Reporting Requirements for Qualifying Private Real Estate Funds Under ASC 946

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Determining whether a real estate entity should be treated as a real estate fund under Accounting Standards Codification (ASC) 946, Financial Services—Investment Companies, or a real estate operating entity can be a challenging endeavor—even for the most sophisticated accounting professional. In this article, we’ll examine the requirements of a real estate entity to qualify as an investment company and use fair value reporting.

Scope Exemptions

In general, you should consider conducting an assessment of ASC 946 for any real estate entity other than the following two scope exemptions:

  • Real estate investment trusts (REIT) are strictly excluded from being considered an investment company as defined within ASC 946. REITs must follow ASC 974, Real Estate—Real Estate Investment Trusts.
  • Any real estate entity regulated under the Investment Company Act of 1940 is by default an investment company; however, such instances will be extremely rare. In general, real estate entities registered with the SEC must register under acts 33 and 34 and fail the passive/flow-through rules, since most must be registered as a corporation.

Qualifying as an Investment Company

The initial determination of whether a real estate entity is an investment company should be completed upon the entity’s formation. An investment company must possess the following fundamental characteristics:

  • Provides investors with investment management services (as a practical consideration, this is generally done through a management company structure)
  • Commits to its investors that its business purpose is investing for investment income and/or capital appreciation (as a practical consideration, this generally is stated within the real estate entity’s private placement memorandum, limited partner agreement or member agreement)
  • Doesn’t obtain benefits from an investee that aren’t normally attributable to ownership interests or that are other than capital appreciation or investment income (as a practical consideration, this generally is viewed as the income generated by the real estate property in the form of current yield (flow-through distributions) and realized gains when the property is exited)

In addition to the fundamental characteristics, an investment company also should adhere to the following typical characteristics:

  • Has more than one investment (as a practical consideration, it’s very common for real estate entities to only have one investment but still be considered an investment entity. This is because the use of special-purpose vehicles and alternative investment vehicles is a very common structure for real estate funds)
  • Has more than one investor (as a practical consideration, it’s very common for real estate entities to establish sidecar investment vehicles that contain a single investor. These entities usually do meet the requirements of an investment entity if the entity attached to the sidecar also meets the requirements of being an investment entity)
  • Has investors that aren’t related parties of the parent or investment manager
  • Has ownership interests in the form of equity (as a practical consideration, this would include partnerships and limited liability companies)
  • Manages substantially all of its investments on a fair value basis (as a practical consideration, this assessment should be done from the viewpoint of the investor, not management. Management may not wish to measure the real estate properties at fair value, but if this level of reporting generally is required by the entity’s investors, then this criterion would be met)

An investment company generally will meet all of these typical characteristics; however, the absence of one or more typical characteristics doesn’t necessarily preclude an entity from being an investment company. If an entity doesn’t possess one or more of the typical characteristics, it should apply judgment and determine if its activities are consistent with those of an investment company. In addition, an entity should reassess whether it correctly determined its status as an investment company only if the entity is no longer regulated under the Investment Company Act of 1940 or there’s a subsequent change in the entity’s purpose and design.

Measurement of Investments Under the Fair Value Model

If it’s been determined that an entity qualifies as an investment company, the investment company must report all of its real estate investments on a fair value basis.

Fair value is defined by ASC 820, Fair Value Measurement, as “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.” Fair value is a market-based measurement and not an entity-specific measurement. A fair value measurement requires assumptions (including assumptions about risk) that market participants would use. The objective of a fair value measurement is to determine the price that would be received to sell an asset or paid to transfer a liability at the measurement date.

Follow-Up

Remember, it’s important for any real estate fund to understand the reporting requirements and assess the qualifications to report at fair value. For more information or assistance with assessing the requirement for your real estate fund, contact Dustin or your trusted BKD advisor.

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