Congratulations on the purchase of your new property! Whether this is your first time in the commercial real estate market or your team’s 100th acquisition, the fun really begins the day after the purchase, at least for your accounting team.
As your asset management team moves on to the next transaction and hopes to hit the next real estate jackpot, your accountants will begin the always interesting process of recording the new purchase on the company’s books. Under current accounting principles generally accepted in the United States of America (GAAP), it’s critical to first determine if the new purchase is a business or asset acquisition. Doing so will help ensure you are recording the transaction appropriately.
In January 2017, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2017-01, Business Combinations (Topic 805): Clarifying the Definition of a Business. This ASU provides a “screen” to determine when a set of inputs and processes is not considered a business. The screen states:
When substantially all the fair value of the gross assets acquired is concentrated in a single identifiable asset or a group of similar identifiable assets, the set is not a business.
This applies specifically to an entity acquiring any type of real estate asset. It doesn’t matter what type of real estate is being acquired, if the asset or assets is concentrated in a single identifiable asset, for example, the building, it is not considered a business and asset acquisition accounting rules apply.
This screen reduces the number of transactions that need to be further evaluated, and generally excludes most entities acquiring only a real estate asset from being considered a business. But, if the screen is not met for any reason, and a single identifiable asset is not acquired, the ASU:
Among other amendments, the ASU also provides a framework to assist entities in evaluating whether both an input and a substantive process are present. We are not discussing these alternatives, as most purchases of real estate assets are considered asset acquisitions.
Before discussing the importance of asset acquisition accounting for real estate, we need to understand the major differences between the accounting treatment for an asset acquisition and a business combination.
The most significant differences relevant for real estate-only transactions are the initial measurement, i.e., the purchase price allocation, of the acquisition. The treatment of acquisition costs and measurement period are as follows:
| Asset Acquisition | Business Combination |
|---|---|
| Initial Measurement of the Acquisition | |
| The purchase price is allocated on the relative fair value of the assets acquired with no goodwill or bargain purchase. | Identifiable assets and liabilities are measured at fair value with goodwill or bargain purchase gain being recognized if the fair value of the assets acquired and liabilities assumed exceed or are less than the purchase price. |
| Acquisition Costs | |
| Capitalized and included in the purchase price. | Expensed as incurred. |
| Measurement Period | |
| The acquirer must complete the purchase price allocation prior to the issuance of the financial statements. | The acquirer can record provisional (estimates) amounts and adjust the adjustment the lessor of one year or when all the information is obtained. |
The introduction of asset acquisition accounting in 2017 for the purchase of a real estate property was a game changer. For those entities required to report on a GAAP basis, either because of lender or regulatory requirements, asset acquisition accounting made recording the acquisition easier and more intuitive for real estate companies and their investors. Prior to 2017, an acquisition of a real estate asset by a company investing in real estate only would be treated as a business combination with the possibility of either goodwill or bargain purchase being recorded.
The concept for real estate acquisitions since the beginning of time, or actually since the first time someone sold a piece of real estate to someone else, is to buy a building at a market price, then use your experience in leasing, development and the local real estate markets to help the property appreciate in value and generate a significant gain to all involved. To record goodwill or bargain purchase for a property at the date of acquisition made little sense to those in the real estate industry who would use their experience to find a property and reposition it to create an increase in value.
In addition, recording acquisition costs as a period expense in the year of acquisition instead of capitalizing those costs to the purchase price of the property was foreign to real estate ownership. The thought that in Year 1 of an acquisition an entity’s profits and losses would be impacted didn’t make sense and really did not show the true operations of the acquisition. More importantly, expensing acquisition costs — which is the most important aspect of reporting for most real estate owners and investors — was completely different than how the acquisition is reported for income tax purposes.
After applying the “screen” and concluding a property acquisition would be accounted for as an asset acquisition, all acquisition-related costs are included in consideration paid and in the basis of the assets acquired. At that point, the company allocates the purchase price, inclusive of acquisition-related costs, based upon the relative fair values of the assets acquired and liabilities assumed, which generally consist of:
Allocating the purchase price based on relative fair values means each asset (both tangible and intangible) is allocated a portion of the total acquisition cost (purchase price plus closing costs) proportionate to its fair value relative to the total fair value of all acquired assets. The following is an example of how relative fair values are applied to the purchase price:
| Purchase price plus closing costs | $1,000,000 | ||
| Fair value of assets acquired | |||
| Land | 200,000 | 17% | 170,000 |
| Building | 600,000 | 50% | 500,000 |
| Acquired in-place lease intangibles | 400,000 | 33% | 330,000 |
| 1,200,000 | 1,000,000 | ||
In estimating the fair value of the assets acquired, the company considers information obtained about the property as a result of its due diligence activities, including historical operating results, known trends and market conditions that may affect the property, and various valuation methods, such as estimated cash flow projections using appropriate discount and capitalization rates, as well as available market information. The fair value of the property also considers the value of the property as if it were vacant. Real estate companies should engage a third-party valuation firm to estimate the fair value of the acquired assets and liabilities assumed to account for and record the transaction properly.
Let’s discuss how a valuation firm looks at the components and what methodology is used to allocate the purchase price plus the closing costs.
Land and Land Improvements
The first component to consider is land. Using comparable land sales close to the location of the acquired property, the valuation firm determines the value of land as if vacant, usually at a sale price per acre, and arrives at the fair value of the land under the acquired property.
Building
Companies use various estimates, processes and information to determine the as-if vacant methodology. The as-if method means when recording a building's value, it is assessed as if the building were completely empty, essentially considering only the land value and the structure itself without factoring in current income generated by occupying tenants or current use of the building. Estimates of value are made using customary methods, including data from appraisals, comparable sales, discounted cash flow analysis and other methods.
Fixtures and Tenant Improvements
Amounts allocated to fixtures and tenant improvements are based on cost segregation studies performed by independent third parties or on the company's analysis of comparable properties in its portfolio.
Acquired In-Place Leases
The company estimates the fair market value of acquired in place leases as the costs it would have incurred to lease the property to its occupancy level at the date of the acquisition. The aggregate value of intangible assets related to acquired in-place leases is primarily the difference between the property valued with existing in-place leases adjusted to market rental rates and the property valued as if vacant.
Factors to consider in the analysis of in-place lease intangibles include an estimate of carrying costs during the expected lease-up period for each property, considering current market conditions and costs to execute similar leases. In estimating carrying costs, include additional rents, such as real estate taxes, insurance, and other operating expenses and estimates of lost rentals at market rates during the expected lease-up period. Estimates of costs to execute similar leases, including leasing commissions, legal and other related expenses, are also used.
Acquired Above-Market and Below-Market In-Place Leases
Acquired above-market (asset) and below-market (liability) in-place lease values are recorded based on the present value of the difference between the amounts to be paid in the leases and management's estimate of market lease rates, measured over a period equal to the remaining non-cancelable term of the lease.
Once the information of the relative fair value of the tangible and intangible assets is determined, the accounting team needs to adjust the books and records to reflect the acquisition on the company’s financial statements. The team will want to ensure the purchase price on the trial balance equals the amount being allocated during the purchase price allocation.
In addition, for financial reporting purposes and on an ongoing basis, the accountants need to record the appropriate levels of amortization and depreciation of the assets acquired. Depreciation on the building is recorded over the estimated useful life of the property. The capitalized above-market lease intangibles are amortized as a decrease to rental income over the remaining term of the lease. While the below-market lease intangibles are accreted to an increase in rental income over the remaining term of the lease.
Equally as important, as tenants move out of the property before their leases are up, management must remember to write off any acquired lease intangibles that remain on the books in the year the tenant moves out. As time passes from the acquisition day things will change at the property, whether tenants move out or the overall and local economies shift. Management must assess whether the property is impaired or if a triggering event has occurred.
Acquiring a new asset is a very exciting time for the entire company, but it is critical for proper financial reporting to ensure the acquisition is appropriately recorded both initially and on an ongoing basis. Once the company has had experience in recording a new acquisition, it should become a much more straightforward process.
Contact Nick Antonopoulos or a member of your service team to discuss this topic further.
Cohen & Co is not rendering legal, accounting or other professional advice. Information contained in this post is considered accurate as of the date of publishing. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts, circumstances and current law with your professional advisers.