Financial Reporting Update: Changes in Accounting for Certain Real Estate Transactions
Until recently, implementation guidance in FASB Accounting Standards Codification Topic 805 (Business Combinations) resulted in many real estate transactions being accounted for as an acquisition of a business even if no processes are included in the transaction when revenue-generating activities continue after an acquisition. For example, in the real estate industry, a market participant who acquires a building with leases and implements its own property management to continue generating lease income would often conclude that this fact pattern meets the definition of a business and must be accounted for as an acquisition of a business under Topic 805.
There are complex and costly challenges involved in accounting for real estate transactions as an acquisition of a business, rather than as an asset acquisition. The following chart summarizes key differences between accounting for a transaction as an acquisition of a business and an acquisition of assets:
|Acquisition of a Business||Acquisition of Assets|
|Determining Cost||Identifiable assets acquired, liabilities assumed and any noncontrolling interests are measured at their acquisition-date fair values.||Asset acquisitions in which the consideration given is cash are measured by the amount of cash paid. Cost is allocated to the individual assets acquired based on their relative fair values.|
|Acquisition-Related Costs||Acquisition-related costs are recognized as expenses when incurred.||Acquisition-related costs are included in the cost of the assets acquired.|
|Goodwill||Goodwill is recognized as of the acquisition date measured as the excess of the fair value of consideration transferred over the net fair value of the identifiable assets acquired and the liabilities assumed.||Transactions accounted for as asset acquisitions do not give rise to goodwill.|
|Operating Leases||The acquirer determines whether the terms of acquired operating leases are favorable or unfavorable by comparison with the market terms of the same or similar leases at the acquisition date. The acquirer recognizes an intangible asset (liability) when operating lease terms are favorable (unfavorable) relative to market terms.||Cost is allocated to the individual assets acquired, including identifiable intangible assets such as leases, based on their relative fair values|
To address concerns about the broad, complex and costly application of Topic 805, the FASB issued Accounting Standards Update No. 2017-01 Business Combinations (Topic 805) – Clarifying the Definition of a Business (ASU No. 2017-01), which is effective for nonpublic entities for annual periods beginning after December 15, 2018, but which may be applied early. ASU No. 2017-01 is designed to reduce the instances in which an entity would need to account for an acquisition of real estate as a business combination.
Among other things, ASU No. 2017-01 excludes from the definition of a business a single identifiable asset or group of similar identifiable assets and provides as an example land and building and in-place lease intangibles. Accordingly, upon application of ASU No. 2017-01, most real estate transactions will no longer be subject to business combination accounting under Topic 805.
The remainder of this discussion addresses key accounting considerations for an acquirer of real estate assets assuming an entity early adopts ASU No. 2017-01 and concludes that its property investments are asset acquisitions rather than business combinations.
Asset acquisitions in which the consideration given is cash are measured by the amount of cash paid, which generally includes the transaction costs of the asset acquisition. Cost is allocated to the individual assets acquired (including certain intangible assets and/or liabilities, as described below) based on their relative fair values in a process commonly referred to as purchase price allocation.
Intangible Assets and Liabilities Associated with Real Property
There is incremental value in a leased-up building versus an empty one, and this intangible value should be recognized separately. Such value includes, but is not limited to, the cost savings of not having to provide tenant improvement allowances to tenants that are already in the space or pay leasing commissions to secure a tenant. Similarly, there is value attributable to above market leases (the value is equal to the discounted cash flows of the above-market leases in-place, less the discounted market rate rents) which the buyer is paying for in the acquisition price, and there is negative value associated with buying a property that has leases in-place that are below market value (negative value is equal to the difference between the discounted cash flows from the below market leases in-place and discounted market rate rents).
Favorable/Unfavorable Leasehold Analysis (Above- and Below-Market Leases)
Beyond the value of the lease contracts in place, there are also potential assets or liabilities in the presence of lease contracts that deviate from the market. From the acquirer’s perspective, above-market leases are considered an asset in that income is attributable to the contract beyond what would be available in the market. To the contrary, below-market lease contracts would be considered a liability via the income impairment throughout the term of the lease.
To determine whether or not in-place leases are favorable or unfavorable, contract leases and current listings of comparable properties are analyzed to determine a rental rate and expense structure typical of the market. If the contract lease rate deviates from the concluded market rate, the annual contract rent is subtracted from the annual market rent to determine the difference in annual cash flows for the remainder of the lease term. For above-market leases, it’s reasonable to assume the tenant would decline any options to extend. For below-market leases, the remaining lease term is typically projected to include all defined, favorable option terms.
Contracts with above-market rents have a positive fair value (i.e., an asset exists)
Contracts with below-market rents have a negative fair value (i.e., a liability exists)
In-Place Lease Analysis
The valuation of in-place leases represents the value to the owner via the cost avoidance of lease-up costs. This component of the allocation essentially fills the gap between the as-vacant income analysis and the leased-fee income stream in place as of the transaction date. The quantification of in-place leases should include the lost rental revenue during the lease-up period — both base rent and any applicable expense reimbursements.
Avoided Lease Origination Costs
Beyond the value of avoided lease-up costs, a property owner would recognize an asset in the cost avoidance of leasing commissions and legal/marketing costs associated with the leases in place. To that end, the unamortized leasing commissions and legal/marketing costs associated with each individual lease should be measured. Similar to the valuation of unamortized tenant improvements, avoided lease origination costs are calculated with market leasing assumptions over the remaining term of each contract.
Notes payable and other long-term debt assumed need to be assigned amounts “at present values of amounts to be paid, determined at appropriate current interest rates.” Therefore, if a mortgage is assumed in the acquisition of a property, there may be an intangible asset to the extent that the assumed mortgage features a below-market coupon. Likewise, assumed mortgages featuring above-market coupons represent an assumed liability to the buyer.
The intent of ASU No. 2017-01 is to narrow the definition of a business and provide a framework that gives entities a basis for making reasonable judgments about whether a transaction involves an asset or a business. In practice, adoption of ASU No. 2017-01 should result in more consistency in applying the definition of a business and reduced cost for many entities that will no longer be required to account for real estate transactions as acquisitions of a business.