PURCHASE PRICE ALLOCATION (ASC 805) FOR REAL PROPERTY ASSETS
Purchase Accounting Valuation for Real Property Assets Complies with GAAP
Purchase Price Allocation (PPAs) are required for every controlling transaction wherein the acquirer complies with Generally Accepted Accounting Principles (“GAAP”), with varying complexity based on the entities and/or assets involved in the transaction.
If the transaction does not meet the definition of a business, the transaction is accounted for as an asset acquisition. Most real estate acquisitions will be recorded as Asset Acquisitions rather than Business Combinations as ASU 2017-01 implementation rolls out effective as of 01-01-2019 mostly. The language of ASC 805 sets out the rules for identifying and separately measuring all identifiable assets and liabilities present in an acquisition.
According to ASC 820, fair value is defined 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."
PPAs can be done for the Financial Reporting purpose or Tax Reporting purpose, or it can be applied to both purposes with different outcomes.
► Allocate the cost of the acquisition to individual asset components acquired and liabilities assumed on a relative fair value basis as discussed in ASC 805-50-30-3
► Cost of the acquisition = purchase price plus direct acquisition costs
► Goodwill and bargain purchase gains are not recognized in asset acquisitions.
The buyer of an institutional multi-tenant office building or regional mall is not only purchasing the underlying land and the bricks & mortar, it is also acquiring all lease contracts in place, along with the various implications driven by those contracts.
As income-generating properties, the appropriate methodology varies to best reflect market participant application. As such, the property is typically valued on an as-vacant basis via the cost and income approaches. A cost approach is first modeled, which appropriately values the land and improvements with no consideration of leases in place.
The cost approach is supported by a ‘go-dark’ income analysis, which capitalizes the future income stream associated with the property, but under the hypothetical scenario of complete vacancy, so as to exclude any contribution from the leases in place (which are valued separately).
The sales comparison approach is also employed, but primarily as support to the Fair Value conclusion of the individual tangible and intangible assets in aggregate. This is due to the leased fee nature of similar investment-grade transactions, in which all real property assets are conveyed in one bundle or rights.
VALUATION PROCESS - TANGIBLE ASSETS
1. Land
Use sales comparison approach, abstraction method or residual land capitalization approach.
2. Building (as-vacant)
-- Cost Approach: An informed purchaser would not pay more for a property than the cost of producing a substitute property with equal utility (MVS or construction comparables)
-- Income Approach, "Go Dark" Analysis
Utilize a discounted cash flow (DCF) model based on the assumption that the building is initially vacant and leased up over a period of time to stabilization
-- Land value and site improvement value are deducted from the value determined through the DCF to arrive at the building value
-- Reconcile the Income Approach and Cost Approach to determine a final value estimate for the building
3. Site Improvements and Furniture, Fixtures, and Equipment (FF&E)
-- Methodology: Cost Approach
Estimate the RCN for each site improvement and FF&E component via industry survey data or cost comparables and adjust the cost for depreciation (physical deterioration, functional and external obsolescence)
Physical deterioration is generally calculated using the age/life method (effective age/economic life)
4. Unamortized Origination Costs (Tenant Improvements/ Leasing Commissions)
-- Methodology: Cost Approach
Represents the value associated with "cost avoidance" of acquiring an in-place lease. Part of the market cost to execute a similar lease are costs related to tenant improvement allowances given as an inducement to rent the space. Other cost include leasing commission and legal/marketing expenses.
The values of tenant improvements and leasing commissions are estimated to be the market tenant improvement allowance and the market leasing commission, respectively, multiplied by the percentage of the original lease term remaining. )
5. Other Personal Property
VALUATION PROCESS - INTANGIBLE ASSETS
1. Lease contracts
Above/ below market lease(s)
Methodology: Income Approach
-- Discount the difference between the contract rent and market rent over the remaining term of each tenant's lease
-- Significant judgment exists with regard to the treatment of renewal options. Consider the following when assessing renewal options:
- Is the renewal within the control of the tenant?
- Does the renewal provide economic benefit to the tenant?
Above/ below market ground lease(s)
Capital lease(s)
Legal/ marketing fees
Leases in-place (forgone rent)
Methodology: Income Approach
-- Represents the value related to the economic benefit for acquiring the property with in-place leases as opposed to a vacant property
-- Measured as the income (rent and expense reimbursement revenue) over the estimated amount of time that it would take to lease the space to stabilized occupancy.
-- The value of the Lease In-Place should not exceed the value of the remaining cash payments under the lease.
Tenant/Customer relationships
Methodology: Income Approach
-- Represents the PV of the NOI difference expected if a tenant renews their lease versus if they vacate and the owner is required to find a new tenant.
-- Tenant relationships are uncommon.
-- Estimated NOI difference is calculated as the sum of the following items multiplied by the renewal probability:
Monthly market rent expense recoveries at the end of the current lease term for the estimated months vacant before a new tenant is in place.
Difference in TI allowance required and leasing commissions paid at the end of the current lease term for a new tenant versus a renewal tenant
-- The expected NOI value is then discounted from the end of the current lease term to the acquisition date to estimate the current value of the tenant relationship.
Unamortized leasing commissions
2. Service contracts
Favorable purchase contracts
Trade names
Above/ below market debt
PPA accounting guidance requires that notes payable and other long-term debt be assigned amounts “at present values of amounts to be paid, determined at appropriate current interest rates.” Therefore, if a mortgage is assumed in the acquisition of a property, there may be an intangible asset to the extent that the assumed mortgage features a below-market coupon. Likewise, assumed mortgage featuring above-market coupons represent an assumed liability to the buyer.
-- Methodology: Income Approach
- If property-level debt was assumed as part of the transaction, the debt should be fair valued in accordance with specific mortgage terms in relation to current market terms as of the acquisition date to determine if a favorable/ unfavorable condition exists.
3. Recognize and measure goodwill
Goodwill shall be recognized as of the acquisition date and measured as the excess of (1) over (b).
(a) The aggregate of the following:
-- The consideration transferred measured in accordance with ASC 805-30-30-1, which generally requires acquisition-date fair value.
-- The fair value of any non-controlling interest in the acquire
-- In a business combination achieved in stages, the acquisition-date fair value of the acquirer's previously held equity interest in the acquiree.
(b) The of the acquisition-date amounts of the identifiable assets acquired and the liabilities assumed measured in accordance with ASC 805.
4. Recognize and measure a bargain purchase gain
-- Bargain purchases occur if the acquisition-date amounts of the identifiable net assets acquired, excluding goodwill, exceed the sum of
(1) the value of consideration transferred
(2) the value of any non-controlling interest in the acquiree; and
(3) the fair value of any previously held equity interest in the acquiree
-- A bargain purchase should be recognized in earnings (profit or loss) and attributed to the acquirer