Understanding the causes and effects of impairment for real estate assets under development allows for better strategic planning and management of the assets under development, financing, and financial reporting obligations.
Market conditions and broader economic factors can have a substantial impact on real estate asset valuations. Real estate entities with development projects navigate a variety of issues and uncertainties.
These include financing or refinancing in a strained borrowing market, finding prospective tenants during an anticipated lease-up phase, and managing development costs in light of inflationary pressures, including supply chain, labor, and other kinds of constraints.
These uncertainties and conditions have contributed to difficulties with compiling accurate forecasts and projections of future value.
The challenge
When there are volatilities and changing market conditions, entities that report their financial statements on a historical cost basis, including new construction or an existing property that’s being redeveloped, are required by U.S. generally accepted accounting principles (GAAP) to evaluate whether the property under development is potentially impaired.
The guidance
Accounting Standards Codification (ASC) 360-10, Impairment and Disposal of Long-Lived Assets, provides accounting guidance for the impairment of assets that are held for use or for sale.
Below is a summary of the evaluation of impairment for real estate assets under development to be held and used, including new construction and operating properties that are undergoing renovations.
Real estate assets classified as under development to be held and used are tested for impairment when circumstances change or events occur that indicate the carrying amount of the long-lived asset might not be recoverable. Any company with an active project under development is responsible for monitoring and assessing whether indicators of potential impairment are present on a routine basis and for documenting their evaluation.
Under ASC 360, assets to be held and used 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, and as a result, the evaluation of impairment is generally 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.
Evaluating whether impairment exists
The following steps are required to identify, recognize, and measure impairment in a real estate asset under development that are to be held and used:
Identify triggering events and conditions indicating potential impairment
Perform recoverability test
Calculate and recognize the impairment loss
Step 1: Identifying triggering events and conditions indicating potential impairment
This list doesn’t include all conditions that could indicate impairment, and entities should carefully analyze the factors observed as part of their analysis:
Significant underperformance — asset level
Projections or forecasts that yield continuing losses or income levels below stabilized operations
Inability to reach stabilized operations generally through a combination of slow leasing activity, high concessions, or rents below forecasted levels
Loss of a key tenant due to project delays or a tenant bankruptcy
Cost overruns, unanticipated events, or an accumulation of costs significantly in excess of the development’s budget
Market decline
A significant decline in market prices for similar properties often driven by increases in financing costs and capitalization or discount rates
Macroeconomic and local conditions that negatively impact property values
Damage to the property that reduces its value
Market dynamics that make the property functionally obsolete or less desirable
Overbuilding or hyper supply in the market for similar properties which impedes lease up phase
Inability to continue with the development or changes in use
Inability to satisfy terms to convert financing from construction to term or permanent financing, or extend debt maturity without raising additional capital
Inability to service the debt, including increasing variable interest rates associated with borrowings, or an event of default
Significant legal factors or contingencies that could affect the recoverability of the asset
Adverse action or assessment by regulatory authority
Decisions to abandon or sell an asset
Step 2: Perform recoverability test
Test for recoverability by comparing the net carrying value as of the balance sheet date, or cost recorded, to the sum of undiscounted cash flows that are estimated from the use and eventual disposition of the asset based on its expected service potential once the development is substantially complete.
ASC 360-10 allows entities to use either a single approach based on the most likely outcome — best estimate approach — or if there are a range of future potential outcomes, it allows for a probability-weighted approach.
This is generally appropriate when there is uncertainty related to potential cash flows generated during the lease-up phase or if there are contingencies tied to the completion of the development.
If the probability-weighted approach is used, the likelihood of each potential outcome should be evaluated while estimating future cash flows, and management would then allocate a proportionate weight based on their anticipation of the likelihood of each potential outcome.
The estimates of undiscounted cash flows should include all necessary cash outflows that are expected to be incurred in order to complete the development including eventual sales, transfer and closing cash flows, regardless of whether these would be capitalized or recognized as an expense in future periods.
Interest payments
While ASC 360-10 states that interest payments should not be included within cash flow estimates for the purposes of performing the recoverability test for a real estate asset held for sale or held for use, since those interest payments will be expensed, these interest payments should be included in cash flow estimates for an asset that is under development when payments are being capitalized. ASC 835-20 states that the capitalization period should end once the asset is substantially complete and ready for its intended use.
Cash flows
The inputs and amounts included within cash flow estimates should be consistent with other information available to the entity or otherwise known, and should reflect the circumstances that are present as of the balance sheet date.
This includes obtaining information from current forecasts, development budgets, and data obtained from other comparable properties. The entity should support each assumption used with relevant market support where available.
Undiscounted net cash flows should include all expected future cash flows to complete the development, including the existing budgeted amounts for the project and management’s estimate of additional amounts anticipated to occur, and should also include any relevant cash flows to maintain the existing service potential of the asset after completion.
This can be challenging regardless of development phase, especially when substantial completion is still several years away.
Fortunately, GAAP only require entities to include estimates of cash flows that they reasonably expect to incur as of the date of measurement. That should generally be adjusted for an expectation of growth over the term of the cash flow analysis. However, it isn’t necessary to incorporate elements that can occur while developing a property but which aren’t predictable, such as future price increases attributed to labor-related delays, material sourcing or supply chain constraints, or other impeding factors.
Where to start
For estimating cash flows to complete the development, we recommend that entities start with evaluating capitalized amounts as of the date of measurement in conjunction with their most recent construction budget, and then evaluate where they reasonably expect additional overruns could reasonably be incurred and the overall likelihood that they will be incurred.
Soliciting information from others directly involved in construction could also help by corroborating the current estimate of the project’s percentage of completion with others directly involved in the construction of the property such as the construction manager. This can include where amounts could overrun and how likely that is, and whether the project is on track for substantial completion.
The length of the term used in the cash flow estimate can vary by entity but should generally align with the period in which the entity is willing and able to hold the asset, and should be through the date in which the entity expects to sell or dispose of the property.
This includes considering the future maturity of any significant outstanding borrowings used to finance the development and ability to repay the obligation or obtain additional financing. This means that if conditions that must be met to refinance or extend the maturity of a loan, the entity must be able to prove they can do it.
In general, the term used should be consistent with the entity’s intent and ability to finish the development of the asset and then hold the asset, if that’s management’s plan upon completion. Management will need to support that conclusion.
In addition, the term of the cash flow analysis used rarely exceeds ten years and generally shouldn’t be less than one year unless management of the entity plans to dispose of the development within that time frame.
If the sum of undiscounted net cash inflows exceeds the net carrying value of the real estate asset under development, an impairment loss should not be recognized.
However, if the undiscounted net cash inflows do not exceed the net carrying value of the asset, an impairment loss should be calculated.
Step 3: Calculating the impairment loss
If the asset under development fails the recoverability test, an impairment loss must be recognized, and the entity will need to compare the net carrying amount to the estimated fair value. An impairment loss would then be recognized in an amount equal to the estimated fair value of the asset in its current state less the carrying value on the measurement date.
The estimated 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 measurement date.
The three most common approaches to valuing real estate include:
Cost approach
Sales comparison
Income approach
Given these circumstances and the fact that the asset is under development, the cost approach is rarely used to estimate value due to the difficulty in measuring economic obsolescence.
ASC 820 doesn’t prioritize one valuation technique over another, instead GAAP prioritizes observable inputs over unobservable inputs when applying valuation techniques.
Market data
Consequently, the availability of comparable transactions and market data is generally significant for the purposes of determining the asset’s estimated fair value.
However, sales activity can be limited in a declining market, and it wouldn’t be appropriate to use older sales or sales of properties that vary substantially from the subject. As it would be unlikely that sales of partially completed property could be frequently identified in the market, stabilized properties are generally used to estimate the stabilized value of the subject property and deductions are made for the remaining development and stabilization activities related to the finished asset.
The sales comparison approach is often used as a reasonableness test for the income approach as opposed to a primary approach.
Income capitalization
In most cases, the income capitalization approach is appropriate since the subject property will presumably generate income upon stabilization through leasing to the open market, and market participants place a greater level of attention to a subject’s capability to produce income in future periods. When the subject property is under development, the estimate of the present fair value may be determined using discounted cash flows to calculate the value as stabilized or as complete based on future expected cash flows after reaching stabilization.
The subject’s estimated stabilized fair value would then be adjusted to an as-is basis to reflect remaining development cash flows on a discounted basis and entrepreneurial incentive or profit for the new buyer. Profit is estimated based on input from market sources and considers remaining risks to be assumed by the buyer including remaining construction, lease-up and cap or discount rate risks.
Sales, closing and transfer tax cash flows need to be considered in the reversion year of an income analysis to estimate the fair value of the asset. Terminal sales, closing fees and transfer taxes are not deducted from the fair value estimate of the asset overall but are deducted in the cash flows to determine fair value. Likewise, these costs are not deducted in a sales comparison technique from the overall asset value. If the development project is a land or condominium project, the sales, closing and transfer fees must be deducted from each individual unit sale.
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.
