Valuation and Valuers

IRS Symposium Proceedings Summary

Mon, 13 Jun 2011 19:14:00 GMT

For the third year, the Los Angeles Chapter of the American Society of Appraisers presented its National IRS Symposium in Los Angeles. This is a program designed by IRS and supported as part of their outreach program.

Such programs are offered in tandem with the onset of §6695A appraiser penalties, signaling that IRS is intent on reducing audits and improving compliance results from two directions: increased awareness and rather intense enforcement provisions – perhaps a classic carrot and stick approach. The underlying message for appraisers as well as lawyers using appraisals is that we want your work to be acceptable, and will tell you what we need, and the extreme and unsupported valuations will stop.

This year's program also featured Judge James S. Halpern of the USTC, and several valuer panelists who were included to provide additional insight into valuation issues.

Please note that the views and opinions expressed are those of the presenters and do not necessarily reflect the views and opinions of the IRS.

Brenda Woolbert, Team Manager Engineers and Appraisers, opened with a few comments on IRS cooperation with LA-ASA since 2005 and directed the audience to the appraisal links at irs.gov which describe appraisal expectations. She emphasized the idea of "talk first, write reports second" when working with taxpayers' valuation issues. These practices are consistent with LB&I Core Emphasis areas of identifying our highest compliance risk work, working cases more efficiently and effectively and resolving casework as soon in the process as possible.

Rob Schlegel, ASA International President, stressed the importance of chapters and these sorts of events, engaging the ASA and IRS.

I provided a short overview of the day, and of the underlying situation with IRS. It was definitely the elephant in the room; namely, that IRS has had ongoing problems with valuations, they have been accumulating tools to go after tax dodges since 1982. The fact that problems have not gone away is emphasized by their asking for and getting new powers to deal with appraisers from Congress, now codified at §6695A. How bad does it have to get? If we keep doing what we're doing, we will continue to get the same result we've been getting…nothing will change…and clearly something needs to change.

According to Albert Einstein, "The significant problems we face… cannot be solved … at the same level of thinking we were at when we created them." I think it's fair to say that, if we stay at the same level, audits will continue, appraisers will be sanctioned, and IRS will prevail.

Personally, I would hate to see what the sequel to the Pension Protection Act might look like. I care about the valuation profession and what it has to offer to the public, but I would be surprised if Congress wants to hear about this any further. And my worry is that parts of the profession will be crushed out of existence if this continues. It is time for us to change our thinking.

I've practiced discount valuation for 15 years, and during that time I have had very successful dealings with the IRS, as have many of my colleagues. I have written and taught quite a lot on the subject. And time and time again, I've observed that tax benefits don't have to be sacrificed for the system to work.

The sort of thinking got us here might be related to some kind of taxpayer v IRS opposition, or egregious claims for undeserved benefits, or simply issuing tax-dodge valuations. From the point of view of the ASA, I would like to think not, but maybe we are tempted to think in these ways. There are certainly a few bad actors, but this is too big to be their fault alone.

What if we changed our thinking – what would it look like? It might look like understanding what IRS valuers want to see. It might look like regarding IRS and the Court as appraisal users and more due diligence on the part of appraisers. It might even look like lawyers stepping in when they read the appraisal and it doesn't make any sense. Changing our thinking would certainly require a cooperative approach across the board.     And clearly, it would not occur at the level that created the problem.

Valuation in the United States Tax Court

Judge James S. Halpern, U.S. Tax Court, opened the Symposium with comments on Ludwick. Was his a taxpayer-unfriendly decision? In the Judge's view, no, because he must be persuaded in each case. In looking over his time on the bench for this talk, he noted that he has heard expert testimony in 32 cases over the past 21 years.

Concerning expert witness, he referenced the Tax Court Rules of Procedure (not the federal rules of civil procedure), rule 143(g), which provides for written reports including qualifications, and states briefly other requirements for evidence (the Rules are available on the USTC website).

He used his decision in Peracchio to address a number of issues with expert opinions as well as very interesting statistical inferences (below). In particular: The Supreme Court has said the Court is not bound by expert opinions; it may accept or reject testimony based on whether it is sound. The Court may also select portions of expert testimony from either or both sides; We can pick and choose (see also Trout Ranch).

In Peracchio, Judge Halpern objected to the minority discount analysis due to the method being imprecise; not supported by statistical analysis. He thought the appraiser should have looked at the different components (types of assets). The Government used 2% as an estimate without explanation, but the petitioner did not meet burden of proof. He noted that the judge is not an investigating magistrate; thus, in this case the side with the burden of proof loses.

When asked about whether the Court established a "benchmark" discount of 35% in Mandelbaum, Judge Halpern stated that he believes the Mandelbaum argument did not set a legal standard, as the example does not resemble a family partnership. (A "Mandelbaum Approach" is used by some appraisers in applying the process that Judge Laro applied in Mandelbaum [essentially Revenue Ruling 59-60] to determine discounts for lack of marketability. It involved minority shares of Big M, a C Corporation.)

Q. Do you believe your opinion in Ludwick stands for the proposition that cost of partition analysis is the only proper method for valuing undivided interests in real property? A. The cost of partition analysis is what's left when experts fail to support anything else.

Q. In a case with a valid partition waiver executed, would that be respected, and change the proper valuation method away from the cost of partition analysis? A. Would need to hear arguments. The judge said he is not an expert in valuation, he merely decides on what is in front of him. He gives no advisory opinions.

Q. Have you even thrown out an opinion based on obvious bias? A. No he has not.

Current Status of the Estate and Gift Tax Statute

The current state of the Estate and Gift tax statute was discussed by Chuck Morris, JD, former IRS Western States E&G Territory Manager, who is now in private practice in Irvine, California. This was mostly an overview of methods used to leverage the current $5million exemption, including defective trusts, transferring assets to annuities and the like. He did not see the estate tax being abolished, and noted that the current administration wants to go back to a 45% rate and permanent portability.

His presentation included commentary on several cases: Noble which involved post-death facts and the notion of strategic buyers, and Mitchell, concerning business purpose of late-in-life transfers (§2036) and (amazingly) stipulated discounts.

Chuck is involved in quite a few examinations (on behalf of the taxpayer). He discussed Judge Halpern's decision in Ludwick and that IRS examiners are indeed throwing the concluded 17% at him. For a detailed analysis of Ludwick and one way to respond to such challenges, see Case Study 1.   Chuck also noted that valuation issues still account for the majority of the work in Estate and Gift.

For guidance in preparing expert reports, especially Federal Rules of Evidence §703, Chuck made reference to Noble, where having only one of three appraisers preparing a report was reason for exclusion, and where facts never made it into evidence. The case also includes a detailed treatment of the implications of sales of other shares in the company for fair market value of the shares being valued.

Recent Court Decisions – Valuation

A panel on recent court decisions featured Miles Friedman, SBSE Associate Area Counsel, Guy Glaser, JD, Area Counsel LB&I, and The Honorable James S. Halpern, Judge U.S. Tax Court, and Mel H. Abraham, CPA, ASA. Please note that the views and opinions expressed are those of the presenters and do not necessarily reflect the views and opinions of the IRS.

Miles Friedman introduced the panel's discussion of the Boltar case, which is citeable and rumbles the ground regarding rules of evidence and expert reports. Some valuations can't even get out the gate.   Taxpayer expert report had significant [actually, mind-boggling] errors that affected reliability (relevant and reliable). The Court applied Daubert and established the court's role as gatekeeper to keep out "junk science," i.e., any expert testimony that is not relevant and reliable. Thus, petitioner's report did not even get considered.

Miles questioning Mel Abraham: What if appraiser writes report and other side files a motion in limine to exclude report? Mel answered that the motion would be rebutted simply because reliability is part of our Standards. We as appraisers create the relevancy. Get it in and let it be determined at trial. However, there is a difference between reliable vs. Errors. Miles then asked Judge Halpern: Who bears the risk of failure if the report is excluded? The Judge answered: The taxpayer attorney. With a 30-day limit, the party will not have enough time for a new report and there will be no grounds for continuance. The attorney needs to review report to have confidence that it will not be subject to a motion in limine.

Miles' advice to appraisers: Make sure you know what counsel wants you to do. It should be in the contract. Get all the facts; you need to talk, decide if you need formal discovery to get all the facts and information you need. We will see more motions in limine, and should expect the quality of reports to increase as a result. Guy Glaser added that when he gets a report, the first thing he does is review it to see if it can be excluded via a motion in limine for not complying with the principlesset forth in Daubert.

Audience question: How much weight is put on credentials alone? Judge Halpern answered that experience alone can qualify an expert without formal training or credentials. He commented that USPAP compliance is not a condition precedent to acceptance of an appraisal report; appeals have affirmed that USPAP isn't a precondition to acceptance, but its adherence does go to the weight given to the appraiser's opinion.

Audience question: What about "more likely than not" standard of proof? Judge Halpern described the burden of proof as a particular "measure of persuasion." In fraud cases in tax court, the measure of persuasion is "clear and convincing evidence." If fraud is not an issue, the measure is a "preponderance of evidence," which is the case if there is a scintilla over 50% likelihood, depending on constituent facts; is it an ultimate fact (i.e., value of property), or a subsidiary fact (i.e., cost to dispose, commissions, etc.)? And is one party's evidence more likely to be true (more persuasive)?

When asked about the Court's role in establishing evidence, Judge Halpern likened his job to "holding coats" (while the parties duke it out). It is the obligation of counsel to bring evidence and object to evidence. It the case of reports, they are either excluded or are in evidence.

Guy Glaser began a new discussion of U.S. vs. Richey [9th Circuit 1/2011]. Please note that the views and opinions expressed are those of the presenters and do not necessarily reflect the views and opinions of the IRS. In Richey, the district court quashed a summons issued by the IRS to an appraiser seeking his workfiles in connection with an appraisalhe had prepared at the request of an attorney and whichwas attached to afiled return to substantiatea donation of a conservation easement. The district court concluded theappraiser's work file was protected by both the attorney-client privilege as well asthe work product doctrine. The IRS filed an appeal to the Ninth Circuit, where the court held that attorney client privilege did not apply to an appraiser's work files, since an appraisal is valuation advice and not legal advice. His observation is that an appraiser's work filesmay be summoned by the IRS and are not protected by the attorney-client privilegeif the appraiser's report isattached to a filed return even if the report wasprepared at the request of an attorney. The work product argument was also reversed since the report was not strictly in preparation for litigation. (Since the report was attached to a tax return, a dual purpose existed.)

According to Miles Friedman, if the appraisal had to be attached to a tax return, it was out there for a third party, and privilege would not exist.

Built-in capital gains was addressed in context of Davis. The case says that the taxpayer should not get a dollar-for-dollar reduction, but issues of value (and gain) growth over time, the realization event and discounting back to present value remain unclear. This remains a heavily technical, fact-dependent situation with inconclusive case guidance.

Tax-affecting S-Corporations was addressed, but again it's a heavily technical issue, this time with extensive works by prominent valuers to contend with (as Chris Treharne addressed in a later panel). Miles Friedman didn't have a big problem with the subject, though: "I can answer this in a second. The cases say no, the IRS says no."

Appeals

Issues with appeals and tips for successful ones were provided by John Schooler, JD, Appeals Team Manager. Please note that the views and opinions expressed are those of the presenters and do not necessarily reflect the views and opinions of the IRS. Most importantly, he noted that appraisers should make sure report/case is fully factually developed before going to appeal. Act with judicial attitude. Appeals officers are not developing and investigating cases, only dealing with what is brought before them (which is impossible anyway, since each officer has about 48 cases at any given time).   Most important to John is a failure to identify appraiser credentials, and common-sense aspects of the appraisal report, such as relevancy of comparables.

Appeals has been emphasizing Fast Track Mediation rather than going to trial since 2002 for non-docketed cases. Fast Track Settlement should also be considered. Appeals Settlement Guidelines ("ASG") for Family Limited Partnerships ("FLP") should be issued soon.

Professional Responsibility – Pension Protection Act

The latest action in the Service's enforcement of appraiser penalties were discussed by Peter S. Crane, AVA, IRS Senior Appraiser. Please note that the views and opinions expressed are those of the presenters and do not necessarily reflect the views and opinions of the IRS. Peter provided a brief history of appraiser penalties; in general, appraisers have been subject to penalties since 1982 under §6700 and §6701. With the Pension Protection Act of 2006, there is now §6695A, which provides penalties for returns or submissions filed after 8/17/2006 (facade easement donation returnsfiled after 7/25/2006). Penaltiescan be applied toanyone who prepared an appraisal of the value of property and who knew, or reasonably should have known, the appraisal would be used in connection with a return or claim for refundand the claimed value of the propertyresults in a substantial or gross valuation misstatement.

For substantial and gross misstatements of value in income tax and estate/gift tax reporting,the threshold is 150%/200% more than the amount to be determined to be correct. For gift and estate tax returns the threshold is 65%/40% less than the amount determined to be correct. In the event that a 6695A penalty is asserted, the appraiser has post-assessment pre-payment rights of appeal.

He noted that applicability of the penalty is not solely mechanical, though. The threshold just alerts IRS to a problem, and that they are looking for egregious behavior. "Are there significant errors, omissions, departures from professional standards, or presenting incorrect information?" They would want to know circumstances (qualitative factors) to take into account before opening penalty case. He stressed early resolution, and commented that "if you just do your due diligence it won't happen to you."

He then discussed professional standards and certifying organizations, with an emphasis on ethics rules and non-advocacy. "Be an advocate for your value, not for your client." In response to a question from the audience, why doesn't IRS adopt USPAP?, Brenda Woolbert answered that IRS has never adopted any particular standards but that its own valuation staff must comply with the valuation standards found in the Internal Revenue Manual. Peter indicated that as a state licensed appraiser and an associate member of the AI, he follows USPAP. He also emphasized that he has experience no internal effort to influence his opinion, and said he was genuinely pleased with the freedom he was given to form his own opinion of value.

In answer to another question, is the taxpayer alerted to a §6695A penalty? Brenda Woolbert answered that a section 6695A penalty will only be discussed with the appraiser, never with the taxpayer.There is a question of due process to protect appraisers. The appraiser will be contacted prior to a 6695A case being opened, but only after the examination case is closed. The appraiser will be invited to a meetingtodiscuss the report and demonstrate thatthe opinion of value is more likely than not correct. If the appraiser can convince the IRS Valuation Specialist that the appraiser's value could be more likely than not correct, then the penalty will not be pursued. The appraiser should bring their entire work file, engagement letter, and limiting conditions on the engagement to the meeting for review.Penalties being considered against an appraiser are not discussed with the taxpayer. The examination of the appraiser is separate from examination of the taxpayer.

Peter's take was that, in his opinion "If you follow your professional standards, do you due diligence, follow the commonly accepted methods of your peers, you will never have to worry about penalties." Issue guidance on §6695A penalties is currently being developed. When this guidance is completed, it will be shared with the public.

Concurrent Session 3 – Business Valuation

The business valuation breakout featured a panel including Neil Mills-Mazer, AVA, JD, IRS Engineer Team Manager, Judge Halpern, and appraiser-panelists Dennis Webb, ASA, MAI, FRICS, and Chris Treharne, ASA, MCBA, BVAL. The panel was moderated by Steve Grubic, ASA.

Fractional Interest Valuation

Neil Mazer's presentation began with an overview of methods he has seen for valuing fractional interests in real property, and some of the more significant problems. Please note that the views and opinions expressed are those of the presenters and do not necessarily reflect the views and opinions of the IRS. For actual transactions of fractional interests, issues are that the appraiser uses comparisons with wildly different types of property, the data is very old, comparable transactions are too complex, facts are incomplete, and parties are related. Partnership transaction data is a problem because the interests don't carry the same rights as tenant in common; management is not shared, and there is no right to partition. Cost to partition has issues with growth rate assumptions, years to partition, underestimated cash flows during the partition period, and the discount rate used to bring the cash flows and eventual sale proceeds back to present value. However, the partition method is a favorite, because "it represents the reality of what the present interest holder would receive."

His presentation then continued with one of his pet peeves, the idea of a minority premium. What happens when a very large interest holder, say 99%, could acquire a 100% interest (thereby eliminating control and marketability impairments) by simply buying out the smaller interest holder. An example was given showing that claiming even a 5% discount for the 99% interest would be the same thing as the 99% holder buying out the 1% holder for a 495% premium over its pro rata share of the whole. Of course, that is extreme, but taking a more typical percentage and discount, say 90/10 and a 20% discount, the amount of the discount would imply 180% premium for the 10% holder. Neil would consider the 20% discount unrealistic on this basis; this method would cap the discount between 5% to 10%, which would produce a premium between 45% and 90% for a 100% buyout for the 10% holder. Extending this logic further, if the relationship were 50/50, then the maximum discount to consider would be 30%.

Of course, there were multiple audience objections: Why is there empirical market data that suggests fractional interests trade at discounts of 30% and higher? Aren't the facts and circumstances of many such holdings much more complicated than the IRS model suggests?

When Judge Halpern was asked for his thoughts on the model, he recommended reading his decision in Holman (in which partnership buyout provisions placed an effective cap on marketability discounts). He asked whether a 99% holder would ever be willing to sell at a large (say 30%) discount? Not if he can buy out the 1% owner at what would amount to a 1%-2% discount.

The idea of such a premium, and an implied cap on the discount, is an interesting one, but there was not nearly enough time to explore the subject fully. We look forward to more dialogue from IRS on this one.

A Statistical Wake-Up

Judge Halpern made a presentation based on Peracchio that should alert appraisers (and counsel) to the implications of common but unsupported references to the use of means and medians when applying data to (in this case) a partnership that holds securities. The Judge takes representations of statistical inferences seriously (to the point that he has audited a number of classes in higher mathematics), and commissioned his presentation from Theodore S. Sims, Professor of Law at Boston University School of Law.

The presentation involved the closed-end investment fund data that was submitted to the Court in Peracchio. The appraisers had selected between median and mean discount indications in their analysis of the partnership. He was not happy with their inability to explain why they selected one or another, and with their lack of understanding of statistical measures. He asked "how can we characterize the data, and what can we infer from it?" He demonstrated how the appraisers might have used such measures as "confidence interval" to communicate a meaningful understanding of the data and their use of it in their analysis. The takeaway for appraisers (and for lawyers reading appraisal documents) is that use of statistical terms and analysis in valuation had better be accompanied by an understanding of what the data mean, and why the appraiser is relying on it. Casual use of means and medians in Judge Halpern's courtroom can be a hazardous activity for an expert.

Question: How much description of statistical method is necessary to insert in report if using statistical analysis? Judge Halpern's answer: Talk to counsel, ask who is the judge, and what does he or she think is important. The lawyer should be studying the judge's cases. Prepare your report for the judge. Talk to the other attorneys involved in the cases, look at other expert witness reports, and look at trial transcripts (if it's a big enough case).

One of the Symposium attendees was Jay Abrams, who commented on the presentation. Mr. Abrams is the author of a comprehensive book on statistical methods for business valuation, titled "Quantitative Business Valuation" (2nd Edition).

Close

So we know that IRS has ongoing problems with valuations, and we also know IRS is the intended user of all the stuff we (appraisers and practitioners) generate. Therefore, knowing how the IRS system works is vital. What if the appraisals sent to IRS all made sense? What if attorneys and accountants were able to count on values being accepted as their clients are led to expect? What if, when it comes to it, the Court gets to work with nice clear, persuasive evidence from both sides?

The Symposium offered a chance to become more aware of what IRS is looking for. They were there to tell us. They didn't have to be there, but they were.   This is a very good sign…

It will take many steps to move to a different level of thinking than the one that created the problem. IRS included.

The Elephant in the Room

Thu, 26 May 2011 14:35:00 GMT

For the third year, the Los Angeles Chapter of the American Society of Appraisers presented its National IRS Symposium in Los Angeles. This is a program designed by IRS and supported as part of their outreach program. Its focus is valuation issues that are of interest to appraisers, lawyers, estate planners and the U.S. Tax Court.

I provided a short overview of the day, and of the underlying situation with IRS. It was definitely the elephant in the room; namely, that IRS has had ongoing problems with valuations, they have been accumulating tools to go after tax dodges since 1982. The fact that problems have not gone away is emphasized by their asking for and getting new powers to deal with appraisers from Congress, now codified at §6695A. How bad does it have to get? If we keep doing what we're doing, we will continue to get the same result we've been getting… nothing will change… and clearly, something needs to change.

According to Albert Einstein, "The significant problems we face cannot be solved at the same level of thinking we were at when we created them." I think it's fair to say that, if we stay at the same level, audits will continue, appraisers will be sanctioned, and IRS will prevail.

Personally, I would hate to see what the sequel to the Pension Protection Act of 2006 might look like. I care about the valuation profession and what it has to offer to the public, but I would be surprised if Congress wants to hear about this any further. And my worry is that parts of the profession will be crushed out of existence if this continues. It is time for us to change our thinking.

I've practiced discount valuation for 15 years, and during that time I have had very successful dealings with the IRS, as have many of my colleagues. I have written and taught quite a lot on the subject. And time and time again, I've observed that tax benefits don't have to be sacrificed for the system to work.

The sort of thinking got us here might be related to some kind of taxpayer v IRS opposition, or egregious claims for undeserved benefits, or simply issuing tax-dodge valuations. From the point of view of the ASA, I would like to think not, but maybe we are tempted to think in these ways. There are certainly a few bad actors, but this is too big to be their fault alone.

What if we changed our thinking – what would it look like? It might look like understanding what IRS valuers want to see. It might look like regarding IRS and the Court as appraisal users and more due diligence on the part of appraisers. It might even look like lawyers stepping in when they read the appraisal and it doesn't make any sense. Changing our thinking would certainly require a cooperative approach across the board. And clearly, it would not occur at the level that created the problem.

So we know that IRS has ongoing problems with valuations, and we also know IRS is the intended user of all the stuff we (appraisers and practitioners) generate. Therefore, knowing how the IRS system works is vital. What if the appraisals sent to IRS all made sense? What if attorneys and accountants were able to count on values being accepted as their clients are led to expect? What if, when it comes to it, the Court gets to work with nice clear, persuasive evidence from both sides?

The Symposium offered a chance to become more aware of what IRS is looking for. They were there to tell us. They didn't have to be there, but they were. This is a very good sign… Still, it will take many steps to move to a different level of thinking than the one that created the problem.

Taxpayers and Short Sticks

Sun, 24 Apr 2011 05:20:00 GMT

Lawyer Larry and Victor Valuer are having a breakdown. They are in a conversation about how to handle a valuation assignment for Larry's client, a family looking to make inter generational gifts using a family limited partnership. It can be an expensive process, and the client is going through it with the expectation that they will receive all the tax benefits that are allowed under the law, but they won't. They are about to get the short end of the stick.

Lawyer Larry has many years of experience with tax planning and sometimes faces IRS audits. The audits are painful. He has become increasingly frustrated when gift and estate returns are submitted to IRS, who then slams the appraisal and assesses a tax deficiency. This is not his fault, but it impacts his clients nonetheless.

The best strategic solution seems to be to limit valuation discounts that are applied to his client's asset transfers. This reduces the tax leverage that the plan might otherwise have, increasing the client's tax bill. But, in Larry's view, this is the best way to avoid IRS scrutiny and protect his client from audit.

IRS, for its part, has been increasingly frustrated with having to wade through taxpayer evidence for value (appraisals) that do little more than talk about discounts, rather than properly analyze market evidence for value and apply it to the taxpayer's case. It introduced little checkboxes on gift & estate forms to make screening easier. The first line on Form 709 Schedule A asks: "Does the value of any item listed on Schedule A reflect any valuation discount? If 'yes' attach explanation." It's the explanation that is most often the problem. That has apparently not been effective enough, though, and IRS obtained new powers from Congress to address the problem of inadequate taxpayer "explanations" (appraisals).

Is the solution to have Larry's clients pay more than they should? After all, gifts are to be reported at their fair market value, according to the law, but it is the taxpayer's responsibility to prove value. There has been a lot of frustration with appraisers who hold themselves out to the public as being experts in this practice area, but deliver appraisals that the IRS refuses to swallow. If Larry can't have confidence in expert evidence for value, what else can he do?

There are many steps that Larry can take in his dealings with experts that fall well short of forcing tax overpayment. The issues are described in detail in a recent issue of Steve Leimberg's Newsletter, and effective steps that the lawyer can take are detailed in an article by Dennis Webb and attorney Susan Beveridge. It is much better for all concerned if the appraiser-provided evidence works; it is absolutely not necessary for taxpayers to end up with the short end of the stick.

Ponzi Economy

Sun, 09 Jan 2011 05:11:00 GMT

The "consumer economy" has been rolling along for quite a few years, now. Consumption has become so important to the overall economy that we have effectively "pulled out all the stops" to make sure this growth continues. The most pernicious of these has been consumer finance. The demands of sustaining the financial system have created a Ponzi scheme whose scope can scarcely be imagined. It is the nature of Ponzi schemes to have an exhaustion point, where the mechanism that keeps them afloat collapses. We are near that point.

First some distinctions around debt. Debt has two principal uses: Leveraging investment and leveraging consumption. Investment returns are enhanced when the return to equity is enhanced with the lower (and less risky) returns earned by the bank. This is a rational system, where the debt load can be managed, hopefully with wise attention to term, exposure to unexpected events and other elements of risk. The investment or business generates wealth which pays for both debt and equity. Leverage can be overdone, certainly, but it is fundamentally a rational and objective activity. The amount of leverage is inherently limited by the scope and extent of productive enterprise.

Leveraging consumption is an entirely different matter. Consumption produces both tangible and intangible returns, but rarely does it produce earnings that can be used to pay off debt. Those earnings have to come from wealth generating activities unrelated to the debt. In our model, the link between the purpose of creating debt (largely an intangible), and its payment, is severed. A surplus must come from somewhere to cover the interest required by the lender; for a homeowner, their wages. But without the essential linkage, the amount of leverage is not directly limited. If a greater intangible benefit can be sold, debt can be increased. The only limit is the amount of surplus earnings, which is in turn limited by wealth-generating activity.

The total debt load can be increased with stagnant wages if interest rates are reduced. But decreasing rates increases demand, which forces asset prices higher, requiring yet further interest rate reductions if the greater associated debt is to be serviced. Lower mortgage rates do the trick, to a point. It's not the cost of the house, it's the "cost of ownership," which is relatively low with a 4% mortgage. This is a positive feedback loop, where prices require rate decreases, which increases prices, etc., akin to Ponzi spiral.

The incentive to keep this process going is great. Finance is incentivized based on the number of transactions (through front-end fees), and the only way to support continuing transactions is to make them ever cheaper to the consumer. But at some point, there is not enough surplus earnings (which have to come from somewhere else) to support the trend - especially with stagnant wages and wealth-generating activities moving to other countries. We are close to that point.

This method of keeping consumption going has been pushed with ever greater effort for at least the past 20 years. Lower and lower rates, with greater and greater asset prices, cause us to think we were doing great - and some were. The financial meltdown might have been a wake-up call, but now we are officially expecting a return to the consumption finance model. But, unless we manage to come up with new and widespread sources of wealth generation, the system has to stop, because consumption and asset prices cannot continue to increase without cheaper and cheaper debt. Zero rates are just around the corner, and are a hard limit on this process. We cannot go much further.

As we sit now, virtually all the surplus wealth has been removed from the system. We think that continuing to do so will constitute "economic activity." It does not. Only in a Ponzi universe, and we know that those have to end.

Financial Meltdown Redux

Tue, 06 Apr 2010 21:35:00 GMT

Did everybody miss the looming financial crisis? Michael J. Burry refuses to buy claims that "everybody missed it," since he didn't. He has company.

Michael J. Burry takes exception to Alan Greenspan's protestations that the financial crisis was only knowable in hindsight. Mr. Burry tried mightily to call attention to the extreme risks posed by mortgage-backed securities, and saw the likelihood of a meltdown as so certain that he staked his reputation on it, placing huge bets for his hedge fund, Scion Capital. He was right, and Scion made bags of money for its investors. Mr. Burry's position is summarized in "I Saw the Crisis Coming. Why Didn't the Fed?" (New York Times, April 3, 2010) and his story is recounted in Michael Lewis' "The Big Short: Inside the Doomsday Machine."

Mr. Lewis' work profiles Steve Eisman, Michael Burry and Jamie Mai & Charlie Ledley, all of whom realized that the financial meltdown was inevitable, and have the profits to show for their prescience. It turns out that the claim that "no one could have known" does not hold up.

There are others. They are part of the valuation profession. Real estate appraisers were not in a position to profit (at least in the context of their profession), nor were they considered helpful. Their work has been marginalized through the force of law, and any suggestion that their voices should be heard has been studiously ignored. Many knew of the bubble as it was occurring. While the analysis of Wall Street financial products continues, and while we try to craft regulations to block its wild and self-serving excesses, any effective solution should build in ways of pushing against asset bubbles directly, blocking the fuel for reckless CDOs and the like. My earlier post, "A Prophylactic Solution For Off-The-Chart Real Estate Risk" states the case.

A Prophylactic Solution For Off-The-Chart Real Estate Risk

Tue, 06 Apr 2010 20:01:00 GMT

Widespread misunderstanding of risk has led banks, property investors and homeowners off a cliff. This could have been prevented; who knew?

Appraisers did. Appraisers knew there was a bubble as it was occurring; they have the capability to understand what underlies the real, long-term supported value of real estate assets. Unfortunately, this knowledge does no one any good, because the appraiser's role in the lending process is focused on current market value, by law, which amounts to asking the wrong question: What is market value?

Relying on current market value as a reference point from which to manage risk is a mistake, for which we have paid dearly. Using appraisers to answer the right question would be one of the most concrete steps we could take to stabilize our thinking about asset values, push against bubbles, mitigate systemic risk, more effectively allocate resources, become more productive, and prevent the kind of wholesale dislocation that is afflicting millions. The solution is surprisingly straightforward.

Appraisals are supposed to give lenders some assurance that the market value of the property, at the date the loan is made, is sufficiently greater than the loan amount that it will cover future value fluctuations, making the bank whole on default/foreclosure. Most of the attention on appraisals concerns any difference between market value and the deal price; low is seen as a deal-killer, and is heavily resisted by loan officers. Appraisals accepting of unsupported high deal prices, on the other hand, are seen as a bias that increases lending risk. Finally, appraisals that give weight to low-priced foreclosure transactions are currently seen as making mortgages unnecessarily hard to obtain because their concluded values are below the "normal market," as described by Leonard Nakamura in a paper published by the Philadelphia Fed, How Much Is That Home Really Worth? Appraisal Bias and House-Price Uncertainty. None of these views gives a useful picture of risk, and actually provides lenders and regulators with only an illusion of safety. See my response in What Do We Know About Lender Risk. The appraisal profession has been marginalized by a system that does not appear to understand risk at all.

Loan originations have historically relied on a safety margin of around 20% for primary residential and 30-40% for commercial properties, so that if values declined, the asset would still secure the remaining loan principal. Over time, the loan balance would be reduced and at least inflation (if not additional market gains) would increase nominal values to further increase this margin of safety. So long as prices follow a relatively low, stable rate of inflation, this can work reasonably well. What if they don't? By 2005, prices were rising so fast that lenders had become unconcerned with safety margins. Down payments became unnecessary; at a more than 10% annual value increase, the lender would soon have its 20% margin even if the loan were 100% of the sale price. Even the ability of the borrower to repay became largely irrelevant, an underwriting decision that rested on the ever-increasing value of the underlying security. The widespread belief was that rapidly increasing prices can decrease risk, automatically washing away all sins. Right?

Reality cannot be denied. Prices were increasing far above any long-term historic measure, and as the bubble inflated, risk for new loans and to new buyers became greater and greater. Our faulty beliefs caused long-established underwriting standards to be jettisoned. Properties were eagerly purchased, at a time when greater caution was essential. Risk was rapidly increasing, and red flags should have been raised all over the place. Alas, based on a widespread misunderstanding of risk, meaningful flags were not raised, and the game continued unabated. Those taken out (those few sellers who did not repurchase) and those who were never in (brokers and lenders whose benefits were front-loaded) did just fine. Banks and holders of derivative securities were seriously hurt; but debt holders could at least foreclose and try to sell the assets (or sell the "toxic" paper to the Federal Reserve). Newer (or heavily refinanced) equity positions – homeowners and commercial property investors – are largely wiped out. Millions who "got in" to take advantage of the bonanza, trading up and reallocating assets, came out the losers.

Risk has everything to do with value over time. The lender should be concerned with value at the time of foreclosure, and equity holders at time of the eventual sale. The property isn't (hopefully) being foreclosed or again sold at the origination date, and value at that date is largely irrelevant to ongoing risk. Thus, knowing current market value has limited usefulness, and concern about the accuracy of appraisals going in is pretty much a red herring. (An accurate appraisal as of the origination date is indeed useful in finding decidedly nonmarket pricing, which can result from fraud or a host of other conditions that legitimately should be identified, but it is of little help with the value at foreclosure.) I have noted that appraisers knew that values were hyper-inflated, but they were only being asked for an opinion about current market value, which is not the most meaningful question. Worse, the opportunity for appraisers to advocate for the truth about even current market value was frequently blocked, as appraisers were often seen as impediments to closing transactions. They gummed up the system. The appraisers who might have contributed greater understanding of value were largely pushed aside, and many were replaced. Of course, since lenders and regulators believed that risk was decreasing, did any of this really matter?

The concept of market value is inherently a short-term proposition. Appraisers interpret the actions of buyers and sellers on their terms, to find how they would price a property on a particular date. But what if the entire market is skewed by short-term conditions (say, by very low interest rates and hopelessly lax lending standards)? What if it is temporarily skewed the other way, by a large number of foreclosed homes on the market? Lending and other long-term positions are not well-served by snapshot information, as conditions will change over the life of the loan/investment, and it is largely exposure to changes that determine risk to both debt and equity.

What if we were to first look at property values over a long period (say, at least 20 years)? We would see short-term price movements, but a long-term trend line as well. We would see correlations with rents and incomes, the influences of interest rates, persistence of demand/supply imbalances, consistency in capitalization rates and many others. The historic view also captures the effects of unexpected events, such as natural and man-made disasters, economic dislocations and the like. While the future remains unknown, risk derives from exposure to unexpected events, and such exposures can be minimized by taking the long view. A well-formed opinion of long-term, stable value can go a long way to mitigating future risk, since the dimensionality of facts that are considered is greatly increased, and the likelihood that a random event will change the outcome is substantially reduced. This is not an idle theory, or an impossible task (see Short- and Long-Term (Sustainable) Property Valuation). Far from it.

The current standard of value—the short-term standard—is market value. A standard that addresses many of the issues raised above is mortgage lending value (MLV). The Basel II Accord provides for consideration of both valuation approaches for commercial real estate. Mortgage Lending Value is considered a long-term, risk assessment technique, and is defined as: "The value that can be expected with a high level of surety, derived from the historic perspective of market events at the time of the valuation, on the basis of the durable characteristics, and which will be achieved in normal property transactions over a long period in the future." German Pfandbrief mortgage banks have used this system to collateralize highly rated covered bonds with great success. The system identifies a baseline level of value and risk, and recognizes a positive margin between such long-term and market values as an increased risk. A negative margin might represent a decreased risk. Suitable loan coverage ratios and interest rates then manage this risk, and have the effect of pushing against price bubbles.

We have seen that the system, as it is currently designed, clearly does not work, under either bubble or depressed market conditions. To create a shift that allows us to see real solutions, we need to reassess our understanding of risk, and develop systematic and institutional perspectives that address it in a realistic and forthright way. In other words, we have to summon the courage to tell ourselves the truth about value. Lack of understanding, and lack of willingness to question prevailing beliefs, opened the door to wild excesses. Now is the time to adopt a valuation system that is far more truthful about risk.

Exposure to Unexpected Events

Fri, 11 Dec 2009 16:06:00 GMT

Income and growth are investment objectives that are sought after in real estate, equities and bond markets, as well as through entrepreneurial efforts (although the latter has more components to the return). Income and growth are thought to be proportional to risk exposure, at least under theories of efficient markets. But, there are unseen attributes to all investments, as completely unexpected events can occur at any moment, challenging the sustainability of any investment or financial position (or, indeed, any position in life). Accordingly, risk can be more appropriately viewed as a situation or investment's vulnerability to such events (as presented by Nassim Taleb in "The Black Swan"). Of course, unknown events are just that: unknown, and cannot be removed entirely from any risk profile, but exposure can be understood to some degree. Taleb's Black Swans can at least turn gray.

Investment decisions usually rely on some type of valuation, whether rigorous or implied. Is a fixed asset or security fairly priced? Is the pricing context short- or long-term? The short-term view usually includes only very recent history, and thus excludes past events that may have had a profound impact on value. While history cannot be counted on to repeat itself, the fact of a vulnerability to unexpected events can be revealed in part by looking at long-term trends. Long-term views can be incorporated in to the valuation process, influencing our current understandings of risk, and revealing whether current valuations are supported, depressed, or riding on a bubble. Short-term analysis, on the other hand, has no relative perspective, being only a narrow slice of market activity. Are your investment decisions informed by the long view? Does your investment capital structure create unwelcome exposure to unexpected events?

Long-held views have been dismantled by the recent financial market meltdown, and new thinking is called for (definitely not the type of thinking that got us here) . Not fear of the unexpected (which does not support action), but respect for changing conditions, and maintaining responsibility (the ability to respond) for one's assets, values and life are being called forth this time around. We are developing views and processes to support a healthy and sustainable way to view the value of assets, (Toward Sustainable Finance: The Trouble with Asset Values) and welcome your contributions to thinking on financial sustainability.

Valuing a Fractional Interest in the Farm? Proxy Data May Be Best

Fri, 11 Dec 2009 16:08:00 GMT

Market value appraisals are used for partner/shareholder buyouts, estate settlements and taxation and many other purposes. Such appraisals are often based on market data, which is fine when data involving obviously comparable properties or interests are available; but, what if they are not? Say the interest being valued is a 25% interest in Colorado farm land, and the only available transactions involve a 65% undivided interest in Mississippi timberland and a 10% interest in an orange grove in Florida. Are they meaningful for the Colorado appraisal? Does the appraiser have other choices? (Yes!)

The courts and professional literature often place high importance on actual transactional data when evaluating expert opinions of fractional interest values. This may make intuitive sense, but is it practical? Analyzing fractional interest transactions is far more complex than analyzing sales of entire properties, because the comparisons must be made to the ownership structure and a lot of other facts and circumstances, on top of any relevant property characteristics that might have influenced the discount (location, land use, soils, etc.). What was the buyer's intent? What were his or her options for exiting the position? Transactional data might seem like a Holy Grail, but they are fraught with problems and can easily lead to unsupportable and unconvincing opinions of value. We recommend proxy methods that can be consistently applied, that incorporate explicitly facts and circumstances that might otherwise be elusive. Publications on this website can be used to gain an understanding of such methods, and facilitate reliable and convincing value opinions. Basic analysis of sale transactions and the partition process are included in Valuing Fractional Interest in Real Estate: Partnerships and Cotenancies and techniques for applying proxy data, based on specific facts and circumstances, are presented in Advanced Modeling for Holding Company Valuation.

Estate Plans and Cases

Fri, 28 Aug 2009 03:22:00 GMT

Estate planning often relies on valuations of assets and business interests,including fractional ownership of assets, to establish value for gift and estate taxation. But… what leads to a reliable, “safe” valuation? There has been a considerable amount of attention given to discounts allowed in tax court opinions to figure out what acceptable discounts might be, under various circumstances. The result is sometimes a strategy based on a perceived safe harbor discount, which amounts to trying to protect the client’s investment in the planning effort, and preserve tax benefits.

Much of this attention is misplaced, and is quite frankly worrying. It is true that the plan may win or lose based on the valuation. But, tracking judicial decisions for discount guidance is not a valuation method. It is not even within the valuer’s domain. Opinions of fair market value are convincing if they are based on a clear understanding of the facts associated with ownership structures and circumstances, as well as real property attributes. The harbor is made safe with a secure valuation – applying the facts in market-based valuation processes. Our experience is that fidelity to the facts makes the valuation persuasive, not concluding a result based on second-guessing how the examiner will see the discount in light of other cases. Our ability to apply the facts in the valuation process is unmatched, and the result is a major advantage for clients seeking to maximize their plan benefits and reduce their risk.

A House Divided

Mon, 20 Apr 2009 21:06:00 GMT

In "A House Divided" [NY Times April 3, 2009], Amy Gunderson describes the trend toward divided ownership of vacation homes – highlighting a list of benefits (mainly limiting the cost of limited usage) and numerous cautions (legal constraints and mortgage difficulties). But… one key long-term issue was missed: the illiquidity and future market value of the fraction. Such ownership arrangements are initially based on common objectives and mutual agreement (or no one would go into the deal), and the price is usually the interest's pro rata share of the whole property, or maybe a little more to cover legal and marketing costs. However, once in, the shoe slowly shifts to the other foot. Owner objectives change over time, conflicts may arise, and interests may be further divided (through inheritance, say). Even without that, it would be difficult to find an outside party that shared the original investor's interest and had the same level of comfort. The price is usually a substantial discount from its pro rata share (unless the whole property is sold and the proceeds divided). Ownership division can take a low-risk, relatively liquid 100% interest in the property, and turn it into a high-risk, illiquid fractional position, not entirely unlike asset-backed derivative securities.

Value can also swing the other way under some circumstances, where fractional interests can sell at a premium over pro rata. This has occurred during periods when affordability of the whole property is a problem, but demand is high. The point is that issues of value need to be addressed, one way or the other. The benefits of fractional interest ownership may be worth it, but such positions should be taken with full understanding of the greatly increased risk and cost of getting out.

Neutrality is an important resource

Tue, 10 Mar 2009 01:04:00 GMT

Valuers are neutral. If you think about it, this is an unusual position in finance. Neutrality is enforced by valuers’ standards of professional practice and ethics, and by they way they are paid (no contingent fees). Standards are most widely promulgated by professional associations, and in the case of real estate appraisers, also state licensing boards. I regard this as a great strength of the financial system, and one that should be used to a greater extent to counter the misplaced incentives and self-dealing that has caused so much damage in recent years. It would have been helpful, for example, if the designers of various derivative securities had actually obtained advice from experienced asset valuers regards the relationship between current values and long-term trends. But, it seems like the participants had an incentive to be wildly optimistic, and we are all paying a big price.

Several other professions fall into this neutral position: accountants in some respects, academics and the judiciary. However, a case before the US Supreme Court on Tuesday considered whether a defendant obtained the swing vote on the West Virginia State Supreme Court by making a $3 million campaign contribution. Clearly a reminder that principles of neutrality need to be continuously monitored. I realize that the expert opinions of academics and valuers can also be swayed, but am encouraged that such behaviors are coming to light. Our financial system must have professions that the public can rely on for dispassionate and objective opinions and insight. It would be good if the public were to demand it, since there is quite enough of the other kind.