Focus on the Investment Conditions: Back to the Future for Real Estate in New Tax and Accounting Rules

Article excerpt

A stream of events over the last 12 months from passage of the Sarbanes-Oxley Act to President Bush's tax cut package to a wave of recently enacted accounting rules has hit the industry and corporate America. So much is new that it will take some time for real estate companies--and companies generally--to sort out all the ramifications for their businesses and the economy. This much is clear: governance, accounting and tax issues are front and center for the foreseeable future, and real estate companies will have to give them close attention, for they could have far-reaching effects on companies' financial statements and operations. In plain terms, the risk management profile for companies in the real estate sector just became much tougher.

Here are some of the changes that are particularly important for the real estate sector.

REITs

Real estate investment trusts may represent only 10 percent of the entire commercial real estate universe but they are a tremendously important and visible minority within the sector. The cumulative effect of Sarbanes Oxley, new tax reforms and various accounting changes, has hit REITs particularly hard. It still remains to be seen exactly how REITs will fare in the capital markets as a result of the removal of the dividend tax on corporate dividends. The dividend tax excludes from the taxable income of individual investors the dividends they receive each year from corporations, but only to the extent that the company pays taxes on this distributed income. This clearly creates an incentive for corporations to raise dividends, a fact that may make REIT dividends less attractive to some investors. REITs would not receive the same benefit because they already make tax-free distributions, and this could cause a possible loss of REIT share values. In fact, REIT prices already have fallen. The good news? Tax-exempt investors like pension funds, IRAs, and 401K investors could see improved yields from REIT investments.

The Sarbanes-Oxley Act required the SEC to issue rules about the disclosure of pro forma financial information in any report filed with the SEC, or in any public disclosures or releases. Regulation G, as it became known when adopted in January 2003, went beyond the requirements of the Act by restricting the presentation of non-GAAP financial information in SEC filings. Funds From Operations or FFO is considered a non-GAAP financial measure and REITs would have to defend its use as a key measurement of company performance.

Reg G requires that when a company presents non GAAP financial measures, a numerical reconciliation of the non GAAP financial measure must be made to the most directly comparable measurement calculated using GAAP (generally either Earnings per share (EPS) or operating cash flow.) If a REIT elects not to present FFO, it would have to use Earnings Per Share as the measuring tool, in which case depreciation would become a key issue for analysts and investors. For FFO calculations, depreciation is an add-back, so investors paid little attention to the useful life of an asset. By contrast, depreciation expense reduces EPS, and the useful lives of assets would be a key focus of investors if the SEC proposal were adopted.

It has been estimated that the overall impact of Sarbanes Oxley and increased corporate governance requirements on REITs could be anywhere from two to five cents per share on an earnings per share basis. There has been an expectation for some time within the industry that there is another major wave of consolidation coming in the REIT sector. Given the new playing field and it's heightened cost of doing business, this wave of mergers and acquisitions may be even closer at hand and there's also the strong possibility that some REITs will abandon the public arena once and for all and return to private status. Some REITs with weak share prices and portfolios of underperforming assets might improve shareholder returns by merging with larger, stronger REITs by converting to private companies or partnerships, or simply by liquidating assets and passing the proceeds along to investors. …