FEATURE ARTICLE, SEPTEMBER 2004

CHANGES IN THE WIND
New issues affect accounting and financial reporting for real estate private equity funds.
Scott Farb

The current post-Enron, Sarbanes-Oxley environment of over-regulation and constant change presents real estate private equity funds with a whole new array of complexities regarding financial reporting and accounting issues. It is also an environment in which institutional investors and their consultants — lenders — as well as other interested parties are demanding greater transparency as well as standardization in the reporting of their investments and related earnings from real estate private equity funds.

Farb

In spite of the structural changes taking place in the world of financial reporting, a fund can still report audited results in any manner it wishes, utilizing several accounting methods the partners agree to up front. However, in the event that the selected method conforms to Generally Accepted Accounting Principles (GAAP), there are certain key issues and potential pitfalls that will have to be addressed sooner rather than later.

Generally speaking, under GAAP, real estate investment trusts, real estate operating companies and other entities that own real estate assets report using the historical cost method. Investment and pension funds investing in real estate are required to report under fair value. Furthermore, the majority of real estate funds with institutional investors report their audited results utilizing the fair value method of reporting on their underlying investments in accordance with the Investment Companies Audit & Accounting Guide (the Investment Guide), which is the authoritative literature on fair value reporting under GAAP.

If the fund uses the fair value method, there are two key issues to consider when reporting under GAAP:

1. Real estate funds reporting at fair value must have the ability and the procedures in place to internally value their assets with accuracy. If these values are audited, they will need to be verifiable as to the assumptions and methodology used in valuing the funds’ assets. This may require the use of outside appraisers on a periodic basis.

2. There are new financial highlight disclosure rules for real estate funds using fair values under the Investment Guide. Basically, these new rules now require funds to disclose the internal rate of return (IRR) since its inception — a requirement that may sound fairly straightforward, but often isn’t.

Currently, the Investment Guide is unclear in its strict definition of an investment company. As a result, many real estate funds report audited GAAP results utilizing the cost method. However, the ambiguity in these accounting rules, the diversity in practice and a certain fund’s ability to report on the fair value basis in accordance with GAAP could change.

The accounting profession (AICPA) has proposed a complicated and ambiguous statement that supposedly determines whether an entity is an investment company or not, and under what conditions it is able to use fair value reporting. If and when these guidelines become effective, these new rules might very well exclude most real estate private equity funds from defining themselves as investment companies and would therefore preclude them from reporting their investments at fair value.

In other words, many real estate funds currently reporting under fair value may have to switch to the cost method in order for their financial statements to conform to GAAP.

As most of us know, the historical cost method records real estate investments at cost, less than an annual charge for depreciation over the estimated life of the asset. Any fund reporting under the cost method, however, would most likely continue to report to investors the fair value of their investments. This would mean that many other accounting rules are not applicable to fair value reporting, including straight-lining of rents, depreciation and purchase price allocations.

In addition, reporting under the cost method may require funds to apply FIN 46, a new, complex and ambiguous accounting rule that could force real estate funds to consolidate all investments. This rule requires significant judgment in its application and, thus far, does not apply to companies utilizing the Investment Guide for fair value reporting. Stay tuned…

Anyone starting up a fund and attempting to raise institutional capital would be wise to ensure that the following financial issues are addressed and items are in place:

• Documented policies and procedures and internal controls prior to the investors’ due diligence efforts;

• The ability to present verifiable past performance statistics to investors;

• The infrastructure to handle the reporting requirements of the investors; and

• Adequate supporting operations and technology to handle investment accounting and quarterly reporting, tax and regulatory issues, and asset management.

Starting out strong by recognizing the extent and complexities of probable reporting requirements and compliance issues will not only give investors and potential investors requisite peace of mind and confidence in the fund’s financial structure, but will, in all likelihood, allow the fund’s management to avoid costly outside audits and restructuring in the future.

Scott Farb is a principal in charge of the National Real Estate Group at Rothstein, Kass & Co. in Los Angeles.

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