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Prudent Valuation: Building a More Resilient Property Market
Breaking down SkenarioLabs’ Prudent Property Valuation Methodology
The 2008 Global Financial Crisis was a defining moment for global markets, triggered by the collapse of the housing bubble in the United States. As property values plummeted and mortgage-backed securities lost their worth, financial institutions across the world faced unprecedented losses.
This crisis exposed major flaws in financial regulations, particularly in how properties were valued, often based on over-optimistic assumptions of continuous growth. Lending was seen as low-risk, and as shown in media like the movie The Big Short, real estate values soared far beyond the true underlying value of the assets.
In response, the Basel Committee on Banking Supervision introduced Basel III, a framework for a more stable and resilient financial system. In the EU, this was reinforced through the Capital Requirements Regulation (CRR3). One of the key changes under CRR3 is the requirement for financial institutions to use prudent valuation for risk management.
At SkenarioLabs, we have developed a methodology for prudent property valuation that aligns with both Basel III and CRR3. Our approach helps institutions manage risk more effectively by ensuring property values remain grounded – even during market fluctuations.
What is Prudent Valuation?
While market valuation reflects the current price of a property at a specific moment, prudent valuation aims to provide a more conservative, stable estimate – one that remains valid over the full course of a loan. For prudent value to remain valid over the loan term, it must account for possible future market volatility – avoiding excessive inflation during booms or steep declines during downturns – thereby reducing the risk of unsustainable lending practices that can destabilise financial markets.
A real-world benchmark of prudent valuation principles is the German Mortgage Lending Value (MLV) model, which helped Germany avoid severe real estate market turbulence during the 2008 Global Financial Crisis. Under German regulations for Pfandbrief banks, the Mortgage Lending Value represents a long-term, sustainable value of a property, excluding speculative elements and short-term economic fluctuations. It is intentionally more conservative than market value, ensuring that mortgage collateral remains reliable throughout economic cycles.
Similarly, prudent valuation under Basel III and CRR3 is based on the idea of producing stable, non-speculative property valuations that are resilient even during market disruptions.
Figure 1: Inflation-adjusted house price index (Source: BIS)
The graph highlights the stability of Germany’s housing market over three decades, especially during the 2008 GFC and beyond. Unlike countries like the U.S, UK, and Canada, which experienced sharp rises and corrections – Germany’s line remains remarkably flat, reflecting minimal speculative inflation and the long-term resilience supported by conservative valuation frameworks like the Mortgage Lending Value (MLV) model.
SkenarioLab's Prudent Valuation Methodology
Breaking Down the Graph
Figure 2: The graph illustrates market value, sustainable value, and prudent value over time using past and present data.
We have been able to calculate the sustainable value going back to 1988 and the prudent value from 2001.
At the beginning of 1988, sustainable and market values align. Soon after, a spike in construction costs signals market instability. In response, the sustainable value freezes and remains frozen due to other signals of market instability in economic indicators, staying flat until around 1996, when economic conditions stabilize and the values realign.
Between 1996 and 2008, there are no signs of major instability. The gap between sustainable and prudent values during this period is primarily attributed to the observed price range of comparable transactions.
Around 2007, that price range widens further, causing the prudent value to increase more slowly than the sustainable value. In 2008, rising interest rate volatility causes both values to freeze for about a year.
After that, the sustainable value begins to rise again, but the prudent value stays flat, reflecting tighter confidence intervals in the market. This cautious approach continues until 2020, when increased construction costs again cause both values to level off.
Why This Matters?
Prudent valuation provides tangible benefits for banks, lenders, and the broader financial system:
- Reduce the risk of loan defaults caused by over-optimistic valuations.
- Make better-informed lending decisions based on real economic fundamentals.
- Achieve full compliance with Basel III and CRR3 regulatory requirements.
- Increase portfolio resilience during future market cycles.
As financial regulations evolve and market cycles grow more unpredictable, having stable, transparent, and compliant property valuation methodology is no longer optional – it is essential. SkenarioLabs’ prudent valuation method provides a clear, transparent way for banks and lenders to reduce the risk of loan defaults caused by over-optimistic valuations, make better-informed lending decisions based on real economic data, and improve financial stability by avoiding risky market speculation, while ensuring compliance with new regulations.
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