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Real-estate depreciation


Laxputs
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Is land depreciated off the balance sheet over time? I can see buildings needing to be depreciated, but land? Or does it get assessed and adjusted based on current market prices of similar selling land? But if that's the case, how are there companies with "hidden value in real-estate that has been depreciated [or written-off] over the years"?

 

TIA

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Is land depreciated off the balance sheet over time? I can see buildings needing to be depreciated, but land? Or does it get assessed and adjusted based on current market prices of similar selling land? But if that's the case, how are there companies with "hidden value in real-estate that has been depreciated [or written-off] over the years"?

 

TIA

 

Land is not depreciated.

 

Land is usually on the books at cost.

 

It does not get re-evaluated.

 

'Old' land is therefore likely worth more.

 

;)

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I can see buildings needing to be depreciated

 

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?

Moreover, we know that generally the value of buildings (if properly cared for through the years) at least keeps pace with inflation (therefore, it generally increases).

 

Gio

 

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You could say the same thing with almost any company.  Equipment get worn down and maint. capex gets spent to make it last longer, but you depreciate the value on the books.  My understanding is that with PPE, you need to be able to prove that the value on the books is equal to the greater of its liquidation value or cash flows it can generate.  IFRS provides the option of maintaining the value of PPE at cost or fair value, but if the fair value option is chosen you cannot revert back to a cost basis in the future.  Either way, most of the time management does not like the fluctuation of their balance sheet (with values changing in booms and busts).  Also the PPE must be revalued each year which has an associated cost.

 

I'm not an accountant and I'm digging deep into my memory, but I'm almost certain that is the reason.

 

Also, to answer Laxputs question.  Depreciation is a way of matching a unit of revenue with a unit of expense (in this case, the amount of wear and tear required to produce something).  Since land cannot be worn out, it becomes an issue of matching expenses to your revenues, and as such land has no depreciation value.

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You could say the same thing with almost any company.  Equipment get worn down and maint. capex gets spent to make it last longer, but you depreciate the value on the books.  My understanding is that with PPE, you need to be able to prove that the value on the books is equal to the greater of its liquidation value or cash flows it can generate.  IFRS provides the option of maintaining the value of PPE at cost or fair value, but if the fair value option is chosen you cannot revert back to a cost basis in the future.  Either way, most of the time management does not like the fluctuation of their balance sheet (with values changing in booms and busts).  Also the PPE must be revalued each year which has an associated cost.

 

I'm not an accountant and I'm digging deep into my memory, but I'm almost certain that is the reason.

 

I'm with Geo on this one.  Even with proper care and maintenance most equipment doesn't hold its value and will eventually need to be replaced.  Equipment either deteriorates in value to the point that it isn't worth fixing it when it breaks or it becomes obsolete and it is worth the investment to buy newer equipment.  In other words it depreciates.

 

None of this is true with a properly maintained building.  It holds its value quite well if maintained properly and doesn't become obsolete by the newest iBuilding 2.0.

 

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I agree with you 100%, but IFRS does allow for a fair value number on the balance sheet, but as i mentioned it must be revalued each year, which gives rise to fluctuating balance sheets and could be an issue for covenants given the higher leverage in RE.  Also, it could provide swings to the equity value.  This is also coupled with the cost of valuing a portfolio, something that could be quite expensive for some of the larger firms.

 

Also, while in most markets buildings hold value well, that's not to say 2008/2009 doesn't roll around again and destroys the value.

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You could say the same thing with almost any company.  Equipment get worn down and maint. capex gets spent to make it last longer, but you depreciate the value on the books.  My understanding is that with PPE, you need to be able to prove that the value on the books is equal to the greater of its liquidation value or cash flows it can generate.  IFRS provides the option of maintaining the value of PPE at cost or fair value, but if the fair value option is chosen you cannot revert back to a cost basis in the future.  Either way, most of the time management does not like the fluctuation of their balance sheet (with values changing in booms and busts).  Also the PPE must be revalued each year which has an associated cost.

 

I'm not an accountant and I'm digging deep into my memory, but I'm almost certain that is the reason.

 

I'm with Geo on this one.  Even with proper care and maintenance most equipment doesn't hold its value and will eventually need to be replaced.  Equipment either deteriorates in value to the point that it isn't worth fixing it when it breaks or it becomes obsolete and it is worth the investment to buy newer equipment.  In other words it depreciates.

 

None of this is true with a properly maintained building.  It holds its value quite well if maintained properly and doesn't become obsolete by the newest iBuilding 2.0.

 

Well that's why you capitalize certain costs of maintaining the building and why depreciation schedules for buildings are 30-40 years.

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You could say the same thing with almost any company.  Equipment get worn down and maint. capex gets spent to make it last longer, but you depreciate the value on the books.  My understanding is that with PPE, you need to be able to prove that the value on the books is equal to the greater of its liquidation value or cash flows it can generate.  IFRS provides the option of maintaining the value of PPE at cost or fair value, but if the fair value option is chosen you cannot revert back to a cost basis in the future.  Either way, most of the time management does not like the fluctuation of their balance sheet (with values changing in booms and busts).  Also the PPE must be revalued each year which has an associated cost.

 

I'm not an accountant and I'm digging deep into my memory, but I'm almost certain that is the reason.

 

I'm with Geo on this one.  Even with proper care and maintenance most equipment doesn't hold its value and will eventually need to be replaced.  Equipment either deteriorates in value to the point that it isn't worth fixing it when it breaks or it becomes obsolete and it is worth the investment to buy newer equipment.  In other words it depreciates.

 

None of this is true with a properly maintained building.  It holds its value quite well if maintained properly and doesn't become obsolete by the newest iBuilding 2.0.

 

"Maintaining" a building is essentially the same as slowly converting it over time to iBuilding 2.0. The timing and lumpiness of replacement costs is totally different with a single machine but not really that different in my opinion.

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Well that's why you capitalize certain costs of maintaining the building and why depreciation schedules for buildings are 30-40 years.

 

Of course depreciation schedules for buildings are longer than for equipments... This doesn't mean they make sense.

 

I live in an apartment of a condominuim built in the early '60s. And I have always seen its price go up. And it will continue going up for many years to come! ;)

 

Gio

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Had a few points to add...

 

1. As was mentioned before, certain expenditures are capitalized such as changing the roof, changing windows, remodeling the kitchen etc. 

 

2. The 1960's condo that appreciates is also do probably largely in part because of the appreciation of the land and not the structure.  The structure is indeed deteriorating over time.  There's no way around that.

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Well that's why you capitalize certain costs of maintaining the building and why depreciation schedules for buildings are 30-40 years.

 

Of course depreciation schedules for buildings are longer than for equipments... This doesn't mean they make sense.

 

I live in an apartment of a condominuim built in the early '60s. And I have always seen its price go up. And it will continue going up for many years to come! ;)

 

Gio

 

My home was built 246 years ago in 1768.  The barn was built in the 1850's.  Both are in excellent condition.  I don't know of any vehicles or manufacturing equipment that are still being used for their original purpose that can say the same.

 

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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.

 

As someone said above that maintenance capex is slowly building "apartment 2.0"

 

Yes, but you and others are missing the points that 1) the maintenance is already accounted for.  2) There is no amount of maintenance you can do on any vehicle or manufacturing equipment which will let you use those things forever.  They will need to be replaced in a predictable time-frame regardless of what you spend on them.  This isn't the case for buildings.  With a reasonable amount of capex (including insurance against disasters) they can last and hold their value indefinitely.

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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!

 

Cheers,

 

Gio

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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.

 

As someone said above that maintenance capex is slowly building "apartment 2.0"

 

Yes, but you and others are missing the points that 1) the maintenance is already accounted for.  2) There is no amount of maintenance you can do on any vehicle or manufacturing equipment which will let you use those things forever.  They will need to be replaced in a predictable time-frame regardless of what you spend on them.  This isn't the case for buildings.  With a reasonable amount of capex (including insurance against disasters) they can last and hold their value indefinitely.

 

1) Huh? You depreciate and add the maintenance capex to the PP&E 2) I've been in a lot of factories. I assure you that this is not absolutely true.  I remember being in substation once where a decent amount of the equipment had originally been installed 70 years ago, had a depreciable life of 40, and Mgmt felt like with appropriate capex would never need to be out right replaced.

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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!

 

Cheers,

 

Gio

No it wouldn't be carried at zero because you pay to maintain it. 

 

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There seems to be a bit of confusion over maintenance and capex.  In the US maintenance and repairs are expensed as incurred.  This includes repairing broken items - leaky roof repair, etc. Capex is capitalized (added to the basis) and depreciated over time.  This is remodels, new roof, new carpet, etc.  The carrying amount for a apartment or commercial building would never get to zero unless all capex stopped for a number of years (40 max but I believe could be less since items such as a carpet could be tracked separately and depreciated faster than 40 years). With an industrial building it would be more possible since the tenant may be doing improvements, and the building is simpler..

 

To the main point earlier, there is a reason REITs report, and investors focus on, FFO - funds from operations which excludes depreciation.  While they are using in terms of cash flow, I think value investors recognize it as reasonably accurate since depreciation is approximately 2.5% (1/40) which is near historical inflation, so it made a decent quick calculation for real return.           

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What I meant is I see no reason why buildings, land, and also equipments shouldn't be recorded on the Balance Sheet at the value they could be sold in the market today.

I don't understand why the value recorded on the Balance Sheet should be different from market value.

So, is the value of buildings, land, and equipments on the Balance Sheet always the same as market value?

If the answer is yes, then this ends the discussion as far as I am concerned! ;)

 

Gio

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There seems to be a bit of confusion over maintenance and capex.  In the US maintenance and repairs are expensed as incurred.  This includes repairing broken items - leaky roof repair, etc. Capex is capitalized (added to the basis) and depreciated over time.  This is remodels, new roof, new carpet, etc.  The carrying amount for a apartment or commercial building would never get to zero unless all capex stopped for a number of years (40 max but I believe could be less since items such as a carpet could be tracked separately and depreciated faster than 40 years). With an industrial building it would be more possible since the tenant may be doing improvements, and the building is simpler..

         

 

Its a question of semantics and accounting rules. From an economic perspective if something is expensed as incurred or capitalized and depreciated is sort of irrelevant (Tax aside). The point remains buildings deteriorate over time and require reinvestment to stay in shape.

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What I meant is I see no reason why buildings, land, and also equipments shouldn't be recorded on the Balance Sheet at the value they could be sold in the market today.

I don't understand why the value recorded on the Balance Sheet should be different from market value.

So, is the value of buildings, land, and equipments on the Balance Sheet always the same as market value?

If the answer is yes, then this ends the discussion as far as I am concerned! ;)

 

Gio

Why would you assume market value is correct? Or that liquidation could occur at current market?  And if you do why don't you just index?

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What I meant is I see no reason why buildings, land, and also equipments shouldn't be recorded on the Balance Sheet at the value they could be sold in the market today.

I don't understand why the value recorded on the Balance Sheet should be different from market value.

So, is the value of buildings, land, and equipments on the Balance Sheet always the same as market value?

If the answer is yes, then this ends the discussion as far as I am concerned! ;)

 

Gio

 

One of my accounting professors always used to call historical cost 'hysterical cost'.  IAS 16 allows for choosing between using the hysterical cost and a revaluation model. 

Under the revaluation model, revaluations should be carried out regularly, so that the carrying amount of an asset does not differ materially from its fair value at the balance sheet date. [iAS 16.31]

 

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.

 

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The whole idea behind depreciation is to match expenses and revenues over time. As buildings are utilized over a long period of time they are depreciated over the "expected life" of the building.  For some reason the shortest life allowed under the tax law seems to be the expected life of a lot of buildings.  ;)

For example cars are usually depreciated over 3-5 years.

Normally in the footnotes they tell you the lives and methods of depreciation.

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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

 

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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

 

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Think of the consequences of marking RE to market every year (or every quarter!) – it's simply impractical. Even if it was easy to get a halfway decent estimate of the value, you'd get wildly fluctuating earnings at the companies using this RE to do their business, e.g. retailers. The underlying assumption would be that they could always sell all of their RE anytime, and this doesn't make sense. Look no further than to SHLD if you need an example. Stocks and bonds are as liquid as cash, RE isn't, especially when it's being used by the company to do its business.

 

I don't agree with the notion that buildings are enduring assets. Look around you: Most people don't live in 500 year old buildings. Why not? There wouldn't be any skyscrapers in NYC on the ground of your assumption. It's not about how long things last theoretically but after what amount of time they will actually be replaced on average. It can be perfectly reasonable to tear down a twenty year old skyscraper and build a new one on the same spot, even though, theoretically, the old building could have been used for another 100 years or so.

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