Get Ready for ‘Fair Value’
- May 10, 2010
Publicly listed companies may be on the road to providing arguably truer pictures of the state of their finances. This is because the Securities and Exchange Commission (SEC) may soon require these companies to comply with an accounting standard that can provide more updated valuations of the real estate they own and report on their financial statements.
Companies that already use this valuation method “think that it provides a more accurate representation of the financial strength of the company,” says George Yungmann, senior vice president, financial standards, at the National Association of Real Estate Investment Trusts (NAREIT).
Currently, companies in the U.S. comply with the standards of the Generally Accepted Accounting Principles (GAAP). But in recent decades, other countries have been transitioning to International Financial Reporting Standards (IFRS). In 2008, the SEC put out a proposal and timeline for mandatory transition to the international standards for fiscal years ending on or after Dec. 15, 2014. The SEC is expected to make a final decision next year about whether public companies will be mandated to transition to IFRS. While only public companies will be affected by any SEC mandate, the accounting standard is also an option for private companies.
One of the main ways that IFRS, if adopted, will affect U.S. public companies is in the use of “fair value” to value properties on financial statements. Currently, under GAAP, commercial real estate properties have been reported mostly at “historical value”—what they cost to purchase—and are subsequently depreciated over a number of years.
The fair value standard, on the other hand, requires the recording of properties on the basis of their present value in the market. IFRS gives companies the option of reporting either under fair value, or under the presently used historical cost, with a disclosure of fair values, according to the accounting firm Deloitte.
The implication of reporting under fair value as opposed to historical cost is that if the market price of the commercial real estate property being carried has decreased or increased, that change will be reflected on the income expense statement. The company’s net income could increase by the amount of the higher market value of the real estate as a result of a fair value adjustment. On the other hand, no depreciation and amortization on the property will be taken, as would happen under GAAP accounting. Conversely, if the property’s value falls, the decline in value will be subtracted from the net income.
Under GAAP accounting currently under use, “the value of properties would be put on the books on the purchase price and a percentage would be depreciated every year,” explains Brian Glanville, interim chairman of RICS (Royal Institution of Chartered Surveyors) Americas Valuation Council Real Property Board. “On the other hand, fair value asks, ‘what can you sell the property for?’”
FAS 157’s definition
It appears that the IFRS’s proposed definition of fair value will be identical to that of Financial Accounting Standards No. 157 (FAS 157) Fair Value Measurements issued by the U.S. Financial Accounting Standards Board (FASB) in 2006. The International Accounting Standards Board (IASB), which sets IFRS, had tentatively defined fair value as it is defined under FAS 157. “The IASB used FAS 157 as a beginning point for their proposed fair value standard and therefore the IASB’s proposed definition of fair value for IFRS is virtually the same [as FAS 157],” says Serena Wolfe, senior manager, Global Real Estate Center at Ernst & Young.
According to a technical guidance from Ernst and Young, FAS 157 does not prescribe what valuation techniques should be used to determine fair value. In some cases, a single valuation technique may be appropriate and in other cases, multiple valuation techniques would be appropriate. However, FAS 157 does indicate that valuation techniques should be consistent with the market, income and cost approaches.
Glanville asserts that appraisers have already been using the fair value standard for years to appraise properties. Determining the fair value under the FAS 157 definition is “what we typically do from a valuer’s perspective, although from the accountant’s perspective that is a whole new concept they have not dealt with,” he says. For example, appraisers employ the cost approach—what the property cost and income capitalization—the income generated by the property and sales comparisons, and/or a combination of the three approaches as appropriate to value the property.
Under FAS 157, “fair value” is defined as “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.” In other words, fair value under FAS 157 is based on “an exit-price concept,” says Matthew Kimmel, principal at Deloitte Financial Advisory Services LLP. This compares to an “entry price” basis for valuation, which takes into consideration what the buyer originally paid to acquire the asset.
Kimmel explains that fair value also makes use of the “highest and best use” concept. “It is relatively new to accounting, but it is a concept that has been around for years in the valuation world—that fair value is an asset that is put to the highest and best use,” Kimmel says. Under this standard, an apartment property can be valued as a condominium if it is determined that the condo use will be the highest and best use in the present market, or vice versa.
Pros and cons
RICS’s Glanville argues that it will be advantageous for apartment companies to report their properties under fair value. “A lot of us, especially on the valuation side, feel that [fair value] provides a better picture of what the assets of the corporation are worth and a more transparent picture for investors of that corporation,” says Glanville.
Indeed, NAREIT’s Yungmann affirms that the majority of companies that are already reporting under IFRS have chosen to use fair value rather than historical cost to record real estate holdings because “most feel the fair value standard provides a better indication of the financial strength of the company.” Glanville agrees, illustrating his point with the example of a REIT that may own 30 properties that have been fully depreciated. “There may not be a lot of value on the books, but these [properties] hold a lot of value,” he notes.
But attorney Stuart Saft, chair of Dewey & LeBoeuf’s Global Real Estate Department, observes the disadvantages of valuing at present market value when the market is depressed. In a soft market, the market value of the portfolio goes down. “Companies have been reevaluating their assets based upon [a] possible distressed sale, which makes no sense unless you are having a distressed sale,” he notes.
Saft also points out that the valuation should not necessarily take into account present market value when the market is greatly depressed. “All you need is for one owner to sell at a discount and all the surrounding properties will be in the distressed zone because of comparables,” he says. “The standard should not be what the property can sell for in the distressed market, but what it is likely to sell for six months from now.”
Conversely, in a hot market, there will be other kinds of distortions. Unlike lenders who have to comply with FAS 157, real estate companies can value their portfolio upwards as the market improves. This, however, can contribute to another bubble when lenders begin to lend against the higher income or valuations of the company. “There are problems at both extremes of real estate markets,” says Saft.
Glanville suggests that it is a function of the appraiser’s skill to avoid allowing market distortions to influence the valuation. The appraiser’s job is to ensure that the valuation is not influenced by the depressed market or distressed sales. For example, the appraiser has to talk to both buyers and sellers to ask if the sale was distressed, and to not use distressed sales in calculation of the fair value.
NAREIT’s Yungmann says that U.S. REITs are generally not transitioning yet to IFRS, as the SEC has said that any requirement to use IFRS would not be effective until 2015. “There is a while to go,” he adds. Companies that are transitioning from GAAP to IFRS may have to incur additional costs, not only in conducting frequent appraisals, for example, but also in updating their computer systems and training their staff in the new standards.
As to the question of how often valuations need to be performed, Ernst & Young’s Wolfe says that, in practice, European companies that comply with IFRS divide their portfolios into thirds, so that properties are appraised once every three years. In between the appraisals, in-house trending or modeling is performed to ascertain changes in value. “What is important is that the valuation represents the market’s view of fair value, using available real estate market information,” Wolfe explains.
Yungmann acknowledges that companies that have qualms about using fair value say that it will require more work, cost more in terms of in-house staff or valuation consultants, and make the companies’ incomes more volatile as “any increase or decrease in values of the assets must be reported.”
Dennis Steen, CFO at the multifamily REIT Camden, says his company is waiting to see whether IFRS will be mandated by SEC. He says it is unlikely the “fair value” will change the way investors already view the REIT, as many analysts already calculate the net asset value of REITs, which equates to the market-based value of their assets. Steen says that he foresees the biggest additional costs of the fair value valuation standard will lie in the additional appraisals needed and increased staffing needs. The question remains whether these will be performed by third-party appraisers or whether the auditors will sign off on internal valuations.
Whether or not SEC will require public companies to adhere to IFRS, Yungmann warns REITs to be aware that major accounting changes are coming down the pike. The U.S.’s FASB and the IASB are both working on converging some major accounting standards, in the areas of leasing accounting, financial statement presentations and revenue recognition, says Yungmann. If IFRS passes for U.S. REITs, these convergences will be superceded by IFRS. However, if IFRS does not pass, these convergences will nevertheless bring changes to existing accounting practices.
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