How to Know if Your Real Estate Entity Has Triggered an Impairment Loss

The real estate markets have endured countless boom-and-bust cycles over the years, resulting in extreme valuation highs and some very significant lows. One day your property has positive cash flow, the valuation has more than doubled, new tenant move-ins are out pacing move-outs and expectations seem to be bright for the next few years. The next day, you lost a large tenant to an unexpected bankruptcy, interest rates begin increasing to the heavens, everyone is working from home and inflation is on the rise, or local government property tax hikes have increased your operating expenses to unseen levels. Real estate professionals have nerves of steel as they ride the industry's daily roller coaster.

One thing is clear whether you are in good or tough times, your management team needs to understand the implications of impairment for GAAP basis financial statements - namely what is or is not a triggering event for impairment. This knowledge will make dealing with the unexpected changes, at least from an accounting perspective, a much easier endeavor.

3 Steps to Evaluating Real Estate Impairment

The general rule on impairment is to follow a three-step process to evaluate whether or not your long-lived assets are impaired:

1. Triggering Event. The property must have a triggering event occur - something that happens specifically at the property or in the market location that would negatively impact the operations - to move on to the next step in the impairment process. If there is no triggering event, the impairment evaluation stops here.
2. Recoverability Test. Once a triggering event has occurred, you must perform a recoverability test. The test compares the future undiscounted cash flow of the property, including potential sale proceeds, through the hold period to the depreciated book value. If the undiscounted cash flow exceeds the book value, there is no need to move on to the next step. If the book value exceeds the undiscounted cash flow of the property, you must calculate if an impairment loss has occurred (step three).
3. Impairment Loss. In this step, the impairment loss is calculated and the discounted cash flow or fair value of the property is compared to the book basis. If the fair value exceeds book value, there is no impairment loss. If the opposite is true, your company will record an impairment loss on the income statement.

The most important step in this process is to understand the definition of a triggering event. If no triggering event has occurred, then there is no need to evaluate a property for impairment. This is an especially important theory to fully understand and implement to avoid having to perform the recoverability test.

What is a Triggering Event for Real Estate Impairment?

Since a triggering event is at the heart of the need to evaluate whether or not there's an impairment loss, it's critical to understand in detail what types of events might qualify.

FASB implemented ASC Topic 360, Property, Plant, and Equipment to address financial and reporting impairment of long-lived assets. For clarification, a long-lived asset or asset group is defined as all the assets associated with a specific property, such as the tangible assets (land, building and tenant improvements) and intangible assets (acquired in-place lease intangibles and above or below market lease intangibles). For example, if an entity owned 10 properties, each property would be evaluated individually to determine if a triggering event has occurred for impairment purposes.

While the ASC provides generic examples of triggering events, we've offered some examples below that relate to triggering events specifically for real estate properties.

1. A significant decrease in the market price of a long-lived asset (asset group). The decrease in market price could be the outcome of several explanations. For a real estate entity, it could be caused by any or all of the following:
   • An increase in the cap rate can result from an amplified economic risk of owning the property, whether from rising interest rates, excessive supply for the sector or overall weakening of the economy. Factors can also be more property specific, such as the property aging compared to other buildings in the area, a large tenant vacating or simply declaring bankruptcy.
   • A change in local market conditions.
   • A reduction of the cash flow due to a large tenant leaving or a significant increase in the operating expenses of the property.
   • An executed purchase and sale agreement (PSA) or letter of intent (LOI) indicating a reduction in the value of the property. Management can reject the PSA or LOI, but if there is evidence that exists, there needs to be an evaluation as to why the lower value of the property is not indicative of an impairment.
2. A significant adverse change in the extent or manner in which a long-lived asset (asset group) is being used or in its physical condition. This can be explained simply as management determining the need to change the use of the property. For example, you could change an office to a residential building to maintain or even increase the return to investors, where the value to be generated from the conversion would be reduced based on market conditions.
   
   At the other end of the spectrum, a natural disaster such as a flood, fire or hurricane could necessitate the evaluation of whether a triggering event has occurred. In many situations, insurance proceeds will be insufficient to cover capital expenditures to fix the property with the ever-increasing costs of building materials. In addition, you must include in your evaluation that the area surrounding the property was devastated, resulting in several years of economic stagnation before the area is restored to its previous condition.
3. A significant adverse change in legal factors or in the business climate that could affect the value of a long-lived asset (asset group), including an adverse action or assessment by a regulator. Here's a real-world example. One of our clients purchased raw land for future development, land the city council had originally designated as multi-family residential. The client submitted numerous development plans, which the local building committee continuously rejected. Over the years, as elections changed the makeup of the council and certain agendas, the city assembly fundamentally altered its intentions on three separate occasions. They went from a multi-family residential development, to senior living and back to residential - but this time for single family homes. Each time the council changed the zoning or the density of housing on the parcel of land, management would assess whether the property had a triggering event. The client recorded several impairment losses on the piece of land over the years and eventually sold the land to a single-family home developer, who went on to build the residences as finally zoned and approved by the city council.
   
   This scenario illustrates how vulnerable real estate is to impairment based on circumstances out of their control, in this case the actions of local government and the changing business climate.
4. An accumulation of costs significantly in excess of the amount originally expected for the acquisition or construction of a long-lived asset (asset group). This happens mostly for properties under development or that have a sizable portion of the building under construction. A triggering event would be significant cost overruns due to any of following:
   • Large increases in building materials, similar to what happened during the pandemic or in 2022 when inflation skyrocketed from supply chain issues;
   • Prolonged delays in construction from shortages in workforce or workers striking;
   • Mismanagement of the project by the contractor, either through scheduling conflicts or under estimation of construction costs in bidding the work initially.
5. A current-period operating or cash flow loss combined with a history of operating or cash flow losses, or a projection or forecast that demonstrates continuing losses associated with the use of a long-lived asset (asset group). Continual net operating losses or projections of future losses could be considered a triggering event. Most auditors would consider an evaluation of a property for going concern as a triggering event for impairment testing. There are many identical occurrences that need to be evaluated for going concern that come into play for consideration of a triggering event. For example, your inability to refinance a mortgage would be both a situation to be evaluated for going concern and whether a triggering event has occurred for impairment purposes.
6. A current expectation that a long-lived asset (asset group) is more than 50% likely to be sold or otherwise disposed of significantly before the end of its previously estimated useful life. Selling prior to anticipated hold can be a positive or a negative. For example, if you receive an unsolicited offer to sell that is above projections and prior to the original hold period, it can be incredibly positive resulting in a great ROI to investors and generating significant amounts of positive cash flow. On the other hand, a forced sale of the property due to needed cash flow or to pay-off a maturing debt could have negative implications. In this instance, any sale happening or projected to happen after year-end must be evaluated as to whether it is a triggering event for impairment testing purposes.

If your management team can conclude, and your auditor agrees, that no triggering event has occurred, you do not need to evaluate any further for impairment. Unfortunately, often management must continue to evaluate the property for impairment due to certain events. Understanding how to determine a triggering event will help eliminate the knee-jerk reaction of immediately recording an impairment loss, when a triggering event might not have even occurred.

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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