Real Estate Investment Vehicles: Operating Entities or Investment Companies?
Over the last several years, real estate funds have been some of the fastest growing 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 in order to raise capital from investors and, therefore, obtain access to a dedicated pool of capital to fund new real estate investment opportunities, eliminating the need to raise capital on a deal-by-deal basis.
Investing in real estate through a fund structure does come with many compliance, reporting and other responsibilities. In complying with the reporting requirements, many real estate funds struggle with the distinction of whether to report as an investment company or an operating company. Investors usually require that the funds in which they invest provide annual audited financial statements. Accounting Standards Codification Topic 946 discusses the criteria and general fact patterns that need to be analyzed in order to determine whether an entity would qualify as an investment company. Generally, if the entity does not qualify to report as an investment company, it would report as an operating entity. If the entity qualifies to report as an investment company, the financial statements would include the real estate investments at fair value, and the results of the entity’s operations would include the changes in value of the real estate investments instead of the operating results of those investments. The following are required fundamental characteristics in order for an entity to qualify to report as an investment company (all characteristics must be present):
- The entity obtains funds from investors and provides them with investment management services.
- Its business purpose and only substantive activities are investing solely for returns from capital appreciation, investment income or both.
- It 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.
In addition to the fundamental characteristics stated above, in order for a real estate fund to qualify as an investment company, it should typically have the following characteristics:
- More than one investment, and more than one investor.
- Investors that are not related parties of the parent or investment manager.
- Ownership interests in the form of equity or partnership interests.
- Manages substantially all of its investments on a fair value basis.
The absence of one or more of the 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 rental income or property management fees, as opposed to capital appreciation, may not meet the requirements to report as an investment company. Further, opportunistic funds that expend cash for development activities may also be considered real estate developers as opposed to investment funds. Even after evaluating all of these factors, the determination of reporting basis may not be clear, and consultation with accountants and attorneys may be necessary.
This determination, which may change over the life of the company, drastically affects the presentation of a company’s financial statements. A real estate entity that does not qualify as an investment company would likely report the real estate (land and building) 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. Comparatively, a real estate entity 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 their income statement. Further, an investment company would disclose financial highlights in the financial statements.
For real estate professionals who are planning to establish a real estate fund, it is crucial that they consult with their accountants and attorneys during the preliminary and initial planning stages to ensure that their governing documents are consistent with their strategy and their investors’ expectations.