Real Estate Accounting (#355)
/Preacquisition Costs
First up is preacquisition costs. These are expenditures relating to a specific property, but before you actually acquire it. This includes things like appraisal fees, engineering fees, feasibility studies, and title searches. You can capitalize these costs only if they’re directly associated with a specific property, and it’s probable that you’re going to buy it. Otherwise, you have to charge it to expense as incurred.
Selling Costs
And then there are selling costs. If you have a reasonable expectation of recovering selling costs, such as by selling the real estate, then you can capitalize those costs. The types of selling costs that you can treat in this way include the costs of model units, model furnishings, and signage. Conversely, there are several types of selling costs that are charged straight to expense, and they include advertising, grand openings, and sales brochures.
Project Expenditures
Next up, we have real estate project expenditures. This is what you’re spending money on after acquiring a property, and it includes things like demolition, permitting fees, construction, construction administration, and even project cost accounting. These costs are capitalized when they’re directly associated with the project. Otherwise, charge them to expense as incurred.
In particular, if the developer incurs any real estate taxes or has to pay for property insurance during the construction phase, then it’s acceptable to capitalize those costs. But, once the property is ready for its intended use, then these items have to be charged to expense as incurred.
Capitalization of Interest
Another issue is the debt funding used to pay for the construction. You should capitalize the related interest expense during the entire property development period, but no longer than that. The amount of interest you should capitalize is that amount of interest that the developer would have avoided by not developing the property.
Accounting for Phases of Work
Now, a big issue for larger developments is to separate out the accounting for successive phases of the work. For example, the earliest phase might have been completed and sold long before the last phase is even started. To do this correctly, the capitalization of real estate should be stopped as soon as it’s been linked to a real estate owners’ association, or been put up for sale.
Cost Assignment
So, when capitalization happens, how do you assign costs? The best approach is the specific identification method, when a cost is directly linked to a specific property. If that’s not possible, then you use the relative value method. Under this approach, the cost of the land and any common costs are allocated to land parcels based on their relative fair values before construction.
Then the costs of construction are allocated to individual units based on their relative sales values. And if it’s not possible to do an allocation based on relative sales values, then allocate costs based on their relative square footage. In short, there’s always a reasonable way to allocate costs.
Donated Property Accounting
Next up, how do you account for real estate that’s been donated to the local government by the developer? For example, the developer might intend that a certain parcel should be treated as open space, which is to be managed by the government. In this case, the cost of the donated real estate is a common cost of the project, so you should allocate its cost to the various components of the project.
Incidental Operations Accounting
You might also have incidental operations for a project, where the intent is to rent some space to offset the cost of developing a property. To account for these operations, the first step is to net the rental revenues against any related costs. If there’s anything left, then subtract it from capitalized project costs.
Real Estate Amenities
And then we have real estate amenities. These are features that improve the attractiveness of a property, such as a swimming pool or a clubhouse. The accounting here is to allocate their cost among those land parcels that benefit from the amenities.
Project Abandonment
So, what about those cases in which a project is abandoned? For example, economic conditions might change, and it’s no longer profitable to continue with a project. If so, you should calculate the recoverable amount of the costs, which is usually from selling the property to someone else. Then subtract this amount from the capitalized cost total, and charge the difference to expense in the current period.
Time Share Accounting
And now for a special case, and everyone’s favorite – time shares. Under these arrangements, the developer sells the right to occupy a property for a certain period of time on a repeating basis.
In a normal real estate transaction, you would charge to expense the costs associated with a specific property. You can’t do that with a time share, because there could be dozens of interval sales associated with a single unit. So instead, the cost of sales is determined with the relative sales value method.
In essence, you divide the estimated total project cost by the estimated total project sales, and then multiply that cost percentage by the sales generated in the period. The outcome is the cost of sales that you can recognize within the period. Of course, since that calculation involves lots of estimates, the amount charged to expense in each period could very well be wrong – but at least it sounds rational. Unlike the whole concept of investing in a time share.
Which brings me to the next point, which is the very high proportion of notes payable that time share owners never pay, because they’ve realized that it’s a crappy investment. This means that there’s a high risk that the amount of profit recognized from time share sales is overstated by the amount of these bad debt losses. To minimize this overstatement, you have to recognize an estimate of uncollectibility, which reduces the revenue recognized.
Participating Mortgage Loans
And here’s another special case, which is participating mortgage loans. In these loans, the lender can participate in the results of operations of the real estate development being mortgaged. Or, the lender might take a chunk of any appreciation in the development’s market value.
The borrower accounts for this participation feature by recognizing its fair value as a liability, where the offset is to a debt discount account. If the borrower ends up paying the lender a share of its profits, then charge it to interest expense, with the offset being to the participation liability account. And, the borrower should adjust the participation liability to match the latest fair value of the participation feature. And finally, if the mortgage is extinguished prior to its due date, then recognize a debt extinguishment gain or loss, which is calculated as the difference between the recorded amount of the debt and the amount paid to settle the debt liability.