Alert July 30, 2013

SEC Issues Staff Guidance on Real Estate Acquisitions

Summary

The SEC’s Division of Corporation Finance posted an updated Financial Reporting Manual on the SEC’s website on July 16. The Manual contains a number of substantive updates to the Staff’s guidance on real estate acquisitions, including regarding the application of Rule 3-14 of Regulation S-X.

On July 16, 2013, the staff of the SEC’s Division of Corporation Finance (the “Staff”) posted an updated Financial Reporting Manual on the SEC’s website. The Financial Reporting Manual contains a number of substantive updates to the Staff’s guidance on real estate acquisitions, including updates regarding the application of Rule 3-14 of Regulation S-X (“Rule 3-14”), which will be of interest to REITs that are SEC reporting companies.

Rule 3-14 sets forth the financial statement requirements for the acquisition or probable acquisition of real estate that generates revenues solely through leasing. The financial statement disclosure requirements in connection with a real estate acquisition and the related Staff interpretations can potentially have a significant impact on a REIT’s ability to buy and sell real estate, raise capital at a time of its choosing and generally comply with the SEC’s reporting requirements.

The Staff’s new guidance can be grouped into the following three categories:

  1. guidance that applies to REITs that are not conducting blind pool offerings[1];
  2. guidance that applies to REITs that are conducting blind pool offerings; and
  3. guidance that applies to all REITs, whether they are conducting blind pool offerings or not.

The new guidance for each of these categories is summarized in more detail below.

Non-Blind Pool Guidance

The following table summarizes the new Staff guidance as it applies to REITs that are not conducting blind pool offerings as compared to the Staff’s previous guidance.

New Staff Guidance

Previous Staff Guidance

Using Pro Forma Financial Statements to Measure Significance

  • If a property acquisition is made by a REIT after reporting an individually significant acquisition in an Item 2.01 Form 8-K that included Rule 3-14 financial statements, the REIT may evaluate “significance,” as that term is defined by the Staff in the Financial Reporting Manual, using the REIT’s pro forma financial information included in that Form 8-K for the acquisition rather than the REIT’s historical pre-acquisition financial statements.
  • If a REIT chooses to compute significance for Rule 3-14 purposes using pro forma information, the Staff expects the REIT to consistently apply that methodology for evaluating all subsequent acquisitions for the remainder of the fiscal year.
  • Pro forma financial information could only be used for determining significance in connection with Rule 3-05 and not Rule 3-14.

Observations

  • Allowing REITs to determine the significance of a property acquisition for Rule 3-14 purposes based on pro forma financial information should be especially helpful for newly formed REITs that have recently completed their initial public offerings and are rapidly building their portfolios.  Many of these newly formed REITs can sometimes be at a competitive disadvantage in bidding on properties where a seller is either unable or unwilling to provide the financial information required to produce Rule 3-14 financial statements.
  • This new guidance should reduce the amount of Rule 3-14 financial statements that these REITs are required to produce. 

Measuring Significance for Individually Insignificant Acquisitions

  • To compute significance for individually insignificant property acquisitions, combine:
    • individually insignificant properties acquired subsequent to the end of the most recently completed fiscal year for which the REIT’s financial statements have been filed, and
    • probable acquisitions.
  • Property acquisitions which would not require S-X 3-14 financial statements even if individually significant, such as triple net leased properties where tenant financial statements are provided and newly constructed properties, should be excluded from this calculation.
  • If a REIT is required to provide Rule 3-14 financial statements for individually insignificant properties and it has provided these for properties over 50% of the aggregate purchase price of the insignificant properties, it need not provide additional financial statements, including for properties that were acquired from related parties.
  • To compute significance for individually insignificant property acquisitions, REITs not only had to combine individually insignificant properties acquired subsequent to the end of the most recently completed fiscal year for which the REIT’s financial statements have been filed and probable acquisitions, but REITs also had to combine properties acquired during the most recently completed fiscal year. 
  • Additionally, if a REIT met the over 50% coverage test for insignificant properties, it did not have to provide additional financial statements for the rest of the group of individually insignificant properties except properties that were acquired from related parties.

Observations

  • As a result of the Staff no longer requiring REITs to (i) compute significance for individually insignificant property acquisitions acquired during the most recently completed fiscal year and (ii) provide Rule 3-14 financial statements for insignificant properties acquired from a related party, REITs can avoid the time and expense associated with tracking these insignificant acquisitions and preparing the related financial statements.

 

In addition to the changes to the Staff’s guidance noted in the table above, the Staff’s new guidance memorializes previous internal positions relating to the ability to conduct securities offerings and file post-effective amendments without triggering the Rule 3-14 financial statement requirements.  Specifically, the new guidance confirms that the following filings do not trigger Rule 3-14 financial statement reporting requirements:

  • Registration statements filed under Rule 462(b);
  • Post-effective amendments filed other than to reflect a fundamental change; and
  • The filing of Rule 424 prospectuses, including for “shelf takedowns.”

Blind Pool Offering Guidance

The following table summarizes the new Staff guidance as it applies to REITs that are conducting blind pool offerings subject to Industry Guide 5 as compared to the Staff’s previous guidance.

New Staff Guidance

Previous Staff Guidance

Significance During the Distribution Period[2]

  • The significance test during the Industry Guide 5 distribution period for all property acquisitions, including properties that are triple net leased, 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. The investment includes any debt secured by the property that is assumed by the purchaser.
  • In estimating the offering proceeds, the REIT should consider the pace of fundraising as of the measurement date, the sponsor or dealer-manager’s prior public fundraising experience and offerings by similar companies.
  • There were different significance tests for property acquisitions that were triple net leased and those that were not triple net leased during the Industry Guide 5 distribution period.
  • For property acquisitions that were not triple net leased, significance was computed by comparing a REIT’s investment in the property to the REIT’s total assets as of the date of the acquisition.
  • For property acquisitions that were triple net leased, significance was computed using a denominator equal to the greater of a REIT’s assets as of acquisition date or the amount of proceeds expected to be raised in 12 months.

Observations

  • By increasing the denominator in the significance test during the distribution period to a REIT’s total assets as of the date of the acquisition plus the proceeds expected to be raised in the registered offering over the next 12 months, this guidance should significantly reduce the financial statements required for those REITs that invest in properties that are not subject to triple net leases. However, for REITs that invest in properties that are triple net leased, the new Staff guidance discussed below may offset any reduction in financial statements that need to be provided as a result of the increase in the denominator for the significance test. See “Combined Guidance – Triple Net Leases.” 

Related Party Acquisitions

  • An individual property acquisition will no longer be considered significant solely because it is acquired from a related party.
  • An individual property acquisition was considered significant if it was acquired from a related party.

Observations

  • Because the Staff no longer considers a property significant solely because it is acquired from a related party, during a distribution period REITs can now avoid the unnecessary costs and burden of preparing financial statements for such insignificant related party acquisitions that should not be material to an investor.

 

Combined Guidance

The following table summarizes the new Staff guidance as it applies to all REITs, whether they are conducting blind pool offerings or not, as compared to the Staff’s previous guidance.

New Staff Guidance

Previous Staff Guidance

Acquiring a Pre-Existing Entity

  • When a REIT acquires an equity interest in a pre-existing legal entity that only holds property under lease and related debt, financial statements of the underlying property meeting the requirements of Rule 3-14 should be provided instead of Rule 3-05 of Regulation S-X (“Rule 3-05”) financial statements if the acquisition is significant.
  • Conversely, when a REIT acquires an equity interest in a pre-existing entity that engages in other activities, such as property management or development, financial statements of that entity meeting the requirements of Rule 3-05 rather than Rule 3-14 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 financial statements are required if the acquisition is significant at 10% or more when the underlying property has a rental history.
  • When a REIT acquired an equity interest in a pre-existing entity owning real estate properties, financial statements of that entity meeting the requirements of Rule 3-05 generally would be required and the REIT would not be required to determine whether the entity only held property under lease and related debt.
  • The Staff had also stated that it would not object to presenting Rule 3-14 financial statements of the real estate properties in lieu of Rule 3-05 financial statements where the entities have no operations other than holding real estate and related debt.

Observations

  • Under the Staff’s previous guidance, if a REIT determined that Rule 3-05 applied to an acquisition, no financial statements were provided if the acquisition was significant at 10% but less than 20%.  However, under the Staff’s new guidance, if the acquired entity has operations other than leasing, but is significant at 10% or greater but less than 20%, Rule 3-14 financial statements are required when the underlying property has a rental history.
  • As a result, either Rule 3-14 or Rule 3-05 financial statements will need to be presented when a REIT acquires an entity where the underlying property has a rental history if the acquisition is significant at 10% or more.  Additionally, the Staff removed a REIT’s flexibility to choose to present either Rule 3-14 financial statements of the real estate properties or Rule 3-05 financial statements of the entity where the entities have no operations other than holding real estate and related debt. 

Rental History of Less Than Nine Months

  • If a REIT acquires an operating property with a rental history of more than three months but less than nine months, the financial statements may be presented on an unaudited basis.
  •  If a REIT acquires an operating property with a rental history of less than three months, financial statements of the property are not required.
  • If a REIT acquired an operating 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 in writing.
  • Previously there was no relief provided for operating properties with operations of less than three or nine months.

Observations

  • By the Staff providing clarity on the financial statements required in connection with the acquisition of operating properties with rental histories of less than three or nine months, REITs can now avoid the time and expense of preparing such financial statements and requesting relief from having the financial statements audited from the Division of Corporation Finance’s Office of Chief Accountant.

Triple Net Leases

  • If a REIT acquires a property subject to a triple net lease and the property has a rental history, the REIT should apply Rule 3-14 in situations where there is not a significant asset concentration[3].
  • If a REIT acquired a property subject to a triple net lease and the property has a rental history, the REIT would not apply Rule 3-14 in situations where there was not a significant asset concentration.

Observations

  • This updated guidance could have a significant impact on REITs that invest in properties that are subject to a triple net lease.
  • Historically, when a REIT purchased a property subject to a triple net lease and the asset concentration was less than 20%, Rule 3-14 financial statements would not be applicable even if the acquisition was 10% or more significant.
  • Under the Staff’s updated guidance, 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%, Rule 3-14 financials would need to be provided.

 

Given the substantive nature and extent of the Staff’s new guidance on real estate acquisitions, REITs should begin working with their outside legal counsel and independent accounting firm to assess the potential impact on financial reporting for future acquisitions.



[1] Historically, the Staff has defined “blind pool” offerings as those offerings where approximately 25% or greater of the offering proceeds have not been allocated to an identified use.

[2] The “distribution period” is the period during which the REIT is conducting a continuous registered offering under the Securities Act of 1933, as amended, through a registration statement subject to Industry Guide 5.  The Staff clarified in the Financial Reporting Manual that the distribution period is not limited to an offering on a REIT’s first registration statement and that the distribution period will continue through subsequent offerings.

[3] When a REIT has triple net leased one or more real estate properties to a single lessee/tenant (including in the capacity as co-lessee or guarantor), and such properties represent a “significant” portion of the REIT’s assets, the Staff has determined that an investor may need to consider the lessee’s financial statements or other financial information in order to evaluate the risk to the REIT from this asset concentration. An asset concentration is generally considered “significant” by the Staff if it exceeds 20% of the REIT’s assets as of its most recent balance sheet.