On May 3, 2019, the SEC proposed rules to amend Rule 3-14 of Regulation S-X, which sets forth the financial statement requirements relating to acquisitions of real estate operations, and Rule 3-05 of Regulation S-X, which sets forth the financial statement requirements relating to acquired businesses that are not real estate operations. The proposed rules are intended to streamline the ability of REITs and other registrants to raise capital and should reduce transaction and audit costs.

Under current Rule 3-14, registrants that have acquired (and with respect to certain registration statements and proxy statements, propose to acquire) “significant” real estate operations must file audited annual and unaudited interim abbreviated income statements (Rule 3-14 Financial Statements) for those operations. The proposed rules would, among other things:

  • raise the individual significance threshold for individual completed acquisitions from “exceeds 10%” to “exceeds 20%”;
  • raise the individual and aggregate significance thresholds for individual probable acquisitions from “exceeds 10%” to “exceeds 50%”; and
  • clarify the test to be applied for determining whether acquired real estate operations are “significant.”

Modified Investment Test for Acquired Real Estate Operations

When determining significance for purposes of Rule 3-14, registrants use the investment test in the definition of “significant subsidiary” in Rule 1-02(w) of Regulation S-X. The current version of the investment test compares the registrant’s investment in the acquired real estate operation, including any assumed debt, to the registrant’s consolidated total assets as of the end of the registrant’s most recently completed fiscal year prior to closing the acquisition. The SEC proposes to modify the investment test. The modified investment test would require a registrant to compare its investment in the acquired real estate operation to the “aggregate worldwide market value” of the registrant’s voting and non-voting common equity, when available. If the registrant does not have publicly traded common equity, the current investment test would continue to apply. The proposed rules would require market value to be determined as of the last business day of the registrant’s most recently completed fiscal year prior to closing the acquisition. If the test results in significance exceeding 20%, the proposed rules would require the registrant to file Rule 3-14 Financial Statements for the acquired real estate operation.

Acquisitions and Proposed Acquisitions of Groups of Properties

In addition to the requirement that registrants provide Rule 3-14 Financial Statements for individual real estate acquisitions that are significant, Rule 3-14 Financial Statements are currently also required when the registrant has acquired or proposes to acquire a group of properties which in the aggregate are significant. In practice, consummated and probable acquisitions since the date of the most recent audited balance sheet that are less than 10% significant are aggregated and, if the significance of the aggregated group exceeds 10%, Rule 3-14 Financial Statements are provided for each acquisition that is 5% or more significant and for enough other acquisitions to cover the substantial majority of the group. This requirement frequently causes registrants to provide Rule 3-14 Financial Statements for acquired real estate operations that are individually not material to the registrant. Under the proposed rules, however, registrants will no longer be required to provide Rule 3-14 Financial Statements for a substantial majority of a group of individually insignificant acquisitions if the aggregate significance of those acquisitions exceeds 10%. Instead, if the impact of:

  • each completed acquisition whose significance is less than 20%;
  • each probable acquisition whose significance is greater than 20% but less than 50%; and
  • each acquisition completed less than 75 days before filing/effectiveness and whose significance is greater than 20% but less than 50%,

is greater than 50% significant in the aggregate, registrants will be required to provide pro forma financial statements in accordance with Article 11 of Regulation S-X and Rule 3-14 Financial Statements for each completed and probable acquisition that exceeds 20% significance.

Changes to Align Rule 3-14 with Rule 3-05

The proposed rules would also make a number of other changes that are designed to align the Rule 3-14 requirements for acquired real estate operations with the Rule 3-05 requirements for acquired businesses, including:

  • allowing registrants to omit Rule 3-14 Financial Statements from registration statements and proxy statements once the acquired real estate operations have been reflected in the registrant’s audited consolidated financial statements for a complete fiscal year;
  • allowing registrants to provide one year (as opposed to three years) of Rule 3-14 Financial Statements for acquisitions of significant real estate operations from related parties;
  • requiring unaudited Rule 3-14 Financial Statements for acquired real estate operations for the most recent year-to-date interim period prior to the acquisition;
  • expanding the circumstances in which a registrant can use pro forma financial information to determine whether Rule 3-14 Financial Statements must be filed; and
  • permitting the filing of Rule 3-14 Financial Statements covering a period of 9 to 12 months to satisfy the requirement for filing financial statements for a period of one year for acquired or to be acquired real estate operations.

The proposed rules would also codify existing SEC staff guidance with respect to the application of a modified significance test by “blind pool” issuers when determining whether they are required to provide financial statements for acquired real estate operations.

Codification of Definition of Real Estate Operations

The SEC also proposes to codify existing staff guidance regarding the definition of “real estate operations.” Under the proposed rules, real estate must generate substantially all of its revenues through leasing of the property. Examples of such properties include office, apartment, and industrial buildings, as well as shopping centers and malls. Properties that generate revenues from operations other than leasing, such as nursing homes, hotels, motels, golf courses, auto dealerships and equipment rental operations, would be excluded from the definition of real estate operations for purposes of Rule 3-14.

Changes to Tests for Acquired Businesses That Are Not Real Estate Operations

The proposed rules also modify Rule 3-05 of Regulation S-X, which sets forth the tests to be applied for determining whether acquired businesses that are not real estate operations are “significant.”

The determination of whether an acquisition of a business that is not a real estate operation is significant under Rule 3-05 is made by applying the investment, asset, and income tests provided in the definition of “significant subsidiary” in Rule 1-02(w) of Regulation S-X. The proposed rules would align the investment test for acquired businesses that are not real estate operations with the investment test for real estate operations under Rule 3-14 (as described above) and leave the asset test (which compares the registrant’s proportionate share of the acquired business’s total assets to the total assets of the registrant prior to the acquisition date) substantively unchanged.

The current version of the income test for acquired businesses that are not real estate operations compares the pretax income from continuing operations of the acquired business to the same measure of the registrant reflected in its most recent annual financial statements required to be filed at or prior to the acquisition date. As the SEC notes in the proposing release, for registrants with low or negative pretax income, the current version of the income test can have the effect of requiring financial statements for acquisitions that otherwise would not be considered material to investors. The SEC proposes to modify the income test by adding an additional revenue prong to this test that would compare the acquired business’s total revenues to the total revenues for the registrant’s most recently completed fiscal year. The new revenue prong of the test would only be applied when both the registrant and the acquisition target have recurring annual revenues. In those situations, the proposed rules would require a registrant to apply both the current income prong and the new revenue prong of the test and use the lower result to determine whether the significance threshold has been met.

Next Steps

The proposed rules may be viewed in their entirety on the SEC’s website. Comments on the proposed rules may be submitted to the SEC on or before the 60th day following the date on which the proposed rules are published in the Federal Register.