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 the same as that under Rule 3-05. 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.
Conversely, Rule 3-05 applies to operations that are susceptible to variations in
costs and revenues over shorter periods as a result of market and managerial
factors. Such operations include golf courses, hotels, parking garages, nursing
homes, assisted living facilities, automobile dealerships, and equipment rental
operations.
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.
If 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. A registrant should consult with the
CF-OCA if it believes that because operations other than leasing real estate are
limited, Rule 3-14 financial statements are more appropriate than Rule 3-05
financial statements. If the entity has no operations other than holding real estate
and related debt, and the significance of the acquisition is greater than 20
percent, Rule 3-14 applies.
We understand that a registrant is considered to have acquired properties if it has
invested in a newly formed partnership or corporation (either consolidated or
accounted for by using the equity method) that will acquire leased properties upon
its formation or soon afterwards. If leasing real property is the new entity’s only
activity, the registrant must provide Rule 3-14 financial statements of the
underlying property being acquired instead of Rule 3-05 financial statements of the
newly formed entity.
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, this could be the case if a registrant acquires:
- Newly constructed property with no previous leasing history.
- Owner-occupied property for which a rental history does not exist.
If a registrant concludes that the acquisition of property
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 rental history, it should consider the
requirements of Form 8-K, Item 2.01.
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, including the following, in which accommodations
are available or in which registrants may wish to seek a Rule 3-13 waiver,
which would permit them to omit the financial statements of an acquiree
under Rule 3-14:
- Limited rental history — A registrant may acquire a new property whose lease history is less than nine months. On the basis of SEC staff guidance, the registrant may (1) omit an abbreviated income statement if the rental history is three months or less or (2) provide an unaudited abbreviated income statement for a period of 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.
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.
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. For Rule 3-14 purposes,
the acquisition of property subject to a triple net lease is treated in the
same manner as the acquisition of other property. Abbreviated income
statements of the property subject to a triple net lease must be provided 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 20 percent or more
of a registrant’s total assets as of the most recent 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. A registrant must perform both assessments and provide the
appropriate financial statements. Rule 3-14 does not differentiate between
the acquisition of property subject to a triple net lease and the
acquisition of any other real estate operation. 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 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). Therefore, for the acquisition, the financial
statements provided in accordance with Rule 3-14 are the historical
abbreviated income statements for the property acquired (not the
lessee/tenant/guarantor financial statements). However, given its ongoing
requirement to assess the significance of asset concentrations (as
applicable) in the filing of an annual report or registration statement, the
registrant may also need to provide the financial statements of the
lessee/tenant (not the abbreviated income statement of the property) even if
such lessee/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.