Debt Purchasing and FASB Rule 159

For those businesses who buy debt from lenders, usually to pursue or to assume the income stream for such activities on favourable terms (i.e. $1 for a cost of 50 cents up front), the world may have just become a bit of a brighter place.

The Financial Accounting Standards Board (FASB) along with many other edits and tweaks, have made a change to the debt purchase arena that will result in significant ripple effects across the industry. The change is particularly helpful for those involved in consolidating financing and investment to support the purchase of inventory.

Beginning in 2008 (fiscal year), the accounting standard “FASB 159″ retools how assets specified are to be listed. In short, the change converts the representation to being fair market value versus the old standard of reporting them valued at cost to obtain. For debt purchasers the difference is huge. The value obviously of a debt could be 100 percent or more as an asset than what was paid to obtain the ownership of the debt.

The objective, according to FASB, is to improve financial reporting by providing entities with the opportunity to mitigate volatility in reported earnings caused by measuring related assets and liabilities differently without having to apply complex hedge accounting provisions. The change is expected to expand the use of fair value measurement, which is consistent with the Board’s long-term measurement objectives for accounting for financial instruments.

The 159 change applies to all entities, including not-for-profit organizations. Most of the provisions apply only to entities that elect the fair value option. However, an additional amendment to FASB Statement No. 115, Accounting for Certain Investments in Debt and Equity Securities, also applies to all entities with available-for-sale and trading securities. Some requirements apply differently to entities that do not report net income.

The change allows a portfolio shift to market value rather than operational value. And, of course, when you have a 100 percent more difference between market and cost, your company is easily going to see an increase in business’ equity side of the balance sheet as well (remember, assets = liabilities plus equity on the balance sheet). For presentation the change clearly increases the equity balance under the company’s own, direct management.

From an examination perspective, the change provides a more accurate view of the company’s worth as well. Your balance sheet reflects market value, and provides investors or partners a better gauge of what your business equates to as venture worth supporting.

A third benefit comes of course in seeking additional financing. By having a larger direct control of the equity side of the business, your management can leverage greater credit lines (under normal circumstances of course, and not in the current credit crisis which has nothing to do with your everyday business). Finally, having a fair market value of your debt assets allows an easier calculation of worth when your business gets involved in dispute resolution or if you decide to sell your business.

The 159 change became effective as of the beginning of an entity’s first fiscal year that began after November 15, 2007. Early adoption was permitted as of the beginning of a fiscal year that began on or before November 15, 2007, provided the entity also elected to apply the provisions of FASB Statement No. 157, Fair Value Measurements. No entity is permitted to apply this Statement retrospectively to fiscal years preceding the effective date unless the entity chooses early adoption.

For a number of reasons, aside for objectivity and avoiding conflicts of interest, we strongly advise against trying to make these adjustments yourself for your own business.

Real Estate Investing – Is it a Wise Investment?

I am often asked the question, “Is real estate a wise investment?”

My answer to this question is yes, I believe in investing in real estate (RE) as an asset class for the long term. But no, I am not a fan of investing in individual real estate properties as an investment.

I want to clarify; I am talking about buying real estate as an investment outside of or in addition to your home residence.

I know there are many people who may disagree with the opinions expressed here. Yes, there are exceptions to the general rule and if you know what you are doing, are an expert at speculative RE and fixing up homes and comfortable with the inherent risk of owning property you can be successful at using RE to increase your wealth. But I would say these people and situations are now the exception.

I always find it interesting that you hear so many stories about people that made tons of money in rental real estate, but rarely about the frequent disasters as people don’t talk about those as much. Just like you always hear about the amount of a gambler’s winnings but rarely the full amount of their losses.

One of the most important aspects of owning an individual investment property is understanding the numbers and viewing it as a business. If you are not sure what the Net Operating Income (NOI) is for the property you are considering, you should NOT buy it.

Here are the primary reasons why I do not recommend directly investing in real estate properties:

1) It is one of the few investments that can cost you significant money and time.
Owning property as an investment can include such costs as: interest on the loan, closing costs, cost of finding renters, cost for months without tenants, cost of additional insurance, cost of repairs and upkeep on an investment property and management fees just to name a few. Many people do not consider all the costs of owning a real estate property.

2) It is a leveraged investment which increases the risk.
Most people take out a loan to buy the investment whether it is a house, apartment building, or land. They are leveraging their initial investment and betting that the investment will be worth more. Leverage magnifies both gains and losses. (This is great on the upside, bad on the downside.) If the real estate market has dropped in value, you may not be able to sell the property for what you put in and you still have a cash outflow requirement every month.

3) It is not a diversified investment.
Most real estate is an investment in one property in one specific location. You are generally putting many of your eggs in this one basket which once again increases the risk. (Diversification is one of the most important tenants of investing. At my firm we are fans of low cost mutual funds and ETFs due to the inherent diversification of this type of security.)

4) It is a highly illiquid and non-marketable asset.
Depending on the real estate market it can take a long time to sell a home. Even during good markets, it usually takes more than two months to sell and close on a real estate property. Anyone who has owned a home during a buyer’s market, such as now can tell you their nightmare and frustration of having the house on the market for over a year (or years).

How about vacation homes?
Even with regards to vacation homes, if you want a vacation home to enjoy as your vacation home, do it, if that makes financial sense for you. I view that differently than just buying a second house purely as an investment. The enjoyment and pleasure you get by having a vacation home makes up for the risks and costs of the real estate. The main objective of a vacation home is to be used and enjoyed is different than a property bought primarily as an investment. (Often times it is much cheaper and more convenient to rent a vacation house for several weeks a year than to have the costs of owning a vacation home.)

REITs
If you believe in and want to invest in real estate, I AM a proponent for Real Estate Investment Trusts or REITs. REITs are a security that trades like a stock and invests directly in real estate by owning a portfolio of properties and/or mortgages. REITs allow you to own real estate as an investment in this asset class with the advantages of:
1) Having an expert picking the properties
2) Without the hassle, costs and obligation of maintaining an individual property
3) Not incurring the individual property risk due to lack of diversification (because many properties, mortgages, and/or locations may be owned by the REIT)
4) It being a marketable asset that can be quickly bought or sold through a major exchange.
5) A REIT by itself is a diversified investment

Conclusion
Although I do not recommend buying individual real estate properties as an investment, real estate as an asset class usually improves your portfolio diversification since it has a low correlation to the general market. Therefore, generally I do recommend committing a small portion of your portfolio to this class, not as a market call on this sector (especially now), but based on my belief in its ability to dampen the overall volatility of your portfolio in the long term.

Please note while we are not big fans of REITs right now, especially commercial property REITs, we should be in the future as the economy improves and supply lessens due to lower prices.