Behind-the-scenes a number of banks, rating agencies, academics, valuation professionals and the Bank of England have been working on a new property valuation metric system which could be used as an early warning trigger. The “Property Industry Alliance’s Debt Group” has issued a very interesting two-year research note on the effectiveness of such systems. Interestingly, the most basic of the systems used in the research programme appears to be the most effective and has correctly indicated periods of overvaluation in commercial property on a regular basis over the last 100 years.
Property valuation metrics
The individuals looking into such metrics reviewed three key measurements which include adjusted market value (AMV), investment value (IV) and mortgage lending value (MLV). The AMV system is the simplest and requires the least data as it is based upon long-term inflation adjusted values of commercial property.
Using historic data the AMV system was able to flag periods of overvaluation in the market taking in different macroeconomic, interest rate and investment environments. It was interesting to see this particular metric used on historic data because when prices were overvalued by 20% this was the flag of most interest. This particular level indicated there was a high probability of a major correction over the next five years and to backup this point the 20% level was reached back in the third quarter of 2004 – just prior to the 2007/8 property market/economic crash.
Additional metrics
The IV and the MLV methods are slightly more technical, requiring more data, and do not necessarily compare favourably to the AMV metric especially in the current low interest rate environment. There will be more work on these particular metrics but we can probably assume that the AMV metric will be more useful going forward.
Regulatory opportunities
While the AMV metric was shown to be particularly useful on historic data, and indeed flagged the 2007/8 crash, there are concerns about using such rigid methods where regulations are involved. It is difficult to say whether this type of metric will be integrated into the current regulatory system or whether indeed it will be used as an indicative metric by the financial community.
There is an argument for reviewing the individual commercial property market exposure of lenders in the UK and grouping them by indicative risk. This would be very useful for regulators and it could prove to be a useful tool for lenders looking to control areas of potential high risk. Metrics are used regularly across the financial industry but this type of specific metric (AMV) avoids complicated algorithms – the components of which can be manipulated and prone to error.
Risk profiles come under the spotlight
Since the 2007/8 worldwide property market crash the control of risk amongst lenders has been under the spotlight. Initially, after the crash, tighter regulations were introduced in an attempt to control high-risk lending. Slowly but surely it would appear that some areas of the lending community are slipping back into their “old ways” and there are indications that risk exposure is increasing. The chances are this will be tested in the years ahead as interest rates slowly creep back towards more traditional levels. There is every chance that those who stretched their finances to the limit in the current low interest rate environment will struggle when their interest payments begin to increase. What impact will this have on the wider property market?