Most real estate sectors appreciated in value and proved to be a successful investment over the past decade, but in the last year, the industry has seen a significant downturn in values. Factors like rising interest rates, a slow return to the office for many businesses, even in the most dominant central business districts, and a significant rise in the cost of materials, among others, have caused the real estate market to decline over the past 18 to 24 months. While some Class A multi-family properties have held their ground with a limited decrease in value from 2022, other real estate sectors, such as office properties, have experienced significant decreases in value caused by rising vacancies, increased concessions, and overall lower rents.

The importance of understanding real estate market conditions

Passive investors may not always focus on how market factors and triggers impact the financial reporting of their real estate investments. These market conditions vary and do not always apply to the entire real estate market, differing greatly by geographic location, class of property, and sector. The market has been volatile, with interest rates rising over the past 18 months, but demand has remained high in some areas of the world. It is important for investors to be aware of these market factors, so they can understand the appropriate value of their investment. Generally accepted accounting principles in the United States (GAAP) provides standards around the presentation of real estate assets in financial statements. This considers market conditions and requires management to assess them in connection with the amount of the reported real estate asset. This is an important analysis for many users of financial statements, and thus, sophisticated investors typically require financial statements to be presented under GAAP.

Financial statement considerations in the current real estate market

• Impairment: Due to higher interest rates and higher vacancies, specifically for commercial and office properties, a property may be impaired. Under GAAP, if events or circumstances indicate that the carrying amount of the asset may not be recoverable, the asset is required to be assessed for impairment. If the carrying value of the asset is greater than the estimated future undiscounted cash flows of the asset, the asset is impaired, and the entity needs to write down the asset to its fair value. Entities or funds that report at fair value mark their assets or investments to fair value each period, and, therefore, impairment does not apply. To read more in depth about impairment, see The Challenge of Impairment Testing for Long-Lived Assets.
• Going concern: Tighter lending markets caused by uncertainty and higher interest rates are causing real estate companies to experience a decrease in options to refinance. Typically, real estate entities secure loans with terms ranging from three to seven years, with one- or two-year extension options. As many of these loans are coming due, there are fewer lenders willing to take on the risk to refinance, and there are fewer buyers in the marketplace willing to pay enough for the owner to repay the outstanding debt upon sale of the property.
  An entity that has a loan maturity within 12 months from the date the financial statements will be available to issue may have a going concern problem. This is because there is uncertainty in the entity’s ability to refinance or sell the property to repay the outstanding debt. In years prior, the ability to refinance a real estate asset was not as uncertain due to the market conditions and rising value of real estate. Furthermore, if the entity has an extension option available and is required to pass certain covenants to utilize the extension option, there may be substantial doubt about the entity’s ability to continue as a going concern if it does not expect to pass the required covenants.
• Unrealized or realized losses: Real estate funds or real estate entities that issue financial statements at fair value may report unrealized or realized losses. Sale prices for properties sold during 2023 may have decreased from the fair value reported at the end of 2022 because of rising capitalization (cap) rates in conjunction with rising interest rates, resulting in realized losses. For properties still held at year end, the fair value may decrease from the prior year due to the same factors, resulting in unrealized losses. If losses are reported, investors should also expect to see this reflected in the disclosure of their total return.

Awareness of market conditions and understanding how they may impact your real estate investments’ financial statements will help you develop expectations and allow you to better assess and utilize the financial reporting for your investment. It is a volatile time in the real estate market compared to the past 10 to 12 years, and it is vital that owners, fund managers, and investors be mindful of the financial reporting implications of the current conditions.

The professionals in Citrin Cooperman’s Real Estate Industry Practice monitor changes affecting the market and their impact on real estate organizations to help clients navigate challenges and achieve their strategic vision. For more information on real estate market conditions and considerations for financial statements, please reach out to Jessica Garber at jgarber@citrincooperman.com, Keith Rennard at krennard@citrincooperman.com, or your Citrin Cooperman advisor.