a horror story in four words
"Change of valuation basis"
Arguably the most frightening four words in business English, I came across this interesting little concept early on in my career, while bouncing around the world of financial regulation looking for someone who could stand me. It’s taken from the world of commercial real estate; it’s surveyor jargon. Like “hakuna matata”, it’s a wonderful phrase, and indeed (christ, Tim Rice is an atrocious lyricist) it ain’t no passing phase. However, very much unlike “hakuna matata”, it definitely does not mean no worries to the end of your days. It’s usually, in context, a sign that the immediate future is one that is going to be full of stress, financial and otherwise.
The concept is simple; among the jobs of chartered surveyors is the giving of valuations of buildings, for a variety of purposes but most usually, for the benefit of bankers lending money with commercial real estate as collateral. How do you value a building? It depends. Buildings aren’t traded in a liquid market, so someone has to actually do the work, and there are various ways they can go about the job.
Most normally, you will value it by taking a multiple of the rent, or by some whizzy discounted cash flow analysis that more or less amounts to the same thing. Make some assumptions about the cash that comes out of the building from tenants, some assumptions about the cash that has to be put into it for maintenance and taxes etc, open up Microsoft Excel, have a crafty glance at the trade press to check you’re not millions of miles away from recent transactions in a similar location, it’s the daily bread and butter of financial analysis.
This method is basically appropriate for the purposes of someone who needs to know what a building is worth, but isn’t interested in actually selling it. However, you might also, particularly if you thought sale was a more likely prospect, put much less weight on the cashflows, and much more weight on comparable transactions, using the analytical capacity freed up to make a different spreadsheet adjusting those transactions for the differences between the buildings recently sold and the one you’re interested in. If you’re doing this, then you’re in a different game – rather than looking at the “fundamental” value of the building, you’re saying “what would this go for, if it was dressed up for sale in the current market, with a reasonable amount of time and budget for making an effort to get the best price”. Of course, depending on how hot your particular local market is, that valuation basis might give an answer that was either less or more than the fundamental valuation – you would hope, in a reasonably efficient world, that it wouldn’t be too far off, but bubbles and crashes do happen.
However … another basis for valuing a building might be to answer the question “what would I get for this thing if I had to sell it right now?” As in, right now, as a more or less forced seller without the ability to wait around or market it properly. Obviously that’s going to be a significantly lower number, and it’s going to have a much bigger element of subjective judgement to it.
“Change of valuation basis” describes the fact that as the world changes, the appropriate method of valuing a building may also change. It tends to describe a situation where someone who previously believed themselves to be a long term holder with the luxury of collecting the rent and realising the full discounted value of the cash flows, has suddenly become a forced seller. Since the most common reason for being a forced seller is that you need cash to pay your creditors, this news about the value of the loan collateral tends to arrive at the worst possible moment for the bankers, a moment when they’re already in a bad mood.
If you can get your head round the “change of valuation basis” (and come on it’s not that difficult) then I think you understand all you need to understand about the protean and confusing concept of “liquidity”, which is clearly extremely important to a modern financial economy, but irritatingly difficult to define. They’re both different aspects of the fact that financial reality is socially constructed – the numbers themselves depend on what you’re planning to do with them.
Concentrating on “change of valuation basis” also helps you understand how bank failures happen, and to take an appropriately sceptical attitude when people in the industry talk about “solvency” and “liquidity”. On a forced seller basis, every bank in the world is insolvent; on a discounted cash flow basis nearly every bank is solvent. What determines the valuation basis to be used? Whether they’re a forced seller or not. Which in turn depends on whether the rest of the system is prepared to let that bank be in control of its own destiny. One of the ways to avoid being confused by the kind of things I discussed in “plumbing and architecture” is to keep it clear in your mind that finance is at its very deepest and most abstract level a system of control, not a commodity. The numbers used look like they’re measuring quantities of things, but this is an illusion, and the occasional change of valuation basis shows it to be so.