It’s the depreciation policy, stupid!

A common problem in corporate real estate is when a property comes to the end of its useful life and needs to be sold and there is the dawning realisation that the net book value of the property is well in excess of the potential sales proceeds. Bad news – an unwelcome hit to the profit and loss (P&L) account and substantially lower cash receipts than may have been expected. It can be an excuse to stay put and do nothing, which is not good news for the business that has to put up with redundant real estate.

This doesn’t typically arise because the property has been re-valued upwards; corporate occupiers tend to record their owned properties at historic cost. The problems arise due to an inadequate depreciation policy.

International Accounting Standard (IAS) 16 governs the treatment of property assets and depreciation. Given that property depreciation is almost always allocated on a straight line basis, there are three critical components: the cost of the asset, its residual value and its useful life.

Very often the cost of owner occupied assets are higher, because corporates tend to build bespoke buildings geared towards their needs and aspirations, without the commercial discipline a property developer might provide. The cost of the asset may also be added to subsequently as capital improvements are undertaken.

When this happens, according to IAS 16, “the carrying amount of those parts that are replaced should be derecognised” – in other words – written off in the P&L account. However, in practice this rarely happens and the asset’s cost base simply grows.

Turning to the useful life of the asset, this is the period over which it is expected to be available for use and is defined in terms of the asset’s expected use to the business. There are probably two key issues here:

i) From a business perspective, what is the time horizon over which it is envisaged future economic benefits will flow from the asset?
ii) What is the typical life span of the asset beyond which it will be commercially obsolete and be likely to need significant refurbishment expenditure?

Corporates rarely, if ever, take these two critical considerations into account. They typically depreciate their buildings over a 30 to 40 year period, because that’s what they have always done. Whereas they would seldom, if ever, sign a 25 year lease; either because their business time horizon does not look that far ahead or because they have no confidence that the leased asset will still have a useful life beyond that point. Isn’t it time that some of that logic was applied to their depreciation policy?

Per IAS 16 “the residual value of an asset is the estimated amount that would currently be obtained from disposal of the asset, after deducting the estimated costs of disposal, if the asset were already of the age and in the condition expected at the end of its useful life.”

Corporates seem to only want to consider the value of their own properties based upon their own occupation. But that is not the premise of IAS 16; at the end of its useful life means that the building is no longer occupied by the corporate – it’s a vacant possession (VP) value.  This may just be land value, although in the case of offices there is usually some value attributed to the fabric of the building.

VP values can vary significantly depending on the property cycle. For example, values of properties in the Thames Valley in 2007-08 were in the range of £200 to £300 psf whereas today such values may be £75 to £100 psf. All too often corporates find they acquire property at the top of the property market cycle and sell at the bottom but the residual value will rarely reflect that.

The combination of overinflated cost bases and excessive useful lives and residual values that bear little relation to the market mean that all too often the depreciation of property assets is understated and net book values are overstated in property accounts. So when you’re looking to sell that corporate property and you’re facing a huge loss – don’t blame the corporate real estate team, don’t blame the property market – blame the depreciation policy, stupid.