NAREIT Submission to the AcSEC Cost Capitalization Task Force


March 29, 2000




Mr. Roy Rendino
Chairman, Cost Capitalization Task Force
AICPA Accounting Standards Executive Committee
c/o Prime Group Realty Trust
77 West Wacker Drive
Suite 3900
Chicago, Illinois 60601


Re:   Comments on January 28, 2000 AcSEC Meeting


Dear Mr. Rendino:


The National Association of Real Estate Investment Trusts (NAREIT) is pleased to provide the Accounting Standards Executive Committee's (AcSEC) Cost Capitalization Task Force with our comments on the materials presented and the discussion at the January 28, 2000, AcSEC meeting. As you know, NAREIT is a national trade association for REITs and publicly traded real estate companies. Our members include real estate investment trusts (REITs) and other businesses that develop, own, operate, and finance income-producing real estate, as well as those firms and individuals who advise, study, and service these businesses.


Our business - owning and operating investment property - regularly involves the acquisition and development of real estate assets. In this context, the accounting standards for capitalizing the cost of these assets are particularly important to producing useful financial reports for publicly traded real estate companies.


We appreciated the opportunity to observe the January 28, 2000, AcSEC meeting. Although we understand that the scope of this AcSEC project is being modified, NAREIT's Cost Capitalization Task Force has reviewed the six issues covered at the meeting and offers its comments below.


General Comments
First, NAREIT would like to reiterate a position stated in our January 3, 2000, letter. NAREIT strongly believes that the componentization question should not dilute the AcSEC Task Force's attention and focus on its primary purpose (i.e., what costs should be capitalized). Comparability and consistency within the industry could be enhanced by the development of guidelines for the capitalization of certain items considered to be "gray areas." However, there are numerous issues, both theoretical and practical, that need to be resolved before implementation of new guidelines would be appropriate.


Further, NAREIT believes that, if the AcSEC Task Force considers componentization of the costs of investment property, it should also consider the depreciable lives and potential salvage values of the components. Current methods of measuring investment property depreciation expense result in an overstatement of this charge to periodic earnings. Componentizing the costs may exacerbate this situation if appropriate ranges of useful lives and salvage, or residual, values are not established.


Second, we urge the AICPA task force to consider that the International Accounting Standards Committee (IASC) has adopted an investment property model with less componentization than currently exists under the historical cost model now used under U.S. GAAP. In International Accounting Standard (IAS) 40, Investment Property, the IASC adopted a fair value accounting model for investment property that would combine land and building into one component. A move toward additional componentization would not be consistent with the international model. Notably, the Securities and Exchange Commission recently issued a concept release seeking comment on the acceptability of IASC standards, and how best to create a global financial structure that could provide a way for companies using IAS to list their shares on U.S. stock exchanges. Significantly different approaches to aggregation or componentization of investment property costs would hinder comparability between domestic and foreign companies.


IAS 40 combines land and building into one component, consistent with the reality that those who develop, acquire, finance, or sell an investment property consider it to be a single economic asset. Clearly, the value of an investment property is based on cash flows generated through the synergy of many components that make up an investment property. However, this value cannot easily be assigned or allocated to the components. NAREIT believes that the most appropriate accounting for investment property, even under the historical cost framework, would provide for reasonable capitalization of costs (as provided for in FAS 67), realistic depreciable lives of components or a composite life, and salvage values linked to fair value. The IASC's single-component model for investment property, in fact, lends itself to the use of the composite method of depreciation.


We note that the AcSEC Task Force in several instances analogized to IAS 16, Property, Plant and Equipment, in the issues paper discussed at the January 28 AcSEC meeting. These analogies include determining whether an item should be capitalized or expensed (Issue #1), guidance on componentization (Issue #3), and whether an item should be expensed or classified as a prepaid expense (Issue #4). NAREIT strongly believes that, if the AcSEC Task Force supports its views with reference to IAS 16 in the development of an AICPA Statement of Position (SOP), the Task Force must also consider the IASC's views on investment property in IAS 40. Moreover, IAS 16 permits property, plant and equipment to be revalued to reflect fair value at the balance sheet date.


Third, we noted that some AcSEC members appear to believe that the real estate industry commonly depreciates short-lived assets over a 40-year period. In the great majority of cases, our member companies segregate and depreciate leasing costs and furniture, fixtures and equipment costs over their useful lives - much shorter than 40 years. In some cases, the 40-year period may represent a weighted-average composite of the components of the property, such that some components are effectively depreciated over periods less than 40 years and some are effectively depreciated over periods more than 40 years.


Issue 1: Criteria for Capitalization versus Expense
NAREIT generally agrees with the proposed guidance for determining whether subsequent real estate costs should be capitalized or expensed. We agree with AcSEC's view that the concept of "extend life" should be factored into the guidance provided in criteria #3.


Issue 2: Accounting for Acquisition, Development, and Construction (ADC) Costs, Including Indirect and Overhead Costs
The AcSEC Task Force proposes to extend the accounting in FAS 67 to pre-acquisition costs for internal use projects, as well as to taxes and insurance for internal use real estate costs and subsequent real estate costs. NAREIT agrees with the extension of this mature standard.


At the meeting, AcSEC raised the issue of accounting for taxes and insurance related to expansions on already owned land. NAREIT believes that an entity should be able to capitalize the real estate taxes and insurance attributable to any portion of the land under development.


With regard to indirect and overhead costs related to real estate capital improvements, the AcSEC Task Force proposes analogizing primarily to SOP 98-1 by limiting capitalization of costs to internal employee costs, including payroll and payroll benefit-related costs. Administrative costs, rent, depreciation, and other occupancy costs would be expensed as incurred. NAREIT does not agree with this proposed guidance because it does not conform to FAS 67's treatment of administrative costs, rent, depreciation, and other occupancy costs (i.e., capitalized rather than expensed as incurred). Further, we note that in the event a company out-sources these activities, whereby they are capitalized, the AcSEC Task Force's proposal would lead to different accounting for the same expenditure.


The AcSEC Task Force's view would result in different accounting for indirect and overhead costs related to internal use or subsequent real estate costs compared with initial costs of real estate assets developed for sale or lease. This treatment would impair comparability within a portfolio between constructed (developed) and purchased (acquired) properties. This treatment would also impair consistency related to the accounting for developed properties (i.e., initial costs would follow FAS 67 and subsequent costs would follow the proposed guidance). NAREIT does not understand why accounting standards would measure the cost of an "internal use" office building differently from an office building held for sale or lease. FAS 67 and its predecessor SOP have served the industry well, and we are not aware of inconsistent practice.


Issue 3: Component Accounting
The proposed componentization guidance would apply to all real estate assets, whether purchased or constructed, whether the costs are initial or subsequent costs, and whether the costs are for real estate assets for internal use or for sale or lease. We focus our comments separately as to component accounting for the original cost and subsequent costs of investment property.


Original Cost
Componentizing the original cost of all investment property is not practical and will lead to a significant lack of comparability and transparency. As further discussed below, it will be very difficult to componentize the cost of new acquisitions, or the billions of dollars currently recorded, beyond basic components. Further, componentizing original costs may exacerbate the already unrealistic measurement of depreciation, regardless of whether the property is developed or purchased.


Attempting to componentize the acquisition cost of investment real estate below a very nominal level (i.e., land and improvements) is frequently beyond the scope of appraisals or other readily available information. In fact, the acquisition cost of an investment property reflects the aggregate value and useful life of its component items (i.e., if a component needs replacement or major overhaul, the acquisition price is adjusted downward). It is certainly more feasible to componentize the cost of developing a similar property, but should accounting standards measure the costs of acquiring versus developing similar assets differently? FAS 67 does not require componentization, and there are literally hundreds of billions of dollars of investment property currently carried in financial statements with no or very nominal cost segregation in the accounts. Also, these inconsistencies in measuring the assets' bases would probably result in differences in measuring depreciation expense. And finally, we cannot emphasize too strongly that using an appropriate salvage value in the calculation of depreciation results in the most appropriate measurement of depreciable costs, under GAAP, when the salvage, or residual, value is compared to the aggregate costs of the investment property.


Many real estate companies use the composite method of calculating depreciation expense for investment property. This method of measuring depreciation for a group of assets or components of an asset is a long established and accepted practice. Under the composite method of depreciation, each component is effectively depreciated over its individual useful life, even though separate records are not maintained for each component, such that the aggregate periodic depreciation charge is reasonable and not materially different than that yielded by the component method.


Fundamentally, an investment property represents a single asset from the perspective of development, acquisition, sale or financing. Even where componentizing items is possible, it is the synergy of all the components of an investment property that generates a single cash flow stream, thereby providing the basis for measuring the potential salvage value of the single asset. Generally, the most useful and transparent reporting within the historical cost framework could be obtained for the original aggregate cost of an investment property by using an appropriate composite useful life and salvage value for measuring depreciation, along with establishing clear and specific guidelines for the capitalization and depreciation of subsequent expenditures.


Subsequent Costs
The determination of whether an expenditure subsequent to an investment property's original cost is capitalizable represents an area of accounting that may lack transparency. Therefore, we support the development of clearer guidelines in this area. As indicated above, we are generally in agreement with the AcSEC Task Force's criteria on which to base the capitalization decision. These subsequent costs can be accumulated in groups based on similar useful lives. Accounting for both the bases and depreciation of these groups of subsequent improvements is not a complex process.


Issue 4: Classification of Certain Costs as Prepaid Expenses
NAREIT agrees that the types of expenditures discussed in the proposed SOP should either be expensed or capitalized, and not charged to prepaid expense.


Issue 5: Inclusion of Lessees in Scope
NAREIT agrees that the scope of the proposed SOP should include not only owners/lessors of real estate but also lessees, whether under capital or operating leases.


Issue 6: Accounting for Contractually Recoverable Capital Expenditures
NAREIT expects to survey its members to determine which methods are most prevalent in the industry. We will share this information with you as soon as it is available.


NAREIT appreciates the opportunity to participate in the AcSEC's deliberations with respect to cost capitalization. If you should have any questions regarding our comments, please contact George Yungmann at (202) 739-9432, David Taube at (202) 739-9442, or me at (484) 530-1888.






Timothy A. Peterson
Executive Vice President and Chief Financial Officer, Keystone Property Trust
Co-Chair, NAREIT Accounting Committee


cc: Marc Simon, AICPA