CBRE are launching a series of three thought pieces challenging the practice of how corporates account for their owned real estate. Our first piece considers current practice, why this method is adopted and the risks that are associated.
Accounting guidelines allow companies to hold their owned real estate assets at either Fair Value or at cost. Typically, most corporates account at cost, which would be the price that they either bought or built the property for, this figure is then depreciated down to a residual land value over a period of 30 to 50 years.
This method of accounting ensures that there is no significant variance to the annual accounts caused by swings in property values and is also a more cost-effective approach negating the requirement for annual asset valuations. However, whilst this method may be appropriate for other items of a balance sheet, where there is a limited usable life and little to no secondary market, real estate does not operate in the same manner. Therefore, in the majority of instances the figures which corporates are providing in their financial statements bear no reflection to what the properties are actually worth.
Real estate funds and REITS value their properties at least annually, if not more frequently and account for their properties at Fair Value in accordance with IFRS. Fair Value is recognised as being in line with the IVSC and RICS definitions of Market Value, which estimates the actual price a property would sell for on the market. As a result, funds hold their property on their accounts at a “real value”.
The largest owners of commercial real estate across the world are global corporates. They own a vast number of office, industrial, logistics and retail properties. The value of these properties is in the trillions of dollars, though by accounting for their real estate at cost there is a significant danger that companies are not showing their real value on their balance sheets. The fundamental principles that cost does not equal value is not being considered, nor is the volatile nature of the property market.
The real estate market operates in a cyclical manner, values can change distinctly and by not reflecting this, organisations are at risk of either grossly under or over assessing the worth of their assets. This can be especially true when considering land. Land is a finite resource and amendments to planning policy over time, can result in drastic fluctuations in value. Cities across the globe have changed dramatically over the years. There are numerous examples of industrial sites owned by manufacturing companies across the globe which now have higher and better uses. In these instances corporates could be sitting on real estate with values significantly higher than what is being reported.
A considerable number of companies are publicly listed on stock exchanges and traded for and on behalf of institutional and private investors. The decision to invest in these companies is made based on the information corporates provide, particularly their accounts. When the balance sheet does not reflect the true value of real estate by showing a value either higher or lower, there is a danger that investors are being misled and companies are either over or under valued. It is taken for granted that the audited accounts are accurate but if the real estate is not being considered in line with the market, are they?