Real Estate Funds Reporting

Investment Company vs Operating Entity

Real estate funds are one of the fastest-growing and most attractive alternative investment vehicles. Although illiquid, real estate is often considered a more stable investment than equity or debt securities, and it has been a popular long-term investment choice.

Successful real estate owners and developers have launched private equity funds to raise capital from investors and use the combined source of capital to make real estate investments.   Advantages to investors who invest in real estate funds include diversification, lower initial investment cost compared to when buying individual properties, and access to a team experienced with managing real estate investments.

Understanding Reporting Requirements Under U.S. GAAP

In today’s regulatory environment, investing in real estate through a fund structure comes with many compliance, reporting, and other responsibilities for the fund manager. Many real estate fund managers who prepare financial statements conforming to U.S. GAAP for funds often face challenges in determining whether to classify their funds as investment companies or operating companies. This determination, which may change over the life of the fund, significantly affects the presentation of the financial statements.

A real estate fund that does not qualify as an investment company would report the real estate (e.g., land, building, improvements) on its balance sheet at depreciated cost, along with receivables and payables from operations. The income statement would reflect the operations of the property, including, but not limited to, rental income, operating expenses, and depreciation expense.

Comparatively, a real estate fund that qualifies as an investment company would report the investment in real estate at fair value on its balance sheet and gains and/or losses, both realized and unrealized, on its income statement. Further, an investment company would be required to disclose financial highlights in its financial statements.

Investment company reporting is a specialized aspect of reporting under U.S. GAAP for which managers are required to evaluate whether the fund meets certain criteria as discussed below.

FASB ASC Topic 946: Investment Companies

FASB Accounting Standards Codification Topic 946 "Financial Services - Investment Companies" (ASC 946) establishes the criteria and general fact patterns that need to be analyzed to determine whether an entity would qualify as an investment company for financial reporting purposes.

When using the term “investment company,” it is important to distinguish between funds that are subject to the obligations and requirements of the Investment Company Act of 1940 (the “Act”) and funds that qualify for exemption from the Act based on how they are structured and how they offer their interests. Funds subject to the Act are automatically considered investment companies for financial reporting purposes under ASC 946.

Funds that operate under an exemption from the Act (that is, the types of private equity real estate funds that this article addresses) must analyze if certain characteristics, as described in the guidance, are present to determine if they should prepare their financial statements using the investment company reporting framework established in ASC 946.

ASC 946 establishes three fundamental characteristics that must be met to qualify as an investment company for financial reporting purposes and lists five additional “typical characteristics,” of which one or more will typically be present in an entity that qualifies as an investment company. The three fundamental characteristics that must be present for an entity to qualify as an investment company are:

• The entity obtains funds from investors and provides them with investment management services; funds can be obtained from one or more investors.
• Its business purpose and only substantive activities are investing funds solely for returns from capital appreciation, investment income, or both. Generally, an entity that invests for capital appreciation should have an exit strategy for how they expect to realize that appreciation.
• The entity or its affiliates do not obtain or have the objective of obtaining returns or benefits from an investee or its affiliates that are not normally attributable to ownership interests or that are other than capital appreciation or investment income. Some relationships and activities inconsistent with the characteristics of an investment company include arrangements to jointly produce, market, or provide products or services and transactions that are on terms unavailable to outsiders or not conducted at arm’s length or represent a substantive portion of business activities.

The five characteristics that an investment company would generally have include:

• The entity has more than one investment.
• The entity has more than one investor.
• The entity has investors that are not related parties of the parent or investment manager.
• The entity has ownership interests in the form of equity or partnership interests.
• The entity manages substantially all its investments on a fair value basis.

The absence of one or more of these typical characteristics does not generally preclude an entity from being an investment company. Each entity should apply judgment and consider all facts and circumstances to determine whether its activities are consistent with those of an investment company.

Although ASC 946 does not apply real estate investment trusts (REITs), there is nuance to the evaluation and of whether a REIT can be an investment company and this should be discussed with accounting advisors.

Determining Reporting Status: Operating Entity vs. Investment Company

There are several fact patterns or strategies that could determine if an entity qualifies to report as an investment company. Entities should utilize their investment strategy as described in their governing documents, to assist with the evaluation. Generally, an investment company whose business purpose includes realizing capital appreciation should have an exit strategy for how it plans to realize such capital appreciation. Also, real estate owners who manage the day-to-day operations of their properties and intend to generate a substantial portion of their revenues from property management fees may not meet the requirements to report as an investment company.

Another important factor to evaluate is if any entities related to the investment vehicle are receiving fees related to the investment. This can include development, asset management, acquisition or disposition fees. As an example, opportunistic funds that expend cash for development activities and utilize an affiliate as the developer may need to analyze the materiality of the development fees received to ensure they still meet the third fundamental characteristic. Even after evaluating all these factors, determination of the reporting basis may not be clear, and consultation with accountants may be necessary.

Conclusion

It is advisable that real estate professionals who are planning to establish a real estate fund consult with experienced accountants during the preliminary and initial planning stages to ensure that their governing documents are consistent with their strategy and investors’ expectations.