“Sarbanes-Oxley was one of the watershed events in a public company’s life,” says Brad Markoff, partner, head of the REIT practice at Alston & Bird LLP. “You need to go back to the 1930s to find laws that have had as much impact on the fundamental systems of REITs and other publicly traded companies.”

The law itself amended the regulatory provisions of the Securities Commission Act of 1934. The Securities Exchange Commission (SEC) is the principal governing body charged with making the rules to enforce the Sarbanes-Oxley changes.

“In general, the impact of Sarbanes-Oxley has been significant on all industries,” Markoff says. “Public REITs are subject to the same rules and disclosure issues as other public companies.”

Sarbanes-Oxley set forth or revised several standards for corporate boards of publicly traded companies and requires rulemaking by the national stock exchanges that will impose additional standards. Parts of the law have taken effect already like rules for audit committees, reporting supplemental financial information and auditor independence. Other parts will be phased in over the course of the year like including accelerated filing requirements for periodic reports. The final standards for still other parts of the law dealing with additional disclosure requirements are still being written.

“Dealing with Sarbanes-Oxley is not a one-time event where action today can cure ‘perceived’ problems forever,” says Gilbert Menna, a partner with Goodwin Procter LLP and co-chair of its REITs and Real Estate Securities practice. “Public companies and their boards and management teams need to act decisively today to deal with some of Sarbanes-Oxley’s immediate mandates. But more importantly, they will need to evaluate, plan, and change corporate behavior for years to come, which is the likely result Congress intended.”

In general, REITs have done a good job in disclosing off-balance sheet financial matters, so some of the practices of Enron, WorldCom, et al have been stopped before they could start, Markoff added.

Another reason the REIT industry has been free from such scandals, according to Markoff, is the high level of scrutiny of REIT financial disclosure and performance by insiders and outsiders alike. While the leading investment banks have sell-side REIT analysts, there are also several independent industry analysts like Green Street Advisors and institutional investors like Cohen & Steers that have followed the industry closely without any ties to investment banks. Part of the problem with the accounting scandals is that the analysts with investment banking firms had vested interests in providing (the non-REIT) public companies with good ratings, Markoff says.

However, Sarbanes-Oxley does set forth some changes in rules and corporate reporting that strongly impact the REIT industry. One of the goals of the law is to require expanded disclosures about accounting measures used by any industry that don’t adhere to generally accepted accounting principles (GAAP). In the real estate business, this would include the use of funds from operations (FFO) as a non-GAAP earnings measure, which Markoff believes is a supplemental indicator of a REIT’s performance.

“Congress and the SEC are looking at some fairly draconian rules (regarding financial reporting),” Markoff says. “It’s like using an elephant gun instead of a flyswatter.”

Ken Betts, partner at Locke, Liddell & Sapp LLP, says the restrictions on non-GAAP reporting will probably have the most effect on the REIT industry, though it’s difficult to say what that effect will be. One concern is that every company does not measure FFO the same way, and the SEC is seeking consistency in reporting, Betts says. “If the REITs don’t conform to the NAREIT white paper definition of FFO, there’s some concern the SEC could restrict its use,” Betts says.

If in doubt, Menna recommends REITs, analysts and investors consult the NAREIT white paper (www.nareit.com/accountingissues/whitepaper.cfm) for guidelines to consider in a company’s reporting practices. The white paper takes a conservative approach in accounting for FFO, which Menna says should dovetail well with some of the SEC’s Sarbanes-Oxley driven guidelines that are designed to take conservative rather than aggressive approaches to accounting and financial reporting.

Many REITs that use the NAREIT guidelines regarding FFO also make supplemental adjustments to FFO when clearly defined and disclosed items warrant it, Menna adds. These adjustments give valuable financial information to investors. The law does permit FFO measures to be used in press releases and in SEC filings as long as expanded SEC disclosure requirements are satisfied.

Another implication from Sarbanes-Oxley is the prohibition of insider loans. While that may be a good idea in industries in which corporate executives use these funds for their own purposes (new house, new car, etc.), loans of the type in the REIT industry are typically used for the insider to buy shares in the REIT, according to Markoff. If this rule stays as it is, REIT executives who have used “insider loans” to buy stock won’t be able to renew these loans or get new ones, Markoff says.

As part of the disclosure rules, Sarbanes-Oxley seeks to generate more comprehensive information about the financial obligations of companies, including loans, joint venture financing, et al. Though he feels that the REIT industry does a good job in making disclosures, the new emphasis on full reporting could mean more exacting disclosure for REITs on joint venture operations, according to Markoff.

New proposed SEC rules as currently written would also require REITs to disclose non-binding letters of intent, and to quickly disclose any changes in financial arrangements (i.e., commitments to buy and sell property, binding letters of intent, guaranteed returns to investor partners, etc.), Menna says. Therefore, directors of REIT companies can expect to spend a lot more time on financial reporting.

There’s still some debate about what level of disclosure will be considered adequate without hurting the business of the REIT itself, Menna adds. A non-REIT example is a good case in point: If word had gotten out that the Disney Corporation was acquiring land in Orlando in the 1960s and early 1970s before all purchases were made, the price of the real estate would have skyrocketed, making the purchases much more expensive.

The same thing could happen, according to Menna, if it’s disclosed a REIT is considering acquiring one or more properties before a deal is actually consummated. Much of the due diligence conducted on potential investments would be hard or impossible to do if confidentiality can’t be guaranteed.

Since many of the ambiguities of the new rules are still unresolved and details of pending SEC proposals are being finalized, Menna expects more changes as precedents are set and confirmed or denied through litigation. To ensure that any future financial reporting changes don’t adversely affect them, Menna recommends that REITs disclose all their activities and reconcile non-GAAP measures back to GAAP measures.

“There have been relatively few financial lawsuits involving the financial disclosures of REITs for a long time,” Markoff says, adding that he doesn’t expect any because the industry has done a good job of disclosure and industry watchdogs closely scrutinize REITs for on-balance sheet and off-balance sheet financing.

Phillip Britt is a regular contributor to Portfolio.