The impact of the COVID-19 outbreak is undeniable. This sudden and unprecedented pandemic has profoundly touched many aspects of people’s lives around the world and rapidly deteriorated the global economy. The real estate industry is no exception.
As many states in the U.S. and countries around the world remain under lockdowns or partial lockdowns, the retail, office, hospitality, and residential sectors of the real estate industry have faced a multitude of challenges. Due to increasing uncertainties associated with the pandemic, real estate impairment assessment has been particularly difficult. To make things easier, here’s a 3-step plan to help you identify, recognize, and measure the impairment of long-lived assets to be held and used, including real estate assets.
Step 1 – Real Estate Impairment Indicators
As required by ASC 360-10-35-21, a long-lived asset or asset group is required to be tested for impairment “whenever events or changes in circumstances indicate that its carrying amount may not be recoverable.” Such events and changes in circumstances are commonly referred to as “triggering events.” As a result of the COVID-19 crisis, many businesses will likely experience one or more triggering events. The following are some examples:
- Retail businesses that provide nonessential services, such as dine-in restaurants, bars, fitness centers, and conference or convention centers, close as a result of “shelter-in-place” and “stay-at-home” directives from the government.
- With travel restrictions and bans globally, hotel businesses temporarily shut down their operations or operate at drastically reduced occupancy levels.
- Tenants fail to make rent payments or request rent concessions. The ordinances enacted by many local governments allow rent deferral for tenants and also prohibit landlords from charging any late fees or evicting the tenants.
- Landlords experience early termination of leases or difficulty in renewing leases or filling the vacant spaces.
- The value of the real estate assets suffers as scheduled developments and improvements suspend.
- The expected holding period of a real estate asset decreases significantly from its previously estimated useful life as a result of the pandemic.
Step 2 – Recoverability Test
If a triggering event exists, management must determine whether a real estate impairment loss should be recognized. The carrying amount of a long-lived asset or asset group is considered not recoverable if its total undiscounted future cash flows from use and eventual disposition are less than its carrying amount. Estimating future cash flows for a real estate asset with a long useful life is a highly subjective and judgmental process.
Predicting future cash flows amid the COVID-19 crisis is even more challenging due to uncertainties over the severity and duration of the pandemic and its economic effects. Management may come up with multiple possible courses of action to recover the real estate asset and may need to use the probability-weighted approach.
Many things could happen in the near future. For example, many small business owners have applied for stimulus loans or the “Paycheck Protection Program” under the CARES Act. The loans may be forgivable if the business owners use the funds for certain purposes, including rent payments. On the other hand, more tenants may stop paying rent or ask for more flexible payment terms as the downward economic trend worsens. As a result, the property’s expected operating cash flows decrease and management may not be able to meet the mortgage obligations collateralized by the property. As a result, management may need to change its exit strategy.
Let’s also not forget the long-lasting effects of the pandemic. Following the age of social distancing, virtual workspaces may replace traditional office spaces. Similarly, an increase in online shopping and meal deliveries may reduce the need for a storefront for many retail and restaurant businesses.
Step 3 – Measurement of a Real Estate Impairment Loss
Once it is determined the carrying amount of a long-lived asset or asset group is not recoverable, a real estate impairment loss should be calculated based on the excess of the carrying amount of the asset over its fair value. ASC 820 provides guidance on fair value measurement. ASC 820-10-05-01 defines fair value as “a market-based measurement, not an entity-specific measurement” and requires using market participant assumptions.
On the other hand, ASC 360-10-35-30 requires the future cash flow estimates used for testing recoverability of a long-lived asset or asset group to “incorporate the entity’s own assumptions about its use of the test.” As such, the future cash flow estimates used to measure the fair value of an asset could be different from the ones used to test its recoverability.
There are three valuation techniques under ASC 820: the market approach, income approach, and cost approach. Management should use a valuation technique that best suits the asset’s circumstances and for which adequate information is available. The fair value of an asset should not only appropriately reflect the risk characteristics of the asset but also inherent market risks. For instance, management may need to adjust the capitalization rates or discount rates used in the income approach to reflect higher risks in the real estate industry during the COVID-19 crisis.
More on Business Stabilization
In times of economic crisis, transparent financial reporting and communication are crucial for successful economic recovery. Due to uncertainties, assessing and estimating the impact of the pandemic is challenging. 8020 Consulting is here to help you with a wide range of technical accounting services.
About the Author
Tae has over 10 years of accounting, audit, and project management experience in financial institutions and real estate industries. She began her career as an auditor at Ernst & Young in Downtown Los Angeles, and from there, she moved to Oaktree Capital and then eventually Colony Capital where she spent 5 years in various roles. Her expertise includes monthly and quarterly closing, financial reporting, corporate consolidations and eliminations, internal controls, process improvements, system implementations, budgeting & forecasting, variance analytics, and ad hoc analysis. Tae holds a Bachelor of Arts in Business Economics and Global Studies from the University of California Santa Barbara.