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Level 2 investments: Best practices for REIT valuation

RFP
REITs best practicesIn recent years, real estate investment trusts (REITs) have confronted increasing regulatory and investor scrutiny of their investments. In response, many companies have taken steps to enhance the quality, transparency and comparability of fair values being reported. The need for established guidelines and supportable valuation methodologies in determining fair value has become increasingly important.

Level 2 financial assets and liabilities
Accounting Standards Codification (ASC) 820, Fair Value Measurements and Disclosures, defines Level 2 inputs as those based on the following:
  • Quoted prices for similar assets or liabilities in active markets
  • Quoted prices for identical or similar assets or liabilities in markets that are not active
  • Inputs other than quoted prices that are observable for the asset or liability

Following are the current best practices for valuing common Level 2 input financial assets and liabilities held in REIT portfolios.

Valuing Level 2 REIT financial assets and liabilities can be particularly complex, due to the lack of public trading markets and increased scrutiny from auditors and regulators, particularly the SEC, the Public Company Accounting Oversight Board and investors.

Regulators and auditors have focused on mortgage REITs’ use of quotes or prices obtained from brokers and other third-party sources, including instances when management did not validate or challenge broker quotes and other pricing service information. Also under the microscope are REITs that obtain several broker quotes for a particular security and calculate an average price to support their Level 2 price, without understanding the specific inputs or methodology used to derive each broker quote. REITs should expect to face scrutiny on the specific valuation methods chosen and/or the significant assumptions used to develop the fair value measurements for Level 2 positions.

Choosing pricing services
• Since vendors differ in the classes of securities in which they offer pricing, it may be necessary to contract with several sources.
• Obtain quotes from more than one vendor to identify and evaluate potential ranges that could be deemed acceptable for more complex securities with subjective valuations, provided that there is transparency into the inputs and valuation methodology used to develop the quote.
• Be prepared to support, explain and reconcile differences.
Residential or commercial mortgage loans
Residential or commercial mortgage loans classified as Level 2 are typically valued using third-party pricing services. The third-party service uses common market pricing methods that may include pricing models that incorporate inputs and assumptions related to coupons; prepayment speeds; default rates; spread to the Treasury Department’s curves and interest rate swap curves; duration; and periodic and life caps, depending on the nature of the security. In addition, the thirdparty service may benchmark its pricing models against pricing inputs being quoted by a range of market participants active in the purchase and sale of residential mortgage loans. Transparency into those quotes is often an important factor in determining the observability of the quotes within the ASC 820 framework.

Management can typically obtain pricing data from a primary third-party pricing service for each mortgage loan. If other available market data indicate that the pricing data are not reflective of market participant assumptions, management should review the inputs used for each pricing model to determine which data are supportable. In those circumstances, management may need to consider retaining a valuation expert to develop an appropriate pricing model using the supportable inputs to price the security. Management should also validate its understanding of the methodology and assumptions underlying the fair value used by the pricing sources.

Residential or commercial mortgage-backed securities
Agency, nonagency and multifamily mortgagebacked securities (MBSs) are generally valued-based on third-party pricing services or dealer quotes. The third-party pricing services typically use pricing models that incorporate inputs and assumptions related to coupons; prepayment speeds; default rates; spread to the Treasury Department’s curves and interest rate swap curves; duration; periodic and life caps; and credit enhancement, depending on the nature of the MBS.

Quotes obtained from dealers may also incorporate common inputs such as spread measurement to the Treasury Department’s curve or interest rate swap curve; coupons; periodic and life caps; collateral type; rate reset period; and seasoning or age of the security, as applicable.

Management may obtain pricing data from a primary third-party pricing service for each agency, nonagency and multifamily MBS. If other available market data indicate that the pricing data from the primary thirdparty service are materially inaccurate or unavailable, management should review other available prices and take additional steps to determine fair value. In all cases, management should validate its understanding of the methodology and assumptions underlying the fair value practices used.

The pricing data from the primary third-party service could be incorrect or inaccurate if they are not materially representative of where a specific security can be traded in the normal course of business. In this case, management would need to follow steps that could include the review of collateral marks from margin departments of repo counterparties; the utilization of bid lists and review of other third-party pricing service data; and yield analysis of each nonagency residential MBS and multifamily MBS based on the pricing data from the primary third-party service and management’s cash flow assumptions.

Management should also consider current market conditions in reviewing the fair value pricing of agency, nonagency and multifamily MBSs to ensure that those conditions are properly reflected. This review includes, but is not limited to, comparisons of similar market transactions or alternative third-party pricing services, dealer quotes and pricing model comparisons.

Consistency
The valuation methodology should be consistent from reporting period to reporting period.

Derivative instruments
Management can also obtain fair value prices for derivative instruments from third-party pricing services. The quotations provided by third-party providers are generally based on valuation models with observable inputs, such as interest rate curves and contractual cash flow. Management can obtain valuation information for each derivative financial instrument from the related derivative counterparty; however, the inputs used by the derivative counterparty reflect the inputs of market participants. If other available market data indicate
that the counterparty’s valuation information is not reasonable, management should review other available valuation information, including third-party pricing services and/or dealers.

Management should also review all valuations of derivative financial instruments used to ensure that current market conditions are properly represented. This review includes, but is not limited to, comparisons of similar market transactions or alternative third-party pricing services, dealer quotes and pricing model comparisons. Management should also assess the derivative instruments for credit valuation adjustments due to the risk of nonperformance by the company and derivative counterparties. Although sometimes convenient, management should not accept counterparty-provided fair values as the sole source of recording derivative value.

Valuation memo
As supporting documentation of the process, management should prepare a detailed memorandum documenting its valuation methodology. The memo should consist of both qualitative and quantitative analysis supporting the key inputs, assumptions and fair value conclusions for each type of instrument. In addition, the memo ordinarily covers the various pricing sources used by management, as well as any due diligence procedures performed to assess the pricing sources’ competence and objectivity, because
the accuracy of third-party pricing information is critical for any valuation.

The pricing data from the primary third-party service are inaccurate if they are not materially representative of where a specific security can be traded in the normal course of business in an active market. In this case, management would need to follow steps that could include the review of collateral marks from margin departments of repo counterparties; the utilization of bid lists and review of other third-party pricing service data; trustee reports; and yield analysis of each nonagency residential MBS and multifamily MBS based on the pricing data from the primary third-party service and management’s cash flow assumptions.

Management should also consider current market conditions in reviewing the fair value pricing of agency, nonagency and multifamily MBSs to ensure that those conditions are properly reflected. This review includes, but is not limited to, comparisons of similar market transactions or alternative third-party pricing services, dealer quotes and pricing model comparisons.

Valuation memorandum
The memo should be updated regularly (e.g., quarterly) to reflect any changes in methodology, internal or external factors, and market conditions. Being able to provide such a memorandum to the company’s auditor is often helpful in coordinating the information the auditor will need to plan the audit approach.

Valuation memorandum format
A. Background
     • Description of the portfolio, including key terms
B. Management’s process
     • Detailed description of management’s valuation methodology for each Level 2 category
     • Detailed support and explanations for each Level 2 category
        – Key inputs and assumptions
        – Adjustments and discounts
     • Comparable calculations or transactions
     • Use of third-party pricing services and management’s review process
     • Analysis of any negative evidence or outliers
     • Perform look back procedures analysis
     • Conclusion regarding the appropriateness of fair value
C. Financial statement disclosures
     • Fair value disclosure checklist
     • Supporting schedule for fair value disclosures, including leveling analysis
     • Recent pronouncements affecting fair value disclosure requirements for Level 2 securities
D. Other documentation requirements (as applicable)
     • Management and investment committee valuation credentials and industry expertise
     • Investment committee meeting minutes

Monitor the situation
There continues to be significant discussion among preparers, regulators and auditors about fair value determinations. These best practices have evolved over time. Although not yet required, we strongly recommend that all REITs adopt these as a current baseline, while closely monitoring future regulations and evolving best practices.

Developing and implementing best practices will enhance the quality, transparency, and comparability of fair values being reported and improve financial statement users’ ability to better assess the nature and risks of REIT portfolios.

How Grant Thornton LLP can help
Grant Thornton’s industry-specialized team is made up of highly qualified partners and managers that have dedicated REIT experience. Our professionals provide practical advice to help drive efficiencies, reduce costs, and minimize penalties and fines. For more information, visit our website or contact any of the listed professionals.

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Contacts
David M. Burns
Audit Partner
REIT Sector Leader
T +1 215 656 3048
E david.burns@us.gt.com

Michael C. Patanella
Audit Partner
National Asset Management
Sector Leader
T +1 212 624 5258
E michael.patanella@us.gt.com

John Ferro
National Managing Partner
Valuation Services
T +1 212 542 9574
E john.ferro@us.gt.com

Christopher DeMartini
Audit Managing Director
Financial Services
T +1 212 624 5321
E christopher.demartini@us.gt.com

Rhodora Pantillo
Audit Manager
Financial Services
T +1 212 624 5397
E rhodora.pantillo@us.gt.com