There’s increasing demand from investors in real estate companies for fair value reporting, particularly in times of market turbulence. Investors want to be sure to understand what their investments are worth and how they’re performing. Fair value reporting can be challenging for real estate firms to jump into if its unfamiliar to them, as it requires technical expertise beyond the typical historical cost reporting most finance teams are used to handling.
One of the first steps is to consult with your accountant about the appropriate way to arrive at fair value reporting in compliance with US GAAP. Companies that meet the definition of an investment company under ASC 946 should clearly report at fair value, but there are other ways to get there as well to meet users’ needs, including supplemental information or disclosures.
A key step is to ensure you have a formally documented valuation process, and that it’s actually adhered to in practice. One of the key features is how often external appraisals will be obtained; commonly this will be annually or bi-annually, but can be as frequent as quarterly.
It’s important to understand the difference between valuing an investment vs. the property itself. Generally, an appraisal will be done at the property level, but the fund or reporting entity will present the value of its investment (also called its equity position), which will be the property value, less any mortgage debt, plus working capital (e.g., cash and tenant receivables) at the fund’s share.
Valuation models are scrutinized by auditors in the annual financial statement audit, as fair value generally comprises the largest number on the balance sheet, as well as the most subjective and therefore risky audit area. In addition to the experienced audit team, frequently auditors will utilize real estate valuation specialists to review the models, assumptions and conclusions reached.
Certain improvements to your valuation process can help facilitate the auditor’s review process. Following are some common shortcomings you should avoid for this upcoming year-end:
- Deviation from external appraisal without clearly documented thought process and reasoning around it. In general, if you’re hiring an appraiser, you should use their value conclusion. We’ll sometimes see companies make significant adjustments to external appraisal conclusions on the basis that the appraiser had incomplete information or didn’t properly consider a certain factor. However, in this case you should engage with them to provide this information and ask them to revisit the conclusion. Where the fair value conclusion differs from a recent appraisal, the reasoning behind the value difference should be clearly explained. The value should be evaluated on a unit basis relative to the comparable sales data provided in the appraisal. It may also be necessary to augment the comparable sales data depending on the passage of time since the appraisal.
- Not following the documented valuation policy, for example regarding frequency of external appraisals as well as the policy for valuation of development projects. If the policy is to keep either recent acquisitions or development deals at cost, as this approximates fair value, it’s critical to apply this policy consistently across the portfolio.
- Not writing off transaction costs. Frequently when recent acquisitions are valued at cost, companies will erroneously include acquisition costs in this total, as these attorney, bank and commission costs can be a substantial part of their cash outflow. However, under ASC 820, these costs shouldn’t be included in the measurement of fair value.
- Valuing a portfolio as a whole without consideration of allocation to the individual assets. If there’s any possibility of the portfolio being split up in the future, it’s important to ascribe a value to the components from the beginning.
- Not utilizing Argus Enterprise or other widely accepted industry valuation software. Companies should avoid Excel cash flow models, except perhaps for a simpler multifamily investment, to reduce room for error. In addition, programs such as Argus Enterprise can clarify the process of explaining component value differences from a recent appraisal.
- Not accounting for promote to operators. JV deals will frequently include a promote to the operating partner if certain performance hurdles are met. With the exception perhaps of very recent acquisitions that haven’t yet increased significantly in value, it’s critical to run the waterfall model for the deal, so the value can be reported after any promote, rather than just the pro rata share.
- Using the same rates across all assets in a portfolio. Discount and terminal capitalization rates employed should be tailored by asset type and geographic region. There are significant differences across markets, and it’s important that rate inputs reflect prevailing investor trends for the specific asset.
- Use of unobservable inputs that aren’t easily validated. Use of rates that are within the ranges reported in trusted industry publications is much more easily supportable.
- Cash flows not matching your budgets for the property. Apart from a few specific components like management fees and capital reserves, year one cash flows in a cash flow model should match your budget for the property. The management fee assumption should reflect a market rate by property type. Rationale for any deviations should be documented.
Best practice is to maintain a valuation memo that outlines the major assumptions of each asset’s model and the support for those, as well as some qualitative commentary on the conclusions reached. Finally, be sure to keep a record of your investment committee’s approval of the valuations each period.
Author: Katelyn Kogan, Senior Manager & Tom Holman, Director