During the six months ended June 30, 2006, the Account had no real estate sales. The $635,693 of realized loss in the six months ended June 30, 2006 was due to post-closing adjustments made in the current period for properties sold in 2005.
For the three months ended June 30, 2006, the Account’s total net return was 4.69% . This was 31 basis points higher than the total net return of 4.38% for the three months ended June 30, 2005 and 148 basis points higher than the total net return of 3.21% for the three months ended March 31, 2006. The Account’s strong performance in the second quarter of 2006 was primarily due to capital appreciation on the Account’s real estate-related assets, including interests in joint ventures and real estate limited partnerships, and an increase in interest earned on marketable securities. The Account’s real estate holdings, including its joint venture holdings, which represented 79.60% of the Account’s total portfolio, had a gross total return of 6.15% . Its real estate limited partnership interests, which represented 1.81% of the Account’s total investments, had a gross total return of 13.92% . The market value of the Account’s real estate and real estate-related portfolios benefited from healthy economic conditions and the continued strengthening of real estate market fundamentals. The substantial amounts of equity available in the capital markets for investment in real estate by institutional and foreign investors continued to drive market values upward, albeit at a marginally slower pace than at the same time last year.
The Account’s net investment income, after deduction of all expenses, increased by 37% for the three months ended June 30, 2006 compared to the same period in 2005.
The Account’s real estate holdings, including real estate joint ventures and limited partnerships, generated approximately 78% of the Account’s total investment income (before deducting Account level expenses) during the three months ended June 30, 2006, as compared to 86% for the three month period ended June 30, 2005. The decline was primarily due to increased income from the Account’s marketable securities and a decrease in joint venture income distributed in the three months ended June 30, 2006.
Gross real estate rental income increased 36% in the three months ended June 30, 2006 as compared with the same period in 2005. The increase in real estate income for the three months ended June 30, 2006 was due primarily to the increase in the number and size of properties owned by the Account. Income from real estate joint ventures and limited partnerships in the three months ended June 30, 2006 was $13,642,202, as compared to $18,706,861 for the same period in 2005. The 27% decrease was due to the properties owned by the joint ventures holding more cash in order to fund certain expenditures, including capital improvements, thereby decreasing joint venture distributions. Interest income on the Account’s interest earning marketable securities for the three months ended June 30, 2006 and 2005 totaled $29,954,222 and $11,251,893, respectively. This increase was due to
an increase in the amount of non-real estate assets held by the Account relative to Total Investments during the first six months of 2006. In addition, interest rates earned on these investments were higher during the period ended June 30, 2006. Dividend income on the Account’s investments in real estate equity securities declined slightly to $4,811,864 from $4,170,430 for the three months ended June 30, 2006 and 2005, respectively.
Total property level expenses for the three months ended June 30, 2006 and 2005 were $91,038,618 and $68,392,772, respectively. The 33% increase in property level expenses during the three months ended June 30, 2006 was a result of the increased number and size of properties held in the Account and an increase in the overall leverage of the Account. The interest expense incurred in the second quarter of 2006 was $16,763,342, as compared to $9,482,304 for the same period in 2005. Without the interest expense, the increase in property level expenses would have been 26% on a period-to-period comparison.
The Account also incurred expenses for the three months ended June 30, 2006 and 2005 of $5,958,340 and $4,312,907, respectively, for investment advisory services, $11,010,515 and $5,970,843, respectively, for administrative and distribution services and $ 2,580,353 and $2,280,792, respectively, for the mortality, expense risk and liquidity guarantee charges. The aggregate 56% increase in these expenses was a result of the larger net asset base in the Account and the increased costs associated with managing and administering the Account.
Net Realized and Unrealized Gains and Losses on Investments
The Account had net realized and unrealized gains on investments and mortgage loans payable of $411,609,818 and $263,101,053 for the three months ended June 30, 2006 and 2005, respectively. The difference was primarily due to the substantial increase in net realized and unrealized gains on the Account’s real estate properties, which totaled $294,846,098 for the three months ended June 30, 2006, as compared to $185,528,527 for the three months ended June 30, 2005. In addition, the Account had unrealized gains on joint ventures and limited partnerships of $103,907,559 in the second quarter of 2006, as compared to unrealized gains of $41,014,573 in the same period of 2005. This substantial increase in unrealized gains was due to the increase in market value of real estate assets owned by the joint ventures and appreciation of the Account’s interests in the limited partnerships. The Account’s marketable securities posted net realized and unrealized losses of $11,043,201 for the three months ended June 30, 2006, as compared to net realized and unrealized gains of $39,624,478 for the same period in 2005. The change was due to a decline in realized gains from sales of marketable securities (to $2,236,929 in the second quarter of 2006 from $15,110,869 in the second quarter of 2005) and an increase in market interest rates during the second quarter of 2006 as compared to the same period in 2005. In addition, the net change in unrealized appreciation on the Account’s mortgage loans payable was a gain of $23,899,362 for the six months ended June 30, 2006 as compared to a loss of $3,066,525 for the same period 2005, due to an increase in market interest rates in 2006.
During the three months ended June 30, 2006, the Account had no real estate sales. The $6,050 of realized loss in the three months ended June 30, 2006 was due to post-closing adjustments made in the current period for properties sold in 2005.
34
Liquidity and Capital Resources
At June 30, 2006 and 2005, the Account’s liquid assets (i.e., real estate equity securities, commercial mortgage-backed securities, commercial paper, government agency bonds and cash) had a value of $2,601,540,850 and $2,247,905,335, respectively. The increase in the Account’s liquid assets was primarily due to the net positive inflow of transfers and premiums into the Account, which management believes was in response to the strong relative performance of the Account.
During the six months ended June 30, 2006, the Account received $530,995,943 in premiums and $704,497,896 in net participant transfers from TIAA, the CREF Accounts and affiliated mutual funds, while, for the same period in 2005, the Account received $471,857,748 in premiums and $850,799,256 in net participant transfers. The Account’s liquid assets are 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). 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.
Effects of Inflation and Increased Operating Expenses
Inflation, along with increased insurance, utilities and security costs, may increase property level operating expenses and real estate taxes in the future. These increases in operating expenses are generally 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 or any other contractual restrictions in the existing leases, the Account may not be able to recover the full amount of such increases in operating expenses and /or real estate taxes.
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.
35
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 entities, which value their real estate holdings and mortgage notes payable at fair value.
Valuation of Marketable Securities:Equity securities listed or traded on any national market or 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. Debt securities, other than money market instruments, are valued at the most recent bid price or the equivalent quoted yield for such securities (or those of comparable maturity, quality and type). Money market instruments, with maturities of one year or less, are valued in the same manner as debt securities or derived from a pricing matrix that has various types of money market instruments along one axis and various maturities along the other. 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 TIAA Board of Trustees and in accordance with the responsibilities of the Board as a whole.
Accumulation and Annuity Fund:The Accumulation Fund represents the net assets attributable to participants in the accumulation phase of their investment. The Annuity Fund represents the net assets attributable to the participants currently receiving annuity payments. The net increase or decrease in net assets from investment operations is apportioned between the accounts based upon their relative daily net asset values. Once an Account participant begins receiving lifetime annuity income benefits, monthly payment levels cannot be reduced as a result of the Account’s adverse mortality experience. In addition, the contracts are required to stipulate the maximum expense charge that can be assessed, which is equal to 2.50% of average net assets per year. Accordingly, a small risk charge is paid by the Account to TIAA to assume these risks.
36
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.
The Account has limited partnership interests in various real estate funds (limited partnerships). The Account records its contributions as increases to the investments, and distributions from the investments are treated as either income or return of capital, as determined by the management of the limited partnerships. Unrealized gains and losses are calculated and recorded quarterly when the Account’s accounting records are compared to the fund’s financial statements and the Account’s equity values are adjusted.
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.
Mortgage Loans Payable:Commencing in 2005, the Account separately reports mortgage loans payable at estimated market value. Estimated market values are based on the amount at which the liability could be settled (either transferred or paid back) in a current transaction exclusive of direct transaction costs. Different assumptions or changes in future market conditions could significantly affect estimated market value. At times, the Account may assume debt in connection with the purchase of real estate. For debt assumed, the Account allocates a portion of the purchase price to the below or above market debt and amortizes the premium or discount over the remaining life of the debt.
Foreign currency transactions and translation:Portfolio investments and other assets and liabilities denominated in foreign currencies are translated into U.S. dollars at the exchange rates prevailing at the end of the period. Purchases and sales of securities, income receipts and expense payments made in foreign currencies are translated into U.S. dollars at the exchange rates prevailing on the respective dates of the transactions. The effect of changes in foreign currency exchange rates on portfolio investments are included in the net realized and unrealized gains and losses on investments. Net realized gains and losses on foreign currency transactions include maturities of forward for-
37
eign currency contracts, disposition of foreign currencies, and currency gains and losses between the accrual and receipt dates of portfolio investment income and between the trade and settlement dates of portfolio investment transactions.
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, some of which are referenced below in “Item 3. Quantitative and Qualitative Disclosures About Market Risk,” 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, changed assumptions, future events or otherwise.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
The Account’s real estate and real estate-related investments, which as of June 30, 2006 represented 81.96% of the Account’s investments (not including real estate-related marketable securities), expose the Account to a variety of risks. These risks include, but are not limited to:
- General Real Estate Risk — The risk that the Account’s property values or rentaland occupancy rates could go down due to general economic conditions, a weakmarket for real estate generally, and changing supply and demand for certain typesof properties;
- Appraisal Risk — The risk that the sale price of an Account property (i.e., the valuethat would be determined by negotiations between independent parties) might dif-fer substantially from its estimated or appraised value, leading to losses or reducedprofits to the Account upon sale;
- Risk Relating to Property Sales — the risk that the Account might not be able tosell a property at a particular time for its full value, particularly in a poor market.This might make it difficult to raise cash quickly and also could lead to Accountlosses; and
- Risks of Borrowing — The risk that interest rate changes may impact Accountreturns if the Account takes out a mortgage on a property or buys a property subject to a mortgage.
38
- Foreign Currency Risk — The value of the Account’s foreign investments, relateddebt or rental income can increase or decrease due to changes in foreign currencyexchange rates or foreign currency exchange control regulations, and hedgingagainst such changes, if undertaken by the Account, may entail additional costsand be unsuccessful.
As of June 30, 2006, 18.04% 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 (CMBS), 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 general financial terms of these instruments, along with their fair values, 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 to pay principal and interest when due, and for common or preferred stock, the possibility that the issuer’s current earnings will fall or that its overall financial soundness 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 or extension risk — i.e., the risk that borrowers will repay the loans early or later than anticipated. 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. If the underlying mortgage assets are repaid later than anticipated, the Account could lose the opportunity to reinvest the anticipated cash flows at a time when interest rates might be rising. 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, real estate equity securities 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 informa-
39
tion 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 participation 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 June 30, 2006. Based upon management’s review, the CEO and the CFO concluded that the registrant’s disclosure controls and procedures were effective as of June 30, 2006.
(b)Changes in internal controls over financial reporting.There have been no 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.
40
PART II. OTHER INFORMATION
Item 1. LEGAL PROCEEDINGS.
There are no material legal proceedings that the Account is a party to, or to which the Account’s assets are subject.
Item 1A. RISK FACTORS.
Not applicable.
Item 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS.
Not applicable.
Item 3. DEFAULTS UPON SENIOR SECURITIES.
Not applicable.
Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.
Not applicable.
41
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, dated February 22, 2006, by and among TIAA, the Registrant, and Real Estate Research Corporation5 |
| |
| | (B) | Custodial Services Agreement, dated as of June 1, 1995, by and between TIAA and Morgan Guaranty Trust Company of New York on behalf of the Real Estate Account (Agreement assigned to Bank of New York, January 1996)3 |
| |
| | (C) | Distribution and Administrative Services Agreement, dated September 29, 1995, by and between TIAA and TIAA-CREF Individual & Institutional Services, Inc.3(as amended effective as of May 1, 2005)4and as amended, effective April 28, 20066 |
| |
| (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 21, 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 the Account’s Post-Effective Amendment No. 2 to the 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 Exhibit 10.(a) to the Annual Report of the Account filed on March 15, 2006 (File No. 033-92990).
6- Previously filed and incorporated herein by reference to Exhibit 1 to the Account’s Pre-Effective Amendment No. 1 to the Registration Statement on Form S-1 filed May 1, 2006 (File No. 333-132580).
42
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: August 11, 2006
| | 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: August 11, 2006 | | | |
| | | | |
| | | By: | /s/ Georganne C. Proctor |
| | | |
|
| | | | Georganne C. Proctor |
| | | | Executive Vice President and |
| | | | Chief Financial Officer |
43
