How Your Private Real Estate Fund Can Use Fair Value Reporting to Value Investments

Whether this is your first fund, or this is your first private fund exclusively invested in real estate, your investors will want relevant information when it comes to the fund's value. However, historical reporting methods, such as accounting principles generally accepted in the United States of America (GAAP) and income tax basis reporting, often provide outdated data.

Enter: Fair value reporting. This method provides relevant information your investors need. It's also the standard they already use to analyze their portfolio's overall performance and make future investing decisions. So, it's imperative for your management team to evaluate if your fund meets the accounting guidance to report under fair value - and then how to actually do it.

Complying with ASC 946 Is the First Step to Fair Value Reporting

While fair value reporting is valuable for a real estate entity, it is not necessarily easy. There is nothing in the accounting literature that talks specifically about real estate and fair value. So, how can a real estate fund use fair value reporting? The "easy" answer is by meeting the qualifications of Accounting Standards Codification (ASC) 946, Financial Services - Investment Companies (ASC Topic 946).

Management must evaluate each of the following steps for the private real estate fund and, most importantly, ensure your auditor is in agreement. An investment company must possess the following fundamental characteristics pursuant to ASC 946:

• Provides investors with investment management services.
• Commits to its investors that its business purpose is investing for investment income and/or capital appreciation (as a practical consideration, this generally is stated within the private placement memorandum).
• Doesn't obtain benefits from an investee that aren't normally attributable to ownership interests or that are other than capital appreciation or investment income.

In addition to these fundamental characteristics, an investment company also should try to adhere to the following typical characteristics of an investment company:

• Has more than one investment.
• Has more than one investor.
• Has investors that aren't related parties of the parent or investment manager.
• Has ownership interests in the form of equity or partnership interests.
• Manages substantially all its investments on a fair value basis.

Create a Thoughtful and Robust Plan for Your Fair Value Reporting Process

Once your management team has decided the fund meets the requirements to report under fair value, set up a documented plan for the fair value process for its investments. The plan begins with a valuation framework consisting of policies and procedures; corporate governance, such as an investment committee; information sources for the market data; and developing internal or external valuation models.

Accountants always talk about internal controls as the starting point to any company's financial and reporting health. This is also key to the valuation process. The valuation process will be the centerpiece of information your investors will be most eager to review - and scrutinize. Therefore, the procedures need to be robust and thoroughly documented.

A thoughtful and thorough valuation policy includes the following:

• Document Accounting Standards Codification (ASC) 820 - Fair Value Measurements (ASC Topic 820) and relevant disclosure requirements. This includes fair value hierarchy and discussion of key inputs for Level 3 investments (Real Estate).
• Include management's policy valuation process timing. Start with identifying the reporting deadlines to meet investor or lender expectations and work backward to document the timing related to draft valuations.
  
  For example, if year-end is December 31 and the financial statements need to be issued by the following April 30, management might use an interim date, such as November 30. The timeline could include projections for December to run the valuation models, with updates only if significant items have occurred at the investment that might alter the valuation one way or another. Areas to address could include a significant change in cash flow due to a key tenant moving in or out of the property, unexpectedly, in December.
• Add clarity when an investment is valued. For example, a fourth quarter acquisition or a project in the initial phase of construction might be valued at cost. Conversely, other investments outside of those parameters would need to proceed through the valuation process. Be clear on the rules by which you will abide.
• Implement procedures to value each sector of real estate the fund possesses. This is important whether the fund owns an asset outright or through a joint venture.
• Explain when the fund will use an outside appraiser, indicating the frequency of appraisals and which assets will be appraised. In addition, to be considered qualified in the eyes of the fund, management should document the qualifications of the appraiser, such as being a Member Appraisal Institute (MAI); their overall experience and locations they generally work within.
• Document who will complete the valuation. Will you use an internal or external team? Either way, what experience and knowledge does that team have to conduct the valuation?
• Document the investment committee and upper management's approval process. The valuation committee should possess the requisite skills to question the models and assumptions used and be able to offer needed guidance to the valuation process.
• Document and understand key market information. This includes cap and discount rates, growth rates and other hard-to-observe inputs, as well as safeguarding the information, including the model.

Do What You Set Out to Do

Once the valuation methodology and inputs are selected, management will need to follow the policy to start the valuation process. Whether you use an internal or external valuation, the valuation will employ one of these three approaches:

Income Approach

• Discounted Cash Flows (DCF). Method used to estimate the value of an investment based on its expected future cash flows using the terminal cap rate and a discount rate.
• Direct Capitalization. Real estate appraisal approach that takes the property's net operating income (NOI) divided by the direct capitalization rate to compute a property's valuation.

Sales Comparable / Market Approach

• Technique used to estimate value using recent sales transactions from similar properties surrounding the property being valued.

Replacement Cost / Cost Approach

• Method involved in estimating fair value based on the current replacement cost, or amount that would be required to replace the service capacity of a specific asset.

What To Do When Your Valuation Intersects with Your Financial Statement Audit

There are key areas to focus on when dealing with a valuation incorporated into your audit. Considering the following scenarios will help you work more efficiently and effectively with your audit firm.

• Management is using a different valuation amount compared to the valuation obtained from a third-party appraiser. The executives of the company might opt to change the value, whether because the appraiser had incomplete information, or perhaps they felt the valuation was too aggressive/conservative. Management and their valuation expert should be on the same page, and if an appraisal is obtained, ensure it's updated to include management's thoughts and changes.
• Management is using a valuation that is inconsistent with a subsequent event sale (prior to the release of the financial statements). Unless there is a material change in the operations of the property subsequent to year-end, the valuation and the sale should be, for the most part, consistent.
• The company is not following the valuation policy. For example, the timing is not followed to obtain an appraisal or to leave a new investment at cost.
• A significant variance exists between the prior year's assumptions, current year assumptions and the actual result of the property. For example, prior year projected NOI for Year 1 in the discounted cash flows (DCF) is significantly different than current year operations of the property. For example, projected NOI in the prior year's DCF was $950,000, compared with the current year actual NOI of $10,000. This can generate several questions from auditors, such as: Why is there such a large variance? Were the assumptions used in last year's valuation too aggressive? How does that compare to the current year valuation model?
• Un-observable inputs do not agree with market industry publications or are on the low/high end of the range. For example, using a 4% cap rate for a property that has an industry valuation range of 5% to 8%.
• DCF projected income amounts do not agree to the property's operating budget.
• Using the wrong valuation model for the type of asset being valued. For example, the direct capitalization model is used for stabilized properties with consistent, predictable and historical cash flow. Using a direct capitalization model for a property not yet stabilized would be the wrong valuation model.
• Not considering the working capital at the property. Sometimes cash, deposits or liabilities on hand at the property level could be significant and could materially impact the valuation.
• Using an appraisal to establish fair value. To establish fair value for a real estate property, many management teams immediately indicate the valuation will come from an appraisal. As an appraisal is usually obtained for another reason, such as obtaining financing on a property by a lender, the value of the property might be higher to obtain certain ratios to qualify the borrower for the loan.
  
  Fair value under accounting falls under ASC Topic 820, which defines fair value as "the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date." ASC Topic 820 looks at fair value from the seller's perspective in the most advantageous situation to sell the property resulting in the most appropriate fair value. While an appraisal looks at the value from the highest and best use for the buyer. A small nuance, but your management team should ensure the valuation will be compliant under ASC Topic 820 before proceeding.
• Not running the hypothetical liquidation amount appropriately through the waterfall as indicated in the operating agreement. This will help ensure any promoted or carried interest - a special allocation of income, usually upon sale of the property, given to the general partner or managing member for managing or sponsoring the deal - is allocated appropriately to determine the correct amount of the valuation for the investment. In addition, if the investment is held through preferred equity interest, the investment will need to be discounted for that interest not being as liquid.
• For recent acquisitions kept on a cost basis, not removing transaction costs, such as due diligence expenses or professional fees, from the calculation if material. ASC Topic 820 indicates transaction costs must be removed from the exit price, since they are uncharacteristic of the asset being measured.

When the management team follows a well-documented and realistic valuation plan for determining the fair value of a wholly owned real estate asset or joint venture investment, the audit can be much more stress free and straight forward with fewer surprises and last-minute conflicts.

Contact Nick Antonopoulos or a member of your service team to discuss this topic further.

Cohen & Company 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.

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