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Flashcards in Chapter 4 Deck (27):
1

Differences Between Real Estate Investments and Other Investments

Fixed Location - real estate is immovable and fixed in location

Value Dependent on location - The value of one property depends upon how adjacent and nearby properties are used. It is very sensitive to inflation and fluctuating monetary policies.

Managerial Skills Required - Ownership of real estate requires a variety of management skills, either directly or through some type of property management arrangement.

2

Legal Limitations

• No more than 10 percent of the legal reserves of a company may be invested in real property.

• The company is limited to the lesser of 10 percent of admitted assets, or the excess of capital and surplus over the minimum requirements of a new stock or mutual company to transact the kind of business that the company is authorized to write.

* • Most jurisdiction laws include a limit for investment in a single parcel of property. The Investments of Insurers Model Act (Defined Limits Version) proposes a limit of 1 percent for any one parcel.

• In some cases, the state insurance department may grant the company permission to invest in an amount in excess of the specified limit, if the department finds such a percentage of the company’s admitted assets to be sufficient “to provide convenient accommodation for the company’s business.”

* • Real estate investments in foreign countries may also be limited to a percentage of legal reserves (typically 10 percent).

* • Usually, there is no quantitative limit on property that is obtained by foreclosure, but, in many cases, the excess over specific state limitations must be disposed of over a certain period (such as 3 years). However, extensions of time for this limitation usually can be secured from an insurance department.

3

RE Valuation

* an investment in real estate may not be valued at an amount greater than its cost, plus capitalized permanent improvements, less accumulated depreciation and impairments

Investment in RE =
cost
+ capitalized permanent improvements
- accumulated depreciation and impairments.

* Cost of the property should be depreciated over the property’s estimated useful life, not to exceed 50 years.

Properties that are intended to be sold should be classified as held for sale and carried at the lower of depreciated cost or fair value less estimated selling costs.

Impairment: If the fair value is less than the carrying value the asset is written down to fair value, establishing a new cost basis. The adjustment is recognized as a realized loss.

Land is never depreciated.

4

RE Valuation

Methods of depreciation for RE.

• Straight-line:It allocates the cost of an asset over its life in equal amounts.

• * Sum-of-the-years digits method: allocates larger amounts to expense in the early years of life and lesser amounts in later years

• * Declining-balance method:is similar to the sum-of-the-years’-digits method in allocating larger amounts of depreciation to the early years of an asset’s life. In this method, a constant percentage rate is applied to the declining asset balance, and the rate will typically be 200 percent or 150 percent times the straight-line rate.

The use of the sinking fund or constant yield methods of depreciation does not constitute acceptable statutory accounting practice.

5

Accounting for Real Estate

Real estate owned generally falls into three Statutory Statement classifications:

1. properties occupied by the company;
2. properties held for the production of income;
3. and properties held for sale.

If the real estate owned is subject to a mortgage, the mortgage is called an encumbrance and is offset against the asset.

Schedule A - RE owned directly
Schedule BA (Under Other Invested Assets) - RE owned indirectly (joint ventures, partnerships, and LLCs)

6

Acquisition Accounting - methods of acquiring RE ownership

Cash Purchases

Cost of RE acquired by purchase
The net cash price paid plus any cost incurred to place the real estate in usable condition.

7

Acquisition Accounting - methods of acquiring RE ownership

Financed Purchases

Recorded at the fair market value of such property or at the fair market value of the asset given up, whichever is more readily determinable.

Cost should include retainage, which is a normal outstanding payable resulting from new construction. Retainage is reported as an encumbrance.

8

Acquisition Accounting - methods of acquiring RE ownership

Group Purchases

If more than one parcel of property is acquired at a group price or if the cost includes both land and buildings, the price paid is allocated among the various assets purchased.

This normally is done on the basis of relative values, which may be determined by
•appraisals made for insurance purposes,
•by assessed valuations made for tax purposes, or
•by independent professional appraisals.

For larger purchases, cost should be determined by the last method.

9

Acquisition Accounting - methods of acquiring RE ownership

Property Acquired in Satisfaction of Debt

Will include the outstanding principal balance of the mortgage loan at the date of foreclosure, foreclosure costs, real estate taxes, insurance premiums, and all other costs necessary to obtain clear title and to place the property in good repair.

10

Acquisition Accounting - methods of acquiring RE ownership

Capital Improvements

two forms:

1. Additions: The entire cost of the addition adds to the cost of the property.

2. Replacement: Replacement accounting includes adding the cost of the replacement to and removal of the cost of the item replaced from the asset account.

Capital improvements should be capitalized and depreciated over the extended useful life of the asset.

Nonoperating: Internal preacquisition costs shall be capitalized if the property is classified as nonoperating at the date of acquisition.

Operating: If the property is classified as operating at acquisition, internal preacquisition costs are expensed.

11

Acquisition Accounting - methods of acquiring RE ownership

Sale/Leaseback Arrangements

A leaseback transaction normally involves the simultaneous purchase of a property from a business and the leasing back of the property to the vendor.

Leaseback arrangements can involve buildings yet to be constructed. The leaseback generally involves a long -term initial lease of 20 years or more and may include renewal options. Rental payments are set to repay the lessor his purchase price plus interest. At the termination of the lease, the lessee may be entitled to ownership rights for a nominal lump sum payment or may continue to occupy the premises for a minimum rental.

* The deposit method is used in a sale/leaseback transaction that involves a sale of nonadmitted assets to a related party

12

Acquisition Accounting

Sale Accounting

The company can sell any RE that it owns as a
1. cash sale or
2. as a sale that includes a mortgage or
3. * an installment sale contract.

1. In a cash sale, title transfers to the buyer when the sale is consummated, and any profit or loss on the sale is realized in the year of the sale.

2. In a sale that includes a mortgage, title transfers immediately to the buyer, but in the event of default on the mortgage, the mortgagee can take possession of the property through court action.

3. * Installment:The IRS defines an installment sale as one in which at least one payment is received in a tax year other than the year of sale, and in that case, profit is recognized in proportion to the payments received each year. * Title is transferred to the buyer only when he has paid the entire sale price, or a contractually
agreed portion of it. a default on the contract can result in the loss of any prior payments made.

Capital gains and losses from sales of real estate are required to be recorded in the real estate and other invested assets subcomponent of the asset valuation reserve (AVR), for life and accident and health companies.

13

Accounting for Real Estate

Income and Expense Accounting

Rental income is reported as investment income as it becomes receivable. If rentals vary from a straight-line basis (for example free or stepped rents), income may be recognized before due.

If unpaid rent is deemed uncollectible, the amount is written off against income during that period.

* If collection is probable and the amounts are over 90 days past due, the amount is classified as a nonadmitted asset.

Real estate investment expenses are recorded on an incurred basis and can be generally classified as depreciation, ordinary repairs and maintenance and other operating expenses, real estate taxes, and interest expense on encumbrances.

14

Accounting for Real Estate

Fair Value, Carrying Value, and Statement Value

• Fair Value: is the price that property would bring in a competitive open market under all conditions requisite to a fair sale.
> Properties held for the production of income: appraisal that is no more than 5 years old as of the reporting date.
> Held for sale: appraisal required when classified as held for sale and appraisal shall be maintained that is no more than 5 years old.

• Carrying Value: value assigned to an asset or liability on the internal records of the company.

*• Statement value or admitted value:
> properties occupied by the company and properties held for the production of income: is depreciated cost less encumbrances
* > Properties held for sale: is the lower of depreciated cost or fair value less encumbrances and estimated selling costs.

15

Accounting for Real Estate

NAIC Risk-Based Capital. Risk factors?

company-occupied real estate and investment real estate: 10% factor

Foreclosed: 15% factor

16

Home Office Real Estate

* Is any real estate property that is owned and >50%occupied by the reporting entity or its affiliates. Occupancy percentage is based on rentable square footage of the property.

The basis for reporting home office property in the Statutory Statement is depreciated cost.

Statutory accounting assumes the company is both landlord and tenant and is required to include in both its income and its expenses an amount for rent relating to the occupancy of its own buildings.

* Leasehold improvements: are considered to be nonadmitted assets and charged against surplus. These nonadmitted assets are amortized against net income over the shorter of the estimated useful life or the remaining life of the original lease.
excluding renewal or option periods.

17

Real Estate Joint Ventures

*Corporate Joint Venture

• corporation owned and operated by a small group of venturers.
• limited liability

18

Real Estate Joint Ventures

*Limited Liability Company

is a hybrid that allows the owners of the LLC the liability protection of a corporation and the tax treatment and management flexibility of common partnerships.

19

Real Estate Joint Ventures

*Limited Partnership

one or more general partners have unlimited liability, and one or more partners have limited liability.

20

Real Estate Joint Ventures

*General Partnership

• Each partner has unlimited liability
• Each is personally liable for the debts of the partnership, each has authority to bind the partnership, and each has equal rights as to the management of the business.

21

Real Estate Joint Ventures

Individual Interest

an ownership arrangement in which the two (or more) parties jointly own property, and title is held individually to the extent of each party’s interest. The life insurance company owns an individual interest in each asset and is proportionately liable for its share of each liability.

22

Real Estate Joint Ventures

Accounting Issues

A life insurance company usually records its investment in and income from a joint venture by using the equity method of accounting.

Joint ventures, partnerships and limited liability companies may use an equity method based upon the underlying audited GAAP equity of the investee if the entity has a minor ownership interest (i.e., less than 10%).

If using the equity method, the reporting entity’s share of undistributed earnings and losses of the investee are included in unrealized gains and losses. The reporting entity’s share of other changes in investee surplus is recorded as a component of unrealized capital gains and losses on investments. Distributions received are recorded as investment income when declared.

a life insurance company has a direct interest in a joint venture, that is, not through a subsidiary, the interest in the joint venture is reported in the Other Invested Assets section of the financial statements and further broken down in Schedule BA.

23

Tax Considerations

Real estate joint ventures are, in most cases, considered partnerships for federal income tax purposes, even though, as a legal entity, they may not be considered partnerships.

A partnership is not subject to tax; However, each of the partners is taxable on its distributive share of the income of the partnership.

24

Reasons for Real Estate Investments

*The motivation for real estate investments has generally been the expectation of a long-term higher return than that available from fixed income investments. Common

Long Term Profit -the expectation of a long-term higher return than that available from fixed income investments.

Social purposes - have been willing to take reduced yields in the interest of being good corporate citizens. The use of certain types of debt investments has resulted in a greater social impact (e.g., mortgage loans).

Home office and branch office facilities - represent a significant portion of the real estate portfolios of life insurance companies.

25

Types of Real Estate Investments

* Life insurance companies have tended to concentrate their investments in office buildings, industrial buildings, and shopping centers. They have shied away from apartments and other residential buildings because of regulatory controls and higher business risks, and they have tended to focus on larger properties, leaving smaller properties to individuals and smaller investors.

26

Real Estate Joint Ventures

Funding the Joint Venture

The commitment made by the life insurance company is usually for a long term mortgage loan, but it might also include a land loan to acquire the real estate and an interim construction loan.

27

Real Estate Joint Ventures

Accounting Issues

* A life insurance company usually records its investment in and income from a joint venture by using the equity method of accounting as set forth in SSAP No. 46. If using the equity method, the reporting entity’s share of undistributed earnings and losses of the investee are included in unrealized gains and losses. The reporting entity’s share of other changes in investee surplus is recorded as a component of unrealized capital gains and losses on investments. Distributions received are recorded as investment income when declared.