U.S. generally accepted accounting principles, also known as GAAP, is a common accounting method but is not the only choice for real estate companies that issue financial statements. Real estate owners should also consider how the use of the income tax basis for financial reporting would impact their reported financial results and balance sheet. 1 The income tax basis of accounting often produces reported financial results that are more closely aligned with certain economics of the business, particularly the cash flows associated with leases.
GAAP reporting would be required if the real estate entity is a public company, such as a publicly traded REIT, and would likely be required by institutional investors who are partners in a private real estate company. But when the entity's choice of accounting method is not dictated by governing bodies, real estate owners should be aware that income tax basis financials might be a more useful management tool and provide greater transparency and insight into how the business is performing. This article will highlight some of the more common differences that occur in real estate financials when using GAAP vs. the accrual basis 2 of income tax basis reporting — not all of them, but rather those that are most likely to arise in the normal course of operations. It will discuss the impact the choice of accounting method will have on a real estate company's financial position and results of operations.
In contrast to the early 2000s when the market saw sales prices never before imaginable and financing transactions which assumed that real estate would continue to appreciate substantially, the current economic climate dictates that real estate companies must take a tough, hard look at the fair value of their real estate in light of current market conditions. Companies that prepare financial statements using GAAP must evaluate whether there has been impairment of their real estate, and if so, record an impairment charge in earnings. A real estate entity that holds property for long term use must determine if the undiscounted future net cash flows expected to be generated from the real estate are more than the property's carrying value (cost less accumulated depreciation). If the undiscounted future net cash flows are less than the carrying value, impairment must be recognized to reduce the carrying amount of the property to its fair value. Often, the fair value of the property would be based on discounting the future net cash flows used in determining if there is impairment under GAAP. There are, however, other methods for determining fair value including the use of comparable sales or capitalization "cap" rates.
For example, let's assume that in 2010 the undiscounted future net cash flows expected to be generated from a commercial property are $30,000,000 and the carrying value of the property is $50,000,000. These projections imply that the real estate is impaired and it must be written down to fair value. In order to calculate impairment, we will discount the cash flows to present value using an interest rate that is appropriate for the risks involved in generating the cash flows. If we assume that discounted cash flows are $20,000,000, impairment charges amounting to $30,000,000 ($50,000,000–$20,000,000) must be recognized for GAAP in the company's 2010 results of operations and the real estate on the balance sheet must be reduced to $20,000,000. If the property appreciates in value in the future, however, no write-up to fair value is allowed under current GAAP.
On the other hand, for tax basis reporting, no impairment charges are allowed to be taken as real estate is generally required to be reported at cost less accumulated depreciation.
When impairment is required to be recorded, as in the example above, the impact to the bottom line on a GAAP financial statement could be significant and impairment charges are presented in the income statement as an ordinary expense, along with other operating expenses of the business; they are not extraordinary items that are segregated as a separately stated line item caption to distinguish it from the day-to-day recurring type expenses. Therefore, if a separate line item sub-total such as Operating Income (or a similar equivalent sub-total) is presented in the income statement, it must include the impairment charge. While a financial analyst calculating EBITDA would likely add back the impairment charge, it is technically not "depreciation" or "amortization"; therefore, when calculating certain financial covenants, including EBITDA, impairment will likely be included baring a special carve-out in the loan documents. A significant amount of time can be spent developing and fine tuning models used to test for impairment and often independent appraisals will be needed to satisfy third parties. Appraisals might even be needed in establishing whether the undiscounted future net cash flows exceed the carrying amount with respect to the assumptions used to calculate terminal value.
Rent Holidays and Rent Step-Ups
Applying GAAP, base rent is generally required to be recognized on a straight line basis over the life of the lease; thus, the same amount of rent is recognized each month regardless of the amount the tenant is actually being billed and the cash flow the lease is generating. If a lease contains step-up provisions and/or free rent periods, the rent bumps and periods of rent holidays are factored into determining a constant rent each month throughout the life of the lease. For example, if a tenant has a three month rent holiday at the beginning of its lease term of January 1, 2010 and pays $100,000 per month in base rent for the remainder of its 10 year lease, using GAAP, $1,170,000 in rent
income would be recognized in the financials in Year 1 (2010) of the lease as follows:
$100,000 per month × 117 months (120 mos. - 3 mos. free) = $11,700,000 total base rent to be billed over the lease life
Divided by 120 month lease life = $97,500 rent recognized each month $97,500 monthly rent × 12 months in Year 1 (2010) = $1,170,000 GAAP rent income.
On the balance sheet at December 31, 2010, the difference between the rent billed ($900,000) and the rent recognized as income ($1,170,000) in Year 1 or $270,000, would be recorded as a deferred rent asset. Beginning in Year 2 of the lease, the deferred rent asset would be reduced by $30,000 per year until it is zero at the end of year 10. If the tenant terminates their lease early, the unamortized deferred rent asset must be written off upon termination.
If the income tax basis of accounting was used, the accounting treatment is generally simple: rent income reported on the financial statements would be $900,000 ($100,000 per mo. billed × 9 mos.) in Year 1 of the lease. Since the landlord actually billed $900,000 and presuming that all rent was paid, the income reported is in sync with the $900,000 of cash flow received from the tenant in 2010 and the amount of income the company will report on its 2010 income tax returns.
If we factor into the lease a rent step-up in Year 6 to $105,000 per month, GAAP rent income in Year 1 of the lease would be $1,200,000 as follows:
$100,000 × 57 mos. + $105,000 × 60 mos. = $12,000,000 total base rent to be billed over the lease life
Divided by 120 month lease life = $100,000 rent recognized each month
$100,000 × 12 months in Year 1 (2010) = $1,200,000 GAAP rent income
However, for financials prepared using the income tax basis of accounting, rent income recognized in Year 1 of the lease would still be $900,000, assuming that Internal Revenue Code ("IRC") Section 467 provisions do not apply. In this example, we again see that using tax basis accounting mirrors the cash flows to be generated from the lease, whereas GAAP produces "phantom income" of $300,000 ($1,200,000–$900,000) in Year 1 of the lease. In Year 6 of the lease, GAAP rent income would remain at $1,200,000 whereas tax basis rent income would be $1,260,000 ($105,000 per mo billed × 12 mos.).
Sometimes (although not often enough for some real estate owners), tenants will prepay the succeeding year's rent in advance of its due date. For instance, some tenants will pay rent due on January 1, 2010 in December 2009. If a real estate company reports on a calendar year using the income tax basis, the rent received in December 2009 would be reported as income when received in 2009. Thus, the cash flow mirrors the accounting treatment. For GAAP reporting, the income received in December 2009 would be recorded as deferred revenue on the balance sheet (essentially a liability) until it is earned under the terms of the lease in January 2010.
Allocation of Purchase Price for Income-Producing Real Estate
Prior to July 1, 2001, all real estate companies using either GAAP or income tax basis reporting typically allocated the purchase price of a income-producing property to the various tangible assets purchased, such as land, land improvements, building and personal property (i.e. furniture, fixtures and equipment) using appraised values, real estate tax assessed values, cost segregation studies, or some other rational allocation methodology. Real estate companies encountered a storm when, effective for real estate acquisitions post July 1, 2001, any company that reports using GAAP is required to allocate the purchase price of an income-producing property not only to the tangible components purchased, but also to the intangible assets purchased including in-place leases and above and below market leases.
The rationale behind attributing value to in-place leases is that there is incremental value in a leased-up building versus an empty one, and this intangible value should be recognized separately. Such value includes, but is not limited to, the cost savings of not having to provide tenant improvement allowances to tenants that are already in the space or pay leasing commissions to secure a tenant. Similarly, there is value attributable to above market leases (the value is equal to the discounted cash flows of the above market leases in-place less the discounted market rate rents) which the buyer is paying for in the acquisition price, and there is negative value, if you will, associated with buying a property that has leases in-place that are below market value (negative value is equal to the difference between the discounted cash flows from the below market leases in-place and discounted market rate rents).
To illustrate the effect on a GAAP balance sheet and income statement, let's assume that an owner purchases an income-producing commercial property as well as the underlying land for $50,000,000 on January 1, 2010 and all of the in-place leases are at current market rents with the value of the in-place leases determined to be $2,000,000. Since all of the leases are determined to be at current market rents, no value is attributed to above or below market leases. Based on comparable sales and other market factors, the value of the land is determined to be $10,000,000 and the balance of the purchase price of $38,000,000 is attributable to the building.
For GAAP purposes, the acquisition would be recorded on the balance sheet as follows: