An investment property’s fair value is typically based either on the market approach by reference to sales in the market of comparable properties, or the income approach by reference to rentals obtained from the subject property or similar properties. The replacement cost approach may not be appropriate for the fair value model under
ASC 820 because the value of an investment property lies in its ability to generate income or to appreciate in value by reference to market prices, not in the cost to rebuild it.
Fair value excludes any estimated price that is inflated or deflated by special terms such as unusual financing, sale and leaseback arrangements, or special considerations or concessions granted by anyone associated with the sale. Fair value is determined without deduction for transaction costs that might be incurred on sale or other disposal.
When a reporting entity has prepaid or accrued operating lease income on its balance sheet, it does not include the value of that income in the fair value of the related investment property, as the prepaid or accrued operating lease income is a separate asset.
The market approach – investment property
The best evidence of fair value is usually provided by current prices in an active market for similar property in a similar location and condition and subject to similar lease terms and other conditions. Such similar properties may not always be present and thus an entity should take into account, and make allowances for, differences from the comparable properties in location, nature, and condition or in contractual terms of leases and other contracts relating to the property. For example, if the property is leased by the entity through a finance lease that contains restrictions on the use of the property by present and future lessees that could significantly affect the property’s fair value because it might restrict the entity’s ability to obtain the optimum market rentals, an adjustment to comparable property values would likely be necessary.
Fair value of an investment property does not reflect the following factors if they would not be generally available to market participants:
- Additional value created by bringing together a number of properties in different locations and combining them into a portfolio of properties
- Synergies between investment properties and other assets
- Legal rights and restrictions specific to the present owner
- Tax benefits or disadvantages specific to the present owner
Where current prices in an active market are not available, entities should consider evidence from alternative sources, such as:
- Current prices in an active market for properties of a different nature, condition, or location or that are subject to different lease or other contractual terms, adjusted to reflect the differences
- Recent prices from transactions in less active markets, adjusted to reflect changes in economic conditions since the date of those transactions
Using the market approach to measure the fair value of investment property is likely to be a Level 2 measurement as long as any multiple used is observable and the reporting entity does not make any significant adjustments using unobservable data.
The income approach – investment property
The fair value of an investment property may be measured using discounted cash flow projections based on reliable estimates of future rental income and expenditures, supported by the terms of the existing lease and other contracts. When practicable, external evidence should also be used, such as current market rents for properties of a similar nature, condition, and location. Discount rates that reflect current market participant assessments of uncertainty regarding the amount and timing of cash flows should be used to discount the projected future cash flows.
Using the income approach to measure the fair value of investment property is likely to result in a Level 3 measurement as the most significant input will be the projected cash flows.
Question FV 7-4 discusses classification of real estate assets within the fair value hierarchy.
Question FV 7-4
Where are fair value measurements of real estate assets classified within the fair value hierarchy?
PwC response
The fair value hierarchy level chosen for real estate assets will vary by the inputs used. For example, a multi-unit condominium development in which each unit has similar floor plans, features, and few differentiating characteristics, may be measured using an appraisal based on a market approach that incorporates a dollar-per-square-foot multiple. As long as the multiple is observable and the reporting entity does not make any significant adjustments using unobservable data, the valuation would represent a Level 2 fair value measurement.
However, the valuation of many real estate assets—such as office buildings, shopping centers, hospitals, manufacturing facilities, and similar build-to-suit facilities—may require adjustments to market-based valuation inputs to reflect the different characteristics between the assets being measured and the assets upon which the observable inputs are based. These adjustments could result in classification as a Level 3 fair value measurement for the real estate asset. Real estate assets may also be measured using an income approach based on unobservable cash flows to be received from expected rents and expenses, which would likely also yield a Level 3 fair value measurement.
In considering the results from appraisals of real estate assets, it is the reporting entity’s responsibility to ensure the third-party valuation specialist appropriately evaluates and documents the assumptions and inputs used in their assessment of the highest and best use of the asset.
Refer to
FV 4.4 and
FV 4.5 for further discussion of available valuation approaches, techniques and the evaluation of related inputs.