What is an SEC S X 3 14 Real Estate Operations Acquisition Audit

If your real estate investment business has decided to conduct an initial public offering (IPO) using a Real Estate Investment Trust (REIT), it's important to consider the impact of SEC Rule 3-14 of Regulation S-X, known as S-X 3-14. This set of regulations provides special instructions for the audited financial statements of the real estate operations you are about to acquire.

Specifically, this rule requires SEC filers (or registrants) to:

• Present audited financial statements of completed and probable acquisitions of entities that have real estate operations, if the acquisition meets certain materiality or significance thresholds; and
• Include in the audited financial statements pro forma financial information, which are projections or estimates of the company's future performance, including the acquired entity.

S-X 3-14, for the most part, applies to newly created REITs that file with the SEC. Below is an overview of what you need to know about the S-X 3-14 financial audit reporting requirements for your real estate acquisition.

What is Considered a Real Estate Operation Under S-X 3-14?

A real estate operation relates to an acquisition of a business or equity investment whose activity is substantially all from leasing. Substantially all is a critical part of the definition. Examples of real estate operations include office and industrial buildings, apartments, retail malls and many other types of properties with leases.

There is no clear definition of the meaning of substantially all, but, generally, if the rent from tenants is significant or material compared to all other streams of income the property generates, it can be considered real estate operations. If, on the other hand, there are ancillary services that in the aggregate are greater than rent, then the substantially all requirement will not apply. For example, if the restaurant, laundry and medical services revenues in a senior living facility exceed the rent paid by tenants, then the substantially all requirement will not be met.

As an example, two different companies your real estate entity acquires own and operate cafes. They offer that service to both tenants and walk-in customers and generate the following income:

		Acquisition A			Acquisition B
Rental Income		$1,000,000	99.0%		$500,000	49.5%
Café income		$10,000	1.0%		$510,000	50.5%
Total		$1,010,000			$1,010,000

The example above indicates that Acquisition A is generating substantially all its income from rental operations, while Acquisition B's rental income would not be considered substantially all, and therefore would fall under other sections of Regulation S-X covering acquisitions of a business.

The determination of rental operations is somewhat subjective in certain situations, but with an understanding of the income streams of the acquisition and discussions with your auditor, you can come to a thoughtful conclusion on how to proceed.

What is Considered a Real Estate Operation of "Significance" and How Is It Calculated?

If an SEC filer acquires an entity that has a real estate operation that has more than a 20% significance, an S-X 3-14 audit must be submitted within 71 days from the originally filed Form 8K describing the material acquisition.

To determine significance, the SEC filer compares the investment (or purchase price) of the acquisition to the registrant's worldwide market value, when available, or total assets from its most recent audit, if the value is not available. The value is determined by multiplying the outstanding shares by the daily share price prior to the acquisition. Therefore, if the filer is a non-traded REIT, total assets of the acquisition will be used for significance. This is the most common method for new REITs conducting their IPO or those that aren't currently being traded.

In the example below, REIT A and REIT B each purchase a residential property for $25 million.

		REIT A		REIT B
Total assets from year-end audit		$500,000,000		$120,000,000
Purchase price-residential property		$25,000,000		$25,000,000
Significance percentage		5%		21%

In these two scenarios, REIT A would not be required to file an S-X 3-14 audit for the real estate operations of the residential property, since the significance is under 20%. REIT B would, however, need to have an audit of the property, include the REIT's proforma information and would include the acquisition of the property in those numbers.

When a REIT is filing a registration statement or a proxy statement, it must aggregate:

• Insignificant acquisitions (those with significance of less than 20%);
• Any probable acquisition (a transaction with an executed purchase and sale agreement) whose significance does not exceed 50%; and
• Any acquisitions greater than 20% significance that have occurred where S-X 3-14 statements are required but have not yet been filed.

If the insignificant, probable and completed acquisitions not yet filed total greater than 50%, the registrant must file an S-X 3-14 audit for any acquisitions that have significance greater than 20%, and proforma financial statements for the all the remaining combined insignificant acquisitions and probable acquisitions.

How Do You File Financial Statements with the SEC?

Since the timing of filing the Rule S-X 3-14 audit and proforma financial information is at the most 75 days after the acquisition, it is important the acquisition team incorporate clauses in the purchase and sale agreement to obtain financial information from the seller either prior to the close or simultaneously. Often, it might take a discussion with the seller to explain the exact information needed for the audit and the related timing, as it's not uncommon for this type of audit and information requests to be new and overwhelming for a seller's internal accounting team.

Form 8-K
For any completed significant acquisition of real estate operations, a filer must file, within four days of the acquisition, a Form 8-K under Item 2.01, Completion of Acquisition or Disposition of Assets, notifying its investors of the significant acquisition. Within 71 days thereafter, the filer will also file S-X 3-14 audited financial statements and the pro forma financial information under Item 9.01, Financial Statements and Exhibits.

Registration or Proxy Statements
If a completed acquisition is greater than 20% significance, and probable and completed insignificant acquisitions total greater than 50% significance, a Registrant must file a Rule S-X 3-14 audited financial statements and pro forma information in a separate Form 8K or incorporated by reference in the registration statement. Note, for a REIT, a registration statement is generally Form S-11.

Title IV Regulation A+
Real estate developers, trying to find capital in a broader marketplace, have started to use Title IV Regulation Reg A+ (Reg A+). Reg A+ is a new type of public filing introduced in 2015 to attract non-accredited investors for deals under $75 million. When a Reg A+ entity acquires an entity that has real estate operations, the SEC requires financial statements for smaller reporting companies to comply with Rule 8-06 of Regulation S-X, which are in essence Rule S-X 3-14 financial statements.

What Financial Statements are Included in the Rule S-X 3-14 Filing?

Rule S-X 3-14 needs to include an audited income statement for the previous year and most recent interim period prior to the acquisition. The income statement, which is commonly referred to as the statement of revenue and certain expenses, excludes items that are not comparable to the operations of the real estate property after the acquisition. For example, the statement could exclude mortgage interest, depreciation, amortization, corporate level expenses, income taxes and other costs of the property that may not be comparable to the expenses expected to be incurred in future operations.

The disclosures of the statement of revenue and certain expenses should include an explanation as to specific costs and why they were excluded.

What are the Requirements for a New REIT?

If a new REIT is in the process of filing its Form S-11 registration statement, the SEC allows for the purchase price of the acquired and probable acquisitions to be used as a substitute for total assets in calculating the significance of the acquisitions. This alternative can determine whether a Rule S-X 3-14 financial statements and pro forma financial information are to be filed.

Understanding the intricacies of financial reporting for an acquisition of an entity with real estate operations under S-X 3-14 is a must to help ensure you and your team meet all deadlines. As any relatively new public filer can attest, keeping the SEC on your good side is a win for everyone.

Contact Nick Antonopoulos or a member of your service team to discuss this topic further.

Cohen & Co is not rendering legal, accounting or other professional advice. Information contained in this post is considered accurate as of the date of publishing. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts, circumstances and current law with your professional advisers.

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