REIT Considerations for Strategic Acquisitions

Real Estate Investment Trusts (“REITs”) are generally either entities that own and operate real estate assets (Equity REITs) or provide financing of real estate related assets which are owned by others (Mortgage-REITs). REITs can be advantageous as they can typically avoid paying corporate income taxes, while offering entities the ability to diversify their portfolio of real estate investments.

REIT qualification requirements of ownership, asset, and income tests must be followed to take advantage of this beneficial tax treatment, or penalties may arise in the form of an excise tax or at worst, loss of REIT status.

As REITs look to grow their operations, one common form of expanding their investment mix is through the acquisition of real estate related assets. However, due to strict requirements to  maintain REIT status, it is critical for REIT operators to perform proper due diligence prior to closing of an acquisition to ensure that no compliance issues will arise.

Property Due Diligence for REITs

One of the first items to be understood is what type of income will be generated from the acquired assets as well as the impact of the asset acquisition on the overall REIT tests for the portfolio. The most common ways to investigate this is through the use of a property due diligence questionnaire to review of the prospective property’s leases, contracts, financial statements, as well as perform inquiries with the seller.

The questionnaire includes detailed questions regarding operations at the potential property so the REIT can understand the rental structure at the prospective property (customary services or good income) as well as list out types of services provided at the property that are not considered customary and would then generally be classified as an impermissible tenant service income (bad income). Examples of these items could be in addition to rental income generated at the property, the property owner may offer dry cleaning services or even weekly happy hours or an annual holiday party which would be considered impermissible tenant services.

Based on the procedures listed above, management should ensure they fully understand the income generated at the property to uncover if there are any potential REIT income or asset tests issues. For a mortgage-REIT acquiring a loan, the REIT should make sure they fully understand the terms of the loan and whether the loan is secured by real property. When acquiring MBS securities, a mortgage-REIT needs to ensure they read the Offering Circular/PPM to understand the tax ramifications of the prospective tranche.

Understanding Business Combinations vs. Asset Acquisitions

Once due diligence is completed and the REIT decides to move forward with the purchase of the property, the REIT must then determine whether, for accounting purposes, it is a business combination or an asset acquisition in accordance with Accounting Standard Codification “ASC” 805. 

As a rule of thumb, if substantially all the fair value of the gross assets acquired is concentrated in a single identifiable asset or a group of similar identifiable assets, the acquisition is not a business combination and would be accounted for as an asset acquisition. It is important for the REIT to evaluate all facts and circumstances as part of the purchase and sale agreement in order to appropriately account for the acquisition in accordance with ASC 805.

Differences between an asset acquisition and a business combination include:

Initial Measurement and Allocation

• Asset acquisitions - acquirer measures the assets acquired based on their cost, which is generally allocated to the assets on a relative fair value basis in which no goodwill is recorded
• Business combinations - the acquirer compares the consideration with the fair value of the identifiable assets, liabilities, and any non-controlling interests with the difference recorded as goodwill

Direct Acquisition-Related Costs

• Asset acquisitions - acquirer includes all direct-acquisition related costs in the cost of the acquired assets
• Business combinations - the acquirer expenses acquisition-related costs as incurred

Considerations for Public Company REITs

When a public REIT acquires real estate, the transaction may trigger financial requirements under SEC Rule 3-14 of Regulation S-X or Rule 3-05 of Regulation S-X. The acquiring REIT would need to perform required significance tests to determine the need for audited year-end and unaudited interim historical financial statements of the acquired properties or assets. The significance tests vary depending on whether the acquisition is defined as a real estate operation under Rule 3-14. Real estate operations, as defined under Rule 3-14, are businesses that generate substantially all their revenue through leasing of real property.

It is important to note that generally properties that generate revenues from operations other than leasing, such as hotels, nursing homes, or golf courses are not real estate operations for these purposes and as such if the Public REIT were to acquire this type of property, the financial statement requirements would be in accordance with Rule 3-05.  

There is no bright line test to make the determination of whether a property is a real estate operation or not and as such, judgement is required.

Significance Tests

The significance tests are complex and full of exceptions and rules relating to the timing of acquisitions. Due to the complexity of the significance tests, it is highly recommended that the entity consults with both its SEC counsel and auditors to ensure that compliance will be maintained.

The significance of an acquisition is generally measured under three separate tests – investment test, asset test, and income test. All three tests are required under Rule 3-05, while under Rule 3-14 only the investment test would apply.

Investment Test

An investment test is generally based on the registrants’ investments into the acquired business or real estate operations as compared to either:

• The aggregate worldwide market value of the registrants voting and non-voting common equity or for non-traded REITs, or
• The value of the consolidated total assets as of the end of the most recently completed fiscal year for pre-IPOs.

Asset Test

Comparison of the entity’s share of the assets of the acquired business to the consolidated total assets of the entity.

Income test

There are two different calculations that both must exceed the applicable threshold:

1. The absolute value of the entity’s equity in the pre-tax income or loss from continuing operations of the acquired business as compared to the absolute value of the pre-tax income or loss of the entities.
2. The entity’s proportionate share of revenue from continuing operations of the acquired business as compared to the entity’s total revenue.

It is important for the Public REIT as part of the due diligence process to discuss its need for financial statements of the acquiree with the seller to ensure that the required financial statements can be provided in a timely basis.