E.3 Real Estate Structures

E.3.1 UPREIT Structures

In a typical umbrella partnership real estate investment trust (UPREIT) structure, all of the REIT’s assets (properties) are indirectly owned through operating limited partnerships. The REIT as the sole general partner of the partnership makes all the decisions for the operating partnership. The REIT will also hold units (limited partnership interests) in the operating partnership, and the former real estate owners that contributed the property to the partnership in exchange for their interests will hold the remaining units. The units held by these external investors are usually convertible into REIT shares at the option of the unit holder after a specified period. However, they usually do not give the unit holders voting, kick-out, or participating rights in the operating partnership. A typical UPREIT is structured as follows:

Under ASC 810-10-15-14(b)(1), a limited partnership would be considered a VIE unless a simple majority of the limited partners or lower threshold (including a single limited partner) of limited partners have substantive kick-out rights (including liquidation rights) or participating rights.4 Rights held by the general partner, entities under common control with the general partner, and other parties acting on behalf of the general partner would be excluded from the evaluation of whether limited partners have substantive kick-out rights. See Section 5.3.1.2.3 for a discussion of which parties are considered to be acting on behalf of the general partner.

In a typical UPREIT structure, the operating limited partnership would be considered a VIE because the unit holders do not have substantive kick-out or participating rights. Accordingly, a REIT with a variable interest in the operating partnership would be considered the primary beneficiary of the partnership (and would therefore be required to consolidate the partnership) if it has (1) the power to direct the activities of the operating partnership that most significantly affect the partnership’s economic performance and (2) the obligation to absorb losses of, or the right to receive benefits from, the partnership that could potentially be significant to the partnership.

Because the REIT would typically have the power to direct the activities of the operating partnership, and no one has the ability to remove the REIT as the general partner, if the REIT also has an interest that could potentially be significant (i.e., under the economics criterion), which is typically the case in an UPREIT structure, the REIT would consolidate the operating partnership.

If the operating partnership is considered a VIE, the REIT may have to comply with the presentation requirements and provide the extensive disclosures currently required for any VIE. However, the REIT may be able to apply the disclosure exemption criterion in ASC 810-10-50-5B (which exempts a reporting entity from providing certain of the VIE disclosures) if the REIT's partnership interest is considered a "majority voting interest." See Section 11.2.1.1 for more information. Accordingly, the REIT would be exempt from providing the disclosures in ASC 810-10-50-5A only if the criteria in ASC 810-10-50-5B are met. See Section 11.2 for a discussion of the disclosure requirements.

E.3.2 Land Option Agreements

The homebuilding industry frequently uses land option (or lot option) contracts to procure land for the future construction of homes. In a typical arrangement, a third-party seller owns a parcel of land, which could be finished lots or zoned raw or partially developed land. A homebuilder enters into an agreement with the seller to potentially acquire the land, usually at a fixed price. The seller can be an individual landowner (e.g., a farmer) or an investor group or financial institution acting as a land banker.

To legally separate the land under option from its other assets, the seller forms a land option entity (a potential VIE) and contributes to it the land to be optioned. As consideration for the right to acquire the land, the homebuilder pays to the seller a deposit or provides the seller with an irrevocable letter of credit. The deposit typically varies from 5 percent to 20 percent of the option exercise price of the land under option and is generally nonrefundable. In some circumstances, the homebuilder may make an additional investment in the land by incurring preacquisition costs such as legal costs, roads, or amenities.

The land option agreement allows the homebuilder to purchase all the lots at once or to conduct a “rolling” takedown in which it purchases them according to a predetermined timetable. If, as a result of market factors, the homebuilder decides not to exercise its option, it forfeits its deposit and any preacquisition costs incurred.

The homebuilder’s involvement and economic interest in the potential VIE can vary substantially depending on the arrangement.

E.3.2.1 Determining Whether a Land Option Entity Is a VIE

To be considered a VIE, a land option entity must meet any of the criteria in ASC 810-10-15-14. A land option entity that holds only one parcel of land (and no other assets) is typically a VIE because holders of the equity interests of the land option entity do not have the right to receive expected residual returns as a result of the homebuilder’s holding a fixed-price call option on the sole asset of the entity.

Alternatively, the land option entity may hold multiple parcels of land that could be subject to multiple land option agreements with multiple parties. The homebuilder may have a land option agreement on one or more of the parcels. When determining whether a land option entity that holds multiple parcels of land is a VIE, the homebuilder should consider the following:

How it was financed and whether it has sufficient equity investment at risk (see Section 5.2).
Which party has the power to direct the activities that most significantly affect its economic performance (see Section 5.3.1).
Whether the homebuilder has made a nonrefundable deposit and whether the interest is in specified assets or silos (see Section 4.3.11 and Chapter 6, respectively).

The homebuilder should analyze each consideration as follows:

Sufficiency of equity investment at risk — The homebuilder should consider how the potential VIE was financed (i.e., through equity, nonrecourse debt, debt that is recourse to the land and equity, or a combination of these sources).
Power to direct the activities of the potential VIE that most significantly affect its economic performance — If, as a group, the equity investors lack the power to direct the activities of the land option entity that most significantly affect its economic performance, the land option entity would be deemed a VIE. To perform this analysis, the reporting entity must determine whether the potential VIE’s equity holder (generally the seller) has the power to direct the activities that most significantly affect the land option entity’s economic performance (see Section E.3.2.2).
Obligation to absorb losses or the right to receive returns of the potential VIE — When the land option entity holds many parcels of land, the homebuilder may only have an interest in certain of these parcels (i.e., an interest in specified assets). In accordance with ASC 810-10-25-55, if the homebuilder has an interest in specified assets of the potential VIE and (1) the fair value of the specified assets is more than half the total fair value of the potential VIE’s assets or (2) if the homebuilder has another variable interest in the potential VIE as a whole, the land option is a variable interest in the potential VIE. Otherwise, the homebuilder — through the land option — may have an interest in specified assets. If so, when determining whether the land option entity is a VIE, the homebuilder does not need to analyze the land option entity further unless it holds an interest in a silo.

E.3.2.2 Which Party Should Consolidate a Land Option Entity (or Silo) That Is a VIE

ASC 810-10-25-38A states that a reporting entity has a controlling financial interest in a VIE if it has both (1) the power to direct the activities that most significantly affect the VIE’s economic performance and (2) an obligation to absorb losses or receive benefits of the VIE that could potentially be significant to the VIE. In this assessment, the homebuilder should consider the design and purpose of the VIE as well as the risks the VIE was designed to create and pass along to the variable interest holders (see Section 7.2 for general information about determining which party has power over a VIE). If the homebuilder concludes that its purchase option represents a variable interest, the interest will generally represent a right to receive benefits that could potentially be significant to the VIE; the probability that the homebuilder will receive significant benefits is generally not a consideration in this analysis (see Section 7.3.2).

To determine whether the homebuilder has the power to direct the activities that most significantly affect the economic performance of the VIE, the homebuilder should consider the risks the VIE was designed to create and pass through to the variable interest holders. For a land option entity, such risks may include (1) fluctuation in the value of the underlying land, (2) the homebuilder’s credit, (3) noncompletion of land development activities, (4) failure to obtain zoning and environmental approvals, and (5) operations risk related to any other activities of the land option entity. Once the homebuilder identifies relevant risks, it should evaluate which of the risks are expected to have the most significant impact on the economic performance of the entity.

After the homebuilder has identified the risks that are expected to have the most significant impact on the economic performance of the land option entity, the homebuilder should consider which decisions are the most important regarding the activities that are used to manage those risks. The decisions and related activities that may affect the economic performance of a land option entity are discussed below.

Assumptions about which activities will most significantly affect the economic performance of the VIE may change as the primary-beneficiary determination is continually reassessed. The homebuilder should consider any new assumptions associated with such primary-beneficiary reconsiderations.

The following activities may affect economic performance:

Land development work — The assessment of which party directs the most significant land development activities may include which party sets and approves the budget, makes decisions related to scope and timing for the work to be performed, and absorbs cost overruns. It may also include whether the other parties hold any approval rights that are substantive.
Zoning and environmental responsibilities — The homebuilder should consider which party directs the activities related to obtaining zoning rights and environmental approvals for the land. If the homebuilder assumes the risk of and responsibility for performing these activities, the homebuilder should consider whether it is required to exercise the option or pay any penalties if these activities are not completed.
Debt/financing transactions — The homebuilder should consider what debt-related transactions the VIE can conduct, if any (i.e., pay off existing debt, incur additional unsecured debt, incur additional secured debt for the nonoptioned land in the VIE); whether it expects that any of these transactions will occur; and which party directs these activities.
Acquisition of additional land — The homebuilder should consider whether the VIE’s organizational documents allow it to purchase additional properties, whether the design of the VIE allows it to purchase additional properties, and whether (1) such decisions are fully within the control of the seller or (2) the homebuilder has approval rights over these decisions.
Disposition of remaining land — If additional land is available in the VIE (either when the homebuilder enters into the option contract or subsequently because more land is acquired), the homebuilder should consider whether the land use, development, and ultimate disposition is at the discretion of the seller or whether the homebuilder may influence these decisions.
Other rights under the agreement — The homebuilder may have the ability to defer or cancel scheduled takedowns under the option contract, push back or cancel a development phase, change the deposit or development fee provisions, or exercise other provisions under the existing contract terms. The homebuilder should consider the ability to exercise such rights in the analysis of which party has the power to direct the most significant activities.

Alternatively, the parties under the arrangement could amend the contract terms. The homebuilder should consider whether an amendment of the contract terms represents a reconsideration event (see Chapter 9). In addition, in performing its continual assessment of the primary beneficiary, the homebuilder should determine whether the amendment changes the primary-beneficiary conclusion.
Expiration of the land option — The homebuilder should consider provisions that specify (1) certain activities to occur after a land option expires and (2) which party directs these activities (e.g., development activities).
Other operating activities of the entity — If the entity is using the land for revenue generating activities, the homebuilder may need to consider decisions related to those activities.

Although the primary-beneficiary analysis focuses on a party’s power to direct the activities of the VIE that most significantly affect its economic performance, the homebuilder should carefully consider situations in which it has significant investment and involvement in a land option entity. ASC 810-10 requires the reporting entity to analyze the substance of the overall arrangement as well as exercise additional skepticism when the relative economic interests of the parties to the arrangement are inconsistent with their stated power. In performing the primary-beneficiary analysis, the homebuilder may find it useful to consider the significance of its investment in the VIE (including nonrefundable deposits and any preacquisition costs) relative to the option exercise price of the land under option as well as the nature of the seller (i.e., financial institution, land banker, or individual property owner). The homebuilder should also consider the impact of forward starting rights (see Section 7.2.10.1) in the primary-beneficiary assessment. In addition, when determining whether it is the primary beneficiary, the homebuilder should consider its indirect interests in the VIE held by its related parties.

To identify the primary beneficiary, the homebuilder must determine the ongoing activities of a VIE that are expected to significantly affect its economic performance. Although ASC 810-10-25-38F states that a reporting entity’s involvement in the design of a VIE “may indicate that the reporting entity had the opportunity and the incentive to establish arrangements that result in the reporting entity being the variable interest holder with . . . the power to direct the activities that most significantly impact the economic performance of the VIE,” determining the primary beneficiary solely on the basis of decisions made at the VIE’s inception — as part of the VIE’s design — would not be appropriate when there are ongoing activities that will significantly affect the VIE’s economic performance.

Footnotes

See Sections 5.3.1.2.4, 5.3.1.2.5, and 5.3.1.2.7 for further discussions of how to evaluate substantive kick-out rights, liquidation rights, and participating rights, respectively.

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This publication provides comprehensive guidance; however, it 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.