The 10 largest companies in the Fortune Global 500 by annual revenue report property assets on their balance sheets valued at in excess of $100bn. However, current accounting practice means that the discrepancy between what is stated in their accounts and the true achievable value may be significant.
Current practice
Accounting guidelines allow companies to account for their freehold real estate assets at either fair value or at cost. Real estate funds and REITs value their properties annually or more frequently and account for their properties at “fair value” in accordance with IFRS. Fair value is recognised as being in line with the IVSC and RICS definitions of market value, which estimate the actual price a property would sell for on the open market. As a result, funds hold their property on their accounts at a “real value”.
In the instance of corporates however, they typically account properties at the cost they either bought or built them for and depreciate them down to a residual land value over a period of 30 to 50 years. While this method may be appropriate for other items of a balance sheet, where there is a limited usable life and little to no secondary market, real estate does not operate in the same manner.
Real estate has an established market, where properties are traded on a regular basis as well as being used as collateral for finance. Real estate prices can move significantly in time and the price that third-party purchasers are willing to pay does not relate to the cost of construction. There are active markets for the majority of real estate assets and as such property can be valued reflecting what “the market” would be prepared to pay for it. There is an argument therefore that periodic assessments of “fair value” would be a more prudent approach to financial reporting than that of cost. Through a periodic, professional review of assets this risk can be managed and priced, as incorrect reporting of both assets and liabilities clearly does not provide shareholders with a clear picture of a company’s financial health.
Risks
The largest owners of commercial real estate across the world are global corporates. They own a vast number of office, industrial, logistics and retail properties. The value of these properties is in the trillions of dollars, though by accounting for their real estate at cost there is a significant danger that companies are not showing their real value on the balance sheets. The fundamental principle that cost does not equal value is not being considered, nor is the volatile nature of the property market.
The real estate market operates in a cyclical manner, values can change distinctly and by not reflecting these, organisations could be at risk of either grossly under or over assessing the worth of their assets. This can be especially true when considering land; land is a finite resource and amendments to planning policy over time can result in drastic fluctuations in value. Cities across the globe have changed dramatically over the years. There are numerous examples of industrial sites owned by manufacturing companies across the globe which now have higher and better uses – in these instances corporates could be sitting on real estate with values significantly higher than what is being reported.
A considerable number of companies are publicly listed on stock exchanges and traded for and on behalf of institutional and private investors. The decision to invest in these companies is made based on the information corporates provide, particularly their accounts. When the balance sheet does not reflect the true value of real estate by showing a value either higher or lower, there is a danger that investors are being misled and companies are either over or under valued.
The same applies to financial institutions that provide finance to corporate businesses. While they will of course consider a number of elements before making their decision, one element of this is their reported real estate value. It is taken for granted that the audited accounts are accurate but if the real estate is not being considered in line with the market, are they?
Best practice
A small number of corporate occupiers have begun to recognise that their current accounting practice is not providing their shareholders with suitable transparency and as such, while they hold their real estate on their balance sheet at cost, they also include the fair value of the assets within their financial statements. While this is a step in the right direction, the number of businesses who report in this way are few and far between.
Rules and regulation around accounting practices are set by the IFRS, with transparency being one of their key objectives. This can be seen from IFRS 16, which will require companies to account for their lease liabilities, including leased real estate. Nevertheless, there is limited regulation to ensure transparency on the real value of trillions of dollars of real estate.
The practice of cost accounting for real estate hides the true value of a company’s balance sheet, misleads investors and over or under values companies. We are firmly of the view that occupiers should adopt a regular valuation programme that assesses the value of their freehold estate, to provide stakeholders with the necessary transparency around the true value of their real estate.
Dominic Burke is a director and head of corporate valuation services at CBRE
