Valuation Update – Planning Strategies in Light of COVID-19

COVID-19 has had a devastating effect on the economy, financial markets and real estate values. This article will provide the technical and factual information on the current situation to help you understand the effects of COVID-19 on the valuation of real estate holding entities.

General

Decrease in business values. Here are just a few reasons why the value of real estate holding entities may have declined due to COVID-19:

1. Actual and expected revenues and earnings of real estate properties may have decreased due to COVID-19-related forced closures of commercial and retail tenants, or lower occupancy in the case of hotel and lodging properties, or the rise in rental defaults in the case of residential properties.
2. Interest-bearing debt may have increased to pay employees and other fixed continuing expenses.
3. For minority interests in real estate holding entities, discounts for lack of control and lack of marketability may have increased due to liquidity issues in the market.

Focus on cash flows, cost of capital (discount rate) and growth. A lot of thinking must now be applied to the risks associated with the cash flow generated by real estate properties and the elements that are factored in the cap rate, as well as the risks involved in realizing the cash flows at the date of the valuation.

A key consideration in valuing real estate holding entities will be assessing the impact of COVID-19 on near-term as well as longer-term financial projections that may not yet be known or quantifiable, or likely will be subject to change. Even with governments reacting much faster than during prior economic crises through massive relief measures, recovery and growth will occur from a lower base than pre-pandemic levels and at a much slower pace, driven possibly by whether the fundamental change in commercial and retail operations and residential demand is favorable or unfavorable in the long term for the property holding business.

December 31, 2019, valuation date versus March 31, 2020, valuation date. COVID-19 is a subsequent event, has no impact on December 31, 2019, valuations and should not be factored in December 31, 2019, valuations. As of December 31, 2019, willing buyers and sellers of a company’s stock would not have considered what we now know as COVID-19 in their negotiations.

A valuation as of March 31, 2020, will yield a dramatically different value versus a December 31, 2019, valuation date. COVID-19 was known and knowable as of March 31, 2020, and the uncertainty along with the more profound systematic and unsystematic risks would impact the valuation as of the March 31, 2020, date.

The standards pertaining to subsequent events issued by both the American Society of Appraisers (ASA) and the American Institute of Certified Public Accountants (AICPA) are consistent. Subsequent events or conditions that affect the value of the property can be taken into account only if they are reasonably foreseeable on the valuation date.

As a best practice, the property appraisal report and the valuation report for the holding entity should include a discussion of “subsequent events” and “known and knowable” concepts.

Tax

The dismal economic forecasts due to the COVID-19 pandemic represent a unique opportunity for individuals to take advantage of low business valuations to minimize estate and gift taxes.

Lower real estate values create a unique planning opportunity by allowing business owners to transfer a greater portion of their business assets and reduce their taxable estate. The recent decline in market valuations provides an opportunity to gift at lower values, potentially allowing you to gift assets using your lifetime exemption that would have otherwise resulted in a taxable event before the decline. Given the additional uncertainty surrounding the U.S. presidential election and what might happen to the estate and gift tax exemption level, now may be the best time to do some gifting.

One of the keys to many of these strategies is to obtain a supportable valuation of the assets involved in the strategy, especially when dealing with a closely held business or fractional interest in an investment partnership.

Financial Reporting

Impairment will be an elevated topic in financial reporting and, given the drastic economic effects of COVID-19, we anticipate that many companies complying with GAAP will need not only to test their goodwill, but also their long-lived assets.

With respect to goodwill, ASC 350 requires an entity to consider whether an interim “triggering event” has occurred between the dates of its annual impairment testing. If a triggering event has occurred, then a quantitative analysis would ensue to determine if the carrying amount of goodwill exceeds its implied fair value. Determining whether a triggering event has occurred pursuant to ASC 350 requires an assessment of the totality of events or circumstances. For instance, a significant decrease in the market price of real property is considered a triggering event. 

The decline in value could be minor and temporary or could be major and permanent. It all depends on an ongoing assessment of a host of factors, such as those highlighted above.

Conclusion

The effects of COVID-19 are manifested in unpaid rents, unused office space, business closures and unprecedented unemployment. These losses can be measured through appropriate valuation methods, and companies must start reviewing their businesses and engaging valuation professionals to assist in measuring the impairments, valuing their businesses and planning for the transfer of interests.