WASHINGTON, DC—REITs are heading into 2016 a little more uncertain than usual about what shape their industry will take for the year. On one hand, Congress has limited the situations in which companies can spin off their real estate into REITs with the passage of the budget bill. 

On the other, in that same measure it loosened FIRPTA's restrictions, giving foreign investors more incentive to invest in REITs. Or take them private.

On one hand, interest rates are rising and REITs tend not to perform in such an environment because financing is more expensive and investors have a wider array of options competition from which to choose. On the other hand, in August of 2016 REITs are expected to receive huge boost from real estate's new classification as a standalone sector within the Global Industry Classification Standard universe. 

So let's call it a wash, shall we? REITs, despite the changes and challenges, will remain a key investment vehicle for both institutional and retail investors next year and beyond.

Now I am going to let you in on a little secret about not just REITs but all public companies. You can glean a lot about their financials from the comments the Securities and Exchange Commission makes on their financial reports.

To be clear, this is not my secret, but rather it is the findings of a new research study released by three finance and accounting professors from the University of Denver. Roughly restated, they have found that the more questions the SEC had about a company's financial reporting methodology and the quality of reporting, the more it correlated with financial distress.

What is a Comment Letter?

First some background. Many people, when they think of comment letters in the context of the SEC, think about the comments the SEC seeks from the public on a particular issue such as a new regulation or accounting standard. But the SEC also makes comments on companies' financial reports, usually asking for further clarification about a statement. Sometimes, as we will see, the SEC will "remind" the company in its comment letter to do something that it neglected to include -- like when an executive forgets to attests that the financial information provided in the report is correct.

The comments, in many cases, are benign and indeed one gets the sense that the accountants at the SEC would have made excellent copy editors in another life as there is a healthy number of directions from the agency to change such-and-such word or reminders to include a forgotten clause. In the above example, the REIT had repeated a paragraph instead of including the necessary clause -- specifically Item 601(b)(31) of Regulation S-K. In other circles such a mistake is called a typo.

In other instances, though, the SEC is harder on the recipient. It will never say it thinks the financial reporting is suspect, or perhaps sloppy (a lot of the comments question the internal controls under which the financial report was produced) but it makes no bones about demanding more information.

It is these comments that the report authors, Accounting Prof. Hugh Grove and Finance Profs. Tommi Johnsen and Pei Lung, studied. The report came to a few conclusions.

• The SEC knows its stuff. "Although the letters themselves do not evaluate the merits or investment potential associated with any reported transaction, they do reflect significant industry, accounting and disclosure expertise," the report said.

• The comments reveal "salient information about a firm's financial condition, valuation, and future performance".

• Not many investors use these comment letters as a data source.

Quality Reports Are a Telling Metric

The quality of the financial reports, it needs to be said here, is what the report authors are targeting -- as well as the SEC for that matter.

Basically, the SEC and related authorities, such as the PCAOB and the standard setters such as FASB and the IASB, have one fundamental mission, which is to make sure that companies' financial reports give investors the information they need about the company and its financial health. Companies are not to withhold bad news by disguising it as something else in a financial report. More recently, the regulators have been focusing on the data dump companies tend to do, which has the effect of hiding bad news within multiple pages of useless jargon.

It is still a work in progress, though, to say nothing of plenty of disagreement among the parties about what is best for the investor.

So consider the above explanation shorthand for what the report authors and others mean when they talk about the quality of the financial reports. Is said report helping or attempting to hoodwink the investor?

Some recent examples culled (by GlobeSt.com, not the report authors) from SEC comment letters to REITs.

Exhibit A

The SEC tells a REIT that it was not clear in its disclosure regarding the relationship between rents on leases that expired in the current reporting period and rents on executed renewals.

Exhibit B

This comment letter was addressed to a company spinning off real estate into a REIT. The company said it had negotiated the rents with the parent company on an arm's length basis. The SEC wants the company to either substantiate that or remove the reference.

Exhibits C through E

The SEC was not done with this company. In other comments it noted that:

• The company cited historical pro forma net income and pro forma AFFO as evidence for the cash it expects to be made available for distribution for the 12-month period following the spin off. More precise information would be necessary.

• The company said it would disclose available credit in its facility and the amount it planned to borrow. The SEC wanted more specifics, such as maturities and interest rates, and it wanted any debt that has not been finalized included as well.

• The company cited a debt discount it secured with its new debt. The SEC wanted more details, namely the terms of the debt.