Pressure Mounts On Investors In European Unlisted Property Funds To Adopt Fair Value Accounting
The increasing requirement for liquidity in unlisted property fund investments is combining with regulatory pressures to push investors and managers to adopt Fair Value accounting for fund positions.
In Europe there are an estimated 492 unlisted real estate funds holding approximately €266bn billion of assets.[i] With IFRS 9 and IFRS 13 mandatory from 2015 and January 2013 respectively as progress is made towards the introduction of Solvency II, the ramifications of these regulations are far reaching.
Historically, investments in unlisted indirect property funds have been carried at net asset value (“NAV”). This has been justified by consistency with direct property, the ability to “touch” NAV at fund maturity, and the absence, in an illiquid asset class, of another systematic basis. NAV is an accounting concept being the assets less the liabilities dependent, at a detailed level, on the accounting policies adopted by a fund manager.
The increasing demand for liquidity in fund investments has highlighted that NAV is not necessarily the same as market, or fair, value, which is the carrying basis for other most other investment assets. At the same time, regulatory developments, including IFRS accounting standards and the Solvency II Directive, are encouraging the adoption of a ‘Fair Value’ accounting basis.
IFRS 13, Fair Value Measurement, defines Fair Value as: the price that would be received to sell an asset, or paid to transfer a liability, in an orderly transaction between market participants at the measurement date.
For a small position in a large, ungeared, open-ended core fund, NAV may be a good measure of Fair Value. But for closed-ended structures this is rarely the case as factors including expectations of liquidity, fund strategy, leverage and cost structures influence what an investor might pay for an interest in a fund on the secondary market.
Investors and the broader industry will benefit from the greater transparency, improved performance reporting and reduced conflict between reporting bases and investment decision making which adopting Fair Value accounting will bring.
Graham Barnes, Senior Director, Real Estate Finance, CBRE, said:
“Whilst the industry has generally used NAV as a valuation basis we consider that, for the majority, this is both conceptually flawed and incompatible with the concept of Fair Value. Even the most sophisticated measure of NAV essentially marks-to-market each of the assets and liabilities. But, investors do not effectively own the assets and liabilities, they have a financial instrument entitling them to a stream of net cashflows with their associated risks and volatility. NAV does not seek to price the cashflows at a discount rate appropriate to the risk to them, and therefore is only equivalent to Fair Value by happenstance.
“The inconsistency between reported values and fair value are a deterrent to investors evaluating opportunities in the sector. Despite increasing investor demand and, for some, the deadline for mandatory adoption of regulations on the horizon there is a surprising lack of preparedness within the industry. Those who put this issue on the backburner will inevitably lose out in the longer term.”
Paul Robinson, Executive Director, Real Estate Finance, CBRE, added:
“To really understand the concept of Fair Value it is vital to understand that it, in common with other asset valuations, is a market based concept, while NAV is an accounting measure. Our own data from PropertyMatch shows that funds consistently trade away from NAV with a spread of trading prices2 of 60%, highlighting the importance of this issue.”
The report concludes that published current secondary market prices for individual funds are a sensible measure of Fair Value but, where these are not available, a more analytical approach is required which reflects proper analysis of the individual fund vehicle, an awareness and appreciation of current secondary market evidence and the ability to factor in evidence from wider markets.