Real Estate Investment Vehicles: Operating Entities or Investment Companies?

Real estate funds are one of the fastest growing and most attractive alternative investment vehicles. Although illiquid, real estate is often thought of as 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 includes diversification, lower initial investment cost compared to when buying individual properties, and access to a team experienced with managing real estate investments.

In today’s regulatory environment, investing in real estate through a fund structure does come with many compliance, reporting and other responsibilities for the fund manager. For funds that prepare financial statements in conformity with U.S. GAAP, many real estate fund managers struggle with the distinction of whether to report as an investment company or an operating company. 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, and 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 to be able to apply investment company reporting.

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 pursuant to an exemption from the Act (that is, the types of private equity real estate fund 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 judgement and consider all facts and circumstances on whether its activities are consistent with those of an investment company.

There are several fact patterns or strategies that could determine the distinction of whether an entity qualifies to report as an investment company. Entities need to follow the investment strategy as described in their governing documents which, for investment companies, generally include exit plans. Also, real estate owners that 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. Further, 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, the determination of reporting basis may not be clear, and consultation with accountants may be necessary.

ASC 946 does not apply to real estate investment trusts (“REIT”). Although an investment company cannot consolidate a subsidiary if it is not an investment company, if a REIT is in the fund structure it could potentially be consolidated with the fund.

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