Ins and outs of audits: Documenting valuations to stand up against market pressures

What auditors are looking for

Audits are a fairly routine process, but that doesn’t necessarily mean they’re easy. Audits take time, energy and resources, and strong valuations conducted by an independent third party can go a long way to ensuring the process goes smoothly. We recently sat down to discuss the audit process with Travis Wilson, Director in Valuation Advisory and Robert Santilli, Director, National Accounts in Valuation Advisory – both from Altus Group and both with extensive experience connecting with auditors in Canada and the United States. Travis and Rob spoke with a handful of auditors for this article, specifically about the audit process from their perspective.

What exactly are auditors looking for? What we at Altus hear most often from auditors is the importance of strong documentation. The ability of the audited firm to have quarter-over-quarter consistency of process, and to present valuation assumptions backed by hard facts. If a property, for example, is appraised at a cap rate of 5%, that needs to be tested to show it’s a realistic rate. There are no judgment calls based on professional opinion. Every assumption needs to be supported.

Detailed processes and documentation are even more critical in an environment of shifting market values and low transactions, as auditors need to delve even deeper to ensure transparency and to manage risk. These days, auditors are selecting a bigger sample of properties to review based on materiality to total holdings. They’re checking the methodology to make sure it is appropriate, as well as checking assumptions on a variety of key metrics, such as cap rates, discount rates and market rents, as well as collection loss, renewal probability and management fees, among other financials.

The auditor perspective on internal vs. external valuations

Regardless of whether an appraisal is done internally or externally, auditors need to be able to say with confidence that the appraised real estate value represents a reasonable market value. It isn’t out of line to say that auditors often spend more time reviewing valuations than the appraisers take to do them.

One of the primary reasons companies do their own internal appraisals is to save on costs. However, arriving at accurate valuations and organizing the paperwork for an audit can require a significant shift of internal resources away from core business functions. In addition to doing the valuations, many specialized firms can assist with other audit requirements that would otherwise create a burden internally.

Internal valuations also usually means more work for auditors. Every real estate firm typically makes their own unique assumptions and calculations. As a result, auditors must adjust to their systems, their exam worksheets and test to make sure the formulas in their Excel spreadsheets are working properly. By contrast, third-party appraisals must adhere to industry and ethical standards and typically leverage an unbiased process consistent in methodology and documentation.

In some cases, companies think they will save cost by doing appraisals internally, but they often end up spending more time with auditors working through challenges to valuations that might be influenced by potential bias.

Investors want transparency

Valuations in some property sectors and markets have changed dramatically over the past year, which has increased pressure to provide more timely and accurate valuation data for both auditors and investors. Commercial real estate values overall are down an average of 17.3% from the peak with office taking the biggest hit with a 30% decline. Given that backdrop, investors are understandably hesitant to put their money into a fund where up-to-date valuation data isn’t available.

“Investors are requiring more and more transparency, especially in a volatile market where fewer sales are occurring,” says Travis Wilson. Many funds are finding that increased frequency of valuations is critical to communicating with existing investors, as well as attracting new capital inflows in a market where fundraising has slowed. “Transparency helps in a volatile market because investors want to see that they’re not getting a mark-to-market once a year with valuations that might drop 30%,” says Wilson. “No one likes to get that big surprise that things have moved down quite that much.”

Pressure to increase the frequency of reporting only puts more pressure and workload on firms – another compelling reason to engage a third-party firm to manage the process.

“Our clients are competing for investment dollars, so if they can differentiate their fund by saying you're going to get this quarterly reporting that is external and has a robust valuation practice, those are all competitive advantages,” says Robert Santilli, Director, National Accounts in Valuation Advisory at Altus Group. “And if their competitors are doing it, they don’t want to be the fund that is not offering that type of governance, transparency and best practice.”

Determining valuations in the absence of comparable sales data

A common challenge for real estate owners, fund managers, auditors and valuation specialists is providing accurate valuations without comparable sales data. “We’re all in the same boat. Auditors don’t have access to an overwhelming number of transactions, nor do appraisers or the clients themselves,” says Wilson. The advantage of working with a valuation specialist is that it provides access to a larger network of resources that they can rely on for data and market insights – even when transaction activity is thin.

In addition to the market data that can be generated, appraisers may utilize other resources, such as a combination of surveys and discussions with market participants. It’s much simpler to determine valuations on an apartment property, for example, when you have 10 apartment sales in a market that are all trading at much the same price per unit. The absence of those trades makes it much more difficult to determine values. Brokers have a good sense of price discovery, and what might be too high or too low in the current market. “I think there's been a shift to more reliance on broker opinions of value and broker insight, because they are having conversations on one side of the table or the other, and they've seen all the deals including those that have failed,” says Wilson.

In the end it’s all about managing risk and investor expectations. The audit process can potentially be cumbersome, but with the right resources and expertise in place it can be done efficiently and to the benefit of investors.

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