Taking a REIT public involves numerous risks as well as rewards.
THE POPULARITY OF real estate investment trusts (REITs) as an investment vehicle in today’s marketplace has made the opportunity for REITs to become publicly traded companies more enticing. Publicly traded REITs offer investors direct access to a traditionally illiquid asset class and relief from what used to be a reputation of high transaction costs and high investment minimums. According to the MSCI World Index, as of December 31, 2014, REITs represented 2.71 percent of world market capitalization, a large increase from years past. Raising money for the expansion of operations, to increase the market value of a company and to boost liquidity for existing owners and shareholders are some of the reasons a REIT might want to turn to the public markets.
But there are challenges as well. The upfront work involved in “going public” can be expensive and time consuming, which may divert management’s focus away from day-to-day operations. Surrounding the REIT with competent staff and outside professionals is often not a slam dunk, nor is it a certainty that the REIT’s infrastructure will enable it to be prepared for scrutiny by the Securities and Exchange Commission (SEC) come initial public offering (IPO) time. In addition, the REIT must satisfy significant compliance and qualification tests.
REIT IPOs experience a high proportion of withdrawals and postponements, especially when compared to non-REIT real estate companies. From the perspective of a public REIT’s independent auditors, all REITs contemplating a public offering should be aware of the following four critical items.
1) REITS must comply with all public company regulatory and disclosure requirements. This is often the area in which a company’s independent auditors have the greatest involvement. However, because of stringent independence requirements, it’s paramount that a REIT itself has the requisite understanding of these regulatory and disclosure rules. Public companies must comply with all provisions of the Sarbanes-Oxley Act of 2002 and should be in full compliance well before the IPO process is complete. Some of the more crucial elements of the act require the following:
- The registrant’s management must provide specific certifications in filings about the company’s internal controls. If weaknesses in the company’s internal control system are disclosed in these certifications or during an annual audit of internal control over financial reporting (except for smaller reporting companies, where such an audit is normally not required), the marketability of a registration statement could be adversely affected.
- An audit committee must have independent members. Boards of directors/trustees must also be independent, with one member serving as the chairman of the audit committee.
- Public companies must have a fully established code of ethics. If one is not established, they must disclose the reason for not having one.
- The SEC is the oversight body for publicly traded REITs, and any REIT contemplating a public offering must become very familiar with SEC requirements. The SEC’s Division of Corporate Finance decides whether a REIT’s S-11 registration statement is effective and allows the REIT to sell shares on the open market.
- All public REITs also must make 8-K, 10-Q, 10-K and other filings, the due dates of which are determined by whether the REIT is a “large accelerated filer,” an “accelerated filer,” a “non-accelerated filer” or a “smaller reporting company.” Additionally, potential audits under Regulation S-X, Rule 3-14 or Rule 3-05, which become part of the REIT’s pro forma statements in its Form S-11, may also need to be performed. Finally, the entity should make sure it has multiple years of historical U.S. generally accepted accounting principles (GAAP) financial statements available; up to three years of audited financial statements are required.
2) REITS face numerous common accounting issues during an IPO. While several issues could fall under this heading, Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) 805, Business Combinations, is one of the most common, since REITs in this stage are likely acquiring properties with in-place leases. With these acquisitions, GAAP requires the purchase price to be allocated to the fair value of the assets and liabilities being acquired or assumed. This can be a complicated transaction that usually results in the recording of several intangible assets, such as favorable/unfavorable leases and brokerage and/or other costs. The independent auditor is required to evaluate, as part of its audit, that these costs are recorded in accordance with GAAP.
Other GAAP topics that are often the subject of SEC scrutiny include liability versus equity classification of certain financial instruments, segment reporting and consolidation issues.
3) Consider cost, cost, cost. While the benefits of going public can be enormous, the upfront expenses can be considerable. In addition, what makes an offering more difficult is that the REIT needs to make sure it is allocating resources by putting the right people in place throughout the entity and by doing so early in the process.
Securing a legal team with expert knowledge of SEC matters is one of the most costly expenses a REIT faces. If the REIT doesn’t have an adequate accounting team in place and needs to seek outside help, this cost, as well as the fees it must pay to its independent auditor, could be substantial. Printing costs for XBRL (eXtensible Business Reporting Language) formatting and reporting can also be significant, because of the many different filings a REIT seeking to become publicly listed must make. In addition, there is no way to avoid underwriting expenses. What’s more important is that the relationship with the underwriter is a strong one, as the underwriter will be representing the company in front of potential investors and analysts.
4) Start acting like a public REIT. It’s important for the company to identify key areas for improvement prior to its conversion into a publicly traded company. Is the company’s general counsel ready to operate under substantially new guidelines? Does the accounting team possess the knowledge needed to file forms 10-Q, 10-K and other filings by established deadlines, while also maintaining a system of internal controls that is compliant with Section 404 of the Sarbanes-Oxley Act? Does the tax team have the infrastructure to effectively monitor REIT compliance before, during and after the IPO? Ensuring that the answers to these questions are “yes” before commencing an IPO is critical to success.
Taking a REIT to the public markets is exciting yet serious business. Going public can certainly bring significant and immediate benefits to a REIT, but there are many things to consider along the way. REITs that decide to go public should surround themselves with talented professionals, both internally and externally, with experience in accounting, tax and SEC compliance and reporting. Doing so will be a huge step toward a successful offering.