The Importance Of Residual Value

Whenever the negotiations for the sale of a ship become serious, one or more of the parties to the deal will try to estimate the future value of the ship, the so-called residual value. The residual value has a substantial effect on the Internal Rate of Return of a proposed ship investment, and both the buyer and the seller know it. Consequently, the final agreement between buyer and seller is often significantly influenced by the residual value.

From the leading institution's perspective, the residual value anchors the depreciation curve of the asset against which the money is lent. The residual value affects the spread between the loan's outstanding balance and the asset's estimated value during the entire life of the loan. And if there is a sizable balloon payment at the end of the loan, the significance of the residual value is magnified.

Given the obvious importance of the residual value estimate, one would expect that a great deal of thought and care would go into calculating it. Often, however, that appears not to be the case. At the recent Sixth Annual Ship Finance Conference in New York, I presented evidence to show that residual value was frequently estimated by simply assuming that current market conditions would continue unchanged into the future.

For the ship resale market, universally regarded being volatile and eccentric, such an unrealistic assumption leads to strange and unexpected results.

Specifically, this method of estimating residual value leads to two situations that are frequently seen and often attributed to luck, good or bad.

First, when markets are weak — low ship prices and low charter rates residual values are underestimated. When the market eventually turns, the owner may experience a windfall profit when the resale price of the vessel exceeds the estimated residual value. The second situation, in parallel to the first, is when markets are strong — high ship prices and high charter rates. Then residual values are overestimated, and when the market eventually turns, the owner may find that the resale price is less than the estimated residual value. Two questions come immediately to mind: first, why are residual values being calculated so poorly, and second, is there a better way to do it? To answer the first question, two factors influence the poor choice of residual values. First, there is little organized historical data available upon which to base estimates of the future. This may seem to be a strange statement when reports of sales are published daily. Nevertheless, there are very few easily accessible databases with information of this type. And second, without reliable historical data, personal memory, experience and market "feel" are used. In the absence of any factually based arguments to the contrary, a continuation of the present market status may seem reasonable.

To answer the second question, there is a better way to calculate residual value, and that is the inflation- adjusted historical average sale price. The reason for this choice is simple. It is not possible to accurately forecast specific market phenomena such as ship values, except possibly in the very near term. When predictions are needed for several years into the future, the most prudent guess — and it is just a guess — is the inflation-adjusted historical average.

In 1986, Shipping Intelligence started collecting data about the sale of ships. Currently, there is information on more than 5,000 sales, and the databases are updated almost daily. The reason for building this database was to construct a statistical model of the ship resale market, and that project now publishes the twice monthly Shipping Intelligence Shipping Monitor.

More recently, Shipping Intelligence has become involved in evaluation of proposed ship investments. The company soon realized it needed better estimates for ship residual values, and decided to use the inflation-adjusted historical average. With this, the company was able to calculate estimates directly from its ship sale database. While the database itself is proprietary, residual value information derived from it is available in several forms. A Ship Resale and Residual Value Guide has been published that contains residual value estimates for 20 different sizes of bulk carriers and tankers at a variety of critical ages. An example of this type of information included in the guide is shown in the accompanying table (below, left). For particular investment evaluations, a report containing extensive statistical and historical information is available.