Real-estate depreciation

[giofranchi]

Think of the consequences of marking RE to market every year (or every quarter!) – it's simply impractical.

 

I have never said it is practical… But when the Balance Sheet doesn’t tell you the true value of what you own, you should take notice.

 

I don't agree with the notion that buildings are enduring assets.

 

I have never said that buildings are enduring assets.

 

Gio

[ni-co]

Think of the consequences of marking RE to market every year (or every quarter!) – it's simply impractical.

 

I have never said it is practical… But when the Balance Sheet doesn’t tell you the true value of what you own, you should take notice.

 

Gio, you asked for the reason for not carrying RE at market values on the balance sheet. And that's the simple reason: practicability – there is no other reason. A balance sheet, or any accounting number for that matter, is always a trade-off between "true" value and practicability. Of course you could try to value every single pencil in a company every quarter and reflect that on the balance sheet. But it's highly impractical and error-prone – which, in turn, would cause a lot of volatility in the company's accounted earnings.

 

Accounting for RE simplifies it in two ways. First, you set the purchase price as the initial value of the asset; maybe your purchase was a bargain and its market value is significantly higher – doesn't matter, because you simplify by taking the only number that you can be absolutely sure of: your purchase price. Then, in a second step, you take the length of the average replacement cycle of this asset – here a building – and spread the purchase price out over this time – that's your depreciation. Now you might say: "but my apartment lasts longer than x years" – that's beside the point. On average a building lasts x years and that's the amount of years they will be depreciated. This has nothing to do with maintenance capex.

 

I don't agree with the notion that buildings are enduring assets.

I have never said that buildings are enduring assets.

 

But you're implying it with your statement that you don't see the need to depreciate buildings. Depreciation is not the 1:1 equivalent to capex. This is only a rule of thumb. For buildings it can be severely off base, especially when you replace perfectly functional buildings long before they become unusable – that's what I tried to point out with my skyscrapers example.

 

I really don’t see why buildings need to be depreciated… Each year you have capital expenditures to maintain their status quo, don’t you? Those capital expenditures reduce your cash flow, which in turn reduces the amount of cash on your balance sheet. Why should you also reduce the value of your buildings on the balance sheet?

 

Because on average buildings are replaced long before they "wear out".

[topofeaturellc]

Why would you assume market value is correct?

 

Because the Balance Sheet should be a picture at any given time of what we use (assets), of what we owe (liabilities), and of what we own (equity). This is the reason why IFRS require securities to be marked to market. Instead, land, buildings and equipment should be recorded at… what??

 

If my apartment were on the Balance Sheet of my company as an asset, initially recorded at cost, later depreciated over the course of 40 years, adding back all the maintenance capex required, it would still be recorded at a value little changed from its initial cost… At best its recorded value would have kept up with inflation, if maintenance capex were higher than depreciation charges.

 

But what about the true economics of the city, the neighborhood, even the street where my apartment is located? What if Milan’s economy booms, what if a new subway is built not far from where I live, what if some very fashionable cafes are opened nearby? I am positive during the last 30 years the value of my apartment has appreciated much faster than inflation.

 

If such an appreciation in value is not reflected on the Balance Sheet, that document ceases to be a reliable picture of what I truly own today.

 

Gio

 

So then a house in the outer ring Phoenix exurbs in 2007 marked to market was properly valued?  Neither solution is perfect, but in the case of real estate where historic returns in aggregate approximate inflation, historic cost isn't terrible, and is unlikely to overvalue the assets.

 

Don't you see the inherent contradiction between calling for marking assets to market on a Balance Sheet and being a value investor who does not believe in efficient markets?  It introduces the worst kind of pro-cyclicality to the accounts.

[ni-co]

Don't you see the inherent contradiction between calling for marking assets to market on a Balance Sheet and being a value investor who does not believe in efficient markets?  It introduces the worst kind of pro-cyclicality to the accounts.

 

Great point. Pro-cyclicality is exactly what I meant by "volatile earnings".

[SharperDingaan]

Deprecation results because the asset has a finite life; typically 40 years for IFRS purposes. Evidence that the estimated life of the asset is infinite, & depreciation falls to zero - the common practice for hydro dams.

 

Maintenance costs are expensed as the admin cost of setting up & maintaining amortization schedules, exceeds the benefit. A REIT might consider capitalizing if their costs are significant, but its rare. If you did capitalize, & maintenance cost exceeded depreciation, historical cost would rise very slowly over time.

 

In most cases, changing highest & best use of the land will render the building obsolete before it physically breaks down. The perfectly good silo on a farmers land, now surrounded by a town, is actually worth nothing - as economics dictate that the land be sold & houses erected instead. Put a mall up in a new development, & 40yrs later you should be knocking it down & re-using the space for offices or houses; therefore economics dictate use of poor quality materials during construction, & not maintaining the mall - to strengthen your case for re-zoning 40yrs out.

 

SD

 

[giofranchi]

Gio, you asked for the reason for not carrying RE at market values on the balance sheet. And that's the simple reason: practicability – there is no other reason. A balance sheet, or any accounting number for that matter, is always a trade-off between "true" value and practicability. Of course you could try to value every single pencil in a company every quarter and reflect that on the balance sheet. But it's highly impractical and error-prone – which, in turn, would cause a lot of volatility in the company's accounted earnings.

 

I thought it was obvious I was referring to discrepancies between recorded values and true values that sometimes become meaningful… Be sure everything that could be overlooked I overlook! If in your experience discrepancies never get to be meaningful, well then we have different experiences.

 

But you're implying it with your statement that you don't see the need to depreciate buildings.

 

No. You are implying it. The fact I think rigid accounting rules might lead to meaningful discrepancies between recorded values and true values, does not mean I think buildings are enduring assets.

 

Gio

[giofranchi]

Don't you see the inherent contradiction between calling for marking assets to market on a Balance Sheet and being a value investor who does not believe in efficient markets?  It introduces the worst kind of pro-cyclicality to the accounts.

 

Great point. Pro-cyclicality is exactly what I meant by "volatile earnings".

 

Yeah! Great point... Except you have not understood I am not suggesting what to do! I don’t care.

All I am saying is: know the true value of what you own… because sometimes numbers on the Balance Sheet might not make much sense… That’s all!

 

Gio

 

[ni-co]

Don't you see the inherent contradiction between calling for marking assets to market on a Balance Sheet and being a value investor who does not believe in efficient markets?  It introduces the worst kind of pro-cyclicality to the accounts.

 

Great point. Pro-cyclicality is exactly what I meant by "volatile earnings".

 

Yeah! Great point... Except you have not understood I am not suggesting what to do! I don’t care.

All I am saying is: know the true value of what you own… because sometimes numbers on the Balance Sheet might not make much sense… That’s all!

 

Gio

 

Ok. Then I really misunderstood you, sorry.

 

Another point:

there is actually a significant amount of academic research that confirms the idea that it is indeed the land that is appreciating in value while the building itself is a slowly depreciating asset.

 

Maybe... But, if I decide to sell my apartment, I will find someone tomorrow morning willing to give 10 times the cost of the underlying land... Because I would not be selling square meters of land, but square meters of an apartment... An apartment in a building that, if depreciated over a 40 years time horizon, would be worth less than zero today!

 

I would guess that this is rarely the case. I don't know Italian law, but at least in Germany by owning an apartment you simultaneously are part of the owners group that commonly owns the underlying land. I guess, over time, this is where the actual value of your apartment comes from.

[giofranchi]

Don't you see the inherent contradiction between calling for marking assets to market on a Balance Sheet and being a value investor who does not believe in efficient markets?  It introduces the worst kind of pro-cyclicality to the accounts.

 

Great point. Pro-cyclicality is exactly what I meant by "volatile earnings".

 

Yeah! Great point... Except you have not understood I am not suggesting what to do! I don’t care.

All I am saying is: know the true value of what you own… because sometimes numbers on the Balance Sheet might not make much sense… That’s all!

 

Gio

 

Ok. Then I really misunderstood you, sorry.

 

I have referred to IFRS only as an example of a standard that requires securities to be marked to market... But I don’t agree, nor disagree with it either… For instance, also mark to market might cause discrepancies between numbers on the Balance Sheet and true values, should the securities you own be much overvalued or vice versa undervalued...

 

In this case also you should be on the look-out for numbers that make little sense!

 

Gio

 

[SharperDingaan]

Re Value. Every reader of XYZ financial statements will have a different opinion as to what the RE or PPE of XYZ is worth. But most don't realize that XYZ has the assets because to XYZ they are worth than MV; if XYZ thought otherwise they would sell the asset & lease/rent the space back.

 

RE is usually also linked to war-chests; the sale & leaseback is not executed until you need the money, & the lease is back end loaded to minimize early rents & boost the P&L as much as possible.

 

SD

[Otsog]

I don't think people are arguing for sticking with hysterical cost, just that the proper attribution of PPE increases will almost always be due to land appreciation instead of building or equipment appreciation.  If you are buying a freehold building you are always buying land + building.  The municipality will value them separately. In condo/apartment buildings, each unit will have a unique lot/sublot allocated that provides rights to the land that has been zoned for a multi-family residential property.  It's those rights to the land that provide the appreciation, the building will always lose value without further capital investment barring drastic shortages in construction commodities.

 

Maybe… But let me give you an example: let’s suppose you own an office building, and after 10 years by a stroke of good luck you get the chance to change its use into a residential property… wouldn’t you say the value of your building is higher now than it was 10 years before?

 

What I mean is that during the life of a building many things might happen that are not strictly related to depreciation nor maintenance capex, things that might affect its value very much.

 

Imo whenever those things are not reflected on the Balance Sheet, and therefore the value recorded differs significantly from the value given by the market, an opportunity arises.

 

Gio

 

I would say zoning is solely a characteristic of land and therefore your change in cash flows from the re-zoning is wholly attributable to the land. Nothing intrinsic about the building changed, but one of the defining characteristics of the land changed drastically.

 

The land should be revalued on the Balance Sheet at market residential property value.  Due to the change in use the building will lose some value.

 

[giofranchi]

I would guess that this is rarely the case. I don't know Italian law, but at least in Germany by owning an apartment you simultaneously are part of the owners group that commonly owns the underlying land. I guess, over time, this is where the actual value of your apartment comes from.

 

Well, if I sell my apartment tomorrow, I will find someone willing to give 7,000 - 8,000 Euros per square meter.

 

It might certainly be only a false impression of mine... But my feeling is I won't be able to find many people willing to pay that sum and sleep in the cold hard ground...

 

Sometime, when you are selling an apartment, you are actually selling opportunities and a way of living. For that the building is as necessary as the land underneath.

 

Gio

 

PS

Btw, it is not an impression of mine... We have just worked for a real-estate developer in a not far location, and for the land he paid 2,000 Euros per square meter. ;)

[bookie71]

Cost is the only objective value as it is what someone was willing to pay and what someone was willing to take.

For the balance sheet fair market presentation that you want - Do you want a high figure (selling) or low figure (buying), then you go get an appraiser that that type of appraisal.  (It is done all the time for donations, estate valuations, etc.)  Be careful for what you wish for.

I would rather do my own judgement of value, not some appraisers.