing and commercial sectors, rather than excess demand as in the earlier period.

This has led to the quest for alternative pricing arrangements incorporating a concept related to future market recovery price levels, rather than current market values. This concept, developed in the NAMA legislation, is predicated on the idea that sales and transactions during a weak market period caused by the recession and credit difficulties are unfair. What constitutes a fair or reasonable price sought by industry interests is unclear, but is linked to an idea of construction or development cost plus a profit or return element.

The reverse of this debate occurred during the property boom. At that stage, cyclical shortages of residential property particularily in Dublin drove up market prices to unprecedented levels as purchasers bid up prices on the available stock, facilitated by a surge in credit availability . Similar arguments were made that these prices were unfairly high and not sustainable over the long term. However, at that point the accepted argument was that any form of price arrangements or temporary controls restricts supply and damages the market process. And so it was, with a free market in price terms facilitating and providing a major boost for housing and development land prices. In recent months, the continued use of optimistic or previously hoped-for values as a basis for valuation or business plans by consultants was severely criticised in High Court rulings.

It must also be remembered that the transactions and linked loans now being debated resulted in parties within the development process receiving large payments based on these loans. The return to the market of some of these interests who sold at the peak of the market with large capital reserves may occur when they assess that the market has stabilised assisted by the governments interventions, or when the market conditions are considered favourable. It remains to be seen whether concepts related to arranged prices and giving a 'fair' basis of involvement to other parties involved in the process will be part of the eventual recovery process.

It may be argued that the current difficulties in the Irish owned and managed banking sector necessitate a major intervention to secure their viability. This may be so. However, it is less certain that an upward property price intervention in a declining property market should be a central component of such a solution. In addition, assessing such prices presents very considerable difficulties due to the nature of the assets concerned. Included in such assets are completed and uncompleted developments in Ireland, and internationally, across all property sectors.

Attempting to define a valuation basis, other than market value, appropriate for all categories of property is extremely difficult - if not impossible. Every property is unique, and each sector and indeed sub sector experiences a market fragmentation process during a recession. This means that, in the upward market period, there is a tendency for the rising tide to lift all locations and sectors. The converse is that this linkage is weaker during a recession. In these periods, the price falls at weak speculative locations (particularily in development land) are very dramatic, while the falls in more established locations are proportionately less. Thus, as the market fragments, establishing general market adjustments is not appropriate and market value trends will vary greatly even within the residential sector.

While we can with some difficulty establish the economic, market, planning and legal context for the property valuation of completed projects, the situation regarding incomplete developments is obviously much more complex. For example, an unfinished mixed use development, or development land in a weak location with little evidence of future demand, begs the question - will some of these developments ever be completed, and do the assets have significant market value now or in the future?

Further complexities arise in trying to establish the potential values of assets in more distant markets, such as in Eastern Europe and the Middle East, where complex legal and other issues may arise. This leads to the conclusion that the real market value of many such assets relating to the NAMA project would have to be subject to a very steep discount from previous levels if the process is to be transparent in relation to the treatment of assets transferred.

From a taxpayer perspective, if this process must happen then it is current market valuations and not a possible future price which should form the maximum basis of the valuation process. In fact, in the real market where a single purchaser is negotiating to purchase a complete package of impaired assets, a significant reverse premium or lower combined price than that assessed for individual assets would be negotiated.

In organising such interventions, a variety of forms of joint ventures and risk sharing arrangements exist and are used internationally in terms of property development project arrangements. The two central elements which emerge from any study of this area are negotiated risk sharing and staged payments structures. This normally involves only part of the current market valuation being paid up front. As this NAMA proposal is effectively a joint venture with the taxpayer as the reluctant partner, the second part of the payment representing the shared risk can be based on the remaining element of market value and/or agreed shares based on the uplift in future value when (and only if) this is achieved. This would represent a future incentive element for the financial institutions at completion of the NAMA process.

In addition, if we are to have a transparent process, the publication of details relating to the precise assets involved, valuations and the transactions or evidence base upon which such assessments were made is essential.

Dr. Brendan Williams lectures in Urban Development at UCD and has worked as a chartered surveyor and property market analyst


SlĂ­ Eile said...

@Brendan Thank you for this very thoughtful and insightful post. A key message I take from this debate is the need for public authorities to avoid haste in buying up assets whose values today, tomorrow and next year are unknown. If ever the Efficient Market Hypothesis got a battering it was in the Great Irish Property Crash of 2008. There must be scope for driving a much harder bargain with banks, borrowers and intermediaries in this climate

Nat O`Connor said...


Thanks for your post. I agree with a lot of what you are saying.

In particular, it is worrying to hear that NAMA "departs from accepted international market value standards"

It is understandable that those with large property portfolios will do anything they can to reinflate prices. But do you think that some of them are actually in denial of the fact that we had an enormous price bubble? Likewise, do you think that some developers, politicians, etc don't realise that prices may never again rise to the equivalent of the dizzy levels attained at the height of the bubble?

Fergus O'Rourke said...

Yes, good stuff. A fair-minded summary of an extraordinary proposal.