The Account also incurred expenses for the nine months ended September 30, 2005 and 2004 of $13,523,265 and $10,225,925, respectively, for investment advisory services, $19,517,975 and $11,166,357 respectively, for administrative and distribution services and $6,678,814 and $4,182,234, respectively, for the mortality, expense risk and liquidity guarantee charges. The aggregate 55% increase in these expenses is a result of the 52% increase in Total Net Assets of the Account from third quarter 2004 to third quarter 2005, and the increased costs associated with managing the Account.
The Account had net realized and unrealized gains of $552,196,148 and $276,304,124 for the nine months ended September 30, 2005 and 2004, respectively. The difference is primarily due to the substantial increase in net realized and unrealized gains of $419,104,295 compared to $96,429,517 on its real estate properties for the nine months ended September 30, 2005 and 2004, respectively. The increase in net realized and unrealized gain for the real estate is due to the capital appreciation of real estate assets resulting from continued inflow of capital into the real estate market from institutional and other investors, which has had the effect of increasing the value of real estate investments. The Account had unrealized gains on its real estate joint venture and limited partnership holdings of $123,095,454 for the nine months ended September 30, 2005, as compared to unrealized gains of $150,829,573 for the same period in 2004. The differential in unrealized gains on the Account’s other real estate related investment holdings is due in part to the unrealized losses resulting from the liquidation of some of the assets owned by a limited partnership in which the Account has an interest, and the moderation in the unrealized gains posted on the three regional malls in which the Account has an interest. The Account’s marketable securities also posted net realized and unrealized gains of $9,996,399 and $29,045,034 respectively for the nine months ended September 30, 2005 and 2004. The primary factor in the decline is due to the negative effect of the weak performance of the REIT market on the Account’s real estate equity security holdings over this period in 2005.
During the nine months ended September 30, 2005, the Account sold seven properties for total net proceeds of approximately $237.7 million for a realized gain of $34.1 million.
For the three months ended September 30, 2005, the Account’s total net return was 4.13% . This was 35 basis points lower than the return of 4.48% for the three months ended September 30, 2004. The returns were slightly lower as compared to the same period in 2004 primarily due to the performance of the Account’s real estate equity securities and other real estate related assets.
Income and Expenses
The Account’s net investment income, after deduction of all expenses, increased by 29% for the three months ended September 30, 2005 compared to the same period in 2004. This was due to an increase in the Account’s real estate holdings, including joint ventures. As of September 30, 2004, the Account owned 101 real estate properties representing 81.53% of total net assets as compared to 107 properties representing 75.37% of total net assets at the end of the same period 2005. For purposes of more efficient asset management, several properties purchased were consolidated into existing portfolios.
The Account’s real estate holdings, including real estate joint ventures and limited partnerships, generated approximately 82% of the Account’s total investment income (before deducting Account level expenses) during the three months ended September 30, 2005, as compared to 90% for the three-month period ended September 30, 2004. The remaining portion of the Account’s total investment income was generated by investments in marketable securities.
Gross real estate rental income increased 64% in the three months ended September 30, 2005, compared with the same period in 2004. The higher real estate income for the three months ended September 30, 2005 was due primarily to the increase in the number of properties owned by the Account. Income from real estate joint ventures and limited partnerships declined by 37%. Interest income on the Account’s marketable securities investments for the three months ended September 30, 2005 and 2004 totaled $17,070,099 and $4,463,220, respectively. This was due to an increase in the amount of non-real estate assets held by the Account, which were earning interest at a higher rate during the three months ended September 30, 2005 as compared to the same period in 2004. Dividend income on the Account’s investments in real estate equity securities increased to $6,192,539 from $5,612,876 for the three months ended September 30, 2005 and September 30, 2004, respectively.
Total property level expenses for the three months ended September 30, 2005 and 2004 were $71,722,244 and $38,131,831, respectively. The 88% increase in property level expenses during the three months ended September 30, 2005 reflected the increased number of properties held in the Account. In addition, during the three months ended September 30, 2005, the Account incurred interest expense of $10,220,655 for mortgages on six of its real estate holdings.
The Account also incurred expenses for the three months ended September 30, 2005 and 2004 of $5,195,916 and $4,322,840, respectively, for investment advisory services, $7,590,274 and $3,952,538 respectively, for administrative and distribution services and $2,521,144 and $1,570,186, respectively, for the mortality, expense risk and liquidity guarantee charges. The 55% increase in these expenses is a result of the larger net asset base of the Account and the increased costs associated with managing the Account.
Net Realized and Unrealized Gains and Losses on Investments
The Account had net realized and unrealized gains of $267,884,516 and $180,629,848 for the three months ended September 30, 2005 and 2004, respectively. The
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increase in net realized and unrealized gains was due to substantial net realized and unrealized gains during the period ended September 30, 2005 as compared to same period 2004 on the Account’s real estate of $208,465,871 and $92,609,910, respectively. The increase in net realized and unrealized gain for the real estate is due to the continued high transaction volume in the real estate property markets, which drove the substantial capital appreciation of the Account’s real estate holdings and realized gains on the disposition of four properties in the third quarter 2005. The Account had unrealized gains on its real estate joint venture and limited partnership holdings of $62,570,272 for the three months ended September 30, 2005, as compared to unrealized gains of $68,500,575 for the same period in 2004. The decrease in joint venture and limited partnership holdings is primarily due to the Account’s investment in a fund which has been liquidating its assets. The Account’s marketable securities also posted net realized and unrealized losses of $3,151,627 as of the three months ended September 30, 2005 as compared to net realized and unrealized gains of $19,519,363 for the three months ended September 30, 2004. This decrease is reflective of the extreme volatility experienced by the Real Estate Investment securities market.
During the three months ended September 30, 2005, the Account sold four properties for a total net proceeds of approximately $114.5 for a realized gain of $14.0 million.
Liquidity and Capital Resources
At September 30, 2005 and 2004, the Account’s liquid assets (i.e., its real estate equity securities, CMBSs, commercial paper, government securities and cash) had a value of $2,554,124,346 and $1,223,928,053, respectively. The increase in the Account’s liquid assets is primarily due to net positive inflow of transfers and premiums into the Account, which is in response to of the strong relative performance of the Account.
During the nine months ended September 30, 2005, the Account received $715,181,837 in premiums and $1,207,597,267 in net participant transfers from TIAA, the CREF Accounts and affiliated mutual funds, while for the same period in 2004, the Account received $524,415,992 in premiums and $808,836,329 in net participant transfers. The Account’s liquid assets, will continue to be available to purchase additional suitable real estate properties and to meet expense needs and redemption requests (i.e., cash withdrawals, benefits or transfers). In the unlikely event that the Account’s liquid assets and its cash flow from operating activities and participant transactions are not sufficient to meet its cash needs, including redemption requests, TIAA’s general account will purchase liquidity units in accordance with TIAA’s liquidity guarantee to the Account.
The Account, under certain conditions more fully described in the Account’s prospectus, may borrow money and assume or obtain a mortgage on a property — i.e., to make leveraged real estate investments. Note that the Account recently changed its borrowing policy to expand the circumstances under which it could borrow. Also, to meet any short-term cash needs, the Account may obtain a line of credit whose terms may require that the Account secure a loan with one or more of its properties. The Account’s total borrowings may not exceed 20% of the Account’s total net assets.
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Effects of Inflation and Increasing Operating Expenses
Inflation, along with increased insurance and security costs, may increase property operating expenses in the future. We anticipate that these increases in operating expenses will generally be billed to tenants either through contractual lease provisions in office, industrial, and retail properties or through rent increases in apartment complexes. However, depending on how long any vacant space in a property remains unleased, the Account may not be able to recover the full amount of such increases in operating expenses.
Critical Accounting Policies
The financial statements of the Account are prepared in conformity with accounting principles generally accepted in the United States.
In preparing the Account’s financial statements, management is required to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses. Management bases its estimates on historical experience and assumptions that are believed to be reasonable under the circumstances—the results of which form the basis for making judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates.
Management believes that the following policies related to the valuation of the Account’s assets reflected in the Account’s financial statements affect the significant judgments, estimates and assumptions used in preparing its financial statements:
Valuation of Real Estate Properties:Investments in real estate properties are stated at fair value, as determined in accordance with procedures approved by the Investment Committee of the TIAA Board of Trustees. Fair value for real estate properties is defined as the most probable price for which a property will sell in a competitive market under all conditions requisite to a fair sale. Determination of fair value involves subjective judgment because the actual market value of real estate can be determined only by negotiation between the parties in a sales transaction. The Account’s properties are initially valued at their respective purchase prices (including acquisition costs). Subsequently, independent appraisers value each real estate property at least once a year. TIAA’s appraisal staff performs a valuation of each real estate property on a quarterly basis and updates the property value if it believes that the value of the property has changed since the previous valuation or appraisal. The appraisals are performed in accordance with Uniform Standards of Professional Appraisal Practices (USPAP), the real estate appraisal industry standards created by The Appraisal Foundation. Real estate appraisals are estimates of property values based on a professional’s opinion.
Valuation of Real Estate Joint Ventures:Real estate joint ventures are stated at the Account’s equity in the net assets of the underlying joint venture entities, which value their real estate holdings and mortgage notes payable at fair value.
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Valuation of Marketable Securities:Equity securities listed or traded on any United States national securities exchange are valued at the last sale price as of the close of the principal securities exchange on which such securities are traded or, if there is no sale, at the mean of the last bid and asked prices on such exchange. Short-term money market instruments are stated at market value. Portfolio securities and limited partnership interests for which market quotations are not readily available are valued at fair value as determined in good faith under the direction of the Investment Committee of the Board of Trustees and in accordance with the responsibilities of the Board as a whole.
Accounting for Investments:Real estate transactions are accounted for as of the date on which the purchase or sale transactions for the real estate properties close (settlement date). Rent from real estate properties consists of all amounts earned under tenant operating leases, including base rent, recoveries of real estate taxes and other expenses and charges for miscellaneous services provided to tenants. Rental income is recognized in accordance with the billing terms of the lease agreements. The Account bears the direct expenses of the real estate properties owned. These expenses include, but are not limited to, fees to local property management companies, property taxes, utilities, maintenance, repairs, insurance and other operating and administrative costs. An estimate of the net operating income earned from each real estate property is accrued by the Account on a daily basis and such estimates are adjusted as soon as actual operating results are determined.
Income from joint ventures is recorded based on the Account’s proportional interest in the income earned by the joint venture that has been distributed from the joint venture to the Account.
Securities transactions are accounted for as of the date the securities are purchased or sold (trade date). Interest income is recorded as earned and includes accrual of discount and amortization of premium. Dividend income is recorded on the ex-dividend date or as soon as the Account is informed of the dividend. Realized gains and losses on securities transactions are accounted for on the specific identification method.
Forward-Looking Statements
Some statements in this report which are not historical facts may be “forward-looking statements” within the meaning of Section 21E of the Securities Exchange Act of 1934 and the Private Securities Litigation Reform Act of 1995. Forward-looking statements include statements about our expectations, beliefs, intentions or strategies for the future, and the assumptions underlying these forward-looking statements. Forward-looking statements involve risks and uncertainties that could cause actual results to differ materially from historical experience or management’s present expectations.
Caution should be taken not to place undue reliance on management’s forward-looking statements, which represent management’s views only as of the date this report is filed. Neither management nor the Account undertake any obligation to update publicly or revise any forward-looking statement, whether as a result of new information, future events or otherwise.
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Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
As of September 30, 2005, 24% of the Account’s investments were in market risk sensitive instruments, comprised entirely of marketable securities. These include real estate equity securities, commercial mortgage backed securities (CMBSs), and high-quality short-term debt instruments (i.e., commercial paper and government agency bonds). The Statement of Investments for the Account sets forth the terms of these instruments, along with their fair value, as determined in accordance with procedures described in Note 1 to the Account’s financial statements. Note that the Account does not currently invest in derivative financial instruments.
The Account’s investments in marketable securities are subject to the following general risks:
financial risk— for debt securities, the possibility that the issuer won’t be able topay principal and interest when due, and for common or preferred stock, the pos-sibility that the issuer’s current earnings will fall or that its overall financial sound-ness will decline, reducing the security’s value.
market risk— price volatility due to changing conditions in the financial marketsand, particularly for debt securities, changes in overall interest rates.
interest rate volatility, which may affect current income from an investment.
In addition, mortgage-backed securities are subject to prepayment risk (i.e., the risk that borrowers will repay the loans early). If the underlying mortgage assets experience greater than anticipated payments of principal, the Account could fail to recoup some or all of its initial investment in these securities. The market value of these securities is also highly sensitive to changes in interest rates. Note that the potential for appreciation, which could otherwise be expected to result from a decline in interest rates, may be limited by any increased prepayments.
In addition to these risks, REITs and mortgage-backed securities are subject to many of the same general risks inherent in real estate investing, making mortgage loans and investing in debt securities. For more information on the risks associated with all of the Account’s investments, see the Account’s most recent prospectus.
Item 4. CONTROLS AND PROCEDURES.
(a)Evaluation of disclosure controls and procedures.The registrant maintains a system of disclosure controls and procedures that are designed to ensure that information required to be disclosed in the registrant’s reports under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to management, including the registrant’s Chief Executive Officer (“CEO”) and the Chief Financial Officer (“CFO”), as appropriate, to allow timely decisions regarding required disclosure. Under the supervision and partici-
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pation of the registrant’s management, including the registrant’s CEO and CFO, the registrant conducted an evaluation of the effectiveness of the registrant’s disclosure controls and procedures as defined in Rule 13a-15(e) under the Exchange Act as of September 30, 2005. Based upon management’s review, the CEO and the CFO concluded that the registrant’s disclosure controls and procedures were effective as of September 30, 2005, except as noted below.
The registrant had previously consolidated its investments in certain joint ventures prior to December 31, 2004, as a result of the registrant’s majority financial interest in, and shared control of, those joint ventures. Based on consultations with Ernst & Young LLP in connection with its audit of the registrant’s 2004 financial statements, it was determined that the investments in certain joint ventures that had previously been treated as consolidated subsidiaries in 2003 and 2002 should instead be treated as investments in unconsolidated joint ventures, despite the fact that the registrant owned a majority financial interest in the entities. Ernst & Young LLP audited both the registrant’s 2003 and 2002 consolidated financial statements. The registrant’s 2003 and 2002 financial statements were restated in the registrant’s 2004 Form 10-K, filed in April 2005, to show the treatment of these investments consistently with the 2004 treatment, which reflected the registrant’s equity in the net assets and operations of the underlying entities. The interim 2004 financial statements contained herein have been restated to conform to the 2004 treatment. This restatement did not affect the registrant’s total net assets, net asset value per accumulation unit, net increase in net assets resulting from operations nor the Account’s total return, as previously reported in the Account’s interim 2004 financial statements.
Ernst & Young LLP determined, in connection with its audit of the registrant’s 2004 financial statements, that pursuant to Public Company Accounting Oversight Board’s Auditing Standard No. 2, a restatement of the registrant’s previously issued financial statements indicated a material weakness, notwithstanding the fact that the adjustment had no net impact on net assets and operations. This determination was reported to the registrant’s Audit Committee.
Subsequent to the review of its disclosure controls, the registrant revised its controls related to the presentation of joint ventures. The CEO and the CFO have concluded that the disclosure controls and procedures that are now in place at the registrant are effective to ensure compliance with the Exchange Act.
Management believes that this matter has been adequately addressed by the corrective action summarized herein.
(b)Changes in internal controls over financial reporting.There have been no significant changes in the registrant’s internal controls over financial reporting that occurred during the registrant’s last fiscal quarter that materially affected, or are reasonably likely to materially affect, the registrant’s internal controls over financial reporting.
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PART II. OTHER INFORMATION
Item 1. LEGAL PROCEEDINGS.
There are no material current or pending legal proceedings that the Account is a party to, or to which the Account’s assets are subject.
Item 2. UNREGISTERED SALES OF EQUITY IN SECURITIES AND USE OF PROCEEDS.
Not applicable.
Item 3. DEFAULTS UPON SENIOR SECURITIES.
Not applicable.
Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITYHOLDERS.
Not applicable.
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Item 5. OTHER INFORMATION.
Not applicable
Item 6. EXHIBITS
| | (3) | (A) | Charter of TIAA (as amended)1 |
| | | (B) | Bylaws of TIAA (as amended)1 |
| | | | |
| | (4) | (A) | Forms of RA, GRA, GSRA, SRA, IRA Real Estate Account Endorsements3, Keogh Contract,4Retirement Select and Retirement Select Plus Contracts and Endorsements2and Retirement Choice and Retirement Choice Plus Contracts.4 |
| | | (B) | Forms of Income-Paying Contracts3 |
| | | | |
| | (10) | (A) | Independent Fiduciary Agreement by and among TIAA, the Registrant, and The Townsend Group5, as amended6 |
| | | (B) | Custodial Services Agreement by and between TIAA and Morgan Guaranty Trust Company of New York with respect to the Real Estate Account (Agreement assigned to Bank of New York, January 1996)3 |
| | | (C) | Distribution and Administrative Services Agreement by and between TIAA and TIAA-CREF Individual & Institutional Services, Inc. (as amended) (filed previously as Exhibit (1))2 |
| | | (31) | Rule 13a-15(e)/15d-15(e) Certifications |
| | | (32) | Section 1350 Certifications |
| |
1- Previously filed and incorporated herein by reference to the Account’s Pre-Effective Amendment No. 1 to the Registration statement on Form S-1 filed December 22, 2004 (File No. 333-121493).
2- Previously filed and incorporated herein by reference to the Account’s Pre-Effective Amendment No. 1 to the Registration statement on Form S-1 filed April 29, 2004 (File No. 333-113602).
3- Previously filed and incorporated herein by reference to Post-Effective Amendment No. 2 to the Account’s Registration Statement on Form S-1 filed April 30, 1996 (File No. 33-92990).
4- Previously filed and incorporated herein by reference to the Account’s Post-Effective Amendment No. 1 to the Registration statement on Form S-1 filed May 2, 2005 (File No. 333-121493).
5- Previously filed and incorporated herein by reference to Post-Effective Amendment No. 6 to the Account’s Registration Statement on Form S-1 filed April 26, 2000 (File No. 333-22809).
6- Previously filed and incorporated herein by reference to the Account’s Post-Effective Amendment No. 2 to the Registration statement on Form S-1 filed April 29, 2003 (File No. 333-83964).
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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
| DATE: November 11, 2005 | | |
| |
| | TIAA REAL ESTATE ACCOUNT |
| |
| | By: | TEACHERS INSURANCE AND ANNUITY |
| | | ASSOCIATION OF AMERICA |
| |
| | By: | /s/ Herbert M. Allison, Jr. |
| |
|
| | | Herbert M. Allison, Jr. |
| | | Chairman of the Board, President |
| | | and Chief Executive Officer |
| |
| DATE: November 11, 2005 | | |
| |
| | By: | /s/ Russell Noles |
| |
|
| | | Russell Noles |
| | | Vice President and |
| | | Acting Chief Financial Officer |
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