Chapter 3 — Real Estate Operations Acquired or to Be Acquired

3.3 Measuring the Significance of Real Estate Operations

The requirements of Rule 3-14 and Rule 3-05 differ with respect to significance tests as well as the form and content of the financial statements presented. In terms of significance tests, for example, Rule 3-14 requires only one of the significance tests described in Rule 1-02(w) (i.e., the investment test) and does not have a tiered threshold for disclosure requirements (i.e., a single 20 percent threshold results in one year of audited statements). See Section 3.6 for key differences between Rule 3-05 and Rule 3-14.

With respect to blind-pool offerings, paragraph 2920.1 of the FRM specifies:

The income test does not apply if the registrant, including a REIT, is conducting a continuous offering over an extended period of time and applies the Item 20.D. Undertakings of Industry Guide 5 [S-X 11-01(b)(4)]. See Section 2920.26 for required adjustments to the denominators of the asset and investment tests.

See Section 3.3.2.1 for further information on blind-pool offerings.

3.3.1 Modified Investment Test

To determine the significance of real estate operations, a registrant only needs to perform the investment test described in Rule 1-02(w)(1)(a) as modified by Rule 3-14(b)(2)(ii). The asset and income tests are not applicable. The investment test is modified as follows to reflect the complexities in the determination of the calculation:

Determination of denominator for the investment test — Under the investment test in Rule 1-02(w)(1)(i), a registrant determines the significance of real estate operations by comparing the investment in such operations (see below) with the AWMV of the registrant’s voting and nonvoting common equity. A registrant that has no AWMV (e.g., when common equity is not publicly traded, including during an IPO) should determine significance by comparing the investment in real estate operations with the registrant’s total assets. See Section 2.3.2.2 for further details on the denominator.
Determination of numerator for the investment test — A registrant determines its investment in a real estate operation on the basis of the “consideration transferred,” which is measured in accordance with the applicable accounting standards (see Section 2.3.2.1 for further details). Rule 1-02(w)(1)(i)(A)(1) indicates that the investment in the acquiree represents the “consideration transferred,” adjusted to exclude the carrying value of assets transferred to the acquiree that will remain with the combined entity after the acquisition. Such consideration transferred is consistent with the total U.S. GAAP purchase price of the acquiree, as specified in ASC 805.

Contingent consideration should be included on the basis of either (1) fair value (if the applicable accounting standards require contingent consideration to be recognized at fair value) or (2) the maximum amount (unless the likelihood of payment is remote) if recognition at fair value is not required under the applicable accounting standards.

Below are two scenarios illustrating the determination of the numerator in the modified investment test. The calculation of the numerator is based on the GAAP purchase price, as discussed above, and may be adjusted for debt, as shown below. Accordingly, the numerator is affected by the applicability of the scenarios.

Connecting the Dots

For the scenarios discussed below, it is important for the registrant to identify the nature of the debt — that is, to distinguish between the assumption of existing debt (such as mortgage debt) and the incurrence of new debt that is obtained on or around the acquisition date. While the treatment of new debt issued on or around the acquisition date is the same in both scenarios (i.e., included in the numerator of the investment test if it is determined to be part of the consideration transferred under U.S. GAAP), the treatment of assumed debt is different in each scenario.

The registrant applies the modified investment test as follows on the basis of whether it has an AWMV and the debt is new or existing:

Scenario 1: Registrant has AWMV — The registrant’s investment in the real estate operation is compared with the registrant’s AWMV, as follows:
- New debt — The numerator of the investment test should include any new debt that is incurred to acquire the real estate operations if the proceeds from such debt are determined to be part of the consideration transferred under U.S. GAAP.
- Assumption of existing debt — The numerator of the investment test should not be adjusted for any assumed debt (i.e., existing debt of the acquiree that was assumed by the registrant) that is secured by the real properties (such as mortgage debt).
The amount of AWMV is determined on the basis of the average of the last five trading days of the registrant’s most recently completed month-end before the earlier of the date on which the registrant (1) announced the acquisition or (2) agreed to it.
Scenario 2: Registrant does not have AWMV — This scenario may occur if a registrant is undertaking its IPO, or its shares are not traded. When performing the investment test, the registrant compares the “consideration transferred” with the registrant’s consolidated total assets as of the end of the most recently completed fiscal year before the acquisition. The treatment of debt in the numerator depends on the nature of the debt, as follows:
- New debt — The numerator of the investment test should include any new debt that is incurred to acquire the real estate operations if the proceeds from such debt are determined to be part of the consideration transferred under U.S. GAAP.
- Assumption of existing debt — Paragraph 2920.5 of the FRM states:
  - Investment Test — Numerator — Real Estate Operations — When this test is based on the total assets of the registrant (because the registrant does not have an aggregate worldwide market value), include any assumed debt secured by the real properties [such as mortgage debt] in the “investments in” determination for the tested real estate operation. For example, if the registrant paid $100 million in cash and assumed $40 million of debt secured by the acquired properties, the “investments in” the acquired real estate operation for the numerator would be $140 million. [emphasis added]

A real estate operation is significant when the investment is greater than 20 percent of the registrant’s AWMV or total assets, as discussed above. When acquired or to be acquired real estate operations are related to one another (see Section 3.3.3), a registrant must use the aggregate investment in these operations when performing the significance test. The registrant should also be aware of the considerations related to aggregating the significance of acquired or to be acquired real estate operations (see Section 3.4.2.3).

Example 3-4

Scenario 1 — Registrant Has AWMV

Registrant A’s fiscal year-end is December 31. It announced the acquisition of Real Estate Operation E on November 5, 20X8, and completed the acquisition on November 15, 20X8. On the basis of the average of the last five trading days of October 20X8, A’s AWMV is $70 million.

On December 31, 20X7, A had total consolidated assets of $100 million. Its total investment in E included (1) a payment of $25 million in cash and (2) the assumption of $5 million in mortgage debt. The investment test calculation is performed as follows:

Scenario 2 — Registrant Does Not Have AWMV

Assume the same facts as in Scenario 1, except that Registrant A does not have an AWMV (i.e., its shares are not traded). The investment test calculation is performed as follows:

3.3.2 Special Circumstances

The sections below discuss additional considerations that may apply in certain circumstances.

3.3.2.1 Continuous Offering Over an Extended Period of Time, Including Industry Guide 5 and “Blind-Pool” Offerings

Certain registrants that conduct continuous offerings over an extended period do not initially own any real estate assets, and the specific intended use of the proceeds raised from investors is not initially identified because such registrants have not yet selected any assets for their portfolios. Such “blind-pool” offerings are subject to the guidance on undertakings in Item 20.D of Industry Guide 5 and therefore have specific reporting and significance measurement requirements. Registrants must calculate significance by using the amounts detailed in Rule 11-01(b)(4) and paragraph 2920.26 of the FRM (discussed below). The distribution period (also discussed below) is the period during which the registrant is conducting a continuous Securities Act registered offering through a registration statement to which Industry Guide 5 applies. See note to paragraph 2920.26 of the FRM.

As indicated in paragraph 1220.11 of the FRM, “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 Undertaking 20.D. of Industry Guide 5.”

Registrants conducting a continuous offering over an extended period who also apply Item 20.D of Industry Guide 5 might acquire (1) real estate operations within the scope of Rule 3-14, (2) businesses within the scope of Rule 3-05, or (3) both. Therefore, the guidance in Rule 11-01(b)(4) on such offerings applies to acquisitions within the scope of Rule 3-05 or Rule 3-14, as follows:

For acquisitions within the scope of Rule 3-05 (i.e., acquisitions of a business), only the investment test (modified for blind-pool offerings) and the asset test apply.
For acquisitions within the scope of Rule 3-14, only the investment test (modified for blind-pool offerings) applies — not the income test or the asset test.

In accordance with paragraph 2920.26 of the FRM (as well as Rule 11-01(b)(4)), the denominator of the investment test is determined as follows when it is based on total assets of the registrant (i.e., when the registrant does not have an AWMV):

During the distribution period, total assets as of the acquisition date plus the proceeds (net of commissions) in good faith expected to be raised in the registered offering over the next 12 months, except that total assets must exclude the acquired business; and
After the distribution period ends and until the next Form 10-K is filed, total assets as of the date of acquisition, except that total assets must exclude the acquired business.

The above modification also applies to the denominator of the asset test, if applicable. After the next Form 10-K is filed, the requirements in Rule 11-01(b)(4) will no longer apply to these registrants’ acquisitions, and significance must be determined as otherwise applicable under Rule 3-05 or Rule 3-14.

3.3.2.2 Real Estate Operations Acquired Shortly After the Registrant’s Most Recently Completed Fiscal Year

A registrant may acquire a real estate operation shortly after its year-end but before filing its Form 10-K for that year. If the registrant does not have an AWMV, the investment test for such an acquisition will be based on the consolidated total assets of the registrant included in its prior-year Form 10-K to assess significance when determining its initial Form 8-K filing requirements. In certain situations, the registrant may reevaluate significance by using its total assets for the most recent fiscal year reported in the Form 10-K filed after the initial Form 8-K filing but before the due date of the amended Form 8-K. See Section 2.3.1.1 and paragraph 2915.3 of the FRM for further discussion and examples.

3.3.2.3 Real Estate Operations Acquired Before Completion of the Registrant’s First Fiscal Year

If a registrant other than a newly formed REIT (e.g., a master limited partnership) has not completed its first fiscal year, the total assets in the most recent audited balance sheet filed with the SEC will be used in the significance test. Typically, this will be the audited balance sheet included in the registrant’s initial registration statement. See paragraph 2920.22 of the FRM for similar discussion.

A registrant that is a newly formed REIT with no significant operations may calculate significance by using a denominator that includes acquired and to be acquired properties. In such situations, registrants should consider consultation with their auditors and SEC legal counsel. See Section 3.3.4.

3.3.2.4 Use of Pro Forma Financial Information in the Significance Test

A registrant may acquire (or it may be probable that it will acquire) a real estate operation after a previously reported individually significant acquisition or disposal of real estate operations for which the registrant had provided historical financial statements for the periods required by Rules 3-05 and 3-14 and pro forma financial information in a Form 8-K or registration statement. In this situation, Rule 3-14 permits the registrant to perform the significance test by using the pro forma financial information that was included in a previous Form 8-K or registration statement reporting the acquisition or disposition of significant real estate operations rather than historical preacquisition financial statements. The pro forma effects of any other transaction should be excluded. A registrant that elects to use pro forma financial information to evaluate significance should apply this approach consistently for all subsequent acquisitions and dispositions until it files its next annual report on Form 10-K. For further discussion, see paragraph 2915.7 of the FRM as well as Section 2.3.1.2, which includes an example.

3.3.2.5 Real Estate Operations Acquired or to Be Acquired by the Registrant’s Subsidiary

If the subsidiary is not itself a registrant, significance should be measured by comparing the investment in the acquiree with the registrant’s preacquisition consolidated total assets or AWMV (if available). However, if the subsidiary is also a registrant, the parent and the subsidiary must each measure whether the acquiree is significant. See Section 2.3.1.3 for further discussion and an example.

3.3.2.6 Plans to Dispose of Certain Acquired or to Be Acquired Assets

If a registrant acquires a group of properties and plans to dispose of certain of them, the assets to be disposed of should not be excluded from the significance calculation. That is, the amount of the investment must include all acquired real estate operations even if the registrant plans to dispose of one or more of them. See Section 2.3.1.4 for further discussion.

3.3.2.7 Previously Issued Financial Statements That Are Retrospectively Adjusted

In certain circumstances, a registrant may be required to file updated financial statements that reflect the retrospective adjustments for periods before adoption of the change. In some cases, such changes may affect the significance calculations. See Section 2.3.1.5 for further discussion and an example.

3.3.3 Measuring the Significance of Related Acquired or to Be Acquired Real Estate Operations

Rule 3-14(a)(3) states that acquired or to be acquired real estate operations are related to one another if they “are under common control or management,” the “acquisition of one real estate operation is conditional on the acquisition of each other real estate operation,” or “[e]ach acquisition is conditional on a single common event.”

When a registrant performs the significance test upon its acquisition or probable acquisition of real estate operations that are related to one another, it must treat the group of related real estate operations as a single operation. Therefore, the registrant must compare its aggregate investment in the related real estate operations with either its AWMV or its total assets. The related real estate operations are significant when the aggregate investment exceeds 20 percent of the registrant’s AWMV or its preacquisition assets.

If the significance of the group of related real estate operations exceeds 20 percent, the registrant must present statements of revenues and expenses for all the related real estate operations, even if a related real estate operation is individually insignificant (i.e., its significance is less than or equal to 20 percent on an individual basis). In addition, a registrant may present combined abbreviated income statements if the real estate operations are under common control or management and they meet the criteria in ASC 810-10-55-1B for presentation on a combined basis. However, the SEC staff may require the combined financial statements of acquired related real estate operations to be presented separately from the combined financial statements of related real estate operations that are to be acquired.

Example 3-5

Registrant A consummated the acquisitions of Real Estate Operations B and C on July 31, 20X9. The acquisitions were announced on July 5, 20X9, and A, B, and C have a December 31 year-end.

Real Estate Operations B and C are related because they were under common control since January 1, 20X2. The table below summarizes A’s investments in B and C as well as the calculation of the combined significance of B and C.

The acquisitions of B and C should be treated as a single acquisition since B and C are related to one another. Therefore, to perform the significance test, A must aggregate its investments in B and C. On the basis of the significance test results, B and C are 30 percent significant in the aggregate. Registrant A must present the abbreviated income statements of both B and C even though C would not have been significant by itself. Because B and C have been under common control and the criteria in ASC 810-10-55-1B for presentation on a combined basis were met, A may present separate or combined abbreviated income statements for B and C.

If a registrant acquires a group of individually insignificant related real estate operations, it should apply the guidance discussed above before applying the guidance on the aggregate significance of real estate operations (see paragraph 2945.1 of the FRM and Section 2.9).

3.3.4 Performing the Significance Test and Determining the Financial Statements Required Upon and After a REIT’s IPO

To determine the financial statements required upon its IPO, a newly formed REIT with no significant operations (referred to herein as a “newly formed REIT”) performs the significance test on its acquired or to be acquired real estate operations. To do so, it uses the total cost of the following as the denominator:

Properties acquired immediately before an initial registration statement is filed.
Properties to be acquired upon closing the IPO.
Properties identified as probable future acquisitions.

That is, a newly formed REIT compares (1) its investment in the acquired or to be acquired properties with (2) the denominator.

In the initial registration statement, the newly formed REIT must include abbreviated income statements for acquired or to be acquired properties whose significance is individually greater than 20 percent along with pro forma financial information.

Further, if there are acquired or to be acquired properties whose significance individually is less than or equal to 20 percent but in the aggregate exceeds 50 percent, the newly formed REIT must provide pro forma financial information depicting the aggregate effects of all such individually insignificant real estate operations. However, the newly formed REIT is not required to provide separate financial statements for any individually insignificant real estate acquiree.

Example 3-6

Registrant A, a newly formed REIT, is planning to file a registration statement for its IPO. Immediately after its formation, A acquired Real Estate Operations B, C, D, and E. In addition, it is probable that A will acquire Real Estate Operations F, G, and H immediately after the IPO.

The table below lists the cost and significance of each of the real estate operations acquired or to be acquired (assuming all such acquisitions occur within the same year).

Registrant A is permitted to compute the significance of the real estate operations by using a denominator equal to the cost of all acquired and to be acquired real estate operations ($14,500). Because C and G are individually more than 20 percent significant, A will present their audited abbreviated income statements in the registration statement along with pro forma financial information. Real Estate Operations B, D, E, F, and H are individually insignificant. However, in the aggregate, their significance is 52 percent (3% + 12% + 7% + 16% + 14%). Therefore, A must provide pro forma financial information depicting the aggregate effects of B, D, E, F, and H.

For acquisitions or probable acquisitions after the IPO but before the initial Form 10-K is filed, the newly formed REIT can use the same denominator discussed above to calculate significance. However, the denominator should not include properties whose acquisition was probable at the time of the IPO but that were not ultimately acquired, unless audited financial statements of the property were included in the initial registration statement and the acquisition remains probable. Thus, the denominator should be reduced for any property not acquired or whose acquisition is no longer probable. The purpose of this restriction is to prevent registrants from using a denominator for significance that is artificially large because of probable acquisitions that will not ultimately occur.

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