SEC staff updates position on commercial mortgage REIT disclosure of "Core Earnings"

Background

Since the modern generation of CM REITs launched in 2009, CM REITs have consistently disclosed "Core Earnings," a non-GAAP performance measure which is generally calculated as GAAP net income excluding (i) non-cash equity compensation expense, (ii) depreciation and amortization, (iii) unrealized gains/losses (including loan loss reserves), and (iv) certain other non-cash items. There has been some variation on whether and how CM REITs further adjust "Core Earnings" for "realized losses."

One of the principal reasons investors invest in CM REITs is the dividend. Like all REITs, CM REITs are required to distribute at least 90% of taxable income to their shareholders annually. While not a substitute for taxable income, historically, over time, the "Core Earnings" measure has proven to be a useful indicator of a CM REIT's dividends.

Effective January 1, 2020, ASU 2016-13 mandated the use of an "expected loss" credit model (CECL) for estimating future credit losses of loans instead of the "incurred loss" credit model that GAAP previously required. Since the first quarter of 2020, filers have been required to recognize changes to the CECL reserve through GAAP net income. For some companies these quarterly CECL reserve adjustments have resulted in significant quarterly volatility in net income, in part as a result of volatile macroeconomic conditions driven by the pandemic impacting loss assumptions.

Unlike CM REITs, which had always excluded provisions for loan loss from Core Earnings, a number of other filers initiated the practice of excluding changes to the CECL reserve from certain non-GAAP performance measures with their adoption of CECL. Starting in the second quarter of 2020, the SEC staff began objecting to certain filers excluding changes in the CECL reserve from non-GAAP performance measures on the basis that the adjustments could make these measures misleading.

In November 2020, a CM REIT announced that the SEC staff had taken a similar position on its CECL adjustment to Core Earnings and that, as a result, the CM REIT would not exclude changes in the CECL reserve from its future computations of Core Earnings. Following this announcement, Hogan Lovells and representatives and members of Nareit engaged with staff from the SEC's Division of Corporation Finance – Office of the Chief Accountant, and the Division of Corporation Finance office that reviews REIT filings. We expressed that the continued exclusion of the loan loss provision from Core Earnings, as used and defined by CM REITs, was not misleading for a number of reasons, and that it was useful to CM REIT investors as an indicator of REIT dividends. We noted that CM REITs had always excluded loan loss reserves from Core Earnings and were not doing so in response to CECL and that such exclusion was fundamental to the usefulness and intended purpose of presenting Core Earnings.

SEC staff feedback

After considering our concerns, the SEC staff advised that it would not object to CM REITs continuing to disclose the measure currently called "Core Earnings" subject to certain conditions.

• First, the SEC staff advised that the term "Core Earnings" could be misleading, given that loan loss reserves are typically integral to the earnings of a lender. The SEC staff indicated that the name of the measure should reflect what the measure presents. Based on our discussions with the SEC staff, we understand that "Distributable Earnings" is an example of a name they would not object to if accompanied by the disclosure below regarding its usefulness to investors.

• Second, the measure should be accompanied by expanded disclosure regarding its usefulness to investors as an indicator of CM REIT dividends. The SEC staff indicated that based on representations we made as to the usefulness of Core Earnings, they would expect to see disclosure explaining (i) that to maintain its status as a REIT the CM REIT is required to distribute substantially all of its taxable income, (ii) that dividends are one of the principal reasons investors invest in the CM REIT, (iii) that over time the measure has been a useful indicator of the CM REIT's dividends per share, and (iv) that the measure is considered by the CM REIT in determining its dividend.

• Third, the CM REIT should provide clear disclosure on how the CM REIT reduces this performance measure when it determines that loan losses have been "realized," including how it defines "realized" for these purposes.

The SEC staff also confirmed that the measure, if satisfying the conditions above, could be presented as a performance measure, reconciled to GAAP net income and presented on a per share basis.

Conclusion

The SEC staff's thoughtful reconsideration of this issue will permit CM REITs to continue to present a measure that is considered highly useful by CM REIT analysts and investors, and will avoid the market confusion that would have inevitably occurred had the industry been forced to significantly change the computation. CM REIT issuers should expect that the SEC staff will be looking out for this issue in their 2021 Form 10-K reviews and that non-GAAP presentations inconsistent with this feedback will likely result in an SEC comment letter.

About the Hogan Lovells U.S. REIT practice: With more than 45 lawyers, our U.S. REIT practice is a leader in advising equity and mortgage REITs and other real estate companies on capital markets offerings, M&A, financings, SEC compliance, activism, governance, and tax matters. We also specialize in advising externally-managed mortgage REIT boards and special committees on related party mergers, manager contract amendments and renewals, and other related party transactions.

Authored by Michael McTiernan, Abigail Smith, and Tifarah Allen