NOTE 6 — FAIR VALUE

Valuation Allowance and Fair Value Measurement of Loans and Real Estate Held for Sale

We perform a valuation analysis of our loans, REO held for sale and derivative investments not less frequently than on a quarterly basis. Evaluating the collectability of a real estate loan is a matter of judgment. We evaluate our real estate loans for impairment on an individual loan basis, except for loans that are cross-collateralized within the same borrowing groups. For cross-collateralized loans within the same borrowing groups, we perform both an individual loan evaluation as well as a consolidated loan evaluation to assess our overall exposure to those loans. In addition to this analysis, we also complete an analysis of our loans as a whole to assess our exposure for loans made in various reporting periods and in terms of geographic diversity. The fact that a loan may be temporarily past due does not result in a presumption that the loan is impaired. Rather, we consider all relevant circumstances to determine if, and the extent to which, a valuation allowance is required. During the loan evaluation, we consider the following matters, among others:


•	an estimate of the net realizable value of any underlying collateral in relation to the outstanding mortgage balance, including accrued interest and related costs;


•	the present value of cash flows we expect to receive;


•	the date and reliability of any valuations;


•	the financial condition of the borrower and any adverse factors that may affect its ability to pay its obligations in a timely manner;


•	prevailing economic conditions;


•	historical experience by market and in general; and


•	evaluation of industry trends.

We perform an evaluation for impairment on all of our loans in default as of the applicable measurement date based on the fair value of the underlying collateral of the loans because our loans are considered collateral dependent, as allowed under applicable accounting guidance. Impairment for collateral dependent loans is measured at the balance sheet date based on the then fair value of the collateral in relation to contractual amounts due under the terms of the applicable loan. In the case of the loans that are not deemed to be collateral dependent, we measure impairment based on the present value of expected future cash flows. Further, the impairment, if any, must be measured based on the fair value of the collateral if foreclosure is probable. All of our loans are deemed to be collateral dependent.

Similarly, REO assets that are classified as held for sale are measured at the lower of carrying amount or fair value, less estimated cost to sell. REO assets that are classified as operating properties or held for development are considered “held and used” and are evaluated for impairment when circumstances indicate that the carrying amount exceeds the sum of the undiscounted net cash flows expected to result from the development and eventual disposition of the asset. If an asset is considered impaired, an impairment loss is recognized for the difference between the asset’s carrying amount and its fair value, less estimated cost to sell. If we elect to change the disposition strategy for our real estate held for development, and such assets were deemed to be held for sale, we may record additional impairment charges, and the amounts could be significant.

We assess the extent, reliability and quality of market participant inputs such as sales pricing, cost data, absorption, discount rates, and other assumptions, as well as the significance of such assumptions in deriving the valuation. We generally employ one of five valuation approaches, or a combination of such approaches, in determining the fair value of the underlying collateral of each loan: the development approach, the income capitalization approach, the sales comparison approach, the cost approach, or the receipt of recent offers on specific properties. The valuation approach taken depends on several factors including:


•	the type of property;


•	the current status of entitlement and level of development (horizontal or vertical improvements) of the respective project;


•	the likelihood of a bulk sale as opposed to individual unit sales;


•	whether the property is currently or near ready to produce income;


•	the current sales price of property in relation to cost of development;


•	the availability and reliability of market participant data; and


•	the date of an offer received in relation to the reporting period.

A description of each of the valuation approaches and their applicability to our portfolio follows:

Development Approach

The development approach relies on pricing trends, absorption projections, holding costs and the relative risk given these assumptions for a particular project. This approach then discounts future net cash flows to derive the estimated fair value. This approach is consistent with a modeling technique known as residual analysis commonly used in our industry which is based on the assumption that completing the development of the collateral was the highest and best use of the property. As indicated by market participants, a development approach and related rates of return are used in determining purchase decisions. As such, the valuation is intended to reflect the project’s performance under certain parameters, paralleling the process employed by market participants. This analysis is very dependent upon end-use pricing and absorption. In addition to consideration of recent sales of comparable properties (which in the current market may include distressed transactions such as foreclosure sales), the valuation also relies on current listings of comparable properties with primary emphasis placed on comparable properties available for resale within the similar competitive market, as well as market participant opinions. This collection of data is used to derive a qualitative analysis using the sales comparison approach in estimating current individual lot pricing and reasonable premium levels. In addition, the valuation contemplates a non-leveraged internal rate of return based on indications from market participants. This approach, which we consider an “as developed” approach, is generally applied to collateral and REO which have achieved entitlement status and whose development is reasonably assured in light of current market conditions. Prior to the disruption in the real estate market, this methodology was generally utilized in underwriting each loan as well as for purposes of annual valuation of our portfolio.

Income Capitalization Approach

The income capitalization approach is a method of converting the anticipated economic benefits of owning property into a value through the capitalization process. The principle of “anticipation” underlies this approach in that investors recognize the relationship between an asset's income and its value. In order to value the anticipated economic benefits of a particular property, potential income and expenses must be projected, and the most appropriate capitalization method must be selected. The two most common methods of converting net income into value are direct capitalization and discounted cash flow. In direct capitalization, net operating income is divided by an overall capitalization rate to indicate an opinion of fair value. In the discounted cash flow method, anticipated future cash flows and a reversionary value are discounted to an opinion of net present value at a chosen yield rate (internal rate of return). Investors acquiring this type of asset will typically look at year one returns, but must consider long-term strategies. Hence, depending upon certain factors, both the direct capitalization and discounted cash flow techniques have merit. This approach is generally applied to our operating properties or collateral consisting of fully constructed buildings with existing or planned operations and for which operating data is available and reasonably accurate.

Sales Comparison Approach

When market participant data is either not available or not accurate (such as in a disrupted market), and other valuation approaches are not relevant to or appropriate for a particular project, the sales comparison approach is generally used to determine fair value. Market participants generally rely on speculative land sales when making a decision to purchase land in certain market area. Thus, in the absence of relevant, accurate market data, this approach is generally applied and is considered an “as is” approach.

Recent Offers Received and Executed Purchase and Sale Agreements

For projects in which we have received a bona fide written third-party offer (or have executed a purchase and sale agreement) to buy our real estate or loan, or we or the borrower has received a bona fide written third-party offer (or has executed a purchase and sale agreement) to buy the related project, we generally utilize the offer or agreement amount in cases in which such amount may fall outside our current valuation conclusion. Such offers or agreements are only considered if we deem it to be valid, reasonable, negotiable, and we believe the counterparty has the financial wherewithal to execute the transaction. When deemed appropriate, the offers received are discounted to allow for potential changes in our on-going negotiations.

Factors Affecting Valuation

The underlying collateral of our loans and our REO varies by stage of completion, which consists of either raw land (also referred to as pre-entitled land), entitled land, partially developed, or mostly developed/completed lots or projects. Historically, for purposes of determining whether a valuation allowance was required, we primarily utilized a modeling technique utilizing the development approach, known as residual analysis commonly used in the lending industry, which is based on the assumption that development of our collateral was the highest and best use of the property.

As a result of disruptions in the real estate and capital markets, and the resulting high volatility of real estate values between 2008 and 2010, we engaged independent third-party valuation firms to provide periodic complete valuation reports for the majority of our loans and REO assets. Subsequent to 2010, we noted indications that a stabilizing trend in real estate market values began to unfold and, in certain circumstances, improved for some markets. As a result, during 2013 and 2012 we reduced the extent to which we utilized independent third-party valuation firms to assist with our analysis of fair value of the collateral supporting our loans and REO. While we continue to utilize third party valuations for selected larger assets on a periodic basis as circumstances warrant, we rely largely on our asset management consultants and internal staff to gather available market participant data from independent sources to update assumptions used to derive fair value of the collateral supporting our loans and real estate owned for assets not subject to third party valuation.

Our fair value measurement is based on the highest and best use of each property which is generally consistent with our current use for each property subject to valuation. In addition, our assumptions are established based on assumptions that believe market participants for those assets would also use. During the year ended December 31, 2013 and 2012, we performed both a macro analysis of market trends and economic estimates, as well as a detailed analysis on selected significant loan and REO assets. Based on our analysis of macro market and economic conditions, market confidence appears to continue to improve in numerous markets in which our assets are located as evidenced by marked improvement in sales activity and pricing.

The following is a summary of the procedures performed in connection with our fair value analysis as of and for the years ended December 31, 2013 and 2012:


1.	We reviewed the status of each of our loans to ascertain the likelihood that we will collect all amounts due under the terms of the loans at maturity based on current real estate and credit market conditions.


2.	We reviewed the status of each of our REO assets to determine whether such assets continue to be properly classified as held for sale, held for development or as operating properties as of the reporting date.

During various quarterly periods during the years ended December 31, 2013 and 2012, we engaged third-party valuation specialists on a periodic basis to provide complete valuations for certain selected loans and/or REO assets. Assets selected for complete valuation generally consisted of larger assets, those for which foreclosure is impending or was recently completed, and assets whose value might be impaired based on recent market participant activity or other value indicators. Specifically, in connection with the acquisition of certain assets via deed-in-lieu of foreclosure that occurred during the quarter ended June 30, 2013 (as disclosed in note 4), we ordered updated valuation reports from independent third-party valuation firms for the three portions of significant collateral acquired in the foreclosure, specifically for the hotel operations acquired and the 28-lot residential subdivision located in Sedona, Arizona. This resulted in a reduction of the related reserves by $6.5 million of which $2.2 million was recognized during the quarter ended March 31, 2013 and $4.3 million during the quarter ended June 30, 2013.

For the period ended December 31, 2013, given the lack of significant change in overall general market conditions since December 31, 2012, we performed internal analysis to evaluate fair value for the balance of the portfolio not covered by third-party valuation reports, negative assurance letters or existing offers or purchase and sale agreements. Our internal analysis of fair value included a review and update of current market participant activity, overall market conditions, the current status of the project, our direct knowledge of local market activity affecting the project, as well as other market indicators obtained through our asset management group and various third parties to determine whether there were any indications of a material increase or decrease in the value of the underlying collateral since the last complete third party valuation for such assets. Our asset-specific analysis focused on the higher valued assets of our total loan collateral and REO portfolio. We considered the results of our analysis and the potential valuation implication to the balance of the portfolio based on similar asset types and geographic location.

In addition, for projects for which we have received a bona fide written third-party offer to buy our loan or REO asset (or have executed a purchase and sale agreement), or the borrower has received a bona fide written third-party offer to buy the related project (or has executed a purchase and sale agreement), we generally utilized the offer or agreement amount in cases in which such amount may outside our current valuation conclusion. Such offers or agreements are only considered if we deem it to be valid, reasonable and negotiable, and we believe the counterparty has the financial wherewithal to execute the transaction.

Following is a table summarizing the methods used by management in estimating fair value for the period ended December 31, 2013 and 2012:



	December 31, 2013						December 31, 2012
	% of Carrying Value						% of Carrying Value
	Mortgage Loans Held for Sale, Net			Real Estate Held for Sale			Mortgage Loans Held for Sale, Net			Real Estate Held for Sale
Basis for Valuation	#	Percent of Carrying Value		#	Percent of Carrying Value		#	Percent of Carrying Value		#	Percent of Carrying Value
Third party valuations	—	—		2	10	%	1	71	%	2	17	%
Third party offers	—	—		7	55	%	—	—		6	34	%
Management analysis	7	100	%	22	35	%	8	29	%	15	49	%
Total portfolio	7	100	%	31	100	%	9	100	%	23	100	%

As of December 31, 2013 and 2012, the highest and best use for the majority of real estate collateral and REO held for sale was deemed to be held for investment and/or future development, rather than being subject to immediate development. A summary of the valuation approaches taken and key assumptions that we utilized to derive fair value, is as follows:



	December 31, 2013						December 31, 2012
	% of Carrying Value						% of Carrying Value
	Mortgage Loans Held for Sale, Net			Real Estate Held for Sale			Mortgage Loans Held for Sale, Net			Real Estate Held for Sale
Valuation Methodology	#	Percent of Carrying Value		#	Percent of Carrying Value		#	Percent of Carrying Value		#	Percent of Carrying Value
Comparable sales (as-is)	6	100	%	21	28	%	6	18	%	16	65	%
Development approach	1	—		3	17	%	2	11	%	1	1	%
Income capitalization approach	—	—		—	—		1	71	%	—	—
Third party offers	—	—		7	55	%	—	—		6	34	%
Total portfolio	7	100	%	31	100	%	9	100	%	23	100	%

•

For the projects that included either unentitled or entitled raw land lacking any vertical or horizontal improvements, given the current distressed state of the real estate and credit markets, the development approach was deemed to be unsupportable because market participant data was insufficient or other assumptions were not readily available; the “highest and best use” standard in these instances required such property to be classified as “held for investment” purposes until market conditions provide observable development activity to support a valuation model for the development of the planned site. As a result, we utilized a sales comparison approach using available data to determine fair value.

•

For the projects containing partially or fully developed lots, the development approach was generally utilized, with assumptions made for pricing trends, absorption projections, holding costs, and the relative risk given these assumptions. For the years ended December 31, 2013 and 2012, annual discount rates utilized ranged from 9% to 30%, depending on property type and location. The assumptions were based on currently observable available market data.

•

For operating properties, the income approach (applicable to our largest loan in 2012 which converted to an operating property in 2013 upon foreclosure), using the direct capitalization and discounted cash flow methods, was used. The anticipated future cash flows and a reversionary value were discounted to the net present value at a chosen yield rate. For the years ended December 31, 2013 and 2012, capitalization rates utilized ranged from 7.5% to 8.5%, depending on property type and location. The assumptions were based on currently observable available market data. The increased demand and availability of debt led to a decline in capitalization rates, an increase in per-square foot pricing, and the initial signs in the recovery of the market in terms of total volume for certain assets.

Selection of Single Best Estimate of Value

As previously described, we have historically obtained periodic valuation reports from third-party valuation specialists, consultants and/or from our internal asset management departments for the underlying collateral of our loans and REO held for sale. The results of our valuation efforts generally provide a range of values for the collateral valued rather than a single point estimate because of variances in the potential value indicated from the available sources of market participant information. The selection of a value from within a range of values depends upon general overall market conditions as well as specific market conditions for each property valued and its stage of entitlement or development. In selecting the single best estimate of value, we consider the information in the valuation reports, credible purchase offers received and agreements executed, as well as multiple observable and unobservable inputs.

Valuation Conclusions

Based on the results of our evaluation and analysis, during the year ended December 31, 2013 we recorded a non-cash recovery of credit losses of $6.5 million on our loan portfolio relating primarily to the improved value for the hotel operations and residential lots acquired through foreclosure as previously described. The improved value was reflective of improved operating results and improved market conditions for the hospitality sector and the pricing and absorption assumptions for the residential lots as it pertains to the related assets. In addition, we recorded and other net recoveries of credit losses of $1.5 million during the year ended December 31, 2013 relating to the collection of cash and other assets from certain guarantors on prior loans. Also, as described in note 5, we recorded no gain or loss resulting from the fair value analysis of our derivative investment during the year ended December 31, 2013.

During the year ended December 31, 2012, we recorded a non-cash recovery of credit losses of $0.3 million as a result of our evaluation and analysis on our loan portfolio, and additional cash recoveries of credit losses of $1.8 million received relating to the collection of notes receivable from certain guarantors for which an allowance for credit loss had been previously recorded.

For the year ended December 31, 2011, we recorded provisions for credit losses, net of recoveries, of $1.0 million. In addition, during the years ended December 31, 2013, 2012 and 2011, we recorded impairment charges of $1.1 million, $0 and $1.5 million, respectively, relating to the further write-down of certain real estate owned.

As of December 31, 2013, the valuation allowance totaled $18.2 million, representing 59.2% of the total outstanding loan principal and accrued interest balances. As of December 31, 2012, the valuation allowance totaled $51.6 million, representing 41.3% of the total outstanding loan principal and accrued interest balances. The reduction in the valuation allowance in total is primarily attributed to the transfer of the valuation allowance associated with loans on which we foreclosed and the resulting charge off of valuation allowance on loans sold during the respective years.

With the existing valuation allowance recorded as of December 31, 2013, we believe that, as of that date, the fair value of our loans and REO assets held for sale is adequate in relation to the net carrying value of the related assets and that no additional valuation allowance is considered necessary. While the above results reflect management’s assessment of fair value as of December 31, 2013 and 2012 based on currently available data, we will continue to evaluate our loans in fiscal 2013 and beyond to determine the adequacy and appropriateness of the valuation allowance and to update our loan-to-value ratios. Depending on market conditions, such updates may yield materially different values and potentially increase or decrease the valuation allowance for loans or impairment charges for REO assets.

Valuation Categories

The were no losses recorded during the years ended December 31, 2013 in the categories for which net mortgage loans and REO held for sale were measured at fair value on a non-recurring basis based upon the lowest level of significant input to the valuation as of December 31, 2013.

During the year ended December 31, 2013, we recorded losses of $1.1 million for one asset that was measured at fair value using Level 2 inputs based on an offer received. Additionally, there were no other assets that were measured at fair value using Level 1 or Level 2 inputs for which any losses were recorded during the year ended December 31, 2012. Generally, all of our mortgage loans and REO held for sale are valued using significant unobservable inputs (Level 3) obtained through third party appraisals, except for such assets for which third party offers were used, which are considered Level 2 inputs. Changes in the use of Level 3 valuations are based solely on whether we utilized third party offers for valuation purposes.