Purchase price allocations in times of uncertainty
Real Estate | Kennett Square, PA
SummaryThe purchase price allocation is a critical audit matter in accounting for a new acquisition. Amid a recession, the valuation of the land, building improvements, and leases in place of an asset requires abundant testing and reconciliation to ensure the conclusions reflect fair market value.
Despite challenging economic conditions, participants in the commercial real estate (CRE) market continue to evaluate acquisitions. Companies with historic cost accounting will need to prepare a purchase price allocation on newly acquired assets. Developing a supportable allocation amidst times of uncertainty presents unique valuation challenges, including a dearth of comparable evidence, displacement of market rates, and uncertainty of speculative cash flow assumptions.
A misallocation of value to tangible and intangible assets can result in material impacts to investor reports and may put the company at risk for a future impairment or cumbersome audit scrutiny. As a result, auditors have deemed purchase price allocations as one of their most critical audit matters. However, a thorough purchase price allocation can not only pass audit but help bolster support for a company’s internal underwriting and instill greater confidence in the financial reporting statements.
The following summarizes key areas of focus to ensure that a purchase price allocation appropriately accounts for current sentiment and behavior of market participants during times of uncertainty.
Reconciling transaction price with fair value
An important first step in preparation of a purchase price allocation is a full reconciliation of fair value to the transaction price. When markets are changing rapidly, the reconciliation will ensure that the dynamic inputs and key performance indicators of the analysis will ultimately be reflected in the forthcoming allocation.
Some important reminders on the overall transaction analysis:
- Document any concessions, earn-outs, or other value-related discussions that were impactful to the finalized deal terms
- Report on insights from brokers, deal teams, and other industry professionals to adequately support capital markets assumptions used in the analysis
- Evaluate how any assumed debt impacted the purchase price
- Prepare multiple valuation methodologies and reconcile with the purchase price
A thoughtful analysis of the overall transaction will yield valuable insights to the valuation of the individual assets and liabilities.
Land valuation in an environment with few sales
Material shifts in real estate pricing are not evenly distributed between land and building improvements. The two components will need to be evaluated independently.
In cycles of economic contractions, land valuations are often the first impacted. As demand weakens, development activity typically slows, and as a result, land transactions are far less frequent.
Traditionally, a “Market Approach” is used to determine the value of the underlying land of an asset. However, a dearth of comparable transactions and deals will make it difficult to support a conclusion using this approach.
Additional means of valuation support – such as brokers’ opinions of value, trend analysis, or use of an alternate methodology (e.g., development method) – will be critical in developing a reasonable and supported land value conclusion.
Building improvements impacted by economic obsolescence
An uprooting of market demand may result in economic obsolescence to the building improvements. Newly identified structural vacancy, oversupply, or other shifts in leasing demand for the asset may not justify a full replacement of the building improvements.
In a challenged environment, a cost approach – an analysis of replacement costs less depreciation – alone likely will not adequately reflect various economic factors impacting building value. Further, changes in soft costs, entrepreneurial rewards, and other development incentives may significantly disrupt replacement cost estimates.
An income approach, or “go dark” scenario, is an alternate method in estimating residual building value. A discounted cash flow is performed where the improvements are assumed to be vacant and subject to lease-up. A building value is then estimated after deducting the value of the land and contributory site improvements. This approach better reflects valuation impacts from external economic factors and should be performed in tandem with the cost approach.
Replacement cost of a lease in place, and other value considerations
Lease economics such as base rent, escalations, downtime, free rent, and tenant improvements are all factors in determining the fair value of a lease agreement. As tenants across all market segments have pushed for additional concessions, deferrals, or rent reductions, granular research into the leasing environment of the micro-market will be necessary to calculate appropriate lease replacement costs.
In the search for credit quality and income security, market participants may find additional intrinsic value in a lease agreement. For instance, a lease with a quality tenant – one that would not be able to be reproduced in today's shifted environment – may justify a premium beyond simply replacement cost. Conversely, a deterioration of tenant credit or other collateral may elevate the probability of default on the lease and correspondingly justify a discount to replacement cost.
While the replacement cost of the lease remains relevant, an appropriate purchase price allocation will need to also contemplate a tenant’s credit quality, ability to service their commitments, and how these factors may have impacted the purchase price.
How Chatham can help
In an environment of uncertainty, thorough documentation and expertise is key in supporting purchase price allocation exercises. If internal resources are constrained, engaging an experienced third-party professional can be advantageous in establishing credible valuations.
Chatham’s team of experts in real estate valuation, accounting, and technology work in tandem to produce comprehensive, transparent, and cost-effective fair value exercises. Chatham has access to proprietary transactional data and deal insights that are leveraged into each valuation, and technological tools that ensure a timely delivered analysis.
Chatham can help
Request a pricing matrix for your purchase price allocations
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