Nonmarket Financing
The net asset value balance sheet requires that all assets and liabilities be marked to their fair market values. Any loans that carry terms different from what is available in the market at the date of value will be worth more (or less) than their remaining balances.
The adjustment process is the same as adjusting a sale transaction that includes financing, as described in The Appraisal of Real Estate, 15th ed. Chicago: Appraisal Institute, 2020, pp. 380–382. The calculation is fairly simple: discount actual debt service over a term and a reversionary balance* at the end of the term back to present value using the current loan interest rate. The loan liability’s fair market value will be reduced if the market rate exceeds the actual loan interest rate.**
| * | You can take advantage of PVX’s internal amortization for this purpose by using the year 10 loan balance from the User Valuation Summary (before adjusting the current balance). |
| ** | The process could also work in the other direction—with current loan rates lower than the actual loan—but higher-rate loans are often refinanced, making the problem short-lived. That is, unless the actual loan has onerous prepayment penalties that would discourage refinancing. A balloon payment due in the near term could create other problems if refinancing the balance would be difficult or impossible, which could, in turn, lead to an early property sale and a reduced restriction period estimate. |
The simple calculation becomes less so if we think about the duration of the loan’s nonmarket status. Do market participants (in this case borrowers generally) expect interest rates to remain at their date-of-value levels for many years, or is the rate increase transient? If long-lived, then the recommended calculation is probably correct. If short-lived, then the effect on value could be overstated. A fairly simple solution would be for your side calculation to use different interest rates to discount each year’s debt service to present, then change those rates to reflect your estimate of how the market thinks about the future. Will it be back to the current rate in 10 years? Or stay high for even longer? The advantage will be reduced anyway if the loan is amortizing, since a higher rate’s effect on a smaller balance is reduced. So perhaps it’s best to reduce the rate faster to compensate a little?
Interest rates are a heavily-reported obsession, but predicting future rates is hugely speculative. Ideally, the market’s view of a low-interest financing benefit would be discoverable, which might be done if we were adjusting a single comparable transaction (ask buyer/seller/broker). But making that determination for the subject partnership will be speculative indeed. Still, something must be done, as ignoring the advantage is unrealistic.
The simple solution is to make a side calculation of the advantage, then reduce the current loan balance by that amount. Changing each year’s interest rate in that side calculation might be a reasonable refinement so long as a return to the original rate has decent support. Other refinements are possible, but this approach should be a good enough approximation for something that is unknowable in the first place.