4C — August 9 - 22, 2019 — Pennsylvania — M id A tlantic
Real Estate Journal
P ennsylvania By Michael Shuster, CPA, EisnerAmper LLP Real estate investment vehicles: Operating entities or investment companies?
launched private equity funds in order to raise capital from investors and, therefore, ob- tain access to a dedicated pool of capital to fund new real es- tate investment opportunities, eliminating the need to raise capital on a deal-by-deal basis. Investing in real estate through a fund structure does come with many compliance, reporting and other responsi- bilities. In complying with the reporting requirements, many real estate funds struggle with the distinction of whether to report as an investment com- pany or an operating company.
Investors usually require that the funds in which they invest provide annual audited finan- cial statements. Accounting Standards Codification Topic 946 discusses the criteria and general fact patterns that need to be analyzed in order to determine whether an entity would qualify as an invest- ment company. Generally, if the entity does not qualify to report as an investment com- pany, it would report as an operating entity. If the entity qualifies to report as an invest- ment company, the financial statements would include the
real estate investments at fair value, and the results of the entity’s operations would include the changes in value of the real estate investments instead of the operating re- sults of those investments. The following are required fundamental characteristics in order for an entity to qualify to report as an investment company (all characteristics must be present): • The entity obtains funds from investors and provides them with investment man- agement services. • Its business purpose and
only substantive activities are investing solely for returns from capital appreciation, in- vestment income or both. • It or its affiliates do not obtain or have the objective of obtaining returns or benefits from an investee or its af- filiates that are not normally attributable to ownership interests or that are other than capital appreciation or investment income. In addition to the funda- mental characteristics stated above, in order for a real estate fund to qualify as an investment company, it should typically have the following characteristics: •More than one investment, and more than one investor. • Investors that are not re- lated parties of the parent or investment manager. • Ownership interests in the form of equity or partnership interests. • Manages substantially all of its investments on a fair value basis. The absence of one or more of the typical characteristics does not generally preclude an entity from being an invest- ment company. Each entity should apply judgement and consider all facts and circum- stances on whether its activi- ties are consistent with those of an investment company. There are several fact pat- terns or strategies that could determine the distinction of whether an entity qualifies to report as an investment com- pany. Entities need to follow the investment strategy as described in their governing documents which, for invest- ment companies, generally include exit plans. Also, real estate owners that manage the day-to-day operations of their properties and intend to generate a substantial portion of their revenues from rental income or property manage- ment fees, as opposed to capi- tal appreciation, may not meet the requirements to report as an investment company. Fur- ther, opportunistic funds that expend cash for development activities may also be consid- ered real estate developers as opposed to investment funds. Even after evaluating all of these factors, the determina- tion of reporting basis may not be clear, and consultation with accountants and attorneys may be necessary. continued on page 10C
ver the last several years, real estate funds have been some
of the fast- est growing alternative investment vehicles. Al- though illiq- uid, real es- tate is often thought of as a more stable
investment than equity or debt securities, and it has been a popular long-term investment choice. Successful real estate owners and developers have
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