Management’s Impairment Considerations for Real Estate

The concept of impairment as it relates to real estate becomes increasingly more relevant during times of uncertainty, which has been a common theme since the start of the COVID-19 pandemic.

The steps for evaluating impairment of long-lived assets, in accordance with ASC 360-10-35-21, include 1) evaluating if an indicator, also known as a triggering event, for impairment exist and 2) testing the asset (or group of assets) for recoverability if an indicator is identified. While these steps may seem straightforward on the surface, there are several factors management should consider when evaluating impairment of real estate assets being held for use.

Foremost, to ensure real estate assets are appropriately assessed for triggering events, it is pivotal that management has a formalized process and controls in place for making this assessment. A triggering event is defined as an instance in which events or changes in circumstances indicate that a) an asset’s carrying amount may not be recoverable and as a result b) should be tested for recoverability. Examples of such events or changes in circumstances include the following:

• Significant decrease in the market price of a long-lived asset.
• A significant adverse change in the extent or manner in which an asset is being used or its physical condition.
• A significant adverse change in legal factors or in the business climate that could affect the value of a long-lived asset, including an adverse action or assessment by a regulator.
• An accumulation of costs significantly in excess of the amount originally expected for the acquisition or construction of a long-lived asset.
• 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.
• A current expectation that, more likely than not, a long-lived asset will be sold or otherwise disposed of significantly before the end of its previously estimated useful life.

If management identifies any instances of the circumstances noted above in relation to any of its real estate assets when making this assessment, documentation should be maintained to ensure management is able to support how the triggering event was determined (i.e., board minutes of any discussions or any agreements or documentation obtained during the assessment). Once a triggering event is identified, the next step is to perform a recoverability test.

The recoverability test will determine if an impairment loss should be measured for the asset under consideration. This test includes comparing the asset’s carrying value to the estimated undiscounted cash flows to be generated from the use of the asset and its eventual disposal.

• If the estimated undiscounted cash flows exceed the carrying amount of the long-lived asset, the long-lived asset is recoverable, and an impairment does not exist and a loss cannot be recognized. However, given the existence of impairment indicators, it may be appropriate to review depreciation policies for the long-lived asset (e.g., reduce the estimated remaining useful life or salvage value).
• If the estimated undiscounted cash flows are less the carrying amount of the long-lived asset, the long-lived asset is not recoverable, and the fair value of the long-lived asset must be determined.

The process for estimating undiscounted cash flows looks at future cash inflows less cash outflows that are directly associated with the asset’s use and eventual disposition. These projections require a certain degree of judgement, estimates and assumptions used by management considering factors like industry knowledge, operating levels previously experienced by the real estate asset being evaluated, and current and projected market conditions. If a company’s real estate assets are managed by an outside property manager, it may be beneficial to collaborate with the property manager to develop budgets and operating forecasts of the property.

Some of the important inputs to be used in the recoverability test include future cash flow projections, an appropriate holding period, capitalization rates and costs to sell the asset. The future cash flow projections depict the expected operating levels for the real estate asset, while the holding period will determine the length into the future in which these levels will need to be estimated prior to the disposal of the asset. At this point, the capitalization rates and costs to sell will need to be taken into account to determine the sales proceeds to be received by the company at the point of disposal. It is important that the company’s processes and internal controls ensure the appropriate level of documentation is maintained to support all of the inputs utilized in the recoverability test.