Fair value accounting—using current market values as the basis for recognizing certain assets and liabilities—is at the core of understanding your portfolio’s value. It is also an important tool when seeking new equity investors or when planning for an IPO.
Getting investors to agree on the company’s future projection is a key issue, one in which fair value accounting will help you more clearly position your firm’s financials for that investment or IPO. Here are some considerations to take into account.
- Compile relevant deal documents and files
The primary document is typically the investment memorandum, which summarizes the underlying property, investment amount and equity ownership structure, as well as the debt structure and terms. The original underwriting model is another pertinent file and includes financial projections and investment return expectations.
- Asset level valuation
Your property valuation needs to be consistent with how investors value similar assets. For most institutional properties, the primary valuation method is a discounted cash flow (DCF) analysis. Key drivers of the DCF include cash flow projections, discount rate and terminal capitalization rate. Cash flow projections should be well supported by the historical cash flows. Any deviance above and beyond actual performance should be noted and supported.
Whether you employ a five-year or a 10-year hold is dependent on the typical holding period of similar assets. However, you should avoid having a target exit date, as this reflects investment value, not necessarily market value.
Discount rate for a real estate asset is applied to the property cash flow, which is before tax and debt service. The discount rate should reflect any changes in the market or property risk factors.
Terminal capitalization—also referred to as the exit capitalization rate—determines the residual/resale value of the property. There is typically a spread between the going-in capitalization rate and terminal capitalization rate, mainly due to a) the uncertainty at the end of the holding period and b) the fact that real estate is a depreciating asset. All things equal, there will be less remaining life at the end of the holding period.
If you have different types of assets in various locations—particularly in foreign countries—compare all of your discount rates and terminal cap rates side by side. Check to see if the discount rate incorporates the country risk premium and evaluate if you’d be willing to make the investment today at the current discount rate and terminal capitalization rate.
- Equity valuation
There are two ways to estimate the value of your investment (or equity position). The most straightforward method is to subtract the debt balance from the property value. However, certain situations call for a different valuation method—for example, investment in a development project, or investment with complex waterfall structure. Cases like those require a DCF, projecting equity cash flow for the entire holding period and discounting the cash flow based on the equity discount rate.
- Investment performance
You may have an investor who wants to invest in your next fund, in which case, the investor will ask for your track record. Assuming your next fund is similar to your previous funds, the most convincing data point will be the historical returns (based on investments that have been sold and realized). You can display various levels of returns, including unlevered IRR, levered IRR and MOIC, which are undisputable.
However, in the case of a first fund or one that lacks sufficient historical data, you will need to provide projected returns on existing investments (based on invested capital plus management’s projections).
Same levels of returns can be utilized, but unlike historical returns, these returns are disputable. Because these investments are not yet realized, the returns are highly dependent upon future projections and the support you have for the underlying assumptions. Many times, both historical returns and projected returns are used as support for what the investor can earn in the new fund.
Here are some best practices for fair value accounting:
- Update your valuation model every quarter. Don’t leave your valuation stale after the deal closes.
- Maintain consistency in your valuation models.
- Keep a consistent input page (assumptions) and output page (cash flow and value conclusion) format for all investments; this makes reviewing the model much easier.
- Use consistent time intervals in your cash flow projections. Mixing monthly, quarterly and annual cash flow can create unnecessary work later on.
- Maintain a “Quarterly Memo,” which ties to the valuation model. This document should include major assumptions used in the valuation model and support for the assumptions.
- Typical support includes third-party surveys, actual transactions, broker opinion of value, and any other market data points.
- The memo should also summarize any significant change and the impact on the projected cash flows, discount rate and terminal capitalization rate.
- More significant changes, such as investment restructuring, loan refinancing, and updates to the JV agreement should also be reflected in the memo.
- Latest financial statements (balance sheet, trailing 12-month income statement) and other operating statistics should be attached to the memo as further support.
The views expressed herein are those of the author(s) and not necessarily the views of FTI Consulting, Inc., its management, its subsidiaries, its affiliates, or its other professionals. FTI Consulting, Inc., including its subsidiaries and affiliates, is a consulting firm and is not a certified public accounting firm or a law firm.
Yunsoo Kim is a managing director in the real estate solutions practice at FTI Consulting Inc. in New York. She specializes in valuation for asset acquisitions, divestiture, financing and financial reporting. She can be contacted at [email protected]