Financial Reporting for Real Estate

Will FASB 157 achieve a higher and better use?

FASB Statement no. 157, Fair Value Measurements, introduces new concepts and practices to the world of financial reporting, including some that are beginning to impact the fair value measurements of real estate assets. "Highest and best use" is one of these concepts.

As it applies to fair value measurements of real property assets, highest and best use is actually a basic concept. Put simply, highest and best use is the use that maximizes the property’s value. Historically, the highest and best use concept has not been consistently applied when valuing real property for financial reporting purposes, and Statement no. 157 will potentially impact the valuation of all tangible and intangible assets. This article addresses some of the more important expected changes to fair value measurements of real property assets, what challenges valuation specialists should expect when performing a valuation using Statement no. 157, and what aspects auditors and accountants should consider when using the work of a valuation specialist.

Statement no. 157 provides guidance on fair value measurements, whenever such measurements are required or permitted in other FASB statements. Think of Statement no. 157 as an overlay for other statements to be used whenever fair value reporting is involved. As many as 60 other FASB statements are affected by Statement no. 157. For a comprehensive overview of the standard, see "Refining Fair Value Measurement," JofA, Nov. 07, page 30. While Statement no. 157’s impact on the valuation of complex financial instruments has come under scrutiny as a result of the financial crisis, we focus here on its impact on real property valuation.

While fair value measurements can be applied to a single asset or group of assets, the maximum price is driven by the highest and best use concept. Although highest and best use is not new as a concept for valuation and is one of the most important factors underlying a real estate valuation, certain standards, such as those for purchase price accounting for business combinations (Statement no. 141 before the issuance of the revised Statement no. 141(R)) or for impairment testing of goodwill or long-lived assets (Statement no. 142 and Statement no. 144, respectively) did not fully embrace the concept of highest and best use.

Historically, a valuation of real property was based on an entity’s intended use of the property. However, because fair value is a market-based measurement and not an entity-specific measurement, under Statement no. 157 the property should be valued at its highest and best use to a typical market participant. That use can be determined only after analyzing alternative land uses and, consequently, the fair value of the property can be determined only after the appraiser concludes what the highest and best use for the site is, as the highest and best use conclusion may help determine which techniques should be used in the valuation.

Some real estate assets and liabilities were affected by Statement no. 157 sooner than others. For all financial assets and liabilities as well as all nonfinancial assets/liabilities that are recognized at fair value on a recurring basis, such as real estate investment fund assets measured at fair value, the statement became effective for fiscal years beginning after Nov. 15, 2007.

For nonfinancial assets and liabilities measured on a nonrecurring basis, such as impaired real estate under Statement no. 144, the statement became effective for fiscal years beginning after Nov. 15, 2008. A calendar year real estate investment company (a private-equity firm, for example) that invests in an office building and marks that investment to fair value on a recurring basis had to implement Statement no. 157 as of Jan. 1, 2008.

However, a calendar year office REIT that invests in the same building but reports the investment on the historical-cost basis had been able to defer implementing Statement no. 157 for that asset until Jan. 1, 2009. As of Jan. 1, for calendar year-end companies all assets are subject to valuation under Statement no. 157.

The Appraisal Institute defines highest and best use for real estate as the "reasonably probable and legal use of vacant land or an improved property that is physically possible, legally permissible, appropriately supported, financially feasible and that results in the highest value."

As the Appraisal Institute indicates, the use should take advantage of the positive attributes of the property while neutralizing, to the greatest possible extent, any negative characteristics. At the same time, the use should operate within the limits of approved and justified development. The criteria of highest and best use are as follows (note that the following definition is from the Appraisal Institute, but conceptually the first three points reflect Statement no. 157):

  • Legally permissible. The uses that are legally permitted by zoning and deed restrictions on the site.
  • Physically possible. The use to which it is physically possible to construct on the site in question.
  • Financially feasible. The possible and permissible uses that will produce a net return to the owner of the site.
  • Maximally productive. From among the feasible uses, the use that will produce the highest net return or the highest net present value of the subject site.

Traditional highest and best use analysis evaluates the site on an as-vacant basis and as-improved basis, and the use that meets all criteria and results in the highest value is the highest and best use of the property. Both the property as a whole (land and building together in use with other contributing assets), and the underlying land by itself, can have a highest and best use, and these two uses may not necessarily be the same. It is precisely because of these potential differences that Statement no. 157 and its highest and best use premise may have an effect on fair value reporting of real property assets.

In addition, appraisal theory holds that as long as the value of a property as improved is greater than the value of the land as vacant, the highest and best use is the use of the improved property. In practice, however, a property owner who is redeveloping a parcel may remove an improvement even when the value of the property as improved exceeds the value of the vacant land. Thus, the cost of demolition and any remaining improvement value are worked into the test of financial feasibility for redevelopment of the land.

As mentioned, before Statement no. 157 many real property valuations were based on a specific owner’s intended use. In other words, assets were valued based on what the asset was worth to that specific user, rather than what that asset was worth to a typical market participant. A highest and best use analysis was normally an afterthought in these situations, and was the reason the highest and best use concept had not been consistently applied in valuing real property for financial reporting purposes.

Under Statement no. 157, the fair value measurements for real property assets assume the highest and best use, as viewed by market participants, even if the intended use by the reporting entity is different. Entities don’t need to identify specific market participants for this exercise. Instead, general characteristics of market participants should be considered, such as typical buyers of the given asset(s), the principal or most advantageous market for the asset, and the buyers that would likely interact with the entity given the asset and the principal market.

Appraisers and valuation specialists must exercise caution in performing the market analysis when determining highest and best use. Although a site may be suited for a particular use, there may be other uses that are equally or more appropriate. The appraiser must test the highest and best use conclusion, ensuring that existing and potential competition from other sites has been recognized. Using market determinants, Statement no. 157 will impact the valuation of real property assets, and if the result is that more value is attributed to nondepreciable land than depreciable improvements, depreciation of those assets may also be impacted.

The standard allows companies to consider the highest and best use of a group of assets compared to the individual asset if the entity assumes that market participants would pay more for the group of assets in combination than they would for the assets individually. For example, a buyer might pay more for several individual vacant lots that could be assembled into a larger parcel than for the individual lots in separate transactions.

While real property assets are typically valued individually using an in-exchange value premise, there may be instances when a grouping of assets, using an in-use premise of value, will return the highest and best use. The "grouping" concept under Statement no. 157 is new; however, the analysis is consistent with traditional highest and best use analysis. Appraisers must compare the in-exchange value of the underlying site with the in-use value of the entire property, that is, the "grouping" of the assets. The use that maximizes value to market participants represents the highest and best use. The key concept is that the highest and best use scenario will be from the perspective of a market participant, not that of the reporting entity.

In addition to highest and best use, Statement no. 157 introduces other concepts that may impact a real estate analysis, in particular the way it addresses selling costs and market-based assumptions. With regard to selling costs, the fair value measurement assumes the sale of the asset occurs in the principal market, or absent this, the most advantageous market for the asset. The principal market is the market for the asset with the greatest volume and level of activity. The most advantageous market is the market in which the reporting entity would sell the asset for the price that maximizes the amount received for the asset, considering transaction costs in the respective market(s).

Although transaction costs may be considered by an entity in determining the most advantageous market, the price (in the principal or most advantageous market) used to measure the fair value of the asset is not adjusted for transaction costs. Transaction costs, such as a broker’s commission, are not typically an attribute of the asset or liability; rather, they are specific to the transaction and will differ between reporting entities. Instead, Statement no. 157 states that transaction costs should be accounted for in accordance with the provisions of other accounting pronouncements. Exceptions to this are transaction (that is, selling) costs associated with a residual or reversionary value as part of a discounted cash flow analysis, which should still be factored into the analysis.

When it comes to market-based assumptions, or inputs, Statement no. 157 introduces a three-tier fair value hierarchy based on whether the inputs to a valuation are observable or unobservable in the market, and allows an assessment of the reliability of the fair value measurement.

  • The first tier, or Level 1, of the hierarchy pertains to the use of quoted prices in active markets for identical assets. Given that each real estate property is unique, it is unlikely that a real estate analysis will incorporate Level 1 inputs.

  • Level 2 incorporates observable valuation assumptions, such as quoted prices for similar assets (either active or inactive markets), or other observable inputs that can be supported by market data. Examples of this would be a market rent estimate derived from recently signed comparable rentals, or a price per acre estimate for the underlying land derived from recent comparable land transactions.

  • Level 3 are unobservable inputs, incorporating an entity’s own assumptions about market participant assumptions. Level 3 inputs are the most subjective. Because there are no observable measures, an appraiser must rely solely on experience and knowledge of the market when using Level 3 inputs for real estate assets. An example of a Level 3 input would be a discount rate derived from published surveys and/or from interviewing market participants.

Now that Statement no. 157 is fully effective for calendar year-end companies, entities will need for financial reporting purposes to look beyond their own intended use for real estate assets and instead consider the assets’ highest and best use from market participants’ perspectives. As this may be a significant change in practice, companies, along with their auditors and service providers, will need to be aware of and understand the requirements of Statement no. 157. A thorough implementation of highest and best use within the context of the standard will be critical to complying with the requirements to maximize an asset’s value and fully understanding its impact on financial reporting.

To what extent this may change a company’s bottom line remains to be seen, but it certainly will create changes from prior practice that accountants, specifically valuation specialists, will need to recognize. In some cases the help of a real estate valuation specialist who has an understanding of highest and best use and its relation to Statement no. 157 may be needed to confirm that a company’s real property assets are properly valued, and that those valuations comply with the new standard.


What’s It Worth? Land and Building Allocation Under FASB 157
Consider an older manufacturing facility bordering a residential district. It is situated on residentially zoned land and purchased as part of a larger business transaction in which the purchaser intends to maintain the industrial use. Before Statement no. 157, the land and building would likely have been valued together as a manufacturing facility based on a continued use value premise. However, although the facility may have use to the buyer as a manufacturing facility, under Statement no. 157 the highest and best use of both the land and the improved property must be considered and analyzed separately.

What if the value of the underlying land is higher as a residential site than as a manufacturing site? What if the underlying residential land has a higher value than the entire improved facility? How would the resulting value affect the financial reporting?

First, assume sales of similar facilities range from $28 to $32 per square foot, after adjustments, which points to a value for the entire facility (land and building) of approximately $1 million for a hypothetical 33,500-square-foot facility. Industrial land sales in the area indicate a value of $65,000 per acre for the property’s 3 acres.

Before Statement no. 157, the allocation of the facility’s value may have been approximately 20% to the land ($65,000 per acre times 3 acres) and the remaining 80% allocated to the building under an "in use" premise.

Now, consider if the underlying land was approved for a six-lot residential subdivision. Assuming similar lots were selling for $200,000 per lot, the underlying land would be valued at $1.2 million, greater than the overall facility value of $1 million. (Note: This example is for illustrative purposes only; timing and expenses associated with the lot sales have not been factored in.) Assuming demolition costs of $100,000 for the existing industrial building, the "in-exchange" value would equal approximately $1.1 million, still higher than the value of the overall industrial facility of $1 million. In this case, the purchaser would need to use the "in-exchange" value, even though the purchaser intends to continue using the facility for industrial purposes.

What if, as in the example above, the value of the land based on a residential use is higher than the value as an industrial use, but the resulting residential land value is lower, not higher, than the overall industrial facility value? These and any number of other scenarios may be encountered, and the specifics of how to allocate the land and building values in these and similar scenarios are still being vetted by companies, their auditors and service providers.

While example 2 in Appendix A of Statement no. 157 (paragraphs A10 and A11) deals with some of these issues, it does not answer all of these questions. Furthermore, the FASB Valuation Resource Group (VRG) discussed how to allocate fair value to the acquired property improvements and other assets in the group if the highest and best use for the land is a vacant lot. A summary of issues discussed by the VRG can be found at (refer to "Issue 2007-12 Highest and Best use – land example").

At the time of the VRG discussion it was determined that no additional FASB guidance was necessary. However, FASB staff will continue to monitor this issue. Readers should be alert to further developments and keep in mind that the full impact of Statement no. 157 may not be known until implementation is well under way.



JofA article
"Refining Fair Value Measurement," Nov. 07, page 30

FVS Section and ABV credential
The Fair Value for Financial Reporting section of the Forensic and Valuation Services (FVS) site is available here. Membership in the FVS Section provides access to numerous specialized resources in the forensic and valuation services discipline areas, including practice guides, and exclusive member discounts for products and events. Visit the FVS Center at Members with a specialization in business valuation may be interested in applying for the Accredited in Business Valuation (ABV) credential. Information about the ABV credential program is available at

Fair Value Measurements Workshop, Feb. 26–27, New York City
AICPA Fair Value Measurement Conference, June 8–9, Chicago
AICPA National Business Valuation Conference, Nov. 15–17, San Francisco

Real Estate Accounting and Auditing, a CPE self-study course (#730608)
Real Estate Accounting and Financial Reporting: Tackling the Complexities, a CPE self-study course (#734620)
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For more information or to place an order or register, go to or call the Institute at 888-777-7077.


FASB’s Valuation Resource Group,
Appraisal Institute,
American Society of Appraisers,



Under FASB Statement no. 157, the highest and best use of all assets, including real property, should be considered when measuring that asset’s fair value.

Fair value should be measured from a market participant’s perspective–what the property would likely sell for in that asset’s principal or most advantageous market—and considering the typical buyers for the asset.

For improved properties, the highest and best use analysis requires an examination of the property’s use "as vacant" and "as improved," and the uses may not necessarily be the same. The potential differences may affect the fair value reporting of real property assets.

Statement no. 157 allows the consideration of the highest and best use of a group of assets if market participants would pay more for the group of assets in combination than they would for the assets individually.

Specifics of how to allocate real property component values under Statement no. 157 are still being evaluated by the market, and the full impact may not be known until implementation is well under way.

Steven Gottlieb and Robert Meulmeester are senior managers with Deloitte Financial Advisory Services LLP. Matthew Bohlin is a senior associate with Deloitte Financial Advisory Services LLP. Their e-mail addresses are, respectively,, and

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