The value of the two portfolios Desert Troon managed led to a dispute in 2013 over whether Messrs. Parham and Hacking had used the appropriate appraisal methods during the previous four years.
The three former PSPRS portfolio managers — Messrs. Selfridge, Orlich and Paul Corens — and former Chief Investment Counsel Andrew Carriker cited the valuation dispute as a reason for their resignations.
Mr. Hacking acknowledged to P&I that the four men had disputed the valuation and “resigned, ostensibly over this issue.”
The controversy came to light last year after Messrs. Orlich and Carriker began questioning how PSPRS was valuing the Desert Troon portfolios.
The roots of the valuation dispute go back to 2009. That's when the pension fund began using a market value for all appraisals. The purpose was to provide “meaningful insight into the value of (the pension fund's) investments” and “specific asset values” in the preparation of PSPRS' financial statements, Mr. Hacking said in a letter to P&I. (Until then, a cost basis — what it cost to acquire a property — was used.)
But in 2010, Messrs. Hacking and Parham discarded the market-value-based appraisal process. They agreed to Desert Troon's request that the pension fund use an investment-value-based approach.
The Governmental Accounting Standards Board requires public pension funds' real estate holdings to be appraised at market value, using factors such as comparable sales or an income approach using discounted cash flow analysis, said William Holder, a former GASB board member and dean of the Leventhal School of Accounting at the University of Southern California, Los Angeles. He is not involved in the PSPRS matter.
For the fiscal year ended June 30, 2012, Desert Troon valued the real estate it managed for the Arizona pension fund using investment value, “to reflect what it fully expected those assets would sell for in the future as the real estate markets revive, especially here in Arizona,” Mr. Hacking said in a July 2013 letter to Arizona Auditor General Debra K. Davenport, requesting that her office evaluate Desert Troon's valuation methods.
He said Desert Troon used the income approach to analyze future cash flows from the properties, the same method used by independent appraiser Ernst & Young LLC.
But they used different discount rates.
While the auditor general said Desert Troon used a 5% discount rate for lifestyle and retail properties, which were the bulk of the portfolios, discount rates of 7.75% to 20.5% were used for commercial properties.
Ernst & Young, however, appraised every property using discount rates of 7.75% to 20.5%.
The auditor general said the 5% discount rate Desert Troon used for lifestyle and retail properties “may not be consistent with accounting standards.” But the auditor general also said the discount rates used for the commercial properties were ones “market participants would use,” and were appropriate.
As a result, Desert Troon's appraisals for the year ended June 30, 2012, totaled $303.5 million; Ernst & Young's appraisals totaled $213.6 million.
Desert Troon's valuation was used in the pension fund's financial statements for the year ended June 30, 2012, which led to a dispute the following year among PSPRS investment staff as to what discount rate to use. That disagreement ultimately led to the resignation of the three portfolio managers and the chief counsel.
Mr. Holder said the 5% discount rate was too low to reflect the market value of real estate, as required by the GASB. He said investors in real estate generally use at least 12% to 15% to reflect the speculative nature of real estate investments. He said 5% would be closer to a risk-free rate.
For the fiscal year ended June 30, 2013, Ernst & Young's valuation was about $82 million less than the approximately $344 million Desert Troon had reported.
Mr. Hacking told P&I that using a market-based valuation would have understated the value of the Desert Troon portfolio by as much as $151 million combined in the two fiscal years ended June 30, 2013.
Valuation issues also surfaced in earlier years. In 2007, the joint venture with Desert Troon purchased Superstition Gateway, a shopping complex in Mesa, Ariz., and tracts of vacant land in other parts of metropolitan Phoenix.
In 2010, the pension fund hired CBRE Group Inc. to appraise the shopping center and land, using PSPRS' new market-value appraisal policy, Christa Severns, the pension fund's former external spokeswoman, has said.
Based on the appraisal by CBRE, the pension fund's entire equity investment of $64.4 million in Superstition Gateway would have to be written down, according to a June 18, 2010, e-mail to Mr. Corens from Desert Troon CFO Daniel Hammons,who questioned the appraisals.
“These values seem criminal,” Mr. Hammons wrote.
That e-mail also said that based on the CBRE appraisal, the pension fund's entire $31.7 million investment in Terra Verde, a partially completed office park in Scottsdale, would be wiped out.
In an e-mail to P&I, Ms. Severns said pension fund and Desert Troon executives were concerned that the market-based appraisals might have “produced 'fire sale' values that would have wiped out the (pension) system's and DTC's equity interests in some of those properties.”
“The resulting values could have arguably violated the loan covenants and potentially caused lenders to issue technical loan defaults or at the very least demand principal reductions,” she wrote.
Ms. Severns said after seeing market-based appraisals that showed a severe decline in property values, Desert Troon executives requested the pension fund use the investment-value approach for its joint-venture portfolio.
She said PSPRS' CIO Mr. Parham then arranged a meeting in the summer of 2010 between Desert Troon and CBRE group officials and both agreed an investment-based methodology should be used to value the properties. And it was.
Mr. Hacking said in his July 2013 letter to the state auditor general that Desert Troon officials had argued in 2010 that it would be unreasonable to report then-current market values for the joint venture, DTR1, since those properties were not going to be sold immediately and could be sold at substantially higher prices in the future.
The properties were ultimately reappraised higher, using investment value, as requested by Desert Troon. The properties — including Superstition Gateway and Terra Verde — were written down by approximately $50 million in 2011.
A 2010 appraisal that valued the properties at about $100 million less using market value was never used. Indeed, for the five fiscal years between July 1, 2009, and June 30, 2013, PSPRS used investment value in appraisals.
In a formal report to the pension fund's board, Mr. Carriker, the chief investment counsel, contested those valuations. But the board adopted a report signed by Mr. Hacking and PSPRS' outside fiduciary counsel Marc Lieberman that said the use of investment value calculations was proper.
Last November, the auditor general responded to Mr. Hacking's July 2013 letter regarding the asset valuation methods, saying the pension fund must adhere to GASB rules of using fair, or market, value.
However, in another section of its report, the auditor general said for the properties in the joint venture, investment value can be used. It said PSPRS, as an investor in the entity that owns the real estate, doesn't value its investments based on the appraisals but rather on values provided by Desert Troon under the joint venture's operating agreement.
Because of that scenario, the auditor general quotes generally accepted accounting principles as allowing Desert Troon to estimate the value of PSPRS' ownership interest. The pension fund used that number.
Mr. Holder, the USC dean, disagreed that PSPRS could report investment value for the Desert Troon joint venture portfolio. He said regardless of whether joint venture real estate assets can be sold at the time they are appraised, the GASB requires public pension funds to list real estate at fair, or market, value.