FEATURE: Mark to market wasteland

Would you blame a heart monitor for causing a heart attack? That's the question supporters of fair value accounting, or mark to market valuations, are asking as the international reporting requirement comes under fire for its part in the global credit crisis.

As one of the most talked about accounting rules of the 20th and 21st centuries, mark to market has its fair share of critics. In March last year, Oaktree Capital Management chairman Howard Marks wrote in his investor memo that mark to market accounting was the “accelerant” that “turned out to be one of the main contributors to the boom/bust cycle”.

Marks would perhaps now concede that real estate and corporate buyers who gorged on a diet of cheap and easy credit might also have contributed to the bursting of the bubble. However, concerns over mark to market, and Financial Accounting Standard 157 {FAS 157}, the standard that introduced mark to market to the valuations process, remain – not least when you are having to mark to an almost non-existent market.

“Real estate is an illiquid asset,” says David Lynn, managing director of research and investment strategy at ING Clarion. “The true value of real estate plays out over time, so right now you have to think more critically about mark to market regulations.”

It's something asked by many fund managers, who question how you can price an asset as though it was trading “in an orderly transaction between market participants” (as required under FAS 157), when real estate transactions plummeted by more than half globally in 2008, and CMBS issuance was down 90 percent.

However, as Brian Glanville, managing director of Integra Realty Resources and a member of the Royal Institute of Chartered Surveyors (RICS) US, says: “GPs should be held accountable about how they are managing their assets. They are managing those assets on behalf of investors and investors should have that information.”

Removing the scales from obese people doesn't mean they will get any thinner, he explains, it just means “there's no way of measuring progress”. Fair value is an attempt to move towards global, and uniform, accounting practices removing the confusion and inconsistency of previous pronouncements. Okay, it has grey areas. Quite a few of them, but as Glanville adds: “Mark to market effectively makes for better management.”

One of the issues arising with FAS 157 is that, when compared to previous practices under US generally accepted accounting principles (GAAP), FAS promulgates the use of an exit (rather than an entry) price, ignoring completely the owner's intentions.

“If you have a performing real estate loan that you intend to hold for the next 10 years, how do you price that? The market today might say it's worth 20 cents on the dollar, but you don't agree. In this uncertain market, it's very difficult to value assets given the unprecedented tsunami of bad economic news,” says David Kessler, principal of accounting advisory firm Reznick Group.

On the other end of the scale, though, how does a private equity real estate fund manager value unrealised assets in their funds? As Joseph Stecher, chief investment officer of Morgan Stanley's alternative investment partners real estate funds of funds business, explains, traditionally GPs have reported valuations of unrealised real estate investments using projections. That is, as a ratio of the final expected IRR and multiple once a project or asset is divested.

“Now, our private equity counterparts would argue that a half finished building is only worth cost, or maybe somewhat more than cost, if you had to sell it in the market today,” says Stecher. However, calculating values “as of” today is something that Morgan Stanley has asked its fund managers to do. And instead of the severe performance reductions some fund managers might anticipate when reporting current values, Stecher says, in many cases “it merely reduces the multiple slightly and vastly increases the IRRs because the project was realised faster”.

Ultimately, all valuations are a summary of the best available information at any pin prick of time. As Kessler adds: “They are really only good for a short period of time given all the changes that have taken place over the last six months, as well as a lack of transactions in the marketplace.”

Mark to market cannot be blamed for causing the credit crisis. It wasn't FAS 157 that forced investors to go out and buy an office block in a third-tier city with 95 percent debt. What it has done is merely accelerate the speed of awareness of the rate of decline.