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Some practical guidance

Implementing SFAS No. 121 for the Impairment of Real Estate

By Abraham E. Haspel

Our previous coverage of SFAS No. 121 appeared in our October 1995 issue in the article "Accounting for the Impairment of Long-Lived Assets," by Anthony Cocco and Tommy Moores. That article provided an overview of the entire statement. The present article is intended to provide practical guidance on the implementation of the statement to real estate and does not cover all aspects of the statement. Readers may find it helpful to refer to the previous article for a general discussion of the statement.

SFAS No. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed of, is the most significant accounting principles pronouncement for owners and operators of real estate since 1982. SFAS No. 67, Accounting for Costs and Initial Rental Operations of Real Estate Projects, required adjustments for impairments of real estate held for sale or rental real estate under construction, using the property's net realizable value as the basis for the adjustment. However, there was no requirement for recognizing impairment of real property that was substantially complete and available for rental other than some very broadly worded requirement in SFAS No. 5, Accounting for Contingencies, that was inconsistently applied. This statement is designed to correct this omission and standardize accounting and reporting by requiring all impaired real estate to be written down to its fair value. The related impairment loss is to be recognized as a loss from continuing operations.

The statement differentiates between assets to be held for use and assets to be disposed of for purposes of determining when an impairment exists. Let's review these concepts in greater detail and see how they specifically apply to real estate.

Assets to Be Held and Used

Indications of Impairment. An entity is required to review its real estate whenever there are changes in circumstances that indicate the recoverability of the carrying amount of the asset is in doubt. There can be numerous indications that real estate may be impaired. Some of the more obvious ones are as follows:

* Environmental contamination of the property or its surrounding area.

* A current period operating cash flow loss combined with a history of operating cash flow losses that were not projected when the property was acquired.

* The expiration of material leases or insufficient rental demand.

* Uncertainty regarding an entity's ability to refinance debt encumbering the subject property.

* Significant cost overruns in the construction of a building.

Impairment Test and Measurement. If there are indications the carrying amount of real estate held for use may not be recoverable, it should be tested for impairment. The impairment test consists of comparing the carrying amount of the real property to the future undiscounted net cash flows (before reduction for any interest charges) expected to be produced by the subject asset including its eventual sale. The use of undiscounted cash flows before interest charges was used as a practical approach by the FASB to avoid writing down an asset before it was probable that it was more than temporarily impaired.

If the total future net cash flows thus determined are less than the carrying amount of the real estate, an impairment exists. If an impairment exists and the carrying amount of the real estate exceeds its fair value, an impairment loss is recognized equal to the amount of the excess carrying amount.

The undiscounted cash flows are determined at the lowest level for which there are identifiable cash flows; cash flow streams from different operating properties cannot be combined. If a property does not produce revenue because it is used exclusively by the entity that owns it, the asset is combined with the entity's other long lived assets and compared to the entity's future undiscounted cash flows.

Once real estate held for use is written down to its fair value, it cannot be subsequently written up if the fair value of the asset should increase. In effect, the fair value at the time of the writedown becomes its new cost--it can be reduced but not increased.

Further, even if the real property is not determined to be impaired, the analysis used to project cash flows may reveal the asset life used for depreciation may have to be shortened to reflect the revised

The statement does not provide much guidance for two components of the impairment test, carrying amount, and net cash flows.

The Carrying Amount of Real Estate includes its acquisition/construction cost, capitalized interest and taxes, other allocable costs during construction, and tenant improvements less accumulated depreciation and amortization.

Some practitioners believe that for purposes of testing for and measuring impairment, the carrying amount of the real estate should be modified to include certain deferred assets and accrued payables related to the subject property. Examples of such deferred items and liabilities are deferred leasing commissions, unbilled rent, receivables arising from SFAS No. 13 straight-lining of rent adjustment, accrued environmental contamination costs, etc.

They argue that all of these items are expected to be recovered from the future net cash flows of the property. Therefore, omission of these items when testing and measuring impairment could produce an unfair result by either avoiding the recognition of an impairment loss or reducing the amount of the impairment loss (see Exhibit 1).

Further, it would be unfair to include in future net cash flows a future disbursement for environmental remediation when the cost of this item has already been accrued as an expense in prior periods. In that instance, a loss for the same cost of environmental remediation could occur twice, once as an accrued environmental loss, and subsequently as an impairment loss.

When questioned on this point, FASB staff indicated that SFAS No. 121 allows for enough flexibility to modify cash flows to include or exclude specific components that may cause misleading results.

Cash Flows. Future cash flows used in the impairment test are the estimate of "future cash flows expected to result from the use of the asset and its disposition. Future cash flows are the future cash inflows expected to be generated by an asset less the future cash outflows necessary to obtain those inflows." The definition goes on to exclude interest charges but does not state whether the related cost of principal payments of debt are excluded. It would seem illogical to exclude interest charges and not also exclude principal payments of the
related debt.

SFAS No. 121 does not provide guidance on how cash flows and fair values are to be estimated. The statement's reference to the exclusion of interest charges, without any reference to its related debt service in determining cash flows, implies that the starting point for this calculation is income before income taxes, interest, and depreciation.

This concept is similar to net operating income (NOI) used in the appraisal of real estate. NOI is defined by one authoritative source as, "...the actual or anticipated net income remaining after all operating expenses are deducted from effective gross income, but before mortgage debt service and book depreciation are deducted." Real estate appraisers generally exclude consideration of debt service cost because debt service terms vary between comparable properties based on a borrower's financial condition, financial history, and when the loan was initiated. SFAS No. 121 expresses a similar thought in its "Basis for Conclusions" section. Therefore, it would appear that future estimated net cash flows can be calculated by determining the total estimated net operating income for the future period in which the asset is to be held, less the cost of replacing building components (roof, boiler, etc.) during the expected holding period, and the result added to the net sales price (less cost of disposal) of the asset at the end of the holding period. Obviously, NOI would exclude any income and expenses unrelated to the operation of the property (e.g., debt acquisition costs, income taxes, etc.).

This method is used by real estate appraisers in assembling the components necessary to calculate the discounted cash flow in valuing real estate. This approach was discussed with FASB staff and they believe this interpretation is consistent with the statement.

The Sales Price of Real Property at the end of its expected holding period would be estimated by capitalizing expected net operating income in the final or subsequent year after the sale using a terminal capitalization rate (i.e., NOI divided by the terminal capitalization rate). The terminal capitalization rate is usually 50 to 200 basis points above the current capitalization rate. This amount will probably have to be estimated even if the entity believes it will continue to use the real property for its remaining useful life. Even if the building were fully wasted or obsolete, the underlying land would generally have a market value unless it was environmentally contaminated, under water, or the cost of demolishing an existing structure would exceed the underlying value of the land.

Holding Period. In determining the holding period, consideration should be given to the entity's financial ability and willingness to hold the property for its estimated useful life. If an entity is perceived to be unable to refinance a mortgage encumbering the subject property at its maturity, or is in default and not expected to recover, the holding period should be modified to reflect the expected period the asset will be held by
the entity.

SFAS No. 121 recognizes that "precise information about the relevant attributes of those assets seldom will be available... Estimates of expected future cash flows shall be the best estimate based on reasonable and supportable assumptions and projections. All available evidence should be considered in developing estimates of future cash flows. The weight given to the evidence should be commensurate with the extent to which the evidence can be verified objectively."

Estimating undiscounted net cash flows over the useful lives of long lived assets such as real estate, assuming they are expected to be held for that period, may be difficult if the useful lives of those assets substantially exceed ten years. Many real estate appraisers will not provide an unqualified opinion for estimates of long term undiscounted cash flows unless those cash flows are reasonably assured by long-term credit, worthy leases, or reflect subsequent substantial expenditures for complete rehabilitation of the subject property.

Real estate appraisers generally hedge risky estimates by increasing the discount rate they use to offset the risk of erroneous estimation of cash flows. However, as previously mentioned, cash flows used to test for impairment are undiscounted and reflect no interest cost. Economists serving the real estate industry generally do not forecast more than five years into the future. The AICPA's Guide for Prospective Financial Information, paragraph 8.33, states, "It ordinarily would be difficult to establish that a reasonably objective basis exists for a financial forecast extending beyond three to five years. Financial forecasts for longer periods may be appropriate, for example, when long-term leases or other contracts exist that specify the timing and amount of revenues and costs can be controlled within reasonable limits." Consequently, caution will have to be exercised in selecting the period used to estimate future net cash flows, and periods longer than five years should be

Sources of Information. Information concerning investor expectations of income and expense growth rates and capitalization and discount/yield rates can be obtained through a variety of surveys including The Korpacz Real Estate Investor Survey, Real Estate Research Corporation's Real Estate Report, and National Real Estate Index, located respectively in Smithtown, New York; Chicago, Illinois; and Emeryville, California.

Rates published in surveys are generally national or regional averages and therefore may not reflect sales of comparable properties in the area in which the property is located. Further, these surveys generally provide a range of rates that generally apply to investment grade properties and may not be applicable to the subject property. Small variations of assumptions such as growth rates, terminal capitalization rates, and lease rollover periods can produce substantially different conclusions as to whether an impairment exists. Those who do not have expertise in this area should use a real estate appraiser as a consultant. Guidance is provided to the auditor by both SAS No. 73, Using the Work of a Specialist, and the Audit and Accounting Guide, Guide for the Use of Real Estate Appraisal Information.

Real Estate Held for Disposal

Real estate held for disposal is measured for impairment solely by comparing the carrying amount of the asset to its fair value less costs to sell. If the carrying amount of the real estate is less than its fair value, it is considered impaired and a valuation allowance is recorded to reflect a net amount equal to the property's fair value less cost to sell. Real estate held for disposal is not subject to depreciation because the cost of the asset will be recovered through sale rather than operations.

If the real estate held for disposal is written down to its fair value less cost to sell, it can be subsequently written up to its new fair value as long as the new value does not exceed its original carrying amount. In effect, the allowance for asset impairment is adjusted to reflect the asset's new fair value when circumstances suggest a change in value has occurred.

Costs to dispose include "incremental direct costs to transact the sale of the asset such as broker commissions, legal and title transfer fees, and closing costs that must be incurred before legal title is transferred." The costs relating to the holding of real estate for sale such as insurance, utility expenses, security, maintenance expenses, and other holding costs are excluded from the cost to sell category and are therefore not used in measuring an impairment loss. However, if a sales contract obligates the seller to incur additional costs as a condition of the sale, those costs are included as a cost to sell the asset.

The statement does not state how operating losses incurred by the property during the period it will be held for sale should be accounted for (i.e., recognize a liability for accrued estimated future operating losses vs. recognized losses when incurred in the income statement). In situations where the planned disposal also involves an exit from an activity, the FASB refers the reader to EITF No. 94-3, Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity for guidance. The consensus of the members of the EITF requires the results of operations of property held for sale be charged or credited to income from continuing operations in the period incurred.

If comparable sales of similar properties are used as the method of determining fair value, discounting of the future sales price is not allowed, because comparable sales reflect current market conditions. However, "if the fair value of an asset is measured by discounting expected future cash flows and if the sale is expected to occur beyond one year, the cost to sell shall be discounted."

Real Estate Development

The appendices to the statement do not clearly state that their references to real estate development only apply to the development of real estate held for sale and do not apply to real estate held for use. Consequently, an incorrect inference can be drawn from SFAS No. 121 that all completed real estate development projects that have carrying amounts greater than their fair values are adjusted to fair value. In fact, only completed real estate projects held for use are adjusted in this manner. Completed real estate projects held for use are only adjusted if they fail the undiscounted cash flow test as previously discussed. This observation has been confirmed by FASB staff.

There are special rules for the development of real estate held for sale. Respondents to the exposure draft of SFAS No. 121 argued that long-term real estate projects developed for sale would have required long-term real estate projects to recognize impairments far too frequently. They said that nearly all long-term projects, regardless of their overall profitability, would become subject to write-downs in their early stages of development, only to be reversed later in the life of the project due to revised estimates of fair value less cost to sell.

Therefore, the FASB decided to treat a real estate project in the development stage as though it were an asset held for use. FASB staff confirmed that a completed development project held for sale written down during its development stage cannot be subsequently written up as a result of a fair value increase.

Nonrecourse Debt

Some respondents to the exposure draft argued that an impaired long-lived asset should not be written down below the nonrecourse debt that it secures. They reasoned that the entity has the legal right to avoid any loss arising from a decrease in fair value below the amount of the unpaid balance of the nonrecourse debt by forcing the creditor to foreclose the debt and acquire the property.

FASB rejected this approach for both assets held for sale and use because recognition of an impairment loss and the recognition of a gain or loss on extinguishment of debt are separate events, and each event should be recognized in the period that it occurs.

We believe that in the case of real property held for use, FASB recognized that nonrecourse mortgages are frequently renegotiated to lower amounts of debt and are partially extinguished by creditors through sales at deep discounts to related parties of the debtor. Further, properties with fair values less than their nonrecourse mortgage balances that have negative cash flows are frequently sustained by continuing capital contributions from their owners.

However, in the case of assets held for sale, it is difficult to understand how any reasonable property owner would dispose of real property for less than its nonrecourse mortgage balance. The FASB staff has taken the position that the unpaid balance of nonrecourse debt cannot be used as a substitute for the subject asset's fair value.


The FASB would like fair value to be determined based on quoted market prices but recognizes they may not be available. Therefore, the statement allows for the use of other valuation methods such as the discounted cash flow (DCF) and other analytic methods.

Discount Rate. If the DCF method is used, the discount rate should be commensurate with the risk involved. "That rate is the asset-specific rate of return expected from the market--the return the entity would expect if it were to choose an equally risky investment
as an alternative to operating the impaired asset."

This implies discount rates for real estate available through services such as Korpacz could be used to identify the range of rates applicable to property type (e.g., suburban office buildings, shopping centers, etc.). However, these discount rates would have to be modified to reflect the specific characteristics of the subject property and its location. In other words, if Korpacz provided a regional range of discount/yield rates for an investment grade suburban office building of 11%-13%, the valuator would determine the specific percentage--generally within that range. The rate ultimately selected to value the property would be influenced by market conditions in the area in which the property is located and risk factors specifically related to the property and forecast assumptions. Comparable sales data,
if available, can be used to verify
assumptions about investors' expectations about discount rates and other assumptions.

Other Methods used to estimate the fair value of real estate are the direct capitalization method, sales comparison, and cost approaches. The statement leaves the selection of valuation method up to the reader. The direct capitalization approach and/or DCF method is generally used to value income producing property. Sales comparison approach is generally used for land and nonincome producing property. This approach can also be used to verify values obtained using the income approach. The cost approach is rarely used by itself and only to verify replacement cost for new buildings that are not available for rent. All of these methods are generally used in an appraisal and reconciled to arrive at an estimate of fair value.

Capitalization Rates

The Direct Capitalization Method divides a normalized net operating income by a capitalization rate. Capitalization rates are usually derived from comparable sales data, but can be deduced from the gross income multiplier (GIM) (GIM=sales price divided by effective rental income) and various investment techniques. Again, the asset specific rate has to be selected. Experience has shown that capitalization rates specific to the property's general location and type (e.g., shopping center, office building, etc.) can be obtained more easily than discount rates. However, the discounted cash flow method is preferable in instances where it is difficult to estimate a normalized net operating income because assumptions regarding vacancy, expenses, replacements, and improvements will vary substantially over the expected holding period.

Again caution has to be exercised in the selection of the capitalization rate from comparable sales data or from various publications. The publications and or comparable sales data used to derive rates may reflect capitalization rates derived from actual net operating income.

Appraisers usually normalize net operating income and therefore reflect expected rather than actual vacancy rates, expenses, and reduction in net operating income for a replacement allowance and leasing commissions. A replacement allowance is usually used by appraisers in calculating an annual sinking fund deposit to fund the replacement of future building components, equipment, and tenant improvements. The effect of the inclusion or exclusion of these items is demonstrated in Exhibit 2.

The book The Appraisal of Real Estate, 10th edition by the Appraisal Institute, page 469, states the following:

"This simple technique for estimating overall capitalization rates is preferred and will produce a reliable indication of value by the income capitalization approach if three conditions are met.

1. Income and expenses must be estimated on the same basis for the subject property and all comparable properties.

2. Market expectations concerning resale prices, tax benefits, and holding periods must be similar for all properties.

3. The financing and market conditions that affect the comparables must be similar to those affecting the subject property or an adjustment must be made for dissimilarities."

As mentioned previously in connection with estimating future cash flows, small variations in assumptions of discount, capitalization, growth, and tenant turnover rates, as well as periods necessary to replace tenants and inducements to acquire tenants, such as tenant improvements and free rent periods, could materially alter the fair value estimate. Therefore reliance on real estate appraisers may be necessary for those lacking the expertise to estimate fair value. Real estate appraisals may not always be necessary if the client has bona fide offers from independent third parties to acquire the subject property.


FAS 121 does not require disclosure of assumptions used to estimate expected future cash flows and the discount rate used when fair value is estimated by discounting expected future cash flows. Non-disclosure of these significant assumptions could be the cause of future litigation because the reader of the financial statements has not participated in the evaluation of these assumptions and estimates. No matter how good these estimates and assumptions may be, they may not be actually realized as predicted.

Appendix A of the statement has a discussion on early warning disclosures and the impact of AICPA SOP 94-6, Disclosure of Certain Significant Risks and Uncertainties. The SOP requires disclosure of significant estimates that may reasonably and possibly change in the following fiscal year. Reasonably possible is defined as the chance of occurrence of an uncertainty is more than remote and less than probable.

The significant estimate disclosure could include the estimates and assumptions used in determining an impairment loss, but this is not required by SOP 94-6. An example of such an uncertainty would be if the estimate of future net cash flows used in the impairment test is marginally more or less than the carrying amount of the subject property. These estimates may be affected by uncertainties with regard to assumptions such as near term lease up, vacancy, rent per square foot, changes in the base interest rate used to determine, the discount rate, and property owners' ability to hold the property for the estimated holding period used in the estimate. *

Abraham E. Haspel, CPA, is with H. J. Behrman & Company LLP, New York City. He is a member of the Real Estate Accounting Committee of the NYSSCPA and wishes to acknowledge the assistance of the following individuals: James D. Allen, Carmine Bailey, Christopher Michael Cotter, Neil H. Keonig, Barry G. Moss, Wayne Nygard, Jack Shohet, Fredric S. Starker, and Hsien Chung Yang.




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