The basis of valuation of commercial investment property for bank lending purposes

Much of the attention in the recent global financial crisis has centred on real estate. As Goodhart (2010) notes, more bank lending is for property than anything else and real estate is the most common form of collateral for lending (whatever the purpose of the loan). Vickers (2011), chair of the UK Independent Commission on Banking, suggests that ìthe shock from the fall in property prices, even from their inflated levels of a few years ago, should not have caused havoc on anything like the scale experienced.î Unfortunately, in his January 2011 statement on the commissionís progress towards a framework for bank regulation, this is the last time that property is mentioned. It appears to be the root of the problem but not part of the solution. This paper examines one part of the bank lending process, the use of valuations in secured lending. In particular it looks at the bases of valuation that could be applied to this role. Definitions of value identified in International Valuation Standards include Market Value, Investment Value and Mortgage Lending Value. Market Value and Mortgage Lending Value figure in the Basel agreements relating to solvency ratios; Investment Value has not been hitherto identified as a basis fit for the secured lending role. The paper discusses the nature of bubbles and crashes and examines real estate markets in the context of this literature. It examines the detail of the three valuation bases and their application and, using UK commercial property market data before and after the property crash of 2007, identifies the level of valuations that would have been produced at those times. Conclusions are then made as to the appropriate basis for bank lending, practical limitations of applying those bases and recommendations for the future.