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What's Your Property Worth "On Paper:" Redefining Fair ValueFinancial Accounting Regulators Think They Have a Better Method of Valuing Assets; Companies Haven't Figured it Out
So this fall, new methods for determining "fair value" from the Financial Accounting Standards Board (FASB) are set to go into effect and they could turn the value of some assets topsy-turvy or, at the very least, add more layers of reporting disclosures for companies on their balance sheets. The big change will mean that companies will no longer value assets by their purchase price, but instead will have to value them by their potential exit price. Before you decide to pass on reading any more about issues in the perplexing world of accounting standards setting, consider this: the way fair value will be calculated matters, because what other entities 'perceive' the value of your properties to be will affect the value of your properties. As for the other big change coming, no longer will the owners' use of the property be used for the basis for its value. Instead, the property's value will be set by what the rest of the market accepts as its "highest and best use." In brief, there are two new accounting standard changes coming: FASB's statement 159 (SFAS 159) restates the fair value option for financial assets and financial liabilities such as securities, mortgage notes, options, or even real estate. FASB's statement 157 (SFAS 157) restates guidance on how to measure the fair value of all assets and liabilities, also including real estate and things such as goodwill. Without getting into technicalities, (because this isn't that type of article) the measures are designed to establish a consistent and transparent framework for measuring fair value. They require companies to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. Observable inputs reflect market data and property comps obtained from independent sources (such as CoStar Group), while unobservable inputs reflect the reporting company's market assumptions. These two types of inputs create three basic levels of fair value hierarchy: 1. Quoted prices for identical assets (for example the value of stock in a publicly traded REIT); 2. Quoted prices for similar assets (for example the sales price per square foot for Class A office buildings in Midtown Manhattan, or the capitalization rate indicated for sales of similar facilities in similar cities); and 3. Assets whose significant value drivers are unobservable (for example, a reporting entity’s estimate of rent, expenses or cash flow on its property). The more level 1 and 2 inputs a company can source in valuing assets, the better. The changes go into effect the first full fiscal year after Nov. 15, 2007, (that would be calendar year 2008 for most companies) but can be adopted any time before then. Very, very few companies have elected early adoption - and no wonder. Just take the case of First United Corp. in Oakland, MD. The bank holding company elected to take early adoption of the standards starting Jan. 1 of this year. Then abruptly in the second quarter rescinded its early adoption of the change. In doing, so it wiped out a $1.5 million gain in the first quarter from the change. After conducting a re-evaluation, "the corporation determined that the uncertainty surrounding the proper interpretation of SFAS 159 required a finding that it would not be in the best interest of shareholders to early adopt SFAS 159 and SFAS 157 in the current fiscal year," the company said. Experts attribute the lack of early adopters to the confusion about what impact the new evaluation standards will have or the potential volatility around what will happen to asset values as a result of the new standards, said Matt Kimmell, a principal with Deloitte Financial Advisory Services LLP. Kimmell participated in a broadcast conference call this week explaining the changes. Deloitte estimates that only about 6% of companies have even figured out what the change will mean for them. Companies that have elected early adoption (and most are financial institutions with large security holdings) are seeing a valuation boost. · Bank of America Corp. recognized a benefit of $208 million. · J.P. Morgan Chase & Co. recognized a benefit of $166 million in derivative liabilities and another $464 million related to valuation adjustments to nonpublic private equity investments. · Lehman Brothers Holdings Inc. an after-tax benefit of about $67 million, about $113 million pre-tax. · NovaStar Financial Inc. recognized a $5.4 million net gain in mortgage securities trading. · Quanta Capital Holdings saw $10 million of net unrealized gains in its securities holdings. Gains are not always going to be the case. The tumult in the mortgage marketplace stemming from the spread of the subprime meltdown hurt SunTrust Bank Inc.'s balance sheet. Early adoption of fair value measure for selected mortgage loans resulted in a $42.9 million reduction in total non-interest income for the bank. What it really means for real estate companies' bottom line is still not at all clear. We found only one: Carl Icahn's American Real Estate Partners LP, which recognized $63.9 million of unrealized gains from early adoption, but the gains were tied to investments in a non-real estate-related company. Fitch Ratings is predicting that SFAS 159 may potentially affect how U.S. REITs value some of their assets for financial statement reporting purposes and thus could lead to an increase in borrowing capacity for some REITs "In the past, selective issuing entities have had to account for various other financial assets at fair value, such as mortgage-backed securities and liquid investments," said Steven Marks, managing director and REIT Group head for Fitch. "However, establishing and reporting fair values for investments in entities that own real estate properties and were historically accounted for under the equity method has the potential of being a unique undertaking." Some of the valuation issues for REITs that own interests in real estate accounted for under the equity method and that elect the fair value option are: · Illiquidity discounts, reflecting the difficulty of monetizing assets jointly owned by a REIT and another investor; · Valuing various fee arrangements embedded in a joint venture agreement, such as property and asset management, acquisition, disposition and development fees; and · Valuation treatment of inter-company financial items such as a loan from a REIT to an entity in which the REIT has an unconsolidated interest. REITs with sizeable fair value option-eligible assets include Regency Centers Corporation, Duke Realty Corp. and ProLogis, given their degree of joint ventures accounted for under the equity method. With so much about the valuation changes mean for companies still up in the air, it is not surprising that last week, the FASB announced that it plans to form a resource group to help it clarify its guidance on issues relating to the application of the new fair value measures. The resource group will be comprised of a cross section of constituents and will have "significant" valuation, accounting, and/or auditing experience. The FASB expects to hold the first resource group meeting in the third quarter of this year to assist it in evaluating any known implementation issues. |
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