RICS draft guidance note - Risk, liability and insurance, 3rd edition

Risk, Liability and Insurance - 3rd edition

Appendix C: Valuations for commercial lending

This appendix is intended to offer guidance to valuers providing advice in commercial lending situations and other commercial valuation situations (as opposed to residential mortgage valuation and 'consumer' work, which is addressed in Appendix B). RICS recognises there is not a hard and fast distinction between 'commercial' and 'residential', and it may be helpful for valuers to read both appendices. This appendix provides guidance for professionals acting in the UK but may have broader applicability across jurisdictions.

Generally speaking, valuations for loan security purposes constitute the highest risk category of valuations undertaken by Registered Valuers.

Within that category, the liability risk for the valuer increases as:

  • the level of debt increases (particularly when the loan to value ratio increases) and
  • more parties are permitted to rely on the valuation
  • investment instruments such as bonds are issued and secured on the debt, particularly if those instruments are issued in public markets.

Figure 1: Valuers' risk - indicative only

Valuers' risk can also be significantly increased by third parties (i.e. individuals and companies who are not party to a valuer's engagement contract) being permitted to rely on the valuation. This opens up the possibility of the valuer's liability to those third parties for the tort of negligence - see sections 2.4 and 4.

Members should adopt as a default position in their terms of engagement that the valuation is to be relied upon only by the lender client who directly instructs the member firm. Members should understand the risks of broadening the permitted reliance, and only consent when they have understood those risks.

The core concepts and lending structures members would need to understand are described in this section. However, members should appreciate that lender clients will have taken legal advice on these structures, and it is important that members do the same before permitting reliance on a broader level. It is beyond the scope of this guidance note to give members anything more than a general understanding of the risks and basic terminology.

In more sophisticated and higher value loan structures, members' liability caps become increasingly important. The other clause of the engagement contract that is very important is what it says about assignment (see C2).

C1 Bilateral loans

A bilateral loan is the simple situation where one lender lends 100% of a loan amount to one borrower. From a structural perspective, these are the least high risk secured lending valuation engagements for valuers. As there is only intended to be one lender client and the engagement is a relatively simple one, the instruction will in many cases be covered by an umbrella Service Agreement or other standardised documentation. If this is the type of loan that a lender client is making, members should ensure that their engagement contract reflects this, and does not include consent to the use of the valuation in other, more sophisticated, lending transactions.

One specific point that is relevant even in the bilateral loan context, and is equally relevant in all of the more complex situations addressed below, is whether the lender client can use the valuation report for additional lending decisions made after the initial loan, without further reference to the valuer. It would be risky for a lender to try to do this without consulting the valuer further, but members should ensure that wherever possible their engagement letter and report record the lending decision for which the valuation is to be used, for the avoidance of any doubt. See section 2.5.

C2 Assignment of your valuation engagement contract

The engagement between members and their clients for the preparation of a valuation is a contract. See section 2 for the basic principles concerning the contract.

In general, as a matter of English law, the benefit to a client of the contract can be assigned by the client to a 'third party' (i.e. someone who is not already party to the contract), unless the contract expressly prohibits assignment.

When a lender client sells a book of loans, one of the assets it will typically wish to sell with that book of loans is the benefit of the engagement contracts with the relevant valuers. In such a transaction, the assignment of the contract with the valuer would typically be part of the loan sale agreement. In general, if the valuer's contract does not prohibit assignment without the valuer's consent, the client would not have to seek consent to that assignment, or involve the valuer in that process in any way. The valuer should receive notice of the assignment, but in practice, may not even be notified until long after the loan sale, and usually, will not be able to object.

This means that members may effectively end up in a contract with a party they do not know, without knowing it has happened.

However, this will not be possible if members include a clause in their terms of engagement by which they prohibit assignment of their engagement contract without their consent. Typical wording to use for this purpose would be as follows:

'[Client's name/you] may not assign this valuation engagement, or any of its rights or obligations under this valuation engagement, without the prior written consent of [valuation firm/us].'

If members do not prohibit assignment, they should at least give thought to including a mechanism to ensure that any assignees are expressly bound by the original instruction terms (including the liability cap). This should happen as a matter of law, but the safest course is to deal with it expressly in the engagement contract.

Note that the concept of assignment is a different legal concept from 'third party reliance', which is the process whereby a valuer can acquire non-contractual legal liability to a third party who is permitted to rely on the valuation, or to whom the valuer assumes a 'duty of care'. That subject is addressed below.

C3 Syndicated loans

Syndicated loans are loans where there is a group or syndicate of lenders. This structure is usually used for higher value loans than bilateral loans. It may be one of two broad types:

  1. a 'pre-syndicated loan' (also known as 'club deals'), where the syndicate is formed before the loan is made or
  2. a 'post-syndicated loan', where the syndicate is formed after the loan has been made, and the lender 'sells down' or 'novates' a part of the loan to each member of the syndicate.

In the case of a pre-syndicated loan, the valuer will typically enter into an engagement contract with all of the syndicate members (or with the syndicate lead as agent for all of the members). In a post-syndicated loan, the valuer will not necessarily even know about the proposed syndication when the valuation instruction is received. However, the syndicate members will wish to ensure that they are legally entitled to rely on the valuation and typically they will seek confirmation of this directly from the valuer.

Valuations for syndicated loans may be commissioned under bespoke engagement contracts with the valuer, an umbrella Service Agreement, or an existing Service Agreement may be supplemented with clauses specific to the engagement. Whenever members enter into an engagement contract, they should look on it as an opportunity to ensure that their liability cap and fee are proportionate to the risks to the firm.

If providing a valuation for a syndicated loan, members should think about how to make sure all of the lenders are bound in to the terms of their engagement contract (and if some of those other lenders are also clients of the firm, members should ensure that the terms for this contract prevail over the general terms in any Service Agreements with those clients). If liaising only with the lead lender as agent for all the lenders, members should ensure that the lead lender has confirmed that all lenders who wish to rely on the valuation are bound by the member's terms of engagement, including the liability cap. If this is not possible, members should consider a direct agreement with each party confirming those terms, and their report should state clearly that no party may rely on their valuation without their express permission and without being bound by their terms of engagement, including their liability cap.

See section 3 about liability caps.

C4 Valuations for mezzanine financing

Mezzanine finance is used in situations where a higher Loan to Value (LTV) is required by the borrower or, for example, where the value of the project is expected to grow quickly such as development and refurbishment situations. It gets its name because it is the middle layer of debt, falling between the secured 'senior' debt of a conventional lender, and the equity of the project owner. A mezzanine lender will usually have the right to convert the debt to an ownership or equity interest in the project if the loan is not paid back in time and in full. Mezzanine finance is usually 'subordinated' to the lending provided by the senior lender, and secured by a second ranking mortgage.

Mezzanine finance is often provided quickly, with relatively little due diligence on the part of the lender. This, and the fact that it is subordinated to the senior debt, means that it is usually higher risk lending, and therefore relatively expensive finance for a borrower.

For a valuer, it is important to understand that:

  • a mezzanine lender is usually the first lender to be exposed in the event that a project fails or a borrower defaults and
  • a mezzanine lender lends against the security of the highest tranche of equity in the property that forms the security.

These factors mean that the liability risk for a valuer in advising mezzanine lenders about the value of a property is high. Members should ensure that their fee and liability cap reflect this level of risk. A default in the mezzanine debt tranche could increase the risk to the senior tranche for the valuer as there can be a greater potential for distress throughout the debt stack once one tranche is in default.

C5 CMBS (Securitisation)

Securitisation (or commercial mortgage-backed security (CMBS)) is the process in which multiple loans are pooled by the originating lender so that they can be repackaged into interest-bearing securities.

Lenders use securitisation to transfer the credit risk of the assets they originate from their own balance sheets to those of other financial institutions, such as other banks, insurance companies, investment funds, and hedge funds. The interest and principal payments from the assets are passed through to the purchasers of the securities.

CMBS essentially takes two forms, of which the most common is 'conduit CMBS', addressed here. The other is 'agented CMBS', which is similar but is not specifically addressed here.

There is also a practical distinction between CMBS in which the securities are sold on a restricted, private basis, and those where the securities are sold publicly, in the capital markets.

Typically, a bank will make a number of loans over a period of time, then sell those loans to a 'Special Purpose Vehicle' (SPV) issuing entity. The SPV will raise money to buy the loans by issuing tradable, interest-bearing securities (usually bonds) that are sold to investors. The security issue is supported by the security for the original loans (i.e. the mortgages given by the borrowers). The transfer of the loans typically takes place by way of 'novation' from the original lender to the issuing SPV. The SPV then becomes the lender under the loan agreement.

As the SPV has no employees and no real existence other than acting as a flow-through vehicle, it has to delegate all of its functions to third party service providers. It therefore typically appoints a servicer to manage the loan on its behalf (although sometimes the original lender will also retain the servicing role). The investors receive fixed or floating rate payments from a trustee account funded by the cashflows generated by the underlying loans.

The property valuation will typically be referred to in the 'offering circular' for the CMBS, which is the document sent to prospective buyers of the bonds to advertise the investment. The arranging bank may also seek to make the valuation available on a data website for investors.

In English law, a valuation cannot be referred to in an offering circular without the permission of the valuer. This means that the initiating lender will need to obtain the valuer's permission before carrying out the CMBS transaction. That may present the valuer with an opportunity to ensure that the firm's fee - and, where appropriate, the liability cap - are commensurate with the risk to the firm.

The risks for valuers in a public CMBS are greater than they are in a private CMBS. This is essentially for two reasons:

  1. In a private offering, the valuer will have a better awareness of which investors are involved, and will probably have an opportunity of agreeing contractual terms with all of them (including, where it can be negotiated, a liability cap).
  2. In a public offering context, the valuer will not have knowledge of who the investors may be, will not be able to agree contractual terms with all of them, and there may be regulatory restrictions on the terms that can be included in the engagement (including as to liability cap).

Please see the guidance in C6 concerning liability caps in the context of public offerings generally, that apply equally in the specific context of CMBS transactions.

Unless members have competent in-house expertise and capability, members should not provide valuations for CMBS transactions without taking specialist legal advice.

C6 Crowdfunding and peer to peer lending

As of the date of publication of this guidance note, the use of valuations in crowdfunding and peer to peer lending is undeveloped. However, the preliminary view of RICS is that the risks can be similar to the risks entailed in public offerings, because the valuer may not know who the investors are who wish to rely upon the valuation, and is unlikely to be able to agree contractual terms with each of them. The arranger of the crowdfunding or peer to peer lending may be content for the valuation report to be provided to potential investors for their information only, on a 'non-reliance' basis, which will reduce the risk for the valuer.

If so, members should ensure that both their engagement letters and valuation reports make this basis clear, and should ask the arranger also to include a note on any website to which the valuation report is uploaded, expressly recording this basis for the valuation. Until the principles affecting the use of valuations in these situations become clear, members should take specialist legal advice if asked to provide a valuation for use in crowdfunding or peer to peer lending.

C7 Restricting third party reliance

Section 2.1 explains that a claim for breach of contract can only be brought by a party to the contract, i.e. the client, but that a valuer can be sued in negligence by those who are not party to the valuation contract (i.e. third parties) to whom the valuer expressly accepts a 'duty of care', or those to whom the court says the valuer has assumed a 'duty of care'. That will usually include any third parties who the valuer has permitted to rely on the valuation.

Valuers therefore need to ensure there is appropriate language in both the instructions they accept and also their reports that suitably restricts the ability of third parties to rely on the report and valuation. In practical terms, the reader of the report should be put on notice by its terms or by the correspondence under which it is distributed as to who may rely on the report and who may not.

In general terms, the addressees of the report (sometime called the beneficiaries) will be able to rely on the report. Members' engagement letters and reports should state that any party entitled to rely on the report will be deemed to accept the whole terms of the instruction including the cap on liability.

As mentioned above, valuers should also prohibit assignment of their engagement contracts to third parties, unless they understand the risks of permitting assignment, and decide it is appropriate to take those risks in the context of any particular engagement.

If consenting to a report being seen by a third party, it is important to specify in the engagement letter and in the report itself whether the third party is also permitted to rely on it, or it is provided for information only on a 'non-reliance' basis. A reliance letter or a non-reliance letter is a useful tool in this respect.

Parties who often ask to be permitted to rely on loan security valuations include:

arranger

  • agent for lenders or investors (if dealing with agents for lenders, including a lead lender acting as agent, a member should seek confirmation that they are authorised on behalf of other lenders)
  • lenders under the original loan documentation (other finance parties).

Parties who it may be appropriate to exclude from reliance on loan security valuations include:

  • lenders for other loans on the property (e.g. mezzanine lenders when valuing for the senior lender) and
  • bond holders (where the bonds are a private issuance - see C5)
  • other potential lenders, if the original lender decides to syndicate the loan
  • receiver
  • borrower or sponsor
  • loan servicer
  • transferees, successors or assignees of the loan
  • lenders' other advisers
  • hedging and swap counterparties
  • trustees.

C8 Invoicing parties other than the client

Care needs to be taken if the commercial valuer is asked to invoice a party who is not the client. The following issues could arise:

By issuing an invoice to a non-client, members could inadvertently permit the party to whom the invoice has been issued to rely on the valuation. Therefore, members should issue a clear statement alongside the invoice to the effect that by invoicing the requested party, they are not permitting reliance on the valuation.

Without a direct contract or fee agreement, it may not be possible to pursue the invoiced party for non-payment. Members should consider raising this risk with the client.

Members should ensure that they are not inadvertently becoming involved in VAT or other tax evasion, and if unsure of the position, take specialist tax advice.

RICS recognises that lenders sometimes ask their borrower customers to pay the costs of valuations provided to the lender. The safest way for a valuer to deal with this in order to avoid the risks described above is to issue the invoice to the lender client and ask the lender client to reclaim the cost from the borrower.

C9 Vacant possession valuations

It is common for clients, especially lenders, to instruct valuers to provide a vacant possession value (VPV) for investment properties. This should be instructed as a special assumption valuation, see Red Book Global Standards VPS 1, paragraph 3.1 (i), VPS 3(i) VPS4 (3) for guidance.

As there is no specific definition or guidance on the basis of VPVs in Red Book Global Standards, there is therefore a heightened risk of misunderstanding. For investment properties, it is recommended that the valuer is either instructed on the following points by the client, or that the valuer clearly states their approach, for example:

Assumed physical state:

  • Has vacant possession been achieved by a managed exit or by way of a default?
  • Is it assumed that the property is in the same state as it currently exists or that the occupier has complied with their repairing and reinstatement obligations?
  • Is any dilapidations money assumed available that can be applied to any refurbishment or repair costs?

Property use:

  • Is the VPV considered only for the current use or are alternative uses to be reflected included redevelopment?
  • What assumptions and investigations are to be made into planning?

Market context:

  • Is it assumed that the present occupier is/is not 'in the market' in the event of the hypothetical vacancy, either to buy or lease the property?
  • The list above is not exhaustive and may vary depending on the circumstances.

C10 Reinstatement cost

It is common for clients, especially lenders, to instruct valuers to provide a reinstatement cost (RC). It is important to understand if this will be used as the basis for insuring the property or as a guide that the current/proposed insurance is broadly appropriate.

If the client wishes to be entitled to place reliance upon the RC for making commercial decisions, it should be undertaken by an appropriate and experienced qualified person, such as a building surveyor. More commonly, lenders only require RC for guidance and formal reliance is not required. In these circumstances, and subject to appropriate guidance, the RC can be undertaken by valuers. In this case the following must be made clear in the letter of engagement and the report:

  • Assumptions on planning and building regulations, particularly for older buildings.
  • The RC has been undertaken by a valuer and is provided in the context of a valuation instruction.
  • The RC is provided as a guide only and without liability, and any decisions taken on the basis of it are entirely at the user's risk.
  • A clear statement of what has been reflected in the RC, which may include: demolition costs; fees (including project management); external works (e.g. car parking and landscaping). The treatment VAT, which is generally not included, should be clear.
  • If the property is in a conservation area, is a listed building or an unusual construction, the valuer may wish to either decline to provide a RC, or state that there is a risk of much higher variation on the cost.

Note: If the valuer is adjusting floor areas to a different basis for the reinstatement cost calculation, e.g. from NIA to GIA or from IPMS 3 to IPMS 2, the adjustment factors should be stated.

C11 Summary: key questions

When agreeing a commercial lending valuation instruction, address the following questions:

  • Consider the basis of the liability cap. For example, a cap for each party or claim, or a total cap for the entire instruction. Please see section 3 concerning liability caps generally.
  • Is it necessary/appropriate to deal expressly with reliance by specific third parties such as receivers, rating agencies, and other advisers?
  • In defining the purpose, members should try to be as specific as possible about the lending transaction for which they are permitting the valuation to be used. Members should consider making it clear - preferably in both the engagement letter and the valuation report - that the valuation may not be relied upon for different, or subsequent, lending decisions.
  • Should the engagement contract with the client include a clause preventing the client from assigning the benefit of the contract to third parties?
  • Who can rely on the valuation, and for what purpose? For example, senior debt provider or mezzanine lender, etc.
  • Is the purpose of the report clear and specific? For example, in connection with new lending, loan monitoring, default, CMBS, etc.?
  • Are both the engagement letter and the valuation report clear about who the report is to be addressed to, and whether third party reliance is permitted?
  • What liability cap is agreed?
  • Particular care should be taken where accepting instructions from a mortgage broker, i.e. where the valuer may be at 'arm's length' from the lender client, in order to ensure that the issues raised in this guidance note are properly considered.