Determining fair value of a real estate acquisition
This article kicks off a brief series on the components of purchase price allocation (PPA) for real estate acquisitions. When a company purchases real estate as an investment and has to follow GAAP codification ASC 805 or international IFRS 3 reporting standards, it is necessary to break the property out into all identifiable assets and liabilities (e.g., land, building, lease intangibles, etc.).
Before allocating the purchase price to individual assets and liabilities, it is necessary to establish some evidence that the price paid represents fair market value. Although recent changes under AUS No. 2017-01 allow most real estate acquisitions to be accounted for as Asset Acquisitions rather than Business Combinations, it is still necessary to consider all of the intangible assets and to demonstrate that the price paid is not materially different than fair market value.
We see transactions in which the acquisitions team feel like they got an exceptionally good deal, but if the sale was widely marketed and multiple bidders were involved, chances are that the price was at least in the range of market expectations. On very rare occasions, an acquisition may be deemed a bargain purchase, where you paid materially less than what a typical buyer would pay for the same property.
There are several ways to determine, and document, whether the price paid is materially similar to fair market value. Here are a few common approaches.
Appraisal: If you used debt in your acquisition, you likely have access to the bank-ordered appraisal. Check to see that the appraised value is +/- 5% of your purchase price.
Widely marketed: A common question external auditors ask when considering fair market value is evidence that the transaction was widely marketed, that multiple possible buyers were considering the deal, and that the seller was not under duress.
Comparable sales: If an appraisal is not available, find similar property sales (comps) in the local market and consider the price per square foot of those sales relative to your price. Make adjustments for factors that could affect pricing and summarize the results.
Direct capitalization: Calculate what the implied cap rate is based on the property's stabilized net operating income (NOI). If an office building generates annual NOI of $500,000 and the purchase price is $7 million, this indicates a capitalization rate as follows: ($500,000 NOI / $7 mill purchase price) = 7.1%. Find some evidence of what the range of market cap rates is by talking with brokers and/or researching individual property sales in which cap rate is either disclosed or can be calculated (again using the formula NOI/purchase price = cap rate).
DCF: If the property is not yet stabilized or requires significant capital improvement to reach your targeted rents, it can be useful to show a cash flow schedule over a holding period of sufficient length to show the property achieving stabilization. In the final year of the cash flow schedule, include the sale of the property based on the next year's NOI divided by a cap rate assumption, less typical costs of sale. Apply a market discount rate to the entire cash flows in the form of a net present value calculation and compare to the price paid for the asset.
Confirming evidence of fair value can be a very quick validation process for your external auditors as long as the company has taken a little time to put some of this documentation together. As with all aspects of real estate financial reporting, we here at Allocation Advisors want to see more of your money stay in the deal and less of it getting sucked up by a lengthy compliance process. Do it right the first time for greatest efficiency and give us a call if you need some help.