A version of this article appeared in Commercial Real Estate Executive on Sept. 18, 2024.
Real estate entities are navigating a spectrum of market variables and uncertainties including the availability of financing, leasing activities, cost management, tenant demand, and geopolitical factors. These evolving trends and uncertainties are exerting pressure on real estate values.
Understanding the causes and effects of real estate impairment allows for better strategic planning. It enables proactive assessment and management of the real estate assets, financing, and financial reporting obligations.
The challenge
When market conditions change or volatilities exist, historical cost reporting entities are required to assess real estate for potential impairment. The evaluation of impairment requires significant judgment and thoughtful analysis and is crucial to the accurate reflection of property values in financial statements and transparent financial reporting.
If an entity uses the fair value reporting framework, the following guidance related to potential triggering events and the calculation of fair value is relevant.
The guidance
Accounting Standards Codification (ASC) 360-10, Impairment and Disposal of Long-Lived Assets, provides the accounting guidance for the impairment of assets that are held for use, held for sale and to be disposed of by other means.
The following provides an overview of the evaluation of impairment for real estate held for use. Real estate assets that are held and used are those assets that an entity uses in its operations or intends to recover through use and for which the held for sale criteria have not been met.
Real estate assets that are classified as held and used are tested for impairment only when events or changes in circumstances indicate that the carrying amount of the long-lived asset might not be recoverable. Accordingly, entities do not need to routinely perform tests of recoverability. However, entities are responsible for routinely assessing whether impairment indicators are present and should have systems and processes to document the evaluation of impairment indicators.
Under ASC 360, assets are evaluated for impairment at the lowest level for which identifiable cash flows are available. Many real estate owners maintain financial information at the property level. As such, the evaluation of impairment is performed at the individual property level.
The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely. The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.
The following three steps are required to identify, recognize, and measure the impairment of real estate:
Identify triggering events
Perform a recoverability test
Calculate the impairment loss
Triggering events
The following are examples of potential triggering events for real estate. These examples are not all-inclusive and careful analysis of the factors for each real estate asset is required:
Significant underperformance — asset level
Operating or cash flow losses
Projections or forecasts that illustrate continuing losses
Flat or negative rent growth patterns with increasing expenses
Increasing vacancy rates or loss of a significant tenant
Project lease-up occurring at much slower rates than originally forecast
Projects under development or significant renovation during a down market
Cost overruns or an accumulation of costs significantly in excess of the amount originally expected
Market decline
A significant decline in market prices for similar properties
Negative market absorption of comparable space
Macroeconomic and local conditions that negatively impact property values
Damage to the property that reduces its value
Changes that make the property obsolete or less desirable such as building heights, low parking ratios, or size of property
Overbuilding or hyper supply in the market for similar properties
Inability to hold the asset
Increasing interest rates on variable debt or maturing debt
Inability to refinance debt or unavailability of financing for similar assets
Inability to service the debt, maturing debt, or debt defaults
Significant legal factors or contingencies that could affect the value
Changes in use
Changes in local government zoning or environmental regulations
Inability to complete construction or renovations
Using the asset in a modified manner
Decisions to abandon an asset or sell an asset
Recoverability test
As asset should be tested for recoverability by comparing the net carrying value of the asset to the property’s undiscounted cash flows to be generated from the use and eventual disposition of that asset. Cash flow estimates should reflect conditions and assumptions that exist as of the triggering event date and should not reflect subsequent events.
Estimating cash flows for the recoverability test is subjective. The entity should support each assumption used, preferably with third party data when available. The estimated cash flows should be consistent with other information the entity has available, such as forecasts, budgets, or data for the asset or similar assets.
Current market data as well as future expectations of operations should be considered in preparing the estimated cash flows. For example, the possibility of lower market rents, declines in occupancy, or increases in costs. If future expenditures are required to maintain the asset and sustain the current cash flows, such cash outflow amounts should be included.
However, future capital improvements that would increase the service potential of the asset are excluded.
Analyze potential cash flow scenarios
If different courses of action or potential scenarios are under consideration, it may be necessary to prepare a range of future cash flow scenarios. ASC 360-10 allows entities to use either a single most likely estimate or a range of possible future cash flows.
For example, Management may consider that there is a 10% possibility that the asset will be sold at the end of year one and a 90% chance it will be sold at the end of three years. If a range of possible future cash flows is considered, the scenarios are weighted for their respective probabilities.
The length of the cash flow period to be analyzed varies but is generally equal to the entity’s anticipated holding period of the asset, the debt expiration or an anticipated near-term sale of the asset.
The cash flow period is rarely more than 10 years and may only be one year if the owner’s intent is to sell the asset immediately. If the intent is not to sell the asset immediately, the owner will need to support their ability and intent to hold the asset over the estimated cash flow term.
If the undiscounted net cash flows exceed the net carrying value of the assets, an impairment should not be recognized. However, if the undiscounted cash flows do not exceed the net carrying value of the asset, an impairment loss should be recognized.
Calculating the impairment loss
If the asset fails the recoverability test, an impairment loss is recognized. The impairment charge is equal to the amount by which the carrying amount of the asset exceeds its fair value. The fair value is determined in accordance with ASC 820, which defines the fair value as the price that would be received to sell an asset between market participants at the triggering event date.
The three most common approaches to valuing real estate include:
Cost approach
Sales comparison
Income approach
In this situation, the income and sales approach are most commonly used.
ASC 820 does not prioritize the use of one valuation technique over another, but rather prioritizes the use of observable inputs over unobservable inputs when applying valuation techniques.
Therefore, the availability of comparable transactions and market data is crucial to the determination of fair value. However, in the early stages of a downturn, sales activity may be extremely limited and it would not be appropriate to use older sales to estimate value in the current market.
The sales comparison approach is often used as a reasonableness test for the income approach as opposed to a primary approach. Vacant land would still use the sales comparison approach first and then the income approach if a holding period is warranted for potential buyers.
Sales and transfer taxes costs must be considered in the reversion year of an income analysis to properly estimate the fair value of the asset. Sales and transfer taxes are not deducted from the fair value estimate of the asset overall but are deducted in the cash flows from disposition of the property to determine fair value. Likewise, these costs are not deducted in a sales comparison technique from the overall asset value.
The cash flow period analyzed in a fair value estimate is equal to the anticipated holding period of the asset by a potential market-based buyer, typically five to 10 years.
