Real estate investment trusts have become increasingly prevalent in the investment landscape, offering investors a vehicle to access diverse real estate assets and income streams.
Financial statement auditors must handle distinct challenges that come with auditing these entities. Whether examining publicly traded or privately held REITs, these investment vehicles present unique obstacles that require a deep understanding of the real estate industry and robust financial expertise.
Let's break down some of the unique complexities and challenges facing those who choose to audit publicly traded and privately held real estate investment trusts.
Challenges in auditing publicly traded REITs
Auditing publicly traded REITs adds unique complexities to common audit practices — practices such as lease accounting, investment property valuation, operating expense reporting and related party transactions. As with many auditing challenges and complexities, these are primarily driven by regulatory requirements and the heightened expectations of stakeholders, including investors, analysts, and regulatory bodies.
1. Lease accounting: One key challenge arises from the intricacies of lease accounting. With a diverse portfolio of properties — each with unique lease terms — auditors must ensure the accurate assessment and reporting of lease income, expenses and related disclosures.
For instance, a publicly traded REIT with a substantial retail portfolio may have complex lease agreements featuring varied escalation clauses, tenant improvement allowances and lease incentives — necessitating meticulous scrutiny.
2. Valuation of investment properties: Another hurdle in auditing publicly traded REITs involves assessing the valuation of investment properties. The fair value measurement of real estate assets is a critical aspect of financial reporting for these entities. An auditor must assess the reasonableness of management's fair value estimates, considering such factors as market conditions, rental rates and property-specific risks.
However, accurately determining valuation has become particularly difficult after the COVID-19 pandemic. It's not uncommon for REITs to hold commercial office space in their portfolios, and those who have a significant percentage of their portfolios in office buildings may be struggling with decreased occupancy rates and potential declines in rental income, requiring a thorough evaluation of property valuations.
3. Operating expenses: In addition to the complexities in dealing with lease accounting and property valuations, auditors encounter challenges related to the reporting of operating expenses.
REITs are structured to require distributing to shareholders at least 90% of their taxable income. This requirement can incentivize management to aggressively classify expenses as "operating" rather than "capital," maximizing reported taxable income and dividend payouts.
It's also not difficult to "accidentally" classify a capital expense as an operating expense. An auditor must carefully scrutinize the classification of expenses to ensure compliance with accounting standards.
4. Related-party transactions: Another area of focus in auditing public REITs is evaluating related-party transactions. These entities often have intricate ownership and management structures with significant related-party relationships, such as contracts with external property managers or advisory firms.
Auditors must assess the terms of these transactions to confirm they are conducted at arm's length and properly disclosed in the financial statements.
Best practices in auditing public REITs
Auditors can take several steps to ensure they are following industry best practices while auditing publicly traded REITs. Experienced auditors often will make it a point to do the following:
- Maintain open communication with management to gain insights into strategic decisions impacting the portfolio.
- Leverage data analytics, AI and other technologies and tools to identify unusual trends or anomalies in financial data.
- Dig into the numbers through detailed testing procedures to validate key financial statement assertions.
Challenges in auditing privately held REITs
As with publicly traded REITs, auditing privately held real estate investment trusts presents a distinct set of challenges. However, while publicly traded REITs gain their complexity from stakeholders and regulatory bodies, privately held REITs usually have fewer investors and less stringent regulatory oversight. Because privately held REITs lack public scrutiny and transparency, there is a greater risk that management will override controls or misstate financial statements.
1. Related-party transactions: Privately held REITs with a concentrated ownership structure are more likely to have related-party transactions and a greater number of them. Because of the lack of public scrutiny and transparency that comes with being publicly held, the auditor must be more skeptical when reviewing all transactions and assess the fairness of all related-party transactions and their impact on the financial statements.
2. Property valuations: The valuation of properties in privately held REITs can be particularly challenging, as there may be limited market data available for comparison and potential conflicts of interest in determining fair values. Auditors should be keen-eyed when evaluating the reasonableness of fair-value measurements' assumptions, as privately held REITs may have restricted access to reliable market data.
3. Weaker internal controls: Another concern for the auditor is assessing the overall control environment for privately held REITs. Without the same level of regulatory oversight and public scrutiny as public REITs, private REITs may have weaker internal controls and a greater risk of management override.
Best practices in auditing privately held REITs
In auditing privately held REITs, additional best practices many auditors use include:
- Conducting thorough inquiries and procedures related to related-party transactions.
- Assessing the competence and objectivity of internal valuation specialists.
- Considering the impact of potential conflicts of interest on the fair value measurements.
Commercial real estate post-COVID
The COVID-19 pandemic has and continues to significantly impact the commercial real estate sector, leading to decreased occupancy rates, tenant delinquencies and other operational challenges. Auditors of commercial real estate entities, including REITs, need to evaluate the impact of these issues on financial reporting.
For instance, a commercial REIT with a portfolio of shopping malls may encounter difficulties in assessing the collectability of rental income, given the uncertainties surrounding tenant businesses and consumer behavior. For this example, auditors should carefully assess the collectability of lease receivables, the appropriateness of rent concessions granted to tenants, and the potential impairment of investment properties resulting from decreased occupancy and rental rates.
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REITs must provide detailed disclosures on the impact of COVID-19 on their operations and financial position. If these disclosures are estimates or based on judgments, they must be understandable and useful to investors, and the financial statements must be consistent with the company's specific facts.
Meanwhile, auditors should ensure that their REIT audit clients are complying with these disclosure requirements and that the information presented is accurate and complete.
Adopting a forward-looking approach, auditors should consider the implications of current market conditions on the recoverability of property values, lease income recognition and impairment assessments.
Best practices for auditing commercial real estate post-pandemic should include:
- Engaging with industry experts to gain insights into market trends and projections.
- Evaluating the sufficiency of management's impairment assessments.
- Considering the impact of government assistance programs on tenant solvency and lease obligations.
PCAOB targets commercial real estate concerns
Amid increasing risks in the commercial real estate sector, a recent report, "
The report, while primarily intended for PCAOB-registered firms, provides valuable insights for all auditors. It presents 22 pertinent questions for CRE audits, emphasizing the need for professional skepticism on potential issues like the impact of higher interest rates and lower occupancy rates on loan repayments. The guidance spans several areas: risk identification and assessment (including fraud), asset impairment and credit loss allowances, going concern issues and interim review considerations. This CRE-focused report forms part of the PCAOB's educational spotlight series, aimed at informing auditors, audit committees, investors and preparers about the board's activities.
REIT auditing is not for the faint of heart
Auditing real estate investment trusts, whether publicly traded or privately held, requires a comprehensive understanding of industry-specific challenges and best practices. Common focus areas include lease accounting complexities, property valuation considerations, expense reporting and related-party transactions, and the impact of external factors such as depressed commercial property holdings.
In short, REITs require a high degree of auditor industry knowledge, professional skepticism and diligence in conducting assessments.
To be successful when auditing either kind of REIT, auditors must do more than stay current on the latest regulatory developments and develop a deep understanding of the real estate industry. Today's auditor must increasingly be comfortable with and leverage technology such as AI, machine learning, big data and more to assist them in navigating the unique challenges they face when auditing REITs.
