Economic Uncertainty Prompts Going-Concern and Impairment Analysis for Real Estate Companies

In the wake of the 2008 financial crisis, interest rates remained historically low to stimulate economic recovery. This environment allowed the real estate market to thrive, driven by low borrowing costs and rising property values. As a result, real estate companies took advantage of large floating-rate loans to finance their acquisitions. However, interest rates have been climbing sharply in recent years, reversing the previous trend. The rapid increase in borrowing costs has significantly squeezed cash flows for real estate entities, raising concerns about the market as refinancing becomes increasingly challenging.

Strategic Risk Management by Lenders

Aware of the challenges borrowers face from rising interest rates and higher monthly payments, lenders are becoming more cautious to avoid defaults. Consequently, they are increasingly hesitant to issue new loans or refinance existing ones as they mature.

To mitigate their risk in the current market, lenders are looking to reduce their exposure by analyzing the loan-to-value (LTV) ratio, which measures the amount of money borrowed relative to the value of an asset. For example, if a property is appraised at $20 million and the borrower secures a $15 million loan, the LTV ratio would be 75% ($15,000,000/$20,000,000). A lower LTV ratio means the lender is providing less money relative to the property's value, which is advantageous for the lender. In the event of a default or foreclosure, the bank is more likely to recover its money since it doesn’t have to recoup as much from the property's value. A lower LTV ratio also reduces the risk of the property's value declining below the loan amount, as there is a larger cushion between the loan amount and the property value.  This also results in more favorable regulatory capital treatment for financial institutions.

Going-Concern Assessments and Asset Impairment Reviews

As lenders tighten underwriting guidelines, real estate companies and investors must also navigate the evolving market dynamics and be vigilant for indicators that could signal underlying issues. Given the current market conditions, these indicators are becoming more pronounced, requiring companies to conduct assessments to determine their ability to continue to operate as a going concern — that is, to maintain profitability and operational continuity in the face of challenges, such as declining property values, economic uncertainties or changes in financing conditions. Assessing these risks helps management understand the current challenges and allows them to formulate proactive measures to lessen potential threats and uncertainties.

In addition to assessing viability, companies may also need to perform certain analyses to assess potential asset impairments. This process involves comparing the carrying values and fair values of their assets (or asset groups) to determine if they have been negatively impacted by various factors, which may require recording impairment charges against the asset or asset group on their financial statements, as required by accounting standards.

Audits May Uncover Hidden Risks and Help Ensure Transparency

During a financial statement audit, auditors conduct procedures to identify and assess indicators that may suggest a company's inability to continue operating as a going concern, typically over the next twelve months. These indicators are often related to liquidity constraints and can include negative financial performance over an extended period, high vacancy rates, difficulty meeting financial obligations, maturing debt and breaches of loan covenants or adverse market conditions, among other factors. These factors do not automatically indicate a problem but serve as red flags that may warrant further assessment.

US generally accepted accounting principles require management to assess the likelihood of the company's ability to continue its operations. If there is significant uncertainty, financial statement disclosures are required, and the audit report may include a paragraph to alert readers of the financial statements if a conclusion that substantial doubt about the ability to continue as a going concern does exist and is not mitigated by management’s plan. Even if the conclusion is such that substantial doubt about the ability to continue as a going concern does not exist, additional disclosures may still be necessary to provide full transparency.  As experts in financial reporting requirements, our team can assist management with these requirements and plan for the potential impact on the financial statements.

Next Steps

The current challenges in the real estate market require that real estate companies closely monitor their financial health. Evaluating their ability to continue as a going concern and assessing potential asset impairments are essential measures for the company's long-term health and compliance with accounting standards.

 For more information on going concern, impairment analysis or audits, please connect with a member of our team.