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4.10 Acquisition, development, and construction arrangements
Publication date: 31 May 2022
us Loans & investments guide
Reporting entities may enter into acquisition, development, and construction (ADC) lending arrangements in which they have virtually the same risks and potential rewards as those of owners or venturers as a result of participating in the projects expected residual profit. Due to the unique nature of these arrangements, lenders will need to determine whether the arrangement should be accounted for as a loan or as a real estate investment (i.e., joint venture) once it has been determined that an entity would not be consolidated under the guidance in ASC 810, Consolidation. If a lender is expected to receive more than 50% of the expected residual profit, the lender should account for the arrangement as a real estate investment subject to ASC 970 (the profit-sharing agreement may be separate from the mortgage contract). If a lender is expected to receive 50% or less of the expected residual profit, further consideration is needed to determine how to account for the arrangement. More specifically, if at least one of the characteristics identified in ASC 310-10-25-20(b) through ASC 310-10-25-20(e) are identified or there is a qualifying personal guarantee by the borrower and/or third party, the arrangement should be accounted for as a loan. Otherwise, the arrangement should be accounted for as a real estate investment. When determining the extent of participation in the expected residual profits, lenders should take into account (1) the contractual interest and fees and whether they are at market, (2) the agreed portion of profit to be shared upon a sale, if any, (e.g., 20%, 50%, 90%), and (3) the sharing of any future cash flows from the project after completion (e.g., gross rent).
Definition from ASC 310-10-20
Expected residual profit: The amount of profit, whether called interest or another name, such as equity kicker, above a reasonable amount of interest and fees expected to be earned by a lender.
Even though the lender participates in expected residual profit, the following characteristics suggest that the risks and rewards of an acquisition, development, and construction arrangement are similar to those associated with a loan:
- The lender participates in less than a majority of the expected residual profit.
- The borrower has an equity investment, substantial to the project, not funded by the lender. The investment may be in the form of cash payments by the borrower or contribution by the borrower of land (without considering value expected to be added by future development or construction) or other assets. The value attributed to the land or other assets should be net of encumbrances. There may be little value to assets with substantial prior liens that make foreclosure to collect less likely. Recently acquired property generally shall be valued at no higher than cost.
- The lender has either of the following:
- Recourse to substantial tangible, saleable assets of the borrower, with a determinable sales value, other than the acquisition, development, and construction project that are not pledged as collateral under other loans
- An irrevocable letter of credit from a creditworthy, independent third party provided by the borrower to the lender for a substantial amount of the loan over the entire term of the loan.
- A take-out commitment for the full amount of the lender's loans has been obtained from a creditworthy, independent third party. Take-out commitments often are conditional. If so, the conditions should be reasonable and their attainment probable.
- Noncancelable sales contracts or lease commitments from creditworthy, independent third parties are currently in effect that will provide sufficient net cash flow on completion of the project to service normal loan amortization, that is, principal and interest. Any associated conditions should be probable of attainment.
Generally, the existence of a guarantee alone rarely provides a basis for concluding that the arrangement should be accounted for as a loan. However, it may provide a basis for concluding the arrangement is a loan when the expected residual profit share is 50% or less and none of the characteristics in ASC 310-10-25-20(b) through ASC 310-10-25-20(e) are identified, but a guarantee is present in the arrangement. In order to determine if loan classification is appropriate, lenders should determine the ability of the guarantor to perform, the practicality of enforcing the guarantee in the applicable jurisdiction, and if there is a demonstrated intent to enforce the guarantee. Some examples of a qualifying guarantee would be liquid assets placed in escrow, pledged marketable securities, and irrevocable letters of credit from an independent credit-worthy third party. The credit worthiness of the guarantor may be taken into consideration absent any other indicators of the ability to perform. However, emphasis should be placed on the guarantor’s liquidity and net worth and whether any other guarantees by the guarantor exist for other projects.
In addition to the guidance above, additional considerations may be needed in order to determine whether the arrangement should be accounted for as a real estate investment or as a loan. ASC 310-10-25-19 provides guidance when determining whether the characteristics of the arrangement would imply a real estate investment.
In an acquisition, development, and construction arrangement in which the lender participates in expected residual profit, in addition to the lender's participation in expected residual profit, the following characteristics suggest that the risks and rewards of the arrangement are similar to those associated with an investment in real estate or joint venture:
- The lender agrees to provide all or substantially all necessary funds to acquire, develop, or construct the property. The borrower has title to but little or no equity in the underlying property.
- The lender funds the commitment or origination fees or both by including them in the amount of the loan.
- The lender funds all or substantially all interest and fees during the term of the loan by adding them to the loan balance.
- The lender's only security is the acquisition, development, and construction project. The lender has no recourse to other assets of the borrower, and the borrower does not guarantee the debt.
- In order for the lender to recover the investment in the project, the property must be sold to independent third parties, the borrower must obtain refinancing from another source, or the property must be placed in service and generate sufficient net cash flow to service debt principal and interest.
- The arrangement is structured so that foreclosure during the project's development as a result of delinquency is unlikely because the borrower is not required to make any payments until the project is complete, and, therefore, the loan normally cannot become delinquent.
ASC 310-20-35-20 provides guidance when determining whether the characteristics of the arrangement would imply a loan. If the arrangement is accounted for as a loan, interest and fees should be recognized as income, subject to recoverability. If the arrangement is accounted for as a real estate investment, lenders should apply the accounting in ASC 970-323 and ASC 835-20. Additional considerations are included in ASC 970-835-35-1 on when the recognition of interest income would not be appropriate.
The accounting treatment for an ADC arrangement should be periodically reassessed. An arrangement originally classified as a real estate investment could subsequently be accounted for as a loan if the risk to the lender diminishes significantly, and the lender will not be receiving over 50% of the expected residual profit. Conversely, if the lender assumes further risks and rewards, its percentage of profit participation may increase to over 50%. Any change in the classification of the arrangement should be applied prospectively.
If the lender’s interest in expected residual profits of the project are sold, the accounting treatment will be dependent on whether the arrangement was accounted for as (1) a loan or (2) an investment in real estate or a joint venture. First, it should be determined if the transfer qualifies as a sale under ASC 860. Assuming the requirements for sale accounting are met, if the arrangement was accounted for as a loan, the proceeds from the sale of the expected residual profits should be recognized prospectively as additional interest income over the remaining term of the loan since the expected residual profit is considered additional compensation to the lender in accordance with ASC 310-10-40-4. No immediate income would be recognized on the date of sale if it is accounted for as a loan. For arrangements accounted for as a real estate investment, the guidance in ASC 860 should be applied for transfers that qualify as sales.
Furthermore, ASC 310-10-S99-1 addresses certain reporting requirements for lenders in situations where nonrecourse mortgage loans may in essence be equity investments in the borrower's project. If the lender is determined to be in-substance an equity participant, the SEC may require the lender to include audited financial information related to the underlying investment in its public filings.
PwC. All rights reserved. PwC refers to the US member firm or one of its subsidiaries or affiliates, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see www.pwc.com/structure for further details. This content is for general information purposes only, and should not be used as a substitute for consultation with professional advisors.
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