One of the objectives that was considered when the 2020 edition of the GIPS standards was drafted was to reduce the amount of asset class specific guidance. The goal was to homogenize the guidance as much as possible so that it could be applied more universally across asset classes. This objective was achieved to some degree – notably with regard to private equity – but, in other instances, requirements based on asset class could not be eliminated completely. One area in particular where this was the case was real estate. The primary reason why real estate specific guidance would not be removed from the GIPS standards completely is because of the valuation complexities associated with real estate.
For background, under the GIPS standards, real estate includes wholly owned or partially owned:
- Investments in land, including products grown from the land (e.g., timber or crops).
- Buildings under development, completed buildings, and other structures or improvements.
- Equity-oriented debt (e.g., participating mortgage loans).
- Private interest in a property for which some portion of the return to the investor at the time of investment relates to the performance of the underlying real estate.
Though real estate specific guidance still exists in the 2020 edition of the GIPS standards, the content related to real estate has been dramatically reduced. Notably, the 2010 edition of the GIPS standards included a section completely dedicated to real estate and a guidance statement specific to real estate was also published. However, in the 2020 edition of the GIPS standards, there is no longer a dedicated real estate section and the guidance statement has been retired.
In the 2010 edition of the GIPS standards, the section dedicated to real estate included specific requirements related to the frequency at which real estate investments were required to be valued. Specifically, real estate investments were required to be valued as least quarterly, as of each quarter end or the last business day of each quarter. The quarterly valuations could be performed internally (by the firm) or externally (by a third party, such as an independent appraiser).
Additionally, real estate investments were required to receive an external valuation at least once every 12 months – unless a written agreement with the client stipulated less frequent valuations. However, at minimum, external valuations were required to be obtained for all real estate investments at least once every 36 months. There were no caveats or exceptions for the type of investment portfolio in which the real estate investments were held or alternate forms of valuation allowed.
Under the 2020 GIPS standards, real estate investments fall under the broad category of “private market investments.” In addition to real estate, private market invests include other real assets, private equity, and similar investments that are illiquid, not publicly traded, and not traded on an exchange. With respect to internal valuations, when private market investment portfolios are included in composites that present time-weighted returns, the private market investments must be fair valued at least quarterly, as of quarter end or the last business day of the quarter. This is aligned with the requirements specific to real estate in the 2010 edition.
While the 2020 edition of the GIPS standards recommends that private market investments should have an external valuation at least once every 12 months, external valuations for private market investments in general are not required at any frequency. However, this general recommendation was concluded to not be sufficient for real estate, which led to need for valuation provisions specific to real estate to be added.
Unlike in previous editions of the GIPS standards, the requirements related to external valuation for real estate investments are bifurcated based whether the investments are held in open-end funds or not. Open-end funds do not have a fixed number of investors and are open for subscriptions and redemptions. Real estate investments that are held in open-end real estate funds must now receive an external valuation at least once every 12 months, without exception. The caveat for delaying external valuations up to 36 months when stipulated by the client has been removed, as such a scenario would not be applicable to an open-end fund. An open-end fund has multiple investors who, by choosing to invest, agree to the terms of the fund, rather than a single client who can direct the manner in which a portfolio will be managed or mandate things such as the frequency of valuation.
For real estate investments that are held outside of open-end funds, the exception that permits external valuation once every 36 months based on client direction remains. Further, an additional option of relying on a financial statement audit rather than an external valuation has been introduced. If the real estate investments are subject to an annual financial statement audit performed by an independent, qualified (i.e., professionally designated, certified, or licensed) accounting firm, then the firm may rely on valuations covered within the scope of the audit rather than obtaining external valuations. The financial statement audit may be at either the property level or portfolio level. If the firm relies on valuations from financial statement audits, this fact must be disclosed in the applicable GIPS Reports.
The 2020 edition of the GIPS standards also stipulates that external valuations for real estate investments must be performed by an independent third party who is a professionally designated or certified commercial property valuer or appraiser. In markets where these professionals are not available, the firm must take necessary steps to ensure that only qualified independent property valuers or appraisers are used. Firms are also prohibited from using external valuations for real estate investments when the valuer’s or appraiser’s fee is contingent upon the investment’s appraised value.
There have also been some key changes to the type of return measures that must be presented related to real estate products. Under the 2010 edition of the GIPS standards, real estate composites were required to present total returns (returns including realized and unrealized gains and losses plus income) as well as the individual component returns – the capital return and the income return. The capital return factors only the change in the value of the assets, adjusted for capital expenditures and net proceeds from sales. The income return, on the other hand, isolates only the income earned on investment during the measurement period. Under the 2020 edition of the GIPS standards, firms are still recommended to present the component returns of both the composite and its associated benchmark, but are not required to do so.
Additionally, historically the GIPS standards required time-weighted returns to be reported for many real estate products. The use of money-weighted returns was reserved for private equity and closed-end real estate products, but those limitations have been removed from the 2020 edition, opening the door for broader potential use of money-weighed returns for real estate portfolios. The option to present time-weighted returns remains, but firms now have the additional option of presenting money-weighted returns in situations where the firm has control over the timing of external cash flows into the portfolios in the composite or the pooled fund and the product also has one of the following characteristics: (1) closed-end, (2) fixed life, (3) fixed commitment, or (4) illiquid investments are a significant part of the investment strategy. Each firm will need to evaluate and determine what the appropriate return measure is for their real estate products.
Even as the GIPS standards move toward more uniform guidance, it is important to remember that real estate in particular has many unique complexities related to it. Because of this, it is likely that some degree of dedicated real estate guidance and requirements will always be necessary.