Valuers dilemma for assets valuation

CLASSIFICATION OF PROPERTY

The land parcels along with the associated project-work-in-progress could be classified as inventory,investment property or fixed assets depending on the ultimate disposition of these assets. Typically,a real estate company would classify a property as inventory where the fully developed property is ultimately intended to be sold with the transfer of ownership to the buyer. In case,where the fully developed property is ultimately intended to be leased or held for long term appreciation,it will be classified as investment property. Further,in case where the fully developed property is ultimately intended to be operated by the Company,it is classified as fixed assets. For example,a hotel property owned and operated by a real estate company is classified as fixed asset,whereas if the hotel is leased to a third party,then it should be classified as investment property.

The classification of property is not always straight forward. Take the instance of SEZ projects where developers can not legally transfer the ownership to the buyer. In such a case,a developer could structure the sale of residential or commercial project on long-term lease of say 90 years wherein the developer collects the entire current market value of the property as upfront lease premium. The recurring lease payment for 90 years could be very nominal. For example,if the prevailing capital and rental rate of commercial office space in a SEZ is Rs 3,000 per sq ft and Rs 30 per sq ft per month respectively. The developer could sign a long-term lease of 90 years wherein he collects Rs 2,910 per sq ft,as upfront lease premium and a nominal lease payment of Re 1 per sq ft per annum for 90 years. One could argue that such projects should be classified as inventory as the developer has realised the entire economic benefit arising out of sale of commercial project. Another viewpoint could be that since the ownership of the property is not transferred to the buyer,the same should be classified as investment property. Accounting standards have same treatment for properties classified as investment property or fixed assets for the purpose of recording in the books. However the treatment for property classified as inventory is different.

NET REALISABLE VALUE OF LAND INVENTORY

As per accounting standard,land inventory should be recorded at the lower of cost and net realisable value NRV. NRV is defined as estimated selling price in the ordinary course of business less the estimated costs of completion and the estimated costs necessary to make the sale. Although the accounting standard gives the guidance on how to calculate NRV,it does not provide detailed methodology for calculation of NRV of land inventory on fully developed basis for real estate companies. The key dilemma for a valuer while computing the NRV is whether or not to include the interest costs incurred during the project period. Since real-estate projects have a long gestation period and have a significant component of debt funding,ignoring interest costs will skew the valuation positively.

NRV as per the above method can be computed only when the management of the company can show a realistic project plan containing the development mix and schedule of the project. Considering the current market scenario,key business plan assumptions such as selling price,expected profitability and time required will always be a point of debate. Further,considering the current illiquid nature of the real estate market,it is increasingly difficult for the valuer to establish a market benchmark of the land inventory.

RECOVERABLE VALUE OF INVESTMENT

In case of land classified as investment property and fixed assets,impairment testing is done to ascertain an impairment loss. An impairment loss is the amount by which the carrying amount of investment property/fixed assets exceeds its recoverable value which is the higher of its fair value less costs to sell and its value in use. However,arriving at fair value of the land would involve a lot of subjectivity. Value in use is the present value of the future cash flows expected to be derived from fully developed property. Since projecting future cash flows can be subjective,As it requires the management to estimate the cash flows based on reasonable assumptions. Again,a valuer faces significant challenge pertaining to the accuracy and rationale of the assumptions used in the business plan with regards to the selling price and time required to sell the fully developed property.

The reader of the financial statements of real estate companies should be aware that the interpretation of the accounting standard and greater subjectivity involved in valuation of land inventory during the economic downturn can have a significant impact on the balance sheet of real estate companies.

The writer is associate vice president,transaction advisory services,Ernst amp; Young.