Do property impairment losses affect developers?

In addition to its property sales and rental income, changes in the value of its properties can also affect a developer’s performance

By Lau Chi Hang

Established developer New World Development Co. Ltd. (0017.HK) is in financial distress, warning at the end of last month it would post a loss of between HK$19 billion ($2.44 billion) and HK$20 billion for its financial year through June. The news caught investors by surprise. Though not particularly hopeful about the company, they were startled by the magnitude of the loss, the highest ever since its listing.

In addition to declining property sales revenue, a major contributor to the loss was a significant downward revision to the value of New World’s properties of between HK$8.5 billion and HK$9.5 billion, according to its assessment of impairments on its portfolio.

Let’s explain the concept of a property’s valuation first. Listed real estate developers usually have two business segments. First, they develop and sell properties. Second, they rent out some of their properties for recurring rental income.

Revaluation impact

Under current accounting rules, companies’ investment properties need to be revalued based on the latest market prices every year. A year-on-year increase in the value of those investment properties adds to a company’s profit, while value depreciation is registered as a loss, which ultimately shows up in the company’s profit and loss statement.

However, there’s a caveat here: the additional profit or loss is simply on the company’s books as long as it continues to hold the properties. The profit or loss is only realized once the properties are actually sold.

That’s why New World Development added in its statement that “The change in the fair value and impairment loss of above assets is non-cash in nature and will not have any impact on the group’s core operating profit or operating cash flow.”

Don’t believe property depreciation has no effect

New World is trying to suggest that the depreciation will only result in non-cash changes and nothing else. But let me assure you that this issue should not be taken lightly despite the developer’s apparent nonchalance.

Recent transactions for comparable properties are often used to determine the value of a developer’s properties, with values regularly updated based on the latest conditions. A depreciation in the valuation of a rental property is often the result of declining rents. In this case, that means New World is estimating it will get less rental income as leases are renewed in the future. You don’t need to be a real estate expert to know that this will affect the company.

And when it comes to the property development segment, declines in the value of developed or to-be-developed land often indicate falling real-estate prices. When home prices suffer, revenue from property sales for companies like New World Development will also surely take a hit, impacting its business.

Moreover, declining valuations mean that developers won’t get paid as much when they sell a depreciating property as they could in the previous year. If New World comes under severe financial stress and needs to sell its property assets to pay down debt, it will have to settle for lower prices due to the overall weak state of the market. That’s not something that can just be shrugged off.

Last but not least, this kind of notification about a major depreciation in property values will lead investors to start discounting a company’s future prospects. Investors will wonder about the source of the problem. Is it a result of operational difficulties or a result of broader market weakness? Many will start selling shares of these developers, putting pressure on their stock.

If you’re still unconvinced about the impact this kind of significant property depreciation is having on the company, let me point out that its shares have fallen by nearly 30% since the earnings warning. I rest my case.

This commentary is the views of the writer and does not necessarily reflect the views of Bamboo Works

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