New accounting rules could make the decline in commercial realty values look worse for many real estate investment managers.
In the past, managers could use a propertys purchase price as its fair value.
No more. Under Financial Accounting Statement 157 which goes into effect for fiscal years starting after Nov. 15, 2007 managers will have to use the expected sale price, even if its lower than the book value.
In a down economy, accounting changes could cause some managers to rack up hefty unrealized losses.
Because of the nature of the market or the return expectations, the value of the property could be less than you paid for it a few years ago. The value could be impaired, said Timothy Croushore managing director, Mesirow Financial Holdings Inc., Chicago.
Commercial real estate already had taken a big hit across several property types and investors anticipate the outlook will worsen next quarter.
Overall, institutional investors expect capitalization rates the net operating income divided by the value of a property to further rise across all property types, driving down returns in the second quarter, according to PricewaterhouseCoopers first quarter 2008 Korpacz Real Estate Investors Survey. Mall cap rates could grow 25 basis points to 100 basis points. Central business district offices cap rates are expected to grow up to 75 basis points. Apartment cap rates are expected to grow about 46 basis points
Indeed, institutional investors in the fourth quarter said cash was a better investment than commercial real estate, stocks or bonds, according to a Real Estate Research Corp. survey released in February. Institutional investors expected lower rental growth and higher expenses among most property types in the first quarter of 2008, the RERC survey noted.
That gloomy outlook means that fair value prices under the new accounting rules could fall below purchase prices.
In the year of acquisition, there may be write-downs, particularly in portfolios in which managers have been assuming that acquisition price approximates fair value, said Dovid M. Frankel, partner at real estate consulting firm Ernst & Young, New York. The new fair value rules reflect an exit price, which would not take into account transaction costs, which potentially could bring about a different reported fair value.
Second hit for REITs
Investment managers with real estate investment trust portfolios might be doubly hurt because other new accounting rules remove a liquidity discount they had enjoyed for owning a large companys public stock.
If you invest in public companies, you will not be able to apply a liquidity discount in determining fair value of your investment, Mr. Frankel said.
For all investment managers, there also could be a reduction in their portfolio property values because they can no longer count the purchase costs as part of the properties value, Mr. Frankel said.
Investors, however, could benefit because the rules might require managers to report valuations in the same way. Standardized valuations would also make it more difficult for investment managers to hide drops in property value by holding them at cost on the books, inflating the value of their portfolios.
To make matters even more complex, not every fund manager uses the same method to value property. Under FAS 159 also going into effect this year companies can choose to measure many financial instruments such as commercial mortgage-backed securities investments at fair value. But companies cannot adopt this rule retroactively and, once elected, consultants say they cant switch back and forth between account methods.
A 2007 Ernst & Young survey of real estate private equity funds revealed that half of the funds report at fair value, and the other half use a historical cost formula.
How fair value is measured could greatly impact the value of each property in a portfolio, said Scott Farb, managing principal in the Los Angeles office of Reznick Group PC, a real estate consulting firm.
Take an investment fund that bought a portfolio in June 2007, for $2 billion, but today couldnt sell it for more than $1.7 billion. Under historical cost reporting, the fund would value the portfolio on its books at its cost, or $2 billion. Under the new fair value accounting rules, the portfolio would be valued at $1.7 billion.
Under historical cost, the building would not be impaired because you could recover the cost of the property. Its a less stringent test, Mr. Farb said. If you are a pension fund or investment company that is required to report under the fair value method, you would report the property at $1.7 billion.
Real estate debt managers such as mortgage REITs might benefit from choosing the fair value option because they already use the fair value method for valuing assets such as CMBS investments, Mr. Frankel said.
In any case, all investment managers will have to adjust to the new way of defining fair value. Under the new definition, investment managers would need to identify the principal or most advantageous market for the property, the investors in that market and how they would value the property, said James Wilson, senior managing director in the valuation practice of Mesirow Financial.