Valuation and Pricing For Private Real Estate
Chapter excerpt from The U.S. Private Real Estate Fund Compliance Guide
During 2011, 346 private equity fund operators lined up almost $250 billion of combined capital to primarily invest in real estate and instruments secured by real estate, including first mortgages, B-notes, mezzanine debt and preferred equity. Pursuant to the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank), many of these private real estate fund operators were required to register as investment advisers with the SEC by March 30, 2012. Each registered investment adviser will need to comply with a number of requirements pursuant to the Investment Advisers Act of 1940, including the one that covers the maintenance of records and reports which are subject to inspection by the SEC relating to the valuation policies and practices of the fund. This chapter addresses industry practices relating to valuation policies and practices of a private real estate fund.
For a private real estate fund, the investments in real estate and instruments secured by real estate(henceforth, real estate investments) can represent nearly the entire balance sheet. A typical strategy with real estate investments is to hold or reposition the asset to achieve desired investment returns. Typical strategies with instruments secured by real estate include holding the instrument if it is performing and attempting to gain control of the real estate for instruments which are non-performing or sub-performing to achieve desired investment returns. With fair value accounting, having nearly the entire balance sheet be comprised of illiquid investments means that the financial statement is inherently based on a great deal of judgment and subjectivity. Both investment performance and the amount at which investors carry the holding on their financial statements hinges on the fair value determined for the fund’s investments. In a volatile market, valuations can fluctuate from period to period.
Fund managers have a fiduciary responsibility to their fund investors, who rely on and make investment and allocation decisions based on these valuations. Given that many fund investors are institutions, pension funds or other entities that have their own fiduciary responsibilities to their various stakeholders, the valuations that fund managers provide will flow into other entities’ financial statements, creating additional layers of investors and constituents who require reliable valuations. Even prior to the discussions of registration, limited partners and institutional investors have inquired about how their investment managers performed valuations, and begun to question those valuations and the valuation process.With the rash of scandals that surfaced in the recent credit crisis, as well as a substantial increase in the number of actions by the SEC against investment advisers, investors have turned up the heat on their investment managers, not only in terms of due diligence and fraud risk assessments, but also in terms of understanding and reviewing the fair values that are reported by the investment managers.
This article was first published in “The US Private Real Estate Fund Compliance Guide” by PEI.