The SEC's Division of Corporation Finance (the "Division") recently published amendments to its Financial Reporting Manual to clarify and/or modify certain requirements related to the filing of financial statements by real estate investment trusts ("REITs") with respect to acquired real estate.
The Division amended the Financial Reporting Manual to, among other things: (1) lessen the burden on REITs to provide financial statements with respect to acquired real estate that is individually insignificant to the REIT, (2) permit REITs to compute the significance of real estate acquisitions on a pro forma basis, taking into account recent acquisitions for which financial statements have been provided, (3) relieve REITs of the obligation to provide audited financial statements for acquired properties that have less than nine months of rental history, and (4) clarify how REITs satisfy the tenant audit requirement with respect to tenant concentrations at triple net leased properties.
These revisions to the Financial Reporting Manual simplify and make more "investor friendly" the financial reporting of real property acquisitions by REITs and reflect a thoughtful balancing by the Division Staff of investors' interests and the significant cost and time required to produce financial statements that were not overly important to investors. The revisions also acknowledge the need to adjust on a continual basis the threshold for determining acquisitions significance of a rapidly growing REIT. Finally, the revisions clarify previously confusing guidance on reporting acquisitions of triple net lease properties.
New Regulation S-X Accounting Guidance
As noted above, the Division's latest update to its Financial Reporting Manual provides helpful guidance under Rule 3-14 of Regulation S-X by amending sections in the Financial Reporting Manual related to financial statements for properties acquired by REITs. Discussed below are some of the key revisions.
- "Significant in the Aggregate" Acquisitions: Prior to the amendment, in connection with registration statements and proxy statements, guidance in the Financial Reporting Manual required REITs to evaluate individually insignificant acquisitions (defined as those acquisitions with a purchase price of less than 10% of total assets per the audited balance sheet for the REIT's last completed fiscal year) by dividing them into two buckets: one consisting of individually insignificant acquisitions consummated during the last completed fiscal year and one consisting of individually insignificant consummated acquisitions and probable acquisitions during the current fiscal year. If a bucket of individually insignificant acquisitions was, in the aggregate, significant, a REIT was required to include in the registration statement or proxy statement audited Rule 3-14 financial statements for the last completed fiscal year for all property acquisitions in that bucket that exceeded 5% of the measurement threshold, and the REIT was required to provide audited statements for at least 50% (determined by aggregate purchase price) of the properties in each significant bucket. The new guidance eliminates the requirement that audited financial statements under Rule 3-14 be provided for insignificant acquisitions in prior years. Moreover, under the new guidance if a REIT is required to file Rule 3-14 financial statements for individually insignificant properties and has provided these financials for properties accounting for more than 50% of the aggregate purchase price, the new guidance removes the requirement to continue providing Rule 3-14 financials for properties that were acquired from related parties.
Takeaway: These changes will save REITs the time and expense associated with tracking insignificant acquisitions in the prior fiscal year and preparing the related financial statements.
- Triple Net Lease Properties: The Staff revised guidance related to triple net lease tenants to provide:
- if a REIT acquires a triple net lease property resulting in a "significant asset concentration" (i.e., the purchase price of the property exceeds 20% of the REIT's total assets as of its most recent balance sheet), the REIT generally should provide full audited financial statements of the lessee or guarantor. If the lessee is a public company, the REIT has the option to include a statement in its filings referring investors to the lessee's financial information on a publicly-available website, such as the SEC's website. On the other hand, if a REIT invests in a triple net lease property that is 10% or more significant, has a rental history and the asset concentration is less than 20%, the revised guidance states that Rule 3-14 financial statements should be provided.
- with respect to the "significant in the aggregate" calculation under Rule 3-14, acquired properties without a rental history or that result in a significant asset concentration may be excluded from such calculation. However, a triple net lease property that has a rental history and does not trigger a significant asset concentration is subject to the Rule 3-14, and thus, if insignificant, would have to be included in the "significant in the aggregate" calculation under Rule 3-14.
Takeaway: Keeping triple net lease properties out of the "significant in the aggregate" calculation under Rule 3-14 (in the event that such properties do not have a rental history or they resulted in a significant asset concentration) should make it easier for REITs to meet the 50% threshold when reporting those property acquisitions that are significant in the aggregate up to the 50% threshold.
- Shelf Takedowns: The Staff confirmed that Rule 3-14 financial statements are not triggered at the time of a shelf takedown. While securities attorneys had generally assumed this was the case, this clarification will eliminate lawyer hand-wringing over this issue.
- Equity Investments: The Staff updated guidance with respect to significant equity investments in a pre-existing legal entity to clarify that Rule 3-14 financial statements should be provided, instead of Rule 3-05 financial statements, if (i) the REIT acquires an equity interest in a pre-existing legal entity that only holds real estate under lease and related debt and (ii) the acquisition is significant. Conversely, if the REIT acquires a significant equity interest in a pre-existing legal entity that engages in other activities, such as property management or development, financial statements of that entity meeting the requirements of Rule 3-05 generally are required if the acquisition is significant. However, if the acquired entity has operations other than leasing, but is significant at less than 20%, Rule 3-14 financials are required if the acquisition is significant at 10% or more when the underlying property has a rental history.
- Real Estate Operations": The Staff further clarified that "real estate operations" for purposes of Rule 3-14 refers to properties that generate revenues solely through leasing (e.g., office, apartment and industrial buildings, shopping centers and malls) and excludes properties that generate revenues from operations other than leasing real property (e.g., nursing homes, hotels, motels, golf courses, auto dealerships and equipment rental operations), which are more susceptible to variations in costs and revenues over shorter periods due to market and managerial factors.
- Pro Forma Financials: The new guidance expands the circumstances under which measurement of significance of an acquisition for purposes of Rule 3-14 may be based on pro forma total assets of the REIT. Specifically, if a property acquisition is made or becomes probable after the REIT has included Rule 3-14 financial statements for an individually significant acquisition in a Form 8-K, the REIT may evaluate significance using the pro forma financial information included in that Form 8-K for the acquisition rather than historical pre-acquisition financial statements. The Staff noted that, if the REIT chooses to compute significance using pro forma information, the REIT should consistently apply that methodology for evaluating all subsequent acquisitions for the remainder of the fiscal year.
Takeaway: Allowing REITs to measure significance against the pro forma financial information in a Form 8-K will raise the amount that is used as the denominator in the significance test under Rule 3-14, and thereby likely reduce the number of acquisitions that are considered significant.
- Rental History Less Than Nine Months: The Division confirmed that Rule 3-14 financial statements are not required if an acquired property has no or nominal leasing history (i.e., less than three months). The interpretive guidance also advises REITs that Rule 3-14 financial statements may be unaudited if rental history of the acquired property is more than three months but less than nine months. Previously, if a REIT acquired a property with a rental history of less than one year, it could request relief from having the financial statements audited from the Division of Corporation Finance's Office of Chief Accountant, and the granting of relief rested entirely within the discretion of the Chief Accountant's office.
- "Blind Pool" Offerings: The Staff provided additional guidance related to the application of the financial statement requirements under Rule 3-14 to "blind pool" offerings by real estate companies subject to Industry Guide 5. For example, the new guidance notes that post-effective amendments that consolidate sticker supplements are not considered new filings for purposes of updating the REIT's financial statements if the duty to file a post-effective amendment is triggered solely by the Item 20.D undertakings of Industry Guide 5. Additionally, the Staff revised its guidance related to determining significance for purposes of Industry Guide 5, and now provides that significance during the distribution period is computed by comparing the REIT's investment in the property to the REIT's total assets as of the date of the acquisition plus the proceeds (net of commissions) in good faith expected to be raised in the registered offering over the next 12 months.
Takeaway: By adding the proceeds (net of commissions) expected to be raised in the offering over the next 12 months, the new guidance for blind pool offerings will increase the denominator used in the significance test during the distribution period, which should, in turn, reduce the number of financial statements required.
If you have any questions regarding the issues addressed in this Corporate and Securities Law Alert, please contact the author.