NAREIT Submission to FASB on Accounting for Derivative and Similar Financial Instruments


Mr. Timothy S. Lucas
Director of Research and Technical Activities
Financial Accounting Standards Board
401 Merritt 7
P.O. Box 5116
Norwalk, CT 06856-5116

Dear Mr. Lucas:

The National Association of Real Estate Investment Trusts("NAREIT") appreciates the opportunity to comment on the proposed Statement of Financial Accounting Standards, "Accounting for Derivative and Similar Financial Instruments and for Hedging Activities". NAREIT is the national, not-for-profit trade association that represents over 230 real estate investment rusts and over 1,600 accountants, analysts, investment bankers, attorneys and other professionals who provide services to REITs. We are aware that the Board has spent years to resolve the complex problems associated with reporting derivatives and are pleased that the FASB continues to consider comments from industry groups including our concerns about the Exposure Draft. Given the importance of derivatives in managing interest rate risk, any change in the accounting for these financial instruments should be approached cautiously and with an appreciation for the consequences of changes to current practice.

Real estate investment trusts ("REITs") hold long term investments in income-producing real estate, typically shopping centers, commercial and office buildings, multifamily residential and other properties that are leased. The long-term nature of real estate assets of REITs requires that debt exists as a major permanent part of their capital structure. Because interest payments on mortgage debt and other financings represent the largest single expense of most REITs, interest rate risk is substantial.

The market provides only limited means to effectively control the interest rate risk that is ever present in a leveraged REIT. Derivatives have indeed allowed REITs to address interest rate risk. For REITs, interest rate risk is primarily manifested in two forms: 1) variable rate cash flows, and 2) future interest rates. Variable rate cash flows represent a risk to REITs when debt is undertaken at a floating rate. Typically REITs will mitigate concerns about potential increases in floating rate debt by using interest rate swaps and swapping the floating rate for fixed or using interest rate caps to limit interest rate risk. NAREIT is concerned that recording derivatives at fair value, especially without recognition of the offsetting expected reduction or increase in future interest expense, will cause significant fluctuations from period to period in the balance sheet and equity statements. While these equity fluctuations may be confusing to investors, our view is that the proposal does not impede the prudent use of hedges for this purpose.

Managing future risk, that is the risk that interest rates will increase over time, presents a treacherous and ongoing challenge to REIT managers. This is due to the capital intensive nature of REITs that involves frequent debt refinancings in any given year. Higher than anticipated interest rates at the time of refinancing can result in a substantial loss in earnings. By using derivatives to "pre-lock" interest rates when interest rates are low, REITs have been able to manage interest rate risk and avoid significant costs of prepayment penalties.

Managing interest rate risk on forward transactions, particularly the issuance of debt, is a material REIT concern. Despite the fact that forward hedge may be successful from an economic point of view, REITs simply cannot accept the earnings volatility that will be introduced by the proposed accounting model.

The Exposure Draft requires that all derivatives be marked to market. In the case of the forward contract to lock-in interest rates on a forecasted issuance of debt, REITs will need to recognize on balance sheet the value of this cash flow hedge. As we understand the Exposure Draft, the accounting would result in earnings volatility that occurs when the REIT closes its forward position and issues the debt at the lock-in rate. In the event that interest rates increase, the Exposure Draft provides that the increased value of the hedge will be recognized in earnings immediately while the time hedged (e.g., the debt issuance) will recognize the loss in value (e.g., higher coupon) over time. In the event rates fall, the opposite will occur.

NAREIT believes that even though future risk is hedged for economic purposes, the accounting treatment will dramatically distort reported earnings. Consider an example of a typical REIT that has debt coming due over the next several years and anticipates a future increase in interest rates. The REIT has three choices:

1) prepay the debt and absorb a large prepayment penalty;

2) wait until maturity and take the risk that rates won't be higher at the time the debt matures;

3) enter into a forward swap or Treasury lock which will eliminate the prepayment penalty and lock in currently attractive rates for the refinance date.

For purposes of this example, the REIT has a $50 million mortgage due in two years. The debt is priced 140 bps above Treasury. Under option #1 above, if the company prepays the mortgage and refinances the debt, it essentially is paying the spread of 140 twice for the first two years--once in the prepayment calculation and once in the new debt. Under option #2 above, the REIT risks foregoing the currently attractive rate environment altogether. Option #3 above utilizes a stand-alone derivative to obtain substantial efficiencies. In this case, its the most logical alternative--it is the least costly and locks in the current lower interest rate while avoiding any prepayment penalties. In this example, option #3 will be less costly to the REIT by approximately $1.4 million, that is, calculated as the savings of paying the spread of 140 basis points for the first two years. Under the proposal, the potential distortion of earnings will eliminate option #3 above.

NAREIT urges the FASB to consider an alternative accounting treatment that will avoid distorted earnings results. We believe that gains and losses from derivatives that are intended as hedges of future transactions should be included in income at the same time as the risk inherent in the hedged transaction results in a changed level of earnings. For example, it is more appropriate to include the gain or loss arising from a forward contract over the life of the resulting debt issuance rather than at the date the debt is issued. The traditional approach of deferring gains or losses on derivatives until completion of the hedged transaction accomplishes proper matching of the derivatives result with the result of the risk that has been hedged.

We appreciate this opportunity to express our comments about the proposal. Should you have any question about issues raised in this letter, please feel free to call me at __________________ or Marti Sworobuk at ____________________.

Mary Jane Morrow, Co-Chair
NAREIT Accounting Committee
Senior Vice President, Finance & Treasurer
Federal Realty Investment Trust