Topic No. 6: Staff Observations Regarding Disclosures of Non-Traded Real Estate Investment Trusts

To qualify as a REIT, a corporation or trust must have most of its assets and income tied to real estate investments and must distribute at least 90% of its taxable income to shareholders annually in the form of dividends. REITs typically own and operate income-producing real estate, such as office buildings, shopping malls, apartments, hotels, resorts, self-storage facilities, warehouses or real estate-related assets, such as mortgages or loans.

Many REITs do not have securities listed for trading on a national securities exchange and often are referred to as “non-traded REITs.” In addition to not having a trading market, non-traded REITs and offerings by non-traded REITs typically have the following features:

• at the commencement of its initial public offering, a non-traded REIT does not yet own real estate assets and has not identified any specific assets to acquire with the offering proceeds;
• offerings are targeted toward retail investors with an emphasis on the anticipated income to be distributed as a percentage of the sale price for the REIT’s shares, which we refer to as the distribution yield;
• a non-traded REIT’s operations are managed by an external, third-party manager, which often is an affiliate of the non-traded REIT;
• offerings are conducted on a continuous basis over a period of years at a fixed offering price;
• and a non-traded REIT offers shareholders limited liquidity through a share redemption plan.

The Commission approved Securities Act Industry Guide 5 for publication in 1976 to provide disclosure guidance for preparing registration statements relating to offers and sales of interests in real estate limited partnerships.2 While Guide 5, by its terms, applies only to real estate limited partnerships, in 1991 the Commission stated that “the requirements contained in the Guide should be considered, as appropriate, in the preparation of registration statements for real estate investment trusts and for all other limited partnership offerings.”3 Offerings conducted by non-traded REITs are the most common types of offerings for which Guide 5 can be used. Non-traded REITs share many features common to public real estate limited partnerships at the time Guide 5 was published, including the use of continuous/best-efforts offerings, the lack of share liquidity, the blind-pool nature of the offering and an external management structure.

While this Disclosure Guidance Topic is focused on disclosures by non-traded REITs, it also may be applicable to disclosures in connection with offerings by traded REITs or other registrants that have the features noted above or to which Guide 5 applies. In addition, these observations may not be material to all non-traded REITs, may not encompass an individual registrant’s particular facts and circumstances and may not address all of the material disclosure issues applicable to each registrant’s circumstances. Each registrant should consider its own facts and circumstances when preparing its filings.

Some of our observations in this Disclosure Guidance Topic reflect comments we have issued to non-traded REITs outside the context of Guide 5. Other observations reflect, expand on or modify our policies and practices for non-traded REITS within the context of Guide 5.

In our reviews of non-traded REIT prospectuses and sales materials, we often see disclosure emphasizing the distribution yield on offered shares. We have observed that non-traded REITs often pay distributions in excess of GAAP cash flow from operations and/or earnings, particularly in their first few years of operations. Given this practice we frequently issue comments requesting disclosure that enables investors to evaluate the registrant’s ability to maintain or increase the historical distribution yield. For example, if the prospectus discloses the payment of historical distributions, we have requested supporting disclosure showing the distributions paid, including amounts reinvested through a distribution reinvestment plan, compared to the amount of GAAP cash flows from operations. We commonly ask for this disclosure in tabular form, and we request information for both the most recent full fiscal year and the current year to date.

To the extent the GAAP cash flow from operations in these periods is insufficient to cover the total distributions paid, we have requested disclosure on the source of the cash used to cover the shortfall, such as offering proceeds or debt. We often ask registrants with a shortfall to include risk factor disclosure on the risks of paying distributions in excess of GAAP cash flow from operations. In addition, we have requested disclosure showing the relationship between the amounts of distributions paid, including amounts reinvested through a distribution reinvestment plan, and the amount of earnings. For these purposes we have not objected if non-traded REITs show the relationship between distributions paid and funds from operations, as defined by the National Association of Real Estate Investment Trusts (NAREIT), instead of GAAP net income, assuming compliance with Item 10(e) of Regulation S-K.

Sometimes a newly-formed non-traded REIT that has not yet paid distributions discloses to investors an estimated distribution yield. When a registrant estimates a future distribution or distribution yield in a Securities Act registration statement, we ask the registrant to demonstrate that it has a reasonable basis for the estimate. Prior to the time of the acquisition of operating assets, we typically object to non-traded REITs disclosing an estimated distribution yield because we do not believe there is a reasonable basis for the estimate. We also object when a non-traded REIT discloses an annualized distribution yield based on a single distribution; however, we typically have not objected to disclosure of an annualized yield when the non-traded REIT has paid distributions at the disclosed annual distribution yield for two or more quarters.

Non-traded REIT offerings typically are conducted by broker-dealers on a best-efforts basis over a period of years at a fixed price per share. Since there is no trading market through which the shares are valued, investors must make their own assessment of the relationship between the offering price and the value of the shares. A key part of this analysis is to understand the extent to which the value of the shares has been diluted below the offering price from the time of the inception of the REIT to the time of investment. Dilution may occur as a result of operating losses, a decrease in the value of the REIT’s assets, the sale of equity at below fair value or the payment to shareholders of distributions in excess of earnings.

In our reviews of non-traded REIT prospectuses, we often issue comments regarding dilution disclosure. For example, we remind non-traded REITs conducting continuous offerings to annually update the dilution disclosure in the prospectus as required by Item 506 of Regulation S-K when the non-traded REIT has had losses for the last three fiscal years or for the fiscal years since it commenced operating activities if less than three years. In addition, as noted above, we have observed that non-traded REITs often pay distributions in excess of earnings, particularly in their first few years of operations. To highlight for investors the dilutive impact of the aggregate distributions paid in excess of earnings from company inception to an investor’s time of investment, we have asked non-traded REITs to disclose cumulative earnings since inception and cumulative distributions paid since inception. For these purposes we do not object if the non-traded REIT uses a non-GAAP performance measure that backs out real estate depreciation and amortization instead of using GAAP net income, assuming compliance with Item 10(e) of Regulation S-K.

Non-traded REITs often provide investors limited liquidity through share redemption programs. These redemption programs typically have significant restrictions, such as a cap on the total number of shares that can be redeemed in a year and limits on the amount and source of funds that the registrant is permitted to use for redemptions. In addition, non-traded REITs generally have broad discretion to amend, suspend or terminate their redemption programs.

Because redemption programs may be the only way for shareholders to liquidate their investments, we often ask registrants to summarize in the prospectus their recent redemption program history. We have asked registrants to describe, for both the last full fiscal year and the current year to date, the number of redemption requests received, the number of redemption requests honored, the number of redemption requests deferred or rejected, the source of funds used to honor redemption requests and the average price per share for these redemptions.

In recent years, some non-traded REITs have begun to provide shareholders with a periodic estimate of the value per share based on a valuation of the REIT’s investment portfolio.4 When a non-traded REIT includes an estimate of share value or asset value in a Commission filing, we have asked that the registrant include the following supporting disclosures to facilitate investor understanding of the basis for the estimate:

• the process by which the value estimate was determined, including the role of each of the parties involved in the process, the valuation methods used, any conflicts with third party advisors, and to the extent the final value disclosed was materially different from the value recommended by any third party advisor, an explanation of the difference;
• a breakdown of the value assigned to each major asset type (e.g., properties, securities, cash), the liabilities, and the share number used to calculate the per share amount, along with a comparable breakdown for any prior period value estimate;5
• the key assumptions used in the primary valuation method, including the weighted average for each key assumption broken out by material property type (such as office, industrial, multifamily), cautionary language regarding the sensitivity of assumptions, and a quantitative example of the sensitivity of the estimate to changes in key assumptions;
• the relationship between the aggregate purchase price of the properties (including property capital expenditures) and the value assigned to the properties; and
• a list of any prior period value estimates and the approximate date on which the next value estimate will be provided.

With respect to non-traded REITs that update their estimated value per share for purposes of offerings and redemptions on a quarterly or more frequent basis, we have asked for updated disclosure on a quarterly basis.6

Guide 5 calls for registrants to undertake to provide investors with certain information. For example, Item 8.A directs registrants to include an undertaking to provide, upon request, the most recent Form 10-K for a sponsor’s public prior program and the Table VI acquisition data. Similarly, Item 20 includes undertakings to furnish to limited partners and shareholders annual statements of transactions with and compensation paid to the sponsor, financial statements required by Form 10-K for the first year of operation, and information about probable acquisitions. In lieu of physically providing this information, we do not object if the registrant satisfies its undertakings by making the information available on its publicly-accessible internet web site, provided the prospectus discloses the website address and investors can obtain the information without a subscription fee. Registrants should consider applicable provisions of state law and their organizational documents in determining the appropriate means of delivering information to investors.

Item 4 of Guide 5 calls for disclosure of compensation, fees, profits and other benefits that the sponsor and its affiliates may earn or receive in connection with the offering or operation of the registrant. Paragraph B of Item 4 indicates that registrants should disclose the maximum aggregate dollar amount of front-end fees7 to be paid during the first fiscal year of operations, assuming that the registrant’s maximum leverage is utilized.8 Non-traded REITs typically have a targeted leverage level that is well below the maximum level permitted in their charters.

In our reviews of non-traded REIT registration statements and periodic reports, we have observed that actual leverage amounts employed by non-traded REITs generally remain at or below targeted leverage amounts and do not approach the maximum leverage levels permitted by the charter. Consequently, we do not object if non-traded REITs use targeted leverage amounts instead of maximum leverage amounts in making these fee estimates. In addition, for any fees and other benefits that are based on the amount of securities sold, we ask registrants to assume the sale of the maximum amount of securities covered by the registration statement in estimating the fee amount. We do not object if registrants also disclose fee amounts based on any offering minimum.

In the initial public offering of a non-traded REIT, the registration statement at the time of effectiveness typically includes disclosure of the estimated compensation to be paid to the sponsor, rather than actual compensation paid, because the non-traded REIT will not yet have commenced operating activities. After effectiveness, registrants must consider their duty to update the prospectus disclosure during the continuous offering to include actual compensation paid to the sponsor. Item 4.A of Guide 5 specifies that registrants should provide disclosure in a tabular presentation that covers all compensation, fees, profits and other benefits. We ask registrants to provide this information for both the last full fiscal year and the current year to date. The table should be organized by stage of operation, e.g., organizational, offering, developmental, acquisition, operational or termination and liquidation stage, and fee type as specified in Item 4.A. In addition, we often ask registrants to:

• disclose the amount of any accrued and unpaid compensation;
• break out any compensation, fees, profits and other benefits paid to the sponsor or its affiliates pursuant to the expense reimbursement provisions of the management agreement; and
• specify any amounts reimbursed to the sponsor for salaries or benefits of a named executive officer of the non-traded REIT.

In a typical public offering of securities registered under the Securities Act, a potential investor can evaluate, among other things, the registrant’s financial condition and operating history in making an investment decision. In the case of an initial public offering of shares of a non-traded REIT, the registrant typically does not yet own real estate assets, has no operating history and has not identified any specific assets to acquire with the offering proceeds. Therefore, potential investors in the initial public offering of a non-traded REIT cannot base their investment decision on the registrant’s financial condition or operating history or on an analysis of its stated use of proceeds. This raises the question of how investors can evaluate the sponsor in order to make an informed investment decision.

Since 1976, Guide 5 has acknowledged the importance of information about the sponsor and included detailed disclosure guidance on the performance of prior programs managed by the sponsor. We continue to believe that prior performance disclosure is appropriate in non-traded REIT offerings; however, in the period since Guide 5 was first published, the real estate capital markets have undergone substantial change, including changes in the corporate structure of the issuers, the tax motivations of investors, and the size of offerings.

Our application of the prior performance guidelines to non-traded REITs has evolved in response to these changes. Given concerns about the length and complexity of prior performance disclosures, our comments often are designed to focus the disclosure on information that is most likely to be material to investors. We believe our current views reflect an appropriate balance between the benefits of providing investors useful prior performance disclosure and the risk that voluminous and complex prior performance disclosure may obscure other material information about the registrant.

The following summarizes our current views on certain Guide 5 prior performance disclosure items, specifically as they apply to non-traded REITs.

Definition of “Public Track Record:” Guide 5 provides that sponsors with a “public track record,” as defined in Item 8,9 generally may limit prior performance disclosure to information about public programs. In evaluating how much information the sponsor should disclose to potential investors about its prior performance, we also consider such factors as the amount of proceeds raised and the value of assets acquired by the sponsor’s prior public programs, as well as the reporting history of prior public programs, to determine whether the sponsor may limit prior performance disclosure to public programs. We find it makes the review process more efficient if registrants contact us to discuss their particular facts and circumstances prior to filing the registration statement.

Summary of Acquisitions: Given the acquisition disclosure called for by Item 8.A(1) and the investment data in Table I, we do not object if a registrant omits the summary of acquisitions called for by Item 8.A(4).

Non-traded REITs conducting registered continuous offerings must regularly update their prospectuses to comply with the Securities Act. The undertakings in Item 20 of Guide 5 facilitate this process and non-traded REITs typically include these undertakings in Securities Act registration statements. We do not object if a non-traded REIT omits the Item 20.A undertaking of Guide 5 as the substance of that undertaking is now addressed in Rule 401 of the Securities Act and Item 512(a) of Regulation S-K.

Item 20.D provides the undertakings that non-traded REITs should include in blind pool offerings. These undertakings describe sticker supplements, post-effective amendments, and 8-K filings that the registrant should make to reflect the acquisition of properties with the offering proceeds.

Because we believe the information provided to investors regarding property acquisitions may be limited to significant acquisitions, we do not object if a non-traded REIT slightly modifies13 the first paragraph of the Item 20.D undertaking as follows:14

The second paragraph of the Item 20.D undertaking relates to commitments to purchase properties that are made after the end of the distribution period. Under this paragraph, registrants undertake to file a Form 8-K containing the financial information required by Rule 3-14 of Regulation S-X to reflect each purchase commitment involving the use of 10% or more of net offering proceeds.

The significance standard imposed by Item 20.D for acquisitions in the post-distribution period is different from our interpretation of significance during the distribution period.15 In addition, while Item 20.D directs a registrant to undertake to file a Form 8-K containing the financial information required by Rule 3-14 of Regulation S-X at the time of any significant purchase commitment made during the post-distribution period, during the distribution period a Form 8-K with Rule 3-14 financial information is not required until the time of acquisition.16 Based on our observations of post-distribution period acquisitions by non-traded REITs, we believe the Item 20.D post-distribution period significance measure and Form 8-K filing trigger do not benefit investors and result in unnecessary regulatory complexity. Therefore we do not object if a non-traded REIT modifies the second paragraph of the Item 20.D undertaking as follows:

Under our current interpretation, the three-month period for filing the first 20.D post-effective amendment starts to run from the acquisition closing date of the initial significant property, rather than the date that the first sticker supplement pursuant to Rule 424(c) is filed. Additional post-effective amendments are due every three months after the filing of the preceding post-effective amendment. If no significant properties have been acquired for any three-month period following the filing of a post-effective amendment, we would not expect the registrant to file an Item 20.D post-effective amendment.17 This is true even if a sticker supplement for a probable acquisition was filed during the three-month period. When a registrant has not filed an Item 20.D post-effective amendment for a three-month period, then the next three-month period starts to run from the acquisition closing date of the next significant property.

Registrants may continue offers and sales after filing a 20.D post-effective amendment, as specified in the Note to Item 20.D of Guide 5. In addition, as highlighted in Section 2325.2 of the Division of Corporation Finance´s Financial Reporting Manual, post-effective amendments that consolidate supplements are not considered new filings for purposes of updating the registrant´s financial statements if the duty to file a post-effective amendment is triggered solely by Item 20.D of Guide 5.

When a non-traded REIT accompanies the base prospectus with numerous supplements, investors may be required to refer to multiple documents in order to understand the complete disclosure on a particular topic, such as the current property portfolio, the material risks of the offering or the plan of distribution. We believe this is inconsistent with the principles in Securities Act Rule 421, and we often ask registrants to consolidate their supplements quarterly into one or two supplements to enhance readability of the disclosure. We also frequently request that non-traded REITs update the base prospectus annually to include information from the prospectus supplements.

The disclosure and liability provisions of the Securities Act require registrants in continuous offerings to regularly update the prospectus. The duty to update the prospectus is particularly important for non-traded REITs given the frequent changes to the property portfolio during the term of the offering. We often ask registrants to update the following information in quarterly updates to the prospectus:

• portfolio operating information, including the number of properties, significant tenants, occupancy rates, and lease expirations;
• offering information, including amount of proceeds raised to date, proceeds in good faith expected to be raised in next 12 months, and anticipated offering termination date;
• diversification of the portfolio by geographic region and property type, such as office, apartment, industrial and shopping centers;
• discussion of acquisition activity, including property information, total costs and occupancy;
• summary selected financial information;
• the amount of securities sold to date in connection with the offering, the amount remaining to be offered, whether the registrant has broken escrow and the offering termination date; and
• updated disclosure regarding distributions, redemptions and sponsor compensation.