The renewed importance of impairment testing
- May 21, 2020
Real Estate | Kennett Square, PA
Real estate market participants remain cautious, requiring significant areas of judgement in quantifying updates to cash flow modeling and discount rates.
Uncertainty in the real estate markets
The COVID-19 pandemic has brought significant uncertainty to real estate and financial markets. Cash flow challenges continue to mount for equity REITs, including anticipated tenant defaults, forgiven rental payments, and an accumulation of expenses. Real estate market participants remain cautious, requiring significant areas of judgement in quantifying updates to cash flow modeling and discount rates.
The last time real estate markets experienced this level of volatility was during the global financial crisis of 2008, which resulted in a wave of REIT impairment charges. While the duration of the COVID-19 crisis and ultimately its impact to real estate asset pricing remains unknown, uncertainty will drive investors, auditors, and regulatory agencies to understand how companies are testing for potential impairments.
Accounting standards guidance on impairment
In periods of economic expansion, REITs may have relied on qualitative impairment testing to evaluate assets, or groups of assets, such as property, definite-lived intangibles, and other debt and equity investments. This is an acceptable and reasonable approach as there would be few market-driven indicators of impairment.
Impairment is addressed in Accounting Standards Codification (ASC) Topic 360, Property, Plant and Equipment, “a long-lived asset should be tested for recoverability whenever events or changes in circumstances indicate that its carrying amount may not be recoverable.” (ASC 360-10-35-21) The accounting guidance lists several specific indicators of impairment, or “triggering events”, relevant to real estate companies including:
- A significant decrease in the market price of a long-lived asset;
- A significant adverse change in legal factors or in the business climate that could affect the value of a long-lived asset (asset group), including an adverse action or assessment by a regulator;
- An accumulation of costs significantly in excess of the amount originally expected for the acquisition or construction of a long-lived asset (asset group); and,
- A current-period operating or cash flow loss combined with a history of operating or cash flow losses or a projection or forecast that demonstrates continuing losses associated with the use of a long-lived asset (asset group).
These indicators are rising in relevance as the duration of the COVID-19 crisis lengthens, suggesting that qualitative tests—used to determine if it is more likely than not that the asset is impaired—may be insufficient. The United States Securities and Exchange Commission will expect full disclosure from registrants on impairment testing procedures and whether any asset group is close to failing an impairment test.
In times of uncertainty, companies should actively perform and document internal measurements of fair value using market-evidenced cash flow inputs and discount rate adjustments. Engaging with a third party to supplement your research and documentation may be a critical step in bolstering financial reporting disclosures on a timely basis. Detailed below are key considerations in cash flow modeling, discount rate adjustments, and reconciliation of impairment.
Cash flow support
To quantify risk, companies will need to develop valuation models that reforecast cash flow projections that are reflective of current market conditions. In modeling cash flows (including estimated disposition proceeds), it is important to monitor the following market implications:
- Structural shifts in market rental rates, renewal probabilities, other revenue sources and vacancy;
- Increased expense burdens (it is important to note that even in a net-lease arrangement, an increase in rates can impact the gross occupancy cost thresholds that tenants maintain);
- The impact of any reduced capital programs and related impact on future profitability; and,
- Shifts in capital markets being adequately reflected in estimated disposition values.
In the event of a sustained downturn, certain market asset classes and locations, as well as recently acquired assets with little accumulated depreciation, may be at greater risk that the asset group’s carrying value is unrecoverable through future cash flows.
Chatham can provide independent guidance and assurances on key modeling inputs, disposition assumptions, and documentation of results in assisting a company with their internal testing.
Discount rate justification
A company’s valuation will also need to document measurable support for any discount rate adjustments. A dearth of market transactions provides additional challenges in developing evidence of discount rate adjustments, so it will be important to maintain a keen focus on both debt and equity markets to establish trends.
Chatham aggregates thousands of verified asset valuation datapoints from both private and public real estate markets, including property appraisals and discount rates. Utilizing this information, Chatham can provide preliminary impairment assessments as a tool to understand the likelihood of impairment on an ongoing basis.
Reconciling fair value in case of impairment
If the cash flows and market discount rates are deemed to be unsupportive of current carrying value, the amount of impairment loss will ultimately be the difference between the property’s fair value and the carrying value.
Once the impairment is estimated, the carrying amounts of the long-lived assets are decreased by that impairment loss. The impairment loss should be allocated based on the fair value of each asset, rather than an equal percentage decrease to each asset, as this testing can done without undue cost and effort (similar to a purchase price allocation).
Chatham's team of experts in real estate valuation, accounting and capital markets are available to bolster and supplement asset valuations, as well as perform allocations of any impairment loss to each long-lived asset.
Contact Chatham's valuations team
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