When GAAP Doesn’t Make Sense: A Nontraded REIT Example

March 29, 2023 | James Sprow | Blue Vault

In preparing the 4th Quarter nontraded REIT report for RREEF Property Trust, Inc., a nontraded REIT that Blue Vault has been covering since 2013, we came across an interesting anomaly in financial reporting. In October 2022 the REIT made 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.” According to the REIT’s 10-K, the investment was for a total of $30.855 million, excluding net accrued interest receivable. Had that size of investment been made in real estate assets, it would have represented less than a 7% allocation of the REIT’s total reported real estate investments of $420.552 million as of December 31, 2022. Instead, the investment in the real estate loans held in the CMBS Trust resulted in an entry into the REIT’s balance sheet assets of $1,156.3 million. The REIT’s total assets that were reported at $491.6 million as of December 31, 2021, ballooned to $1,625.5 million as of December 31, 2022.

By the accounting standards followed by the REIT’s accountants (GAAP), the entire value of the CMBS portfolio of over $1.1 billion was reported on the REIT’s balance sheet as an asset. Along with the portfolio value reported as an asset, an offsetting liability was also reported as a “Bonds payable held in consolidated CMBS Trust, at fair value.” Accounting standards required consolidation of the entire CMBS Trust, both the assets value and the offsetting liability, into the REIT’s balance sheet, as if the REIT owned or controlled the entire CMBS portfolio.

Ironically, the REIT purchased only Class D certificates and certain interest-only certificates of commercial backed securities (“CMBS”) sponsored by Freddie Mac for just $30.855 million. The “tranches” of securities purchased by the REIT were the most junior subordinate tranches, but the trust designates the most junior subordinate tranche as the “controlling class.” Because the Class D certificates represent the most subordinate tranche of the CMBS Trust, the REIT is considered the primary beneficiary of the CMBS Trust, and the REIT must consolidate the CMBS Trust on its books in its entirety.

According to the 10-K, “As of December 31, 2022, we owned a CMBS real estate loan investment with a net fair value of $31.167 million (such investment is reported on a gross basis on our consolidated balance sheet in accordance with U.S. generally accepted accounting principles (“GAAP”)).”

In this unique case, the REIT’s investment in the CMBS tranche resulted in a massive increase in the reported assets total and a nearly equal increase in its reported liabilities. The only difference between the two was the roughly $31 million actually invested in the CMBS Trust. In the notes provided in the REIT’s Statement of Cash Flows, the details are shown ($ in thousands):

Bottom line, this treatment by the accountants of a relatively minor investment in a small portion of a CMBS portfolio resulted in significant distortions in several of the metrics that Blue Vault reports for all nontraded REITs. For example, Cash to Total Assets went from 1.0% to 0.0003%. The debt to total asset ratio goes from 55.0% to 86.5%. The return on assets that Blue Vault calculates over the trailing four quarters would go from 6.08% to 4.15%. Because of these distortions due to the accounting treatment, Blue Vault will back out the CMBS impacts and report the REIT’s performance based upon the actual investment made.

Source: SEC