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Do appraisal methods commonly used internationally meet acceptable standards?

01/26/2021

“The only function of Economic Forecasting is to make Astrology look responsible.”
John Kenneth Galbraith (1908-2006)

The standards that are taught in academia are the three approaches to value. They each have strengths and weaknesses.

In the absence of comparable sales, and even with comparable sales being available, lenders have gone to the income approach or, Discounted Cash Flow (DCF) method. It is true that the value in a vessel is its intrinsic value, i.e., its ability to generate income over its economic lifetime. Therefore doing a DCF calculation can give you a value of that marine asset.

Lenders are also only too aware of the cyclical nature of the marine industry.

For one to do a DCF there are a number of assumptions to be made. The simplest may be its remaining economic life with the cascade of technological and economic obsolescence factors that arrived, and will continue to arrive this decade, that figure may become fuzzy. There are already comments that vessels may have a physical life of 20-25 years but a technological life closer to 15 due to economic obsolescence. In a previous blog I mentioned the possibility of “stranded assets”.

Not so easy is estimating the future expenses. While such things as maintenance costs, crewing costs, insurance costs, and stores may be estimated 10-to-15 years into the future, fuel cost, the major outlay in vessel operations, may vary greatly over that time period.

As someone who once did DCF calculations for almost 30 container ships, my estimate of fuel costs over the life of these ships, in hindsight, were not particularly accurate. And for the next 10-to-15 years the valuer may not even know what type of fuel, LNG, Ammonia, hydrogen cells, will be in use.

So how do you handle value when future expenses can be based on multiple assumptions, and, in an industry known for the wild fluctuations among vessel types, future income?

After 2009 when there were no vessel sales for comparison purposes the Hamburg Shipbrokers Association, with the assistance of PriceWaterhouse Cooper (PwC) developed what is called the Hamburg Rule, later to be named the Long Term Asset Value Method (LTAV).

Proponents, in one example, say that you use the current charter rate for such a vessel and adjust it up or down to the historical average charter rate for four years, then simply increase that charter rate by 2% inflation over the remaining life of the vessel.

Such a calculation, fully explained in an appraisal report, may satisfy International Valuation Standards (IVS) for transparency, as there are no mirrors. But there is a lot of smoke. And it doesn’t satisfy other aspects of IVS like consideration of the other two approaches to value and using them or clearly explaining why they weren’t used.

Making the assumption that a vessel will have good utilization and a positive cash flow throughout its life is, in my opinion, a bridge to far.

An aircraft evaluation group, ISTAT, has a theory called Base Value. This assume an aircraft’s value in a balanced market apparently ignoring the market conditions on the date of value, similar to the idea behind LTAV. Yes, in a balanced market there should be good utilization and therefore good prices and charter rates. Eventually. Whenever the balanced market returns. So such a view is a grand hypothetical assumption.

But is the Market Approach, i.e. comparable sales, the answer?

Most appraisers can agree that the market approach can be the most accurate measure of value. With the willing buyer and willing seller, both well educated in the market, unmoved by other outside factors, there should be few, if any, unknowns, and their joint opinion of value should be the most accurate.

The problem lies in a market where there are no sales to track as there may be willing sellers but no willing buyers in that market at that time. And another catch that is always there is if the “comparable sale” is really a comparable to your subject vessel. In marine equipment where there are few standard or “production” designs, comparable may be a loose term and need some clarification.

But when sales are available, the standard for decades in international finance has been the Shipbroker’s Certificate of Valuation. This is a one page certificate giving the basic identification of the vessel and a value. This may even be paid for and provided by the entity that is selling the vessel.

There is no question that this type of valuation is in no way acceptable under the International Valuation Standards, RICS Red Book Standards, or the Uniform Standards of Professional Appraisal Practice and would be rejected by any Big Four auditors. Yet these Certificates are accepted by lenders.

A step up from a Certificate of Valuation is the valuation provided online through calculations made via a computerized program. This is a hybrid of market information based on sales and an algorithm that takes into account freight rates and freight market sentiment and calculated with regression analysis.

As with the Shipbroker’s Certificate of Valuation, the opinion of value given by a computer program may be very accurate. But do either satisfy some of the important standards that are the basis for appraisals that are used in international lending and accounting? The computerized program hits some of the required steps via disclaimers, but not all of the steps.

The major required standards for a report, as per IVS, that are omitted by one or both of the above sources are:

The appraisers at DLS have to cover these standards in our appraisal reports and often cover these items again when the appraisal report is audited by representatives of the lender, or auditors for an accounting firm or taxing authority.

And additionally, the questions of who requested the appraisal, who paid for the appraisal, who are the specified user(s) of the appraisal – these are not always apparent in the other sources.

Why are the above noted “short cut” appraisals accepted by entities that have their own lending and accounting standards that they must follow? Yes, they are inexpensive and expeditious, but they are not acceptable under United States USPAP standards and not acceptable under International Valuation Standards. IVS, while voluntary in many countries, are recognized as standards that are necessary for transparent international commerce.

Unintended Consequences

When doing research, one gets to read some very interesting and enlightening technical papers. Some contain information that branches off from the main line of research, but is interesting in its own right. Such as this…

A conservation group called OceansAsia, based in Hong Kong, estimates that 8-to-12 million metric tonnes of plastic enter the oceans each year. And a recent Maritime Executive article speaks of research indicating large amount of polyester microfibers found in the Arctic Ocean, reportedly the result of laundry discharge water passing through city’s water systems.

The OceansAsia further estimates that of the estimated 53 billion COVID-19 masks manufactured in 2020, as many a 1.56 billion, at least partially made with polypropylene, will end up in the ocean.

So, in order to make things better, we sometimes can make things worse. Base Value and LTAV provide short term answers during poor market conditions, but are they transparent answers or answers that stand up to probing questions of auditors?

The DLS appraisal team works hard to produce competent transparent appraisal reports, each prepared in the thought that what we produce can be reviewed and questioned by auditors and attorneys. And this goes beyond the appraisal work into the work products produced by our hull and machinery surveyors for insurance and consultations and the damage and condition reports done by our cargo group.

No one likes the surprises of unintended circumstances.

If you’d like to keep this conversation going, send me an email at nlaskay@DLSmarine.com or you can find me on LinkedIn.   -Norm Laskay