Evaluating Real Estate for Impairment

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Many real estate developers have been forced to write down significant asset values in the past five years.  With the housing bubble also causing a bubble in the price of land, it resulted in overpaying for significant amounts of land with expectation homes could be developed and sold at prices that ended up not being sustainable in the market.  One of the toughest tasks many companies faced was valuing that land in order to determine the appropriate write-down that would need to be taken.

 

The rules for impairment evaluate assets held-for-sale slightly differently than assets held-for-use.  Held-for-sale assets are those generally ready for intended use, actively being marketed and will be sold within a year.  Held-for-use assets are basically all other assets that do not meet the held-for-sale criteria.  Held-for-sale assets are valued at fair value less selling costs.  Most companies use a discounted cash flow model based on expected sales prices as observed through sales of similar homes or land in the surrounding area.  As loans secure many properties, many banks ordered appraisals on a yearly basis so that was an even better method of obtaining a fair value for the asset.  The excess of the carrying value over the fair value less costs to sell should be recorded as impairment.  Impairments recorded on held-for-sale assets are recoverable under certain, rare circumstances.

 

Evaluating potential impairments on held-for-use assets is a slightly different test.  The first part of the evaluation is to review the undiscounted cash flows of the asset or asset group and determine if those amounts exceed the carrying value of the property.  These cash flows should include any interest capitalized as a part of constructing an asset.  If the undiscounted cash flows exceed the carrying value, the asset is not deemed to be impaired and not further evaluation is considered necessary.  However, if the undiscounted cash flows are less than the carrying value, then the cash flows must be discounted and an impairment adjustment should be recorded for the amount by which the carrying value exceeds the total discounted cash flows.  Future recovery of impairment adjustments is not possible for held-for-use assets.

 

There are significant judgments involved when determining comparable properties as well as the amounts and timing of cash flows.  All of these judgments should have underlying supportable comparable information from nearby sales paces and amounts of similar properties wherever possible.  Additionally, judgment must be exercised in multi-phase long-term projects as certain phases may need to be evaluated as held-for-sale while others will need to be evaluated as held-for-use.  With economic conditions improving and real estate in recovery, impairments are expected to decrease in frequency.  Additional impairment adjustments recorded going forward will face a different type of scrutiny and may be viewed as producing overly aggressive losses in order to inflate future profits with sales volume and pricing starting to increase.  A careful, bias free approach is necessary to produce accurate, reliable financial statements as the industry adjusts to the changing conditions.

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