April 3, 2023
How CMBS Accounting Creates an Anomaly
How CMBS Accounting Creates an Anomaly
April 3, 2023 | James Sprow | Blue Vault
In a recent article by Blue Vault entitled When GAAP Doesn’t Make Sense: A Nontraded REIT Example, we pointed out that one nontraded REIT, RREEF Property Trust, Inc., reported an investment in CMBS, “which are securities that evidence interests in, or are secured by, a single commercial mortgage loan or a pool of commercial mortgage loans,” of $1.156 billion, even though the actual net outlay for the investment was less than $32 million. Accounting rules forced the REIT to report the entire CMBS portfolio, in which the REIT held a very minor percentage, as if it all belonged to the REIT. The reporting on the balance sheet included both an asset of $1.156 billion and a liability of $1.127 billion. The result was a huge distortion of some standard metrics that Blue Vault uses in quarterly reports for nontraded REITs, including the debt ratio, return on assets, and the cash to total assets ratio.
This case, which only arose in October of 2022 and was first reported in the 2022 10-K filing by RREEF Property Trust, Inc., led us to search the filings of other nontraded REITs for investments in CMBS portfolios and any other possible anomalies due to GAAP standards. What we found was a limited number of nontraded REITs that invest in CMBS portfolios, and none that reported a percentage of their total assets anywhere near the percentage reported by RREEF Property Trust, Inc.
The table below shows those nontraded REITs with a significant investment in CMBS and the percentage of their total assets in CMBS as reported in their year-end 2022 filings. As we can see, RREEF Property Trust, Inc., stands out due to the treatment of their investment in a very minor portion of a CMBS portfolio. For a fuller explanation of the GAAP treatment of their investment, refer to “When GAAP Doesn’t Make Sense: A Nontraded REIT Example.” Suffice it to say, the unusual and somewhat non-sensical treatment of the CMBS investment by RREEF Property Trust, Inc., makes this NTR stand out.
All totals reported below are from the Q4 2022 10-K filings by the nontraded REITs:
The investment by RREEF Property Trust, Inc. in CMBS was reported in their annual report to investors as follows: ”In October 2022, we invested $30.9 million into our first real estate loan investment, a purchase of the B-piece certificate and certain interest-only certificates of a securitized pool of multifamily loans. This investment provides an attractive risk-adjusted return profile with underlying loans secured by highly occupied properties spanning 23 states.”
Given that RREEF Property Trust, Inc. is consolidating the entire CMBS portfolio on its books, it will be interesting going forward to see if changes in interest rates will hit the REIT’s income statement. As their 10-K states:
“We are exposed to market risk with respect our investment in the CMBS Trust due to changes in its fair value. We are required to consolidate the entire CMBS Trust because we have the power to control certain activities of the CMBS Trust that could most affect the performance of the CMBS Trust. Under GAAP, we have elected to record the CMBS Trust at fair value which means we record an asset that encompasses the full amount of all outstanding securities issued by the CMBS Trust, and a liability for the amount of the CMBS Trust’s securities which we do not own. While all of the underlying loans have fixed interest rates, the fair value of the CMBS Trust may be influenced by interest rates, market pricing of similar CMBS securities, investor sentiment for CMBS investments generally, the performance of the underlying loans and other factors. As of December 31, 2022, our net investment in the CMBS Trust was valued at $31,167. While it is difficult to project how the various factors will impact the fair value of the CMBS Trust, a 10% change in the value of our investment in the CMBS Trust would result in an unrealized gain or loss of $3,117.”
Typically, investments in debt instruments such as CMBS tend to lose value when interest rates rise. Companies that invest in debt instruments may hedge interest rate risks using swaps and caps contracts.
RREEF Property Trust, Inc. states:
“We will seek to limit the impact of interest rate changes on earnings and cash flows and to lower our overall borrowing costs. We intend to manage market risk associated with our variable-rate financing by assessing our interest rate cash flow risk, through continually identifying and monitoring changes in interest rate exposures that may adversely impact expected future cash flows, and by evaluating hedging opportunities. We may use derivative financial instruments to hedge exposures to changes in interest rates on loans secured by our assets.”
We will be watching this REIT going forward to see if GAAP reporting for its CMBS investments continues to distort the REIT’s metrics.
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