How can you value collateral in Risk Management?

Collateral valuation often involves subjective judgments and relies on the expertise and experience of appraisers or valuation professionals. Different appraisers may have varying opinions, leading to inconsistencies in valuations. This subjectivity can introduce challenges in accurately assessing the true value of collateral assets. Risk management professionals should implement robust processes and controls for collateral valuation. This includes ensuring transparent and consistent valuation methodologies, leveraging multiple data sources for valuation assessments, regularly monitoring collateral values, and conducting independent reviews or audits of the valuation process.

Never underestimate the importance of liquidity. In many situations, the asset in question can go "no bid" in a heartbeat. In that situation, risk managers should expect a sizeable haircut to "fair value."

Valuing collateral in risk management is like putting a price tag on things used as security. We check how much these things can be sold for and how quickly. If it’s easy to sell, it’s better. We also see how the prices of these things go up and down. To decide the value, we use expert guesses, real-time market info, and models that predict changes. But we need to be careful because markets can be tricky. So, we play it safe to make sure we don’t overestimate. Checking regularly helps us keep up with any changes, making sure these security things stay reliable against possible problems.

The collateral valuation should combine local market knowledge and practices with the international or local standards; the lender should understand what weight they can allocate to a certain asset in the view of the loan, especially if the lender has stakeholders from outside the subject country. Standards will help communication in a single language while local expertise will ensure optimal estimates.

When looking at collateral valuation in emerging markets, you will find high levels of interest rates, inflation and accordingly lending rates, this situation will boast what so called the “Replacement cost” of an asset which considered one of the most common valuation methods. Simply, saying what would be the cost of a brand new asset which will replace the old one. For sure it has a more technical side, specs and other technical things, while the most important thing is how you would finance this asset, how you will source US dollars to replace the old with new one. All these add up to the replacement cost giving a boast to the valuation for sure.

Collateral can be tangible or intangible. It can be specifically related to the loan itself (such as the residence purchased with the proceeds of a mortgage) or completely unrelated. It's important to ensure your rights to the collateral are not subordinate to the rights of another party (another lender, for instance). This requires proper due diligence (potentially a UCC check and filing). The value of collateral is impacted by the liquidity of the market for the assets/collateral (a US Treasury bond for instance is much more liquid than a piece of fine art) and the enforceability of your rights to that collateral. Enforceability can be affected by many factors, but most notably how one's rights are legally documented.

For sure, the economic conditions are influencing the property value (see the office and commercial property occupancy rates during Covid versus industrial properties). Other major factor is the management quality, because a good management team can find ways to maximise the asset value (cash flows generated). The third factor is the asset quality (old one versus refurbished one versus new ones), which will influence the demand, respectively asset value. Of course, there are other factors, but from my perspective, those are the most important.

While what is defined as valuation method above refers actually to bases of value, more thoroughly defined in the standards, the most important basis of value is the Market Value - this would be of utmost importance from a risk perspective. From the Market Value, one can derive several other premises of value (liquidation value, long term value, etc), but market reference should be the basis in assessing all the other risk implications to the portfolio. In terms of valuation methods, it is really down to the property, context, market development; however, once Market Value is targeted, a market driven method should be considered - direct comparison, DCF, direct cap, profits, etc - assuming the asset in question has a market.

Collateral valuation is a tricky process. Every state has different rules when it comes to land valuation. One more thing to remember that circle rates vary from one zone to another.Also collateral is a game of demand and supply. There is no full proof strategy to get this right. It is a normal practice by lenders to appoint at least two valuation agencies for a location to make informed decision.