Cities across the U.S. grapple with excess office inventory and changing community requirements, adaptive reuse has emerged as an effective solution. Renovating commercial buildings that are not being used like warehouses, offices, or retail centers into multifamily hotels, housing or mixed-use areas can rejuvenate communities and generate long-term investment value.
From a financial perspective, however, these projects tend to blur the lines between redevelopment, acquisition and new construction, posing new challenges under U.S. GAAP. Knowing the correct treatment for componentization, impairment, capitalization and leasing is crucial to the accuracy of financial reporting and compliance.
Determining the nature of the Transaction
The most common adaptive reuse projects begin by purchasing an existing property. It could qualify as a business combination as per ASC 805 or as an acquisition of assets if the majority worth is accumulated in one asset (often the real estate).
Important factors (ASC 805)
Business Combination: The acquired property incorporates inputs (e.g. in-place leases) as well as processes (e.g. the property management workforce) the deal may be categorized as being a business. Costs of transactions are expensed. This is especially true when multiple properties are bought together alongside an established property management team, leases for tenants exist, or current systems are being acquired.
Asset acquisition: The most common reason for this is for adaptive reuse if one asset is purchased without a workforce established and existing systems. The property is valued at a cost (including the transaction cost) and then allocated between tangible and intangible components (land, building, lease intangibles, etc.) Based on relatively fair rules.
Costs of Capitalization for Redevelopment Costs
After the property has been acquired, the subsequent costs are analyzed according to ASC 970-360 (real estate, general) and ASC 360 (property plant and equipment) to determine the capitalization eligibility.
Capitalizable costs:
The price of the purchase and the directly related acquisition expenses (legal title, escrow, broker fees, transfer taxes) along with demolition costs that form included in the price of the new structure or redevelopment plan. If the property was bought with the intention of demolishing it completely, the purchase price as well as associated demolition costs are usually capitalized on land.
- Construction materials as well as contractor and labor costs
- Engineering, design and architectural costs
- Permits, inspections, and cost of supervision on site
- Taxes on real estate as well as insurance and utilities during construction activities
- Interest on capitalized project-specific debt (ASC 835-20)
Noncapitalizable costs:
- Preliminary feasibility studies as well as market research and Zoning exploration
- Costs of projects that are abandoned or not successful
- General overhead or administrative expenses not directly linked to construction
- Marketing, advertising, and leasing efforts following the completion of a project.
- Maintenance, repairs and operating costs once the property has been put in service
Builders must keep a clear cutoff point to define “development period.” When the property is fully completed and ready for usage, capitalization is stopped regardless of whether leasing or tenant improvements are ongoing. Post-development items such as lease commissions, tenant improvements and FF&E are counted like any existing nondevelopment property.
Accountability for Demolition as well as Partial Retention
The most common adaptive reuse projects include partial demolition but retaining some central structural components (e.g. frames, facades, foundations).
As per ASC 360-10-35 as well as ASC 970-360-25, the purpose of the property acquired determines the way to allocate the purchase price and how to treat demolition costs. If demolition is planned at the time of acquisition, the current structure is not a separate long-lived asset. It’s essentially an expense of acquiring the property and preparing it to be redeveloped.
For example, if a developer holds 30% of the structure’s shell, the undepreciated cost of demolished portions is written off. Costs for modifying the remainder of the shell are capitalized as improvements with a new useful life.
Componentization and Depreciation
Because of the hybrid characteristics of reuse projects, components-based accounting becomes crucial to make sure that useful lives are aligned with the economic realities:
- Components of structural construction (e.g. foundations, framing) 30-40 years
- Systems and building improvements 10-20 years
- Tenant improvements: Lease term or the useful life whichever is less
This ensures that depreciation accurately reflects the different age groups and the remaining service capacity of the new and retained elements.
Impairment Factors
Since adaptive reuse is often seen in markets that are experiencing declines in value or occupancy, companies must assess long-lived assets in accordance with ASC 360-10-35 to determine if they are at risk of impairment.
The indicators include unfavorable changes to zoning and unexpected cost overruns, loss of financing or decrease in anticipated cash flow.
The recoverability test compares the value carried by an asset with its undiscounted future cash flows. Successful adaptive reuse projects generate significant value if projected cash flows match the value of the property being redeveloped. This can help avoid impairments and also shows strong future income potential. This type of analysis requires a higher degree of judgment than required for stabilized or predevelopment properties, where there are less uncertainties. If the property is not recoupable, write down to fair value (typically supported by an appraisal from a third party).
Financial Statement and Disclosure Presentation
Investors and lenders are increasingly looking for the same level of transparency when it comes to redevelopment projects. Important disclosures include:
- Major component of capitalized costs.
- Methods for testing impairment and the assumptions
- The Fair Value Hierarchy Levels (ASC 820) If appraisals are used
- Composition of revenue and lease commitments
These disclosures offer insight into the economics of projects and management’s decisions which allows for better comparison across companies and markets.
An Accounting Frontier
More than just an architectural trend, adaptive use poses challenges at the edges of accounting. For funds, developers and REITs, the complex instructions in the U.S. GAAP takes technical precision and practical knowledge to ensure that they are executing properly. Companies that have explicit capitalization guidelines, adhere to strict component tracking and proactively examine impairment risks are best placed to present accurate financial reports and present an inspiring story to investors regarding the sustainability of the business and its value creation.
Parr & Ibarra‘s fixed asset advice and cost segregation team can assist in understanding the accounting process for adaptive reuse of real estate. Contact us for more information and help.
