Tag: REIT

More on the SEC and Funds’ REIT Subsidiaries

reit stock certificate

I discovered some additional information about the SEC’s position on the application of the Custody Rule to the REIT subsidiaries of private real estate funds. A few months ago, a real estate fund was undergoing an SEC exam and the examiners focused on custody. The examiners used the June 2014 Guidance on SPVs to take the position that the fund must issue audited financial statements to the accommodation shareholders in the REIT subsidiaries.

I discovered that the SEC office involved in the exam was the Philadelphia office. So real estate funds in Delaware, Maryland, Pennsylvania, Virginia, West Virginia, and the District of Columbia should be especially focused on this issue.

Second, I discovered that the firm disagreed with the SEC’s position (obviously) and fought the deficiency through several rounds. Ultimately, the firm apparently decided to cede to the SEC’s position. I assume the firm decided the cost of obeying was less than the cost of fighting. Too bad.

The IM Guidance Update 2014-07 was a poorly put together document from the SEC. The key problem with the Guidance is Scenario 4 when a fund invests in another investment vehicle. Unlike the three previous scenarios in the Guidance, this clearly is not an SPV. The investment vehicle could be another fund, a joint venture or co-investment. The Guidance reaches the conclusion that the fund manager should get audited financial statements for the investment vehicle to comply with the custody rule because it is a separate advisory client.

Many people (and apparently SEC examiners) skip over footnote 10 that states that the SEC assumes that the SPVs in the four scenarios are investment advisory clients. But in many situations, that investment vehicle may not be an investment advisory client. The assumption in footnote 10 drives you directly to the conclusion in the Guidance

The Guidance also makes the mistake of stating that compliance with the Custody Rule can only be be achieved through providing audited financial statements. A fund manager can use the standard Custody Rule method of having information sent directly to investors by a third-party custodian and a surprise exam.

I don’t have the details on how that firm used REITs in its structure. The deficiency jumps right into the position that the REITs are advisory clients. But it also makes an overly broad statement:

“[T]his guidance indicates that Registrant must distribute the audited financial statements of all pass-through entities or special purpose vehicles that are controlled by Registrant or a related person and have outside investors to each such entity’s beneficial owners.”

That is not what the Custody Rule requires and it is not what the Guidance on the Custody Rule requires.

I would be interested to hear what other real estate fund managers are doing with their REIT subsidiaries for the Custody Rule. You can email me directly at my office or at [email protected].

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SEC Demanding Audited Financial Statements for Funds’ REIT Subsidiaries

reit stock certificate

The Custody Rule is a well intentioned beast of regulation designed to prevent investment advisers from stealing money from their clients. The Rule works well for retail investment advisers and most hedge funds. It starts falling apart for private equity funds and real estate funds. The Securities and Exchange Commission tried providing some additional guidance in June with its IM Guidance Update 2014-07. Unfortunately, I think the guidance only made it more confusing for funds trying to comply with the rule and the examiners trying to do their jobs in the field.

The problem with the Guidance was Scenario 4 when a fund invests in another investment vehicle. Unlike the three previous scenarios in the Guidance, this clearly is not an SPV. The investmentvehicle could be another fund, a joint venture or co-investment. The Guidance reaches the conclusion that the fund manager should get audited financial statements for the investment vehicle to comply withe custody rule because it is a separate advisory client.

Many people skip over footnote 10 that states that the SEC assumes that the SPVs in the four scenarios are investment advisory clients. But in many situations, that investment vehicle may not be an investment advisory client. The assumption in footnote 10 drives you directly to the conclusion.

The Guidance also makes the mistake of stating that compliance with the Custody Rule can only be be achieved through providing audited financial statements. A fund manager can use the standard Custody Rule method of having information sent directly to investors by a third-party custodian.

Getting back to the headline, one question for real estate funds has been what to do with REIT subsidiaries in the fund structure. This was also an issue pre-Dodd-Frank in deciding whether to include them as clients in determining whether you had reached the old 15-client threshold.

The subsidiary REITs could fit into the bucket of scenario 4. The fund is an investor in the subsidiary REIT and there are third party owners in the REIT. One of the requirement of REIT status is that you must have at least 100 shareholders. Since it’s a subsidiary, the fund manager is focused on its interest and typically uses accommodation shareholders to fill in the other 99 slots. I remember in my early years of practice that REITs would round up lawyers, accountants, family and friends to fill in the empty slots. Now, third party vendors will fill up those slots.

Those 100 accommodation shareholders get a preferred return paid to them, but have no interest in the ultimate economics of the REIT subsidiary. The accommodation shareholders collect their annual payment but have no concerns about investment performance. The current market rate is about 12% on their $1000 investment. They get their $120 a year and then the $1000 back at the end of the fund life.

In speaking with a group of real estate fund CCOs we discussed what their approach is for subsidiary REITs under the Custody Rule. We were startled to learn that the SEC had recently issued a deficiency letter to another real estate fund manager during an SEC exam for failing to issue audited financial statements for the REIT subsidiaries. From a redacted copy of the deficiency letter:

“This guidance [IM Guidance Update 2014-07] does not contemplate whether a client pays fees to the investment adviser, because entities are not required to pay advisory fees in order to be considered investment advisory clients. Accordingly, this guidance indicates that Registrant must distribute the audited financial statements of all pass-through entities or special purpose vehicles that are controlled by Registrant or a related person and have outside investors to each such entity’s beneficial owners.”

I think this is a shocking overreach by those SEC examiners. They seem to skip right over Footnote 10 and its assumption for purposes of the guidance that the investment vehicle, in this case the subsidiary REITs, are advisory clients.

I would be interested to hear what other real estate fund managers are doing with their REIT subsidiaries for the Custody Rule. You can email me directly at my office or at [email protected].

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Mortgage REITs Get Relief from the CFTC

The CFTC continues the journey out of the hole it dug itself. In February the CFTC stated that one swap contract would be enough to trigger the registration requirement. This runs with the CFTC long standing narrow interpretation of the commodity pool definition. The CFTC retreated from this position with respect to REITs in October. The CFTC has also retreated from this position for Mortgage REITs.

Mortgage REITs are a bit trickier because the underlying assets are real estate loans instead of real estate. There is likely to be more financial engineering with derivatives to mange the risks in the portfolio.

The CFTC lays out four tests for relief:

  1. No more than 5% of assets are for initial margin and premiums
  2. Net income from derivatives is less than 5% of income
  3. Interests in the mortgage REIT are not marketed as a commodity pool
  4. The company has made or will make the IRS filing as a mortgage REIT

Unlike the REIT relief, the mortgage REIT relief is not self-executing. The Mortgage REIT needs to send an email no-action relief claim.

In footnote 19, in bold type, the CFTC continues to backpedal:

The Division notes that we remain open to discussions with mREITs to consider the facts and circumstances of their mREIT structures with a view to determining whether or not they might not be properly considered a commodity pool.

The CFTC also release an interpretative letter offering no action relief for securitization vehicles. Word is that there may be a few more letters providing relief in the works.

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REITs and the CFTC

Dodd-Frank’s Title VII is likely to sweep a bunch of private equity fund operators under the CFTC’s registration requirement. The CFTC stated that a single interest rate swap or foreign exchange hedge could drag the fund manager into the definition of “Commodity Pool Operator” (7 USC §1a(10) and have to register with the CFTC. The National Association of Real Estate Investment Trusts was also concerned the equity REITs that use interest rate hedges could be considered a commodity pool.

The CFTC released an interpretative letter releasing REITs from the grasps of the CFTC. The CFTC agrees with the NAREIT position that REITs are operating companies and are therefore not commodity pools.

But will this interpretative letter help real estate private equity funds? Most real estate private equity funds have a REIT somewhere in their structure, so the letter offers some benefit.

The CFTC notes that equity REITs are, in part, operating companies because they engage in substantial management and operational function. (Check for real estate funds.)

Equity REITs use derivatives is limited to supporting its primary focus on real estate ownership and operation. (Check for real estate funds.)

The CFTC list three criteria for this relief:

  • The REIT primarily derives its income from the ownership and management of real estate and uses derivatives for the limited purpose of “mitigat[ing] their exposure to changes in interest rates or fluctuations in currency”;
  • The REIT is operated so as to comply with all of the requirements of a REIT election under the Internal Revenue Code, including 26 U.S.C. §856(c)(2) (the 75 percent test) and 26 U.S.C. §856(c)(3) (the 95 percent test); and
  • The REIT has identified itself as an equity REIT in Item G of its last U.S. income tax return on Form 1120-REIT and continues to qualify as such, or, if the REIT has not yet filed its first tax filing with the Internal Revenue Service, the REIT has stated its intention to do so to its participants and effectuates its stated intention.

I’m not yet sure if this gets a real estate fund all the way out of CFTC registration. I think there will be more to come.

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