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New Document Real estate’s latest challenge just moved from theory into practice. Second-quarter 10-Qs are being filed with the Securities and Exchange Commission, and already we are beginning to see the dramatic impact that recent years’ major business issues have had on public companies in the real estate sector.

Financial Accounting Standards Board Interpretation No. 46, also known as FIN 46, requires companies to analyze their individual assets and investments and make a determination as to whether or not those assets should be consolidated on the balance sheet. Despite its innocuous moniker, FIN 46 is an incredibly complex rule that is widely perceived to be one of the most far-reaching accounting changes to hit the business sector in the past 30 years.

Of course, FIN 46 was born out of the regulatory response to the likes of Enron (and other non-real estate companies) exploiting the legitimate practice of holding certain assets off balance sheet in “special purpose entities” for accounting purposes. The depth of Enron’s usage of those entities sent shockwaves through the business world, and a regulatory and legislative response ensued. But what was expected to be a crackdown on the kinds of special-purpose entities used by Enron quickly developed into a far broader interpretation that includes almost every real estate entity one can think of.

Last month, we saw the first few examples of publicly traded homebuilders and REITs announcing they were bringing certain assets onto their balance sheets. For the most part, these were land options put on hold or yet-to-be-completed development joint ventures, producing no income or losses whatsoever. Nevertheless, under FIN 46, if company management determines that the company holds a “variable interest” that will result in the company absorbing the venture’s losses or returns, management is required to consolidate the entity on the company’s books.

These public companies were required to move quickly into compliance, since the rule comes into effect for these filers in third-quarter financials. Other filers, including private real estate companies, have a little more breathing room in which to comply but, since the rule isn’t going away, companies should consider pushing forward with a detailed analysis of all their assets to determine if consolidation will be required.

There’s little doubt that FIN 46 will have an impact on virtually every transaction completed, underway or contemplated by a real estate investor or lender, as well as on many users of real estate. (FIN 46 is not specific to the real estate industry; it must be followed by all businesses and industries.)

The fact is that, for many years, real estate has successfully and efficiently operated by financing transactions and developments through a plethora of complex financial and ownership entities such as limited partnerships, development partnerships, joint ventures and UPREITs. It’s also a fact that the nature of the real estate business involves significant risk, especially in the early days of a land play or development. In the homebuilding sector, for example, builders routinely hold a forward pipeline of land or lots for future construction. They may not develop these lots for several years, and it has been a standard practice to hold such assets off balance sheet until the project gets underway. FIN 46 requires builders to determine if those lots should now be consolidated on the balance sheet.

There’s no escaping FIN 46, and companies should be proactive in complying. At the time of this writing, FASB has delayed adoption of FIN 46 for private equity funds, and there may be a modification of the rule coming for these firms. It’s a temporary reprieve that could potentially provide good news for real estate opportunity funds but isn’t likely to extend throughout the industry to help REITs or other public or private companies.

If many companies are forced to bring more assets back onto their books, it may mean that real estate ventures will be much more thinly capitalized in the future. That is likely to create a significant change in the overall economics of the real estate sector as the industry moves forward. It is very possible that there will be much more of an uphill battle for public real estate companies seeking to raise debt and equity. For private companies, debt may also be harder to come by and will almost certainly be more expensive.

The industry has been presented with serious challenges before and yet it has always seemed to emerge fitter, more efficient and stronger. It is positioned to adapt to these new rules and emerge even more vital as a result. As the old saying goes: You ain’t heard nothin’ yet.Dale Anne Reiss is global and Americas director of Real Estate, Hospitality & Construction at Ernst & Young. She is based in New York City.

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