Value Fluctuations in a Real Estate Investment Financed with Debt

Working Draft of New Case Study 4A Value Fluctuations in a Real Estate Investment Financed with Debt (which will be added to AICPA Accounting and Valuation Guide Valuation of Portfolio Company Investments of Venture Capital and Private Equity Funds and Other Investment Companies) Released December 17, 2018 Prepared by the PE/VC Task Force Comments should be sent by January 14, 2019 to Yelena Mishkevich at yelena.mishkevich@aicpa-cima.com 1

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Case Study 4A Value Fluctuations in a Real Estate Investment Financed with Debt Note: This case study is provided to demonstrate concepts discussed in the preceding chapters of this guide and is not intended to establish requirements, best practices or safe harbors. It was developed from a real-world situation, which was complex and involved numerous nuances that needed to be evaluated when estimating the fair value of the investment. However, this case study reflects only the high-level approach that the fund would have considered in reaching its valuation conclusions and does not show the calculations or the support for each assumption. The specific facts and circumstances of each individual situation should be carefully considered when performing an actual valuation, and professional judgment should be exercised in evaluating those facts and weighing various alternatives. This case study summarizes the key considerations that were encountered by the fund manager(s) described in the example. The judgments that were made in this case were specific to those facts, not all of which are highlighted herein. See the preamble in paragraphs C.00.01.10 for a more detailed description of the purpose of the case studies and factors to consider when reading the case studies. Case Study 4 Prestige Worldwide LLP real estate fund Type of Security Equity Interest Industry Real Estate Primary Concepts Illustrated Various considerations around off-market debt when measuring the fair value of equity (chapters 4 and 6) Debt and equity valuation in a simple capital structure (chapter 5) Value of mortgage debt for the purpose of valuing equity (chapter 6) Additional Concepts Illustrated Transaction costs (chapter 12) The primary purpose of this case study is to illustrate real estate specific valuation considerations as well as the impact of mortgage debt valuation on the equity value of a real estate investment. Specifically, the following example shows an investment in a real estate asset, from the initial acquisition of the property prior to stabilization and the eventual sale of the property after the initial lease-up period (that is, upon reaching stabilization). The example illustrates the way that changes in the fair value of a mortgage note can have an impact on the equity value of an investment in real estate. Finally, the example shows the impact of transaction costs on the initial acquisition as well as on the realized value at exit. 3

NOTE: The example assumes that Prestige Worldwide LLP follows the guidance in FASB ASC 946, Financial Services Investment Companies. Initial Transaction and Calibration on December 31, 2X07 C.04A.01 C.04A.02 C.04A.03 Prestige Worldwide LLP (Prestige) was a $100 billion alternative investment fund with platforms including credit, private equity, and real estate. Prestige qualified as an investment company under FASB ASC 946, Financial Services Investment Companies. Prestige typically made its investments through investment holding companies that were not consolidated. Accordingly, Prestige carried its real estate investments at fair value in accordance with FASB ASC 820, Fair Value Measurement. 1 Prestige s strategy was to invest in non-stabilized assets and then to engage in a capital improvement and leasing program designed to reposition the asset within the market and attract new tenants paying higher rents. The investment horizon of market participants investing in such assets typically spans three to eight years but is highly dependent on lease-up velocity and the transaction market. Prestige s typical time horizon was consistent with other market participants in this segment. In late 2X07, Prestige identified an office property, known as Catalina Square (Catalina), for purchase near the business center of a suburban submarket outside of a major US city. Prestige believed that this asset fit within its investment mandate. Catalina was a 4-story, 100,000 rentable square foot mid-rise Class B office property. After completing its underwriting process, Prestige purchased Catalina on December 10, 2X07 for $14,000,000, or $140 per square foot. Prestige considered its operating projections for the asset and used a discounted cash flow analysis when assessing the value at the transaction date. The investment featured a goingin capitalization rate of 9.50%. The asset was 68% occupied upon acquisition, with lease renewal options within the next 18 months for several tenants. Prestige 1 Certain real estate funds are not in the scope of FASB ASC 946. For these funds, the investment is typically reported on a gross basis with the property as an asset of the fund, and the mortgage debt is reported as a liability of the fund. Further, certain of these funds elect to report the mortgage debt at fair value, using the fair value option in FASB ASC 825, Financial Instruments. The principles illustrated in this case study may also be useful in assessing the fair value of the mortgage debt for funds that elect the fair value option for the mortgage debt liability (where the unit of account is the debt liability). Note that the fair value of the mortgage debt reported as a liability of the fund most often would be measured from the perspective of a market participant (lender) that holds the identical item as an asset. Please see paragraphs 16.16L of FASB ASC 820-10-35 for further guidance on valuing a debt liability as a separate unit of account. For funds that are not in the scope of FASB ASC 946, where the units of account are the total asset (the property) and separately the debt liability (the mortgage debt), the net equity position would not be the appropriate unit of account for valuation purposes. Therefore, the fund would not report the fair value of the net equity position using a value of debt for the purpose of valuing equity that is different from the fair value of debt. The fair value of debt would be estimated using a market participant (lender) perspective. See paragraphs 6.05.18 for a discussion of the principles to consider in estimating the fair value of debt. 4

incurred transaction costs of 1.5%, or $210,000, capitalized as part of the initial investment, for a total invested capital of $14,210,000, less financing. C.04A.04 C.04A.05 To finance the acquisition, Prestige formed a holding company for Catalina and obtained a non-recourse mortgage loan for the holding company in the amount of $10,500,000 (par) from a regional bank at a fixed rate of 3.10%. The original principal balance represented a 75% loan-to-value (LTV) ratio and was to be amortized over 360 months from origination. The note was pre-payable at 101% of par during a lockout period of 60 months, and pre-payable without penalty thereafter. The note had a 10-year term and matured on December 31, 2X17, with the unamortized balance payable at that time. The loan agreement permitted the note to be assumed by a third party; that is, the note did not include a change of control provision that would require pre-payment upon a change of control of the holding company. Prestige determined its unit of account was its equity investment in the holding company, which was a pass-through entity for income tax purposes. Prestige further determined, consistent with the approach used when analyzing the investment and with the approach that market participants would typically use to value such investments, that the two primary inputs in valuing the equity investment in the holding company would be the fair value of the property held by the holding company and the value of the mortgage debt that a market participant would subtract from the property value for the purpose of valuing equity (see paragraphs 6.19.31 for additional discussion). As of December 31, 2X07, Prestige valued its interest in the equity of the holding company at $3,500,000 (purchase price of $14,000,000 less the value of the debt $10,500,000) based on a view that a market participant would pay the same amount for the property that Prestige paid in its recent transaction, excluding transaction costs. In assessing the value of the debt to use in estimating the fair value of the equity in the holding company, Prestige determined that the fair value of the mortgage debt was unchanged from origination given the recent nature of the transaction coupled with no significant changes in property-level or market metrics. Prestige s initial fair value assessment of their equity interest was $3,500,000 (total initial equity investment of $3,710,000, less transaction costs, resulting in an initial fair value equal to 94% of cost). (This situation illustrates the impact of transaction costs on fair value at the first measurement date after the transaction close, which is discussed in further detail in chapter 12.) Valuation at June 30, 2X08 C.04A.06 During the first two quarters of 2X08, Prestige s leasing team had some significant successes in re-tenanting Catalina. Several new 10-year leases were negotiated and signed with tenants agreeing to occupy spaces ranging from 1,000 square feet to 4,600 square feet. No leases expired and no tenants vacated during the first two quarters of 2X08. As of June 30, 2X08, physical occupancy had increased to 88% with the addition of the new tenants, which was in-line with the market vacancy rate 5

of 12% in the submarket. Catalina had achieved stabilization several months ahead of the lease-up plan contemplated in Prestige s underwriting analysis and projections. C.04A.07 As a result of the recent leasing activity at Catalina, Prestige now projected that net operating income (NOI) would be higher than it was projected to be as of the previous measurement date. Further, in its assessment of the risk profile of Catalina, Prestige noted that although several lease expirations for large tenants still loomed on the horizon, the risk profile of the asset had been reduced somewhat by the boost in occupancy. On the other hand, transactions for office properties in the submarket indicated that capitalization rates and return requirements had increased relative to the previous measurement date. Prestige considered these factors and estimated that the gross asset value of Catalina had increased to $14,750,000 (or $147.50 per square foot) at June 30, 2X08 based on the results of a discounted cash flow analysis. The fair value was supported by several recent transactions involving similar office properties that traded at prices ranging from $135 to $158 per square foot. C.04A.08 The mortgage note commenced amortization in January 2X08, and by June 30, 2X08 had an outstanding principal balance of $10,393,041. Market lending spreads and credit market conditions had not changed since origination, nor had there been any significant changes in the asset quality. Therefore, Prestige concluded that a market participant would estimate the value of the mortgage debt for the purpose of valuing their equity interest as equal to the outstanding principal balance. C.04A.09 As of June 30, 2X08, the fair value of Prestige s equity in Catalina was $4,356,959, calculated by deducting the value of the mortgage debt for the purpose of valuing equity (which was equal to the outstanding principal balance) from the gross property value. Valuation at December 31, 2X09 C.04A.10 C.04A.11 Subsequent to the initial success that Prestige had in attracting new tenants to Catalina, it was unable to persuade two large tenants to remain in the building when the leases reached the end of their terms. One tenant was lured away by an attractive tenant improvement allowance at a newly constructed office asset that came to market nearby during the second quarter 2X09. The other tenant informed Prestige that it was consolidating headcount in another location closer to the central business district of the nearby city under a new office of the future concept and would no longer need space at Catalina or elsewhere in the submarket. As a result of the loss of these two major tenants, physical occupancy at Catalina had dropped to 60% by the fourth quarter of 2X09. As part of the December 31, 2X09 measurement, Prestige valued its unit of account (the equity investment in the holding company) considering the fair value of the property less the value of the mortgage debt for the purpose of valuing equity. To estimate the fair value of the property, Prestige updated its projections to reflect 6

the loss of the two tenants, for which it previously had assumed a high probability of renewal. Based on analyzing past history and considering current market conditions, Prestige expected to incur nine months of vacancy in the two empty suites before it would be able to begin collecting rent from new tenants. Broader market conditions had not changed significantly over this period and, therefore, Prestige made no major changes to the other key valuation assumptions. As a result, Prestige revised its estimate of the gross property value to $12,750,000. C.04A.12 C.04A.13 In estimating the value of the mortgage debt for the purpose of valuing equity, Prestige noted that the debt was assumable, and considered whether market participants transacting in the equity would benefit from assuming the debt, leaving the debt in place following a change in control of the equity of the holding company. Over the last year and a half, Catalina s cash flow had been sufficient to service principal and interest payments on the mortgage note, which had been amortized to $10,062,048. However, Prestige estimated that the deterioration of the occupancy at the collateral and the resulting increase in the LTV ratio to over 80% had impacted the credit risk of the lender s position. While market lending conditions had remained relatively stable since the note was originated, Prestige estimated that a buyer of the equity would not be able to obtain new debt at this leverage, and that given the decline in the value of the property, the coupon for the debt was below the market yield. Therefore, it would be advantageous for the buyer of the equity to assume the debt. To estimate the value of the mortgage debt for the purpose of valuing equity, Prestige estimated based on current market conditions that lenders investing in the debt would demand an additional spread of 50 bps for a similar loan as of December 31, 2X09. Because the remaining term of the debt was only eight years, Prestige considered this remaining term of the debt in assessing the benefit that market participants would realize from the below-market coupon; a buyer who wanted a mortgage for a longer term would not be able to maintain the below market coupon for the period beyond the maturity of the current mortgage, but instead would need to refinance or renegotiate the mortgage at that date. Using an all-in market rate of 3.60% to discount the eight years of remaining cash flows under the mortgage note resulted in a fair value of $9,744,834, or 96.85% of par. At December 31, 2X09, Prestige estimated that the fair value of its equity in Catalina was equal to $3,005,166, calculated as the gross property value of $12,750,000 minus the debt value of $9,744,834, considering the benefit that market participants transacting in the equity would realize from the below-market debt coupon as discussed in the previous paragraph. Prestige noted that the total decline in the property value of 13.56% relative to the initial investment impacted both the debt, which declined by 6.24%, and the equity, which declined by 31.03%. Although the now below-market interest rate on the mortgage note provided some benefit to Prestige s equity interest over the remaining term of the mortgage, this benefit provided only a partial offset to the decline in the total equity value driven by the reduction in the gross property value. 7

Valuation at December 31, 2X10 C.04A.14 C.04A.15 C.04A.16 Over the next several quarters, Prestige was able to locate tenants to backfill the two suites that had been vacated during the last year. Prestige combined the two large suites with some existing vacant space and demised this area into five smaller spaces, with tenants moving into each of these suites at various times during 2X10. These new tenants increased occupancy to 92% by the start of the fourth quarter of 2X10. Each of these new leases featured 10-year terms, triple net expense reimbursements, and 2% annual base rent escalations. The weighted average lease term across all tenants in Catalina was approximately 8.4 years. Transaction volume in the submarket had recently been growing, and several nearby office properties had traded at capitalization rates below 9.00% (below the going-in rate of 9.50% at which Prestige had acquired Catalina, pointing to an increase in prices for office properties). Believing that these recent developments indicated that it was likely that the fund would be able to sell Catalina at a price that would achieve its target return, Prestige engaged a broker to provide a range of preliminary price opinions and commence a marketing program for the investment. Beginning in December 2X10, Prestige s broker, McCauley & Associates (McCauley), distributed an offering memorandum to various market participants, including a group of REITs and private equity groups. After receiving several preliminary indications of interest, McCauley opened a data room and conducted several tours of Catalina for potential investors. A call for highest and best offers was made, which resulted in three different bids that Prestige weighed in consultation with its broker team. Prestige ultimately selected the bid tendered by SAF Capital (SAF), which was the highest offer price ($15,400,000). Additional factors swayed Prestige in favor of the SAF bid, such as their reputation for deal execution and a 21-day due diligence contingency period that was several weeks shorter than the other two bids. In the SAF term sheet, Prestige learned that SAF s investment team had underwritten to a year 1 NOI projection of $1,386,000, which implied a going-in capitalization rate of 9.00%. Prestige s internal NOI projections for Catalina in 2X11 now stood at $1,364,000, which it believed was slightly different from SAF s projections based on the probability of renewal attributed to a tenant with a lease expiration in mid-2x11. SAF was unwilling to disclose its underwriting model and the derivation of its NOI projections. Prestige and SAF retained their lawyers to draft a purchase and sale agreement that was executed on December 30, 2X10, with the closing scheduled for January 24, 2X11. SAF deposited $1,000,000 in escrow as earnest money, which was refundable until the close of the due diligence period on January 20, 2X11. Prestige uploaded a more detailed set of materials to the data room including all leases, surveys, title documents, and engineering and environmental reports. At December 31, 2X10, Prestige again estimated the fair value of its equity in Catalina by subtracting the fair value of the mortgage debt from the gross fair value of the property. In estimating the fair value of the mortgage debt, Prestige believed that market participants would no longer require an additional spread of 50 bps on the market rate used to discount the note payments. The credit position had 8

improved significantly to around 65% LTV based on the recent offer of $15,400,000. Moreover, credit market conditions had loosened over the past several quarters with index rates falling approximately 25 bps. A survey of market participants investing in mortgage debt (including third-party lenders as well as Prestige s observations from similar transactions into which it had recently entered) and published data sources indicated that lending spreads for similar instruments with the same remaining maturity had also contracted slightly by approximately 10 bps. As a result of the improvements in collateral quality and the changes in index rates and lending spreads, Prestige concluded that the appropriate market interest rate to apply to the cash flows on the mortgage note over the remaining term was 2.75%, 35 bps below the 3.10% coupon. C.04A.17 At this point, the mortgage note had been amortized to a par value of $9,832,690. The application of a market interest rate of 2.75% in Prestige s discounted cash flow model yielded a net present value for the note of $10,032,949, or 102% of par. Given that the loan was still within the 5-year lockout period, it remained subject to a 1% prepayment penalty. Prestige, therefore, concluded in this case that the value of the mortgage debt for the purpose of valuing the equity in Catalina was equal to the pre-payable balance (101% of par or $9,931,017), since it would be optimal for a market participant investing in the equity to prepay the note and refinance at the lower market rate of interest rather than continue to pay an above-market rate. For further discussion of prepayment penalties, see the Time Horizon for the Investment section in paragraphs 4.17.24. C.04A.18 Prestige then estimated the gross property value for the asset in light of the sale contract it had just executed. The sale price had been negotiated at $15,400,000 and Prestige s exclusive broker arrangement with McCauley indicated that a broker fee of 1.5% of the gross sale price would be paid by Prestige upon closing. Prestige also anticipated that other administrative and legal costs would accumulate and total approximately 0.50% of the sale price. Prestige used the gross sale price of $15,400,000 as the starting point for the estimation of fair value, which properly did not deduct the 2.00% in transaction costs it expected to pay. Prestige then considered the contingency provisions in the purchase and sale agreement and other risk factors. In particular, Prestige was aware that in its term sheet, SAF had projected a higher NOI than Prestige did, which could change after the buyer delved deeper into the operations of the property during the due diligence period. Until the earnest money deposit was no longer refundable after the close of the due diligence period, SAF could back out of the deal without financial consequence other than the time and expenses it had invested to date. Despite these concerns, Prestige was confident that SAF wanted to close the transaction as planned, and, therefore, assigned a probability of 85% to that outcome. The other two bids received during the highest-and-best round were for $14,900,000 and $15,100,000, which Prestige considered to be the next best alternative to the SAF deal. Prestige therefore estimated the fair value of Catalina to be $15,340,000, which was the weighted average of the SAF deal (85% probability) and the average of the two other bids ($15,000,000 at a 15% probability). 9

C.04A.19 Prestige deducted the value of the mortgage debt for the purpose of valuing equity of $9,931,017 (101% of par) from its estimate of the fair value of the gross asset value of Catalina ($15,340,000) to arrive at an equity fair value as of December 31, 2X10 of $5,408,983. Task Force Observations C.04A.20 Estimating the fair value of real estate investments requires consideration of several nuances, including: Assessing the appropriate unit of account (see chapter 4) Assessing the value of debt that a market participant would use for the purpose of valuing equity (see chapter 6) Considering transaction costs when estimating fair value (see chapter 12) Using appropriate market participant-based valuation methodologies (see chapters 3 and 5) Calibration (see chapter 10) Assessing the appropriate unit of account C.04A.21 The unit of account illustrated in this case is the equity interest in the office building. The fair value of that equity interest, consistent with an assumed sale of the equity interest on the measurement date, is impacted by the fair value of the building unencumbered by debt and the value of debt that a market participant would use for the purpose of valuing equity. Assessing the value of debt that a market participant would use for the purpose of valuing equity C.04A.22 Assessing the value of debt that a market participant would use for the purpose of valuing equity requires judgment. This case illustrates that based on specific facts and circumstances the value of debt for the purpose of valuing equity may be equal to par value or to the payoff amount for the mortgage, or may be less than par or greater than par. In this case study, since the mortgage was assumable, the value of debt for the purpose of valuing equity was equal to the fair value, capturing the benefit (or cost) that market participants would realize from a below (or above) market coupon over the expected remaining term of the mortgage (through maturity or through the expected prepayment date, if any). If the mortgage was not assumable, the fair value of the mortgage would be an input that market participants would consider in estimating the value of equity, adjusted for the implicit restriction on the equity position associated with the inability to transfer the debt. 10

Considering transaction costs when estimating fair value C.04A.23 As noted in chapter 12, fair value excludes transaction costs. This case study highlights the impact of transaction costs at entry, which resulted in an initial fair value less than the invested capital. This case study also illustrates the measurement of fair value near an exit transaction, considering the risks of that transaction as well as the proper exclusion of transaction costs at exit. Using appropriate market participant-based valuation methodologies C.04A.24 The value of an unencumbered real estate investment is determined using appropriate market participant assumptions. As outlined in this case, market participants would typically consider comparable market transactions when available, as well as either a discounted cash flow approach or applying a market capitalization rate to net operating income. It is also possible that properties that have reached stabilization may revert back to a non-stabilized basis, depending on the facts and circumstances associated with the property. Calibration C.04A.25 As discussed in chapter 10, calibration ensures that the assumptions used in the valuation model are consistent with the transaction on the initial investment date. To estimate the fair value of the investment at future measurement dates, these assumptions would be updated to reflect the changes in the property and the changes in the markets between periods. Conclusions C.04A.26 C.04A.27 This case study is focused on real estate funds that apply investment company accounting in accordance with FASB ASC 946. The unit of account in this case study is the equity interest in the real-estate investment held by the fund. Certain real estate funds are not in the scope of FASB ASC 946. For those funds, the entire property is typically reported as an asset of the fund, and the mortgage debt is reported as a liability of the fund. Further, certain of these funds elect to report the mortgage debt at fair value, using the fair value option in FASB ASC 825. The principles illustrated in this case study may also be useful in assessing the fair value of the mortgage debt for such funds. 11