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Fair's fair: reporting changes in wind for owners, operators.

Why is real estate reporting going to fair value?

Under the Financial Accounting Standards Board's ("FASB") current technical plan, Real Estate owners and operators can soon expect another accounting standard that would significantly change financial reporting for real estate entities.

In a continuous movement towards reporting at fair value, the FASB has a project in the works that is considering giving the option or may even require real estate owners and operators to reflect the fair value of their investments in Real Estate on their financial statements.

Land or buildings held to earn rental income, held for capital appreciation or both (referred to as "Real Estate" or "Investment Property") would qualify for fair value accounting if the new rules are approved by FASB.

Currently, only real estate funds that have attributes of an investment company are required to report their investments in real estate at fair value.

In a global society, it is more transparent for financial statements users to access the true economic performance of real estate investments. Therefore, to further align Generally Accepted Accounting Principles in the United States ("GAAP") with International Accounting Standards ("IAS"), the fair value model for real estate is being considered. IAS currently allows Real Estate owners to choose either a fair value model or a cost model.

What does it mean for REITs, real estate owners, and operators that did not previously report under fair value?

Under the current model, real estate companies report Real Estate at cost and depreciate the cost over the estimated useful life of the building.

The current model contradicts the underlying economics of a real estate investment because Real Estate has historically proven to appreciate over time. Under the model being considered by the FASB, Real Estate will be reported at fair value; that is, the price that would be received to sell an asset in an orderly transaction between market participants at the measurement date.

REITs and other operating real estate companies will be required to value Real Estate using an acceptable valuation methodology including discounted cash flow approach, comparable sales approach, and/or replacement cost approach to determine the fair value at each reporting date.

This is a significant undertaking for companies and will require owners to make assumptions about occupancy levels, leasing activity, rental rates, need for capital improvements, capitalization and discounts rates, among other estimates that will be required to be made on a continuous basis.

For some real estate companies, the fair value approach will likely add a significant amount to the equity reported on the financial statements to the extent the fair value exceeds the current carrying value of the Real Estate.

For others, it might mean a decrease in equity if the fair value of the Real Estate is lower than the current carrying value.

The annual change in fair value will be recognized as an increase or decrease in current earnings.

Current IAS permit an entity to report Real Estate at cost if fair value cannot be reliably determined. To avoid inconsistency in financial reporting, this exception will likely not be available to real estate companies reporting under GAAP in the United States.

Advantages: Currently, Real Estate held for an extended period of time may be fully depreciated, or significantly depreciated under GAAP, therefore not reflecting the true equity value of a real estate company.

Under the standard being considered, the value of the Real Estate will reflect its current fair value at the measurement date, which will provide transparency in financial reporting by capturing the economic performance of the Real Estate on a periodic basis.

Challenges faced by the real estate industry

The real estate industry can expect an exposure draft to be issued by the FASB in the fourth quarter of 2010 to provide further guidance on this topic; and the final standard is expected to be issued in the second quarter of 2011.

Implementation considerations for real estate companies will include developing and implementing processes and procedures for determining fair value. Asset valuations require significant judgment relevant to market trends and will require specific expertise in ever-changing national and international markets.

Whether you hold assets in New York City, across the United States, or in international markets, you will need to be well-versed in current industry trends and assess the changing landscape to identify new trends by monitoring population shifts, occupancy levels and other factors that could affect real estate values.

Under IAS, it is encouraged but not required for the fair value of an investment company to be determined by an independent appraiser.

With increased scrutiny by investors and other users of the financial statement, it may be in the best interest to consider using a trusted advisor to perform these valuations, at least on an annual basis.

It's important to note, significant additional disclosure will be required in the financial statements.

This includes describing the relevant methodology used to determine fair value, reflecting the change in beginning of the period values compared to end of the period values, identifying any restrictions on the ability to increase rent, collect rent or sale of the investment property, as well as disclosing any contractual obligations related to the Investment Properly.

The expanded disclosures and change to fair value measurement will provide more transparency relevant to the underlying economic performance of Real Estate, as well as provide more consistent reporting on a global basis.

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Comment:Fair's fair: reporting changes in wind for owners, operators.
Author:Moreh, Shahab; Dutoit, Noelle
Publication:Real Estate Weekly
Date:Oct 6, 2010
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