Viewpoints

Accounting the Change: Rules, Technology and Fundamentals

Posted on July 3, 2013 in Viewpoints by admin

As the more immediate crisis of the recession gave way to the ongoing stress of recovery, it has become increasingly difficult to understand what the priorities should be, what the rules of engagement are, and how best to chart a path to recovery. As Graeme MacWilliam once wrote, “Life would be much easier to understand if Mother Nature gave us the source code.”

That’s why, after a hiatus of several years, NAREIM held its Accounting and IT meeting May 1st and 2nd in Chicago. About 50 high-level industry participants reflected on recent developments in the regulatory environment, discussed IT tools and methodologies for improving effectiveness, and shared insights to help industry peers understand and adapt to the machinery of changes affecting the industry today and in the near future.

(for a full print version of this report, click here)

The challenges that IT and Accounting face—whether wrought by agencies like the FASB and the SEC, or new process and technology for how data is gathered, processed and analyzed—cut to the core of the investment management business. At the end of the day, investing is a business of numbers. Numbers flanked by dollar signs on one side and the word “million” on the other; and numbers with percent signs, revealing trends in demographics or occupancy levels or cap rates.

At a time when the interpretation of some numbers can point in more than one direction, and when regulatory agencies regularly consider moving or blurring the “bright lines” of compliance, openly sharing expertise across the industry is more important than ever. The discussions that emerged out of this meeting were an important part of understanding just what the new source code might be in this post crisis-world. Here are just a few of the insights that emerged from the meeting.

Demographic Trends Inside the M.S.A’s Are Not What They Always Appear

If one measures population growth in the Metropolitan Statistical Areas (MSA’s) of the largest US cities, at first glance it appears that they are growing at a slower pace than the U.S. population, as a whole or of smaller communities. But a closer look reveals a different story.

From 2000 to 2010, U.S. population increased by about 10 percent, and in smaller MSA’s – with 500,000 to 1 million people – that increase was higher than average with 11.9 percent. MSA’s between 1 and 2.5 million grew 12.3 percent, and MSA’s with 2.5 to 5 million grew 13.6 percent. When you compare that with MSA’s of over 5 million people – including core cities like New York, Chicago and Los Angeles – the average growth rate drops to only 6.2 percent. In other words, it appears that urbanization of America is mostly happening in smaller cities, and that perhaps the current low cap rates in the largest cities might be overly aggressive.

That is, unless we are looking at the wrong numbers…

Instead of looking at the entire MSA’s of these larger cities, when one considers population changes within a two-mile radius of city hall, the numbers flip, with cities over 5 million in population showing 13.3 percent growth from 2000 to 2010, while cities under 500,000 shrinking their urban cores. According to Paul Briggs of Bentall Kennedy, in cities like Dallas, Philadelphia, New York, and Washington DC, “growth has been centered in and around the core but not necessarily reflected in overall city.”

Chicago is one of the more striking examples of this trend. Overall, the city’s population declined by 4 percent in the last decade, but within two miles of City Hall, it grew by 36.2 percent. “The younger age cohort is driving a big part of this trend,” Briggs said. “People are looking for density so they can be close to the things they want.” This suggests a trend of cities growing in population, but contracting somewhat in geography; cities are essentially distilling around the core.

Regulatory Rule Book Shifts a Little Bit…Slowly

NAREIM meeting participants discussed several changes to accounting standards now being considered by the Financial Accounting Standards Board (FASB) and the U.S. Securities and Exchange Commission (SEC). Their deliberations are taking many years to complete and may actually result in little change to the status quo; but, there will be some change to come. For example, lease accounting rule changes that were once expected to be implemented in 2012 and 2013 are now unlikely to take effect until about 2017, and may be a less dramatic change than originally anticipated for the typical real estate landlord and tenant.

Meanwhile, FASB decided in August 2012 not to continue developing new standards for investment property accounting. According to Brian Ruben of Deloitte, after non-real estate sector owners complained about FASB’s approach in making the rules more entity-based rather than asset-specific, they felt compelled to pull back.

Another long-term standard-setting process is the SEC’s plan to eventually incorporate U.S. Generally Accepted Accounting Principles (GAAP) into the International Financial Reporting Standards (IFRS) adopted by many countries around the world. “There is a consensus for a global standard to improve comparability,”…“In the real estate investment sector, there is wide support for retaining U.S. GAAP rules to ease contractual and regulatory burdens.”

Concerns about incorporating GAAP into IFRS include heightened litigation risks, the resources and costs involved in making the change, and—perhaps most significantly— the reluctance of IASB to issue interpretative guidance. “In the U.S., if there is a rule with a bright line, we’re comfortable walking right up to that bright line without crossing it. Overseas, they’re not as concerned about bright lines,” said Patrick Scheibel of Deloitte. IFRS is more principles-based and less rules-based, with many countries adopting their own version of IFRS. This leaves the U.S. with the task of converging its highly complex rules-based accounting standards to international standards that are principles-based, leaving many questions unanswered.

Another accounting issue of concern to investment managers is whether it is necessary to file Form-PF with the SEC. In 2011, under new authority granted by the Dodd-Frank Act, the SEC adopted a final version of Form-PF, a reporting requirement for managers of private funds. Funds that do not own securities generally would not be “private funds” for which filings are required—and their managers may not be “investment advisers” required to registered with the SEC—but certain investors, such as public pension funds, may require their real estate fund managers to be SEC-registered, which may indirectly result in these fund managers treating their real estate funds as “private funds” for which annual filings are required on Form-PF. Moreover, if the funds engage in borrowing in excess of certain limits set out in the instructions to Form-PF, they may be categorized as “hedge funds,” and a quarterly filing could become necessary.

“When we talk with SEC staff about how to treat real estate funds, they say real estate doesn’t have to file Form-PF – unless it does – which doesn’t help much,” said Adam Kanter of Mayer Brown. In funds with many borrowers, the SEC may want the fund manager to disclose who the largest borrowers are and the length of the fund’s term. “In case a bank fails, the SEC wants to know who it has credit facilities with,” he said.

Changes in Tax Treatments Must be Watched Closely

If accounting is a major issue in investment management, taxation is every bit as important. The vast majority of private equity investment is designed to bring together investors with widely different tax profiles; however, all of whom share the common goal of seeking the most efficient tax treatment possible, said John Ferguson of Goodwin Procter. Typically, the “best” tax treatment means having as much income treated as capital gains rather than ordinary income and avoiding a filing obligation in the U.S. for non-U.S. investors.

This can be challenging because of the wide variety of investors, investment strategies, fund structures, and terms, Ferguson noted. Investors include taxable entities such as U.S. corporations, non-taxable entities such as ERISA plans, foundations and endowments, and a similarly wide range of foreign investor types, some of whom may be sovereigns and/or some of whom may have certain treaty benefits.

Ferguson also updated meeting participants on common structures and issues associated with the two U.S. federal income tax issues relating to non-U.S. investors and certain tax-exempt U.S. investors. In the case of the non-U.S. investors, these include U.S. return-filing obligations, effectively-connected income, commercial activity, and, perhaps most hotly watched, FIRPTA. For certain U.S. investors, the primary issue is “unrelated business taxable income”, or UBTI, which can come from the use of leverage, the underlying character or activity of the investment, or both.

Big Data, Valuations, and Strategy…and What About Those Interest Rates?

“More and more, sophisticated data capture and analysis methods allow real estate investors to reach better decisions faster and with less labor involved,” said Jim Costello of CBRE. That may be bad news, however, for future employment trends, as businesses across many sectors seek ways to reduce headcount via technology-enhanced productivity.

“By 2007, employment growth reached its peak,” Costello said, “and it may still be a while before we get back to where we were.” The past few years have seen double-digit annual growth in the stock market and single-digit GDP growth, but anemic employment growth. “The unemployment rate is coming down somewhat, but not very quickly, and part of the reduction is due to a shrinking labor-force participation-rate as Baby Boomers come to the end of their working lives,” Costello said.

Income growth has been stronger in the past two years, but that trend is unlikely to continue for long. “The next seven years will look more like the long term average – not the peak years,” Costello said. That trend has implications for the retail industry, where retailers are already gravitating to smaller footprint stores as e-commerce transactions increase. Income trends may also affect the multi-family residential market, as more Americans are renting today than in the past, either by necessity or due to disenchantment with the benefits of home ownership.

Another concern highlighted by econometric analysis is the impact of interest rates on property values. “In the current low interest rate environment, everyone is looking at what that means to real estate values,” Costello said. The thinking is that low debt costs allow investors to accept lower cap rates and thus pay more for properties. Now that Federal Reserve monetary policy has caused treasury rates to rise, investors are wondering: “Will cap rates go up in response?”

Such a rise, Costello said, doesn’t mean that cap rates would rise proportionally. “That’s not the way it works—there’s no one common spread between interest rates and cap rates,” Costello said. “Today, there is a lot of risk priced into the system…if we can get some increase in income from properties—rent and occupancy gains—values may remain stable as interest rates rise.”

Are We Behind the Curve on Technology?

The advent of mobile communications and the infiltration of the Internet in people’s work and personal lives impacts the real estate investment business in so many ways that almost every discussion at the NAREIM Accounting and IT meeting touched on some aspect of technology-induced change. At the same time, the investment management business itself is affected by increasingly sophisticated internet technology, and it’s important the companies keep up, observed Robert Teel of Yardi Systems.

“CEOs are worried about falling behind on technology,” Teel said, “people’s computers at home are often faster than what they have at the office, and if software at the office isn’t compatible with what they have at home, it can be a problem.” More investors are asking for raw data rather than a PDF of findings, and investment managers are trying to determine the limits of what they should report to clients. Software systems and outsourcing organizations focused on data management continue to improve, but there may be limits to what technology can provide. Panelists agreed, there are many potential risk factors—tenant concentrations, leverage ratios, exposure to a particular lender or retail tenant—that will require human analysis.

“When you’re smaller, you can do everything on spreadsheets, but as you grow, gradually those bad processes can get to the point where it is a big challenge to migrate over to a better system,” said John D’Angelo of Real Foundations. Having one system for all situations may not lead to the best solution. “Some people prefer to pull information from multiple data sources, and use the strengths of different systems.”

Data security is also a rising threat, as criminal gangs and others cost companies billions of dollars by stealing confidential information and draining financial accounts, according to Nicholas Percoco of Trustwave, SpiderLabs. “Every single piece of software in your computer and your mobile device has a possibility of having a vulnerability,” he said. “Most people in this room, I imagine, have information that could be devastating to your company if it fell into the wrong hands.”

Professional criminals sometimes pay hackers to write customized malware for a particular industry that is unlikely to be detected by standard data security software programs, Percoco said. The problem is more challenging today because most business people access company email accounts and other files from mobile location and smart phones, which are more vulnerable to hackers. It’s extremely easy, for example, to create Android apps with hidden malware that can penetrate corporate security by entering through employees’ phones.

Percoco suggested several techniques for improving data security, including simply making passwords – or, as he suggests, passphrases – longer. An eight-character password can be cracked in minutes by a computer application, while a 12-character password requires over a century to crack. He also suggested that investment managers should consider retaining firms like Trustwave to find vulnerabilities in their data security in order to address those security issues before they are hacked.

One of the biggest surprises of the day for NAREIM members was the revelation that a black market exists for all kinds of business information—even theirs. Percoco explained that there are online message boards where hackers offer to sell proprietary data they have acquired but can’t use themselves. On these same sites, business people can connect with hackers who—for a fee—will go into any company’s system to extract specific information that the buyer wants. Although the public hears mainly about hacks of credit card databases and celebrities’ personal texts, attacks on companies in all sectors are not uncommon and often, companies may not even know their security has been breached.

The news that their proprietary knowledge could be stolen by a competitor seemed to make a bigger impression on attendees than any of the other threats to the sector discussed at the meeting. In a way, that is not surprising. NAREIM members are well-versed on accounting rules and demographic shifts that have a greater direct impact on commercial real estate than on other industry sectors; accordingly, much of the new information presented merely updated or deepened their knowledge of issues investment managers think about every day. By contrast, most investment managers think of data security as an issue of relatively minor concern to their business—or at least, that’s what they thought before Percoco shook up the room a bit.

The challenge of keeping up with technology in general, and with data security in particular, illustrates not only the pace of change but the connectedness of different areas of business which at first glance seem unrelated. A big part of the value of face-to-face conferences is that they expose business people to ideas and information that they don’t realize might be important to their success.

In the age of Internet search engines, it is easy to find virtually any piece of information you need—once you realize that you need it. The most dangerous threats are the ones we don’t prepare for, because we are unaware of them. And by the same token, the greatest opportunities often come from connecting ideas that no one else realizes may be related.

At the same time, investment managers must keep current on the accounting, tax and IT information that allow them to keep their businesses running. Adapting to change as it occurs and anticipating the direction of change in the future is often a matter of controlling information and being able to make smart decisions based on what the data indicates. It all boils down to numbers – getting accurate numbers on the right metrics, understanding what they mean, and taking action to capitalize on opportunities and mitigate risks.