Since the Sarbanes-Oxley Act (SOX) was signed into law in 2002, publicly traded companies, including REITs, have had to adjust to tougher reporting requirements. Most REITs have made the transition successfully, say industry experts, but smaller REITs have carried a disproportionate compliance burden in terms of time and expense. To lessen the burden, industry groups and lawmakers are working to implement changes. Whether reform will actually occur, however, is an open question.

“By now, most companies have made SOX so routine that they have policies and procedures to deal with it,” says Dale Anne Reiss, Ernst & Young's global and Americas director of real estate, hospitality, gaming and construction. “Although it's still a burden, its day-to-day impact is less dramatic than it was during the first two years.” Some companies have embraced SOX, Reiss adds. “They've used it as a vehicle to focus on making their internal operations work most effectively. Other entities are a lot less positive.”

Making lemonade out of SOX

Pennsylvania Real Estate Investment Trust in Philadelphia, which invests in regional malls and power shopping centers, has turned SOX to its advantage, explains Bob McCadden, the company's executive vice president and CFO. In 2003, the company went through a series of transactions in which it shed all 7,200 of its multifamily units, acquired six regional malls, and merged with another REIT. According to McCadden, it used SOX as a way to create uniformity at the new entity.

“In a span of 12 months, the company tripled in size. We saw SOX as an opportunity to unify the three business practices,” he says. “Now we have reached the maturation stage, have our systems in place, and are functioning relatively smoothly.”

McCadden says the cost during the first year of SOX compliance was 2 to 3 cents per share, a figure Reiss describes as average. Her studies, taken shortly after SOX came into law, showed that compliance cost 3 to 5 cents per share in the first year. “The burden fell harder on smaller REITs because they had less internal infrastructure to begin with,” Reiss says. “Now it's harder to tell because it's more institutionalized, and audit fees aren't necessarily broken out. Costs have gone down, but they haven't disappeared.”

Wading into minutiae

George Yungmann, senior vice president of financial standards at the National Association of Real Estate Investment Trusts, says most of its members are in the same boat as McCadden. “The general attitude is that REITs don't want to see any dramatic changes in the rules because they now have their processes and systems set up, documented, and tested.”

But it's not all smooth sailing, Yungmann emphasizes. His group sent a letter in September to the U.S. Securities and Exchange Commission asking that Section 404 — which requires publicly traded companies to establish internal controls for financial reporting and assess their effectiveness at the end of each fiscal year — be clarified. The group seeks changes to reflect the commission's philosophy of top-down, risk-based auditing, or setting ethical and accuracy standards at the top of a company.

“Our industry feels that SOX and Section 404 will improve and enhance the quality of financial reporting,” says Yungmann. “At the same time, the auditor requirements are driving management into minutiae. The problem is that the SEC has a view of how Section 404 has to be implemented, in a top-down risk-based approach, but the Public Company Accounting Oversight Board issued an audit standard that's far more detailed,” according to Yungmann.

“For instance, if you use the SEC's principle in applying Section 404, you'd be worried about controls over significant transactions,” Yungmann says. The standard that outside auditors have to comply with would require that they delve into minor detail, adds Yungmann. “It might require auditors to document and test whether there are two versus three signatures on a bill that needs to be paid.”

Reiss says she's also heard REIT managers express frustration. “They comply with SOX, but because they're putting more time into complying, like signing certificates, that's less time they could be leading the company.”

Not standing idle

U.S. Rep. Tom Feeney (R-Fla.) has introduced legislation, called the Compete Act (H.R. 5405), “to advance the reasonable application of” SOX, says Pepper Rae Pennington, a spokesperson for Feeney. “Section 404 of SOX is only 168 words long but is regarded as the most burdensome part of this legislation,” she says.

One of the bill's provisions would allow public companies with market capitalization of under $700 million to opt out of Section 404 reporting requirements. Another would provide for less-frequent random audits after the first year of compliance. The bill currently has some 25 co-sponsors in the U.S. House of Representatives, and its companion bill in the U.S. Senate has 10 co-sponsors.

But Reiss says REITs shouldn't expect to put SOX behind them anytime soon. “I don't anticipate any significant modifications in the next few years,” she says. “It's a fact of life, and it's a price for having access to the public market. In 10 years, we won't even think about it because it'll be part of a company's routine.”

G.M. Filisko is a Chicago-based reporter and attorney who writes on legal and real estate issues. She can be contacted at gabifil@rcn.com.