In a previous article, I discussed some recent regulatory changes related to troubled debt restructurings. Continuing on the theme of regulatory changes, I would like to focus on another potential change and how that might impact real estate investors. The Financial Accounting Standards Board has released a new exposure draft on investment property entities, with one goal being to continue to promote transparency.

Periodically, the FASB releases new guidance, and does this through a process where they first release their proposed guidance in the form of an “exposure draft.” After releasing the exposure draft, the board obtains and considers feedback from many firms and then potentially adopt some version of what it originally proposed. In October, the FASB released its expected investment property entity exposure draft. This proposal would change the way many entities that invest in real estate account for their investments, potentially creating additional data gathering efforts and requiring them to implement significant process changes.

Currently, real estate funds that are investment companies account for their investments at fair value, but they do not consolidate the underlying assets and liabilities of controlled entities. REITs, on the other hand, usually carry real estate properties on their books at cost less accumulated depreciation. Both situations mean investors do not always have complete insight into the fair value of the owned or controlled real estate. If there is one thing we have learned from the past few years, it is that fair value of real estate may be far different than what is on the books.

The proposed exposure draft would thus require certain real estate entities to measure their investment properties at fair value. Any changes in fair value of the property going forward would be recognized in net income. The proposed lessor accounting changes that you may have heard of, however, would not apply to these situations as the fair value of in-place leases would be included in the fair value of the investment property rather than as a separate asset or liability.

In addition to presenting the property’s fair value, a company classified as an investment property entity would be required to separately disclose a number of other items including:
•    Rental income;
•    Restrictions on rent;
•    Operating expenses; and
•    Contractual obligations.
As before, any disclosures required under ASC 820 (Fair Value) will still apply.

Who Is Affected?

There are a number of criteria to determine if an entity will be classified as an investment property entity including nature of the business activities, express business purpose, unit ownership, pooling of funds, and reporting entity. Specifically, two major signs that an entity should be classified as an investment property entity include:
1.    Its primary business activities are investing in real estate; and
2.    Its express business purpose is investing in real estate for a return with an exit strategy.
As proposed, this guidance will affect real estate funds but not land developers or homebuilders.

The Implications

An investment property entity would present all investment property assets, related debt and all other assets and liabilities on a gross basis. That is, it would not report investment property net of property debt. Also, because investment property entities would consolidate other controlled investment property entities, the investment property assets and debt of controlled investment property entities would be reflected on a gross basis on the consolidated balance sheet.

In the first year, the investment property is measured at its transaction price, including transaction costs. Thereafter, it will be measured at fair value, with changes in fair value recognized in net income. It is important to note that a real estate fund may be required to separately measure the real estate investment property assets at fair value while other assets and liabilities measured pursuant to other standards such as amortized cost.

As of this writing, the FASB has not yet suggested an effective date, since it’s currently reviewing feedback it has received.

As one can imagine, the proposed level of disclosures will certainly create an increased workload for firms, probably exacerbated in joint venture situations where another entity has control of much of the operating data. Investment property entities will need to gather and analyze operational data and implement valuation procedures. If adopted in its current form, this exposure draft could create significant new work in not only data gathering but fundamental changes in processes. While this exposure draft is just that—a draft—it is certainly a hot topic to watch.

Brett D. Thompson is a principal with Ernst & Young LLP’s Transaction Real Estate practice. He may be reached at [email protected]. The views expressed are those of the author and not necessarily those of Ernst & Young LLP.