Chapter 3 — Real Estate Operations Acquired or to Be Acquired

3.2 Determining Whether Real Estate Is Subject to Rule 3-14

The SEC staff has held that Rule 3-14’s reduced financial statement requirements, which are premised on the continuity and predictability of cash flows ordinarily associated with leasing real property, apply to the acquisition or probable acquisition of real estate operations. Rule 3-14 does not define the term “probable”; however, the concept is consistent with how probability is applied under Rule 3-05. In accordance with paragraph 2905.4 of the FRM, registrants should consider “all available facts and circumstances” in their assessment of probability. The paragraph notes that “consummation of an acquisition is considered probable whenever a registrant’s financial statements alone would not provide investors with adequate financial information with which to make an investment decision.” See Section 2.2 for further discussion.

Rule 3-14(a)(2)(i) states, “The term real estate operation means a business . . . that generates substantially all of its revenues through the leasing of real property.” Real property generally includes offices, apartments, and industrial buildings as well as shopping centers and malls. See paragraph 2905.9 of the FRM.

In a manner consistent with paragraph 2905.9 of the FRM, real estate operations exclude the following:

Businesses that generate revenues from operations other than leasing real property, such as nursing homes, assisted living facilities, hotels, parking garages, motels, golf courses, auto dealerships, and equipment rental operations. Such businesses are more susceptible to variations in costs and revenues over short periods as a result of market and managerial factors.
Businesses that generate revenues from leasing real property and other activities, such as property management or development, when less than substantially all of their revenues are from leasing.

Rule 3-05, rather than Rule 3-14, is applicable in the two circumstances discussed above in which the acquired or to-be-acquired business is not a real estate operation.

In addition, the acquisition of a real estate operation encompasses the acquisition of an interest in such an operation that is accounted for by the registrant under the equity method or the fair value option (see Rule 3-14(a)(2)(ii)).

The ability of a registrant to file only statements of revenues and expenses for acquired or to be acquired real estate operations in accordance with Rule 3-14 is not affected by whether the real estate operation is a business for accounting purposes. For example, an apartment building may not meet the definition of a business under ASC 805 and still be subject to Rule 3-14 if it qualifies as a real estate operation. Paragraph 2910.1 of the FRM states:

The determination of what constitutes a business for reporting purposes (e.g., in the S-X Acquisition Rules and Item 2.01 of Form 8-K) is based upon the definition of a “business” in S-X 11-01(d). The determination of what constitutes a business for accounting purposes is based upon ASC-MG, ASC 805 and IFRS 3. A transaction could constitute an asset acquisition for accounting purposes but constitute a business for reporting purposes, depending upon the specific facts and circumstances.

As indicated in paragraph 2910.2 of the FRM, registrants can identify a business “by evaluating whether there is sufficient continuity of the acquired entity’s operations prior to and after the acquisition so that disclosure of prior financial information is material to an understanding of future operations” (see Section 2.1.1 for additional discussion of the definition of a business). In addition, the note to Section 2910.2 states:

The staff’s analysis of whether an acquisition constitutes the acquisition of a business (rather than assets) for reporting purposes focuses primarily on whether the nature of the revenue producing activity previously associated with the acquired assets will remain generally the same after the acquisition. New carrying values of assets, or changes in financing, management, operating procedures, or other aspects of the business are not unusual following a business acquisition. Such changes typically do not eliminate the relevance of historical financial statements. Registrants that have succeeded to a revenue producing activity by merger or acquisition, with at least one of the other factors listed above remaining with the acquired component after the acquisition, are encouraged to obtain concurrence from the staff in advance of a filing if they intend to omit financial statements related to the assets and activity.

In the context of real estate acquisitions, paragraph 2910.4 of the FRM indicates that if a registrant acquires real property that is not generating leasing revenues at the time of acquisition but has a history of being leased and is intended to be leased again, the registrant should assess whether the absence of current leasing revenue is substantive under Regulation S-X, Rule 11-01(d). If it is not substantive and leasing operations are expected to continue, the acquisition is considered a business that generates substantially all of its revenue from leasing, and Rule 3-14 applies. However, if the property is demolished and replaced with a new rental property, the acquisition is generally not considered a business. This interpretation does not apply to properties that will only be renovated. See Section 3.2.1 for discussion of special circumstances.

Connecting the Dots

As in current industry practice, when a registrant acquires an equity interest in an existing legal entity (e.g., a partnership, limited liability corporation, or corporation) that engages in activities other than leasing (e.g., property management or development), the requirements of Rule 3-05 generally apply if the acquisition is significant. However, when a registrant acquires a significant equity interest in an existing legal entity that only holds real estate under lease and related debt, it should provide financial statements of the underlying property that meets the requirements of Rule 3-14 instead of Rule 3-05 financial statements. A registrant should consider consulting with the CF-OCA in cases in which it believes that Rule 3-14 financial statements are more appropriate than Rule 3-05 financial statements because operations other than leasing real estate are limited.

We understand that for the application of Rule 3-14, the staff views an investment in a newly formed partnership or corporation (either consolidated or accounted for by using the equity method) that will acquire properties under lease simultaneously with or soon after its formation as, in substance, the acquisition of properties by the registrant. In these circumstances, the staff will require Rule 3-14 financial statements of the underlying property being acquired instead of Rule 3-05 financial statements of the newly formed entity. This assumes that the new entity has no other activities besides leasing real property.

Example 3-1

Registrant A owns several apartment buildings for which it also serves as leasing agent and manager. It acquires Apartment Complex X from Company Y, which owns several apartment complexes. Rentals are the principal source of X’s revenue before the acquisition.

Since X qualifies as a real estate operation, A reports the acquisition in accordance with Rule 3-14.

Assume instead that X was held by a limited partnership that had no operations other than holding X and related debt. If A acquired the limited partnership, the same conclusion would apply.

Example 3-2

Registrant G owns and operates several golf courses. It acquires Golf Course Complex R, which consists of a golf course, hotel, and restaurant. In addition to charging greens fees for the use of the course, R obtains revenues from cart rentals, food and beverage sales, golf equipment sales, and hotel rooms.

Although the acquisition involves real estate and rental revenue (i.e., greens fees and cart rental fees), R’s revenues also include food and beverage sales, sales of golf equipment, and hotel room charges, which are highly susceptible to variations attributable to market and managerial factors. Since the acquisition of R does not qualify as an acquisition of a real estate operation, G reports it in accordance with Rule 3-05.

3.2.1 Special Circumstances

3.2.1.1 Rental History That Is Unavailable, Limited, or Unrepresentative

Under Rule 3-14, a real estate operation must generate “substantially all of its revenues through . . . leasing.” There may be circumstances in which the acquisition of real property does not meet the definition of a real estate operation. For example, paragraph 2910.4 of the FRM (discussed above) states that this could be the case if a registrant acquires:

Newly constructed properties, and
Previously owner-occupied and owner-operated properties [for which third-party rental history does not exist]. The registrant is not acquiring the previous owner’s business; rather, the registrant intends to start a different revenue stream from leasing the real estate property to either the previous owner or a new lessee upon acquisition.

In the above scenarios, it is important to understand the distinction between starting new leasing operations and acquiring existing leasing operations.

Connecting the Dots

We understand that an acquired or to be acquired property may sometimes have a limited rental history, or the rental history may be unrepresentative of future operations. In such cases, Rule 3-14 applies regardless of the limited rental history or expected changes in future operations. However, there may be circumstances in which accommodations are available or in which registrants may wish to seek a Rule 3-13 waiver that would permit them to omit the financial statements of an acquiree under Rule 3-14. The following scenarios are based on our interpretation of the accommodations:

Limited rental history — A registrant may acquire a new property whose rental history is not substantive (e.g., less than nine months). In such cases, the registrant may (1) omit an abbreviated income statement if the rental history is very limited (e.g., three months or less) or (2) provide an unaudited abbreviated income statement for situations in which the rental history is limited (e.g., between three and nine months).
Unrepresentative rental history — A registrant may acquire properties on which it intends to demolish the current structure(s) and redevelop the land. In such cases, the registrant may omit the abbreviated income statement because the information is not material given the intended change in operations. However, the registrant should clearly explain why it is not providing the income statement (e.g., it intends to redevelop the property and thus the leasing history is not representative) in the Form 8-K filed upon the close of the transaction.

Note that the above interpretative guidance is based on historical industry practice and, therefore, a registrant should consider consulting with the CF-OCA regarding its specific facts and circumstances.

In addition to the circumstances described above, there may be other instances in which rental history is unavailable, limited, or unrepresentative. In such cases, registrants may wish to seek a Rule 3-13 waiver to omit the financial statements of an acquiree under Rule 3-14 if the information may not be material given the total mix of information available to investors.

If a registrant concludes that the acquisition of a real estate operation is not within the scope of Rule 3-14 (and does not provide the abbreviated financial information required by Rule 3-14), it should consider whether it is subject to the Form 8-K filing requirements for acquisitions of assets. Form 8-K, Item 2.01, requires disclosures for acquisitions of significant assets that differ from the financial statements required by Rule 3-14. In accordance with Instruction 4 of Form 8-K, Item 2.01, an asset acquisition is deemed significant if “the registrant’s and its other subsidiaries’ equity in the net book value of such assets or the amount paid or received for the assets upon such acquisition or disposition exceeded 10 percent of the total assets of the registrant and its consolidated subsidiaries.”

Example 3-3

Company A sells an office building that it used as its corporate headquarters to Registrant B, a real estate investment trust (REIT). Registrant B subdivides the building and will lease it to several tenants.

If B concludes that it does not need to present separate abbreviated income statements for the building under Rule 3-14 because it did not have a prior third-party rental history, it should consider the requirements of Form 8-K, Item 2.01.

3.2.1.2 Properties Subject to Triple Net Leases

A triple net lease requires the lessee to pay costs associated with ownership of the property, such as property taxes and insurance, utilities, and maintenance expenses. Accordingly, such a lease operates as a financing arrangement for the lessee. Rule 3-14 does not differentiate between the acquisition of property subject to a triple net lease and the acquisition of any other property.

Abbreviated income statements of the property subject to a triple net lease must be provided as of the acquisition date if the significance requirements in Rule 3-14 are met. However, a registrant must also assess whether it has to include a tenant’s separate financial statements on an annual basis after the acquisition if the triple net lease represents a “significant asset concentration” (see Section 2340 of the FRM). This would be the case if, for example, a property that is subject to a triple net lease with a single lessee/tenant represents more than 20 percent of a registrant’s assets as of the most recent annual balance sheet date. In such an instance, the registrant must provide audited financial statements of the lessee/tenant for the same periods required for the registrant. A registrant may seek modifications to these requirements through the waiver process.

The requirement to assess the significance of an asset concentration (when a registrant is providing a lessee’s or guarantor’s financial statements) is separate from the requirement to assess significance under Rule 3-14 related to providing financial statements for the property (i.e., historical abbreviated income statements). A registrant must perform both assessments and provide the appropriate financial statements (see Section 3.3.2.1 for further discussion of blind-pool offerings). At the 2020 AICPA & CIMA Conference on Current SEC and PCAOB Developments, the SEC staff clarified that, for acquisitions of real estate operations subject to triple net leases, registrants may no longer provide financial statements of a significant tenant/lessee/guarantor in lieu of Rule 3-14 financial statements of the acquired real estate operation to report the consummation of the acquisition (for Form 8-K reporting purposes). Registrants are encouraged to request preclearance with the CF-OCA if they believe that less detailed financial information is appropriate on the basis of their facts and circumstances in the event that (1) there are modifications to the significance of the asset concentration test or (2) the financial statements of the tenant or lessee are not available.

A registrant also has an ongoing requirement to assess the significance of asset concentrations (as applicable) in the filing of an annual report or registration statement and may also need to provide the financial statements of the lessee/tenant/guarantor (not the abbreviated income statement of the property) even if such tenant financial statements are not required at the consummation of the acquisition (for Form 8-K reporting purposes).

3.2.2 Materiality Under ASC 805 Versus Significance Under Rule 3-14

If a business acquisition does not meet the Rule 3-14 significance thresholds for financial statement presentation, a registrant may still need to provide the financial statement disclosures required by ASC 805 in the period in which the acquisition is consummated. Materiality under ASC 805 is not the same as significance under Rule 3-14. See Section 2.3 for further discussion.

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This SEC Reporting Interpretations manual provides comprehensive guidance; however, the manual does not address all possible fact patterns, and the guidance is subject to change. Consult a Deloitte & Touche LLP professional regarding your specific issues and questions.