ating positive results in the disposition of five assets during the third quarter of 2006. In addition, the unrealized gain on the Account’s mortgage loans payable was $9,080,182 for the nine months ended September 30, 2006, as compared to an unrealized loss of $39,770,940 for the same period in 2005. Every quarter the mortgages on the properties owned by the Account are valued. During the nine months ended September 30, 2006, the net effect of these valuations was positive to the Account due to the increase in market interest rates, resulting in decreases in the valuations of the mortgage loans payable.
During the nine months ended September 30, 2006, the Account sold five real estate properties for total net proceeds, after selling expenses, of $231.2 million for a cumulative net gain of $61.4 million, based on the properties’ capitalized costs.
For the three months ended September 30, 2006, the Account’s total net return was 3.43% . This was 70 basis points lower than the total net return of 4.13% for the three months ended September 30, 2005. The negative variance between the periods ended September 30, 2006 and 2005 was due to a moderation in the capital appreciation (i.e., unrealized gains) on the Account’s real estate and real estate-related assets, including interests in joint ventures and real estate limited partnerships, which was partially offset by increased unrealized gains on the Account’s marketable securities.
For the three month period ended September 30, 2006, the Account’s real estate holdings (including its joint venture holdings), which represented 76.2% of the Account’s total portfolio, had a gross total return of 3.88% . The market value of the Account’s real estate and real estate-related portfolios benefited from stable economic conditions and positive commercial real estate market fundamentals. Management believes that there continues to be a strong interest in real estate, evidenced by the substantial amount of equity available in the capital markets earmarked by institutional and foreign investors for increasing their exposure to the real estate asset class. The pricing of commercial real estate transactions in the market is still driving increases in market values, however, 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 51.6% for the three months ended September 30, 2006, as compared to the same period in 2005. This increase was primarily due to a 65% increase in income from its marketable securities.
The Account’s real estate holdings, including real estate joint ventures and limited partnerships, generated approximately 82.0% of the Account’s total investment income (before deducting Account level expenses) during the three months ended September 30, 2006, as compared to 83.4% for the three month period ended September 30, 2005.
Gross real estate rental income increased 39.5% in the three months ended September 30, 2006, as compared with the same period in 2005. The increase in real estate income for the three months ended September 30, 2006 was due 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 September 30, 2006 was $ 40,173,452, as compared to $19,568,393 for the same period in 2005. Investment income on the Account’s marketable securities and mortgage receivable for the three months ended September 30, 2006 and 2005 totaled $35,295,331 and $21,434,909, 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 nine month period ended September 30, 2006. In addition, interest rates earned on these investments were higher during the period ended September 30, 2006.
Total property level expenses for the three months ended September 30, 2006 and 2005 were $102,469,043 and $71,722,244, respectively. The 42.9% increase in property level expenses during the three months ended September 30, 2006 was a result of the increased number and size of properties held in the Account and the 76.9% increase in interest expense incurred in the second quarter of 2006, due to an increase in the amount of leverage on the properties.
The Account also incurred expenses for the three months ended September 30, 2006 and 2005 of $7,687,795 and $5,195,916, respectively, for investment advisory services, $13,055,491 and $7,590,274, respectively, for administrative and distribution services and $ 2,617,152 and $2,521,144, respectively, for the mortality, expense risk and liquidity guarantee charges. The aggregate 52.6% increase in these expenses was a result of the larger net asset base in the Account, on which the fees are calculated, and the increased costs associated with managing and administering the Account.
Net Realized and Unrealized Gains and Losses on Investments and Mortgage Loans Payable
The Account had net realized and unrealized gains on investments and mortgage loans payable of $267,403,413 and $268,054,276 for the three months ended September 30, 2006 and 2005, respectively. Although the overall variance was minimal, the contributions of the various components changed on a period-to-period basis. The quarter-to-quarter change was not significantly affected by the net realized and unrealized gains on the Account’s real estate properties, which totaled $224,442,940 for the three months ended September 30, 2006, as compared to $218,570,286 the three months ended September 30, 2005. The Account had unrealized gains on joint ventures and limited partnerships of $10,993,671 in the third quarter of 2006, as compared to unrealized gains of $62,570,272 in the same period of 2005. This decline was partially offset by the Account’s marketable securities, which posted net realized and unrealized gains of $47,123,225 for the three months ended September 30, 2006, as compared to net realized and unrealized losses of $2,981,867 for the same period in 2005. The increase from marketable securities was associated with a decrease in market interest rates during the third quarter of 2006. In addition, the net change in unrealized appreciation on the Account’s mortgage loans payable was a loss of $15,156,423 for the three months ended September 30, 2006 as com-
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pared to a loss of $10,104,415 for the same period 2005; the decrease in market interest rates in the third quarter of 2006 resulted in increases in the valuations of the mortgage loans payable.
During the three months ended September 30, 2006, the Account sold five real estate properties for total net proceeds, after selling expenses, of $231.2 million for a cumulative net gain of $61.4 million, based on the properties’ capitalized costs.
Liquidity and Capital Resources
At September 30, 2006 and 2005, the Account’s liquid assets (i.e., cash and marketable securities) had a value of $3,219,105,295 and $2,557,476,629, respectively. The increase in the Account’s liquid assets was primarily due to the net positive inflow of transfers and premium into the Account, which management believes was in response to the strong relative performance of the Account, an increase in the Account’s net investment income, and increased leverage on the Account’s real estate properties.
During the nine months ended September 30, 2006, the Account received $800,921,075 in premiums and $1,248,590,704 in net participant transfers from TIAA, the CREF Accounts and affiliated mutual funds, while, for the same period in 2005, the Account received $715,181,837 in premiums and $1,207,597,267 in net participant transfers. The Account’s net investment income increased from $306,131,027 for the nine month period ended September 30, 2005 to $424,821,568 for the comparable period in 2006. The Account’s mortgage loans payable were $1,368,996,357 at September 30, 2006, as compared to $710,750,928 at September 30, 2005.
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 (as supplemented from time to time), 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. Effective December 15, 2006, the Account’s total borrowings may not exceed 30% of the Account’s total net asset value at the time of incurrence. In calculating this limit, only the Account’s actual percentage interest in any borrowings is included, and not that of any joint venture partner. Further, the Account may only borrow up to 70% of the then current value of a property, although construction loans may be for 100% of costs incurred in developing the property.
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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. The Account generally will recover from tenants the majority of these increases based on contractual lease provisions in office, industrial, and retail properties or through rent increases in apartment complexes. The Account will remain responsible for the expenses for unleased space in a property or from any other contractual restrictions in the existing leases.
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 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 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.
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.
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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: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 foreign 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 include the assumptions underlying these forward-looking statements. Forward-looking statements appear in this report, among other places, in “Management’s Discussion and Analysis of Financial Conditions and Results of Operations.” Forward-looking statements involve risks and uncertainties, some of which are referenced below in the sub-section entitled “Risk Factors” and 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.
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Risk Factors
The Account’s assets and income (particularly its real estate assets and rental income) can be affected by many factors, and investors should consider the specific risks presented below, among others, before investing in the Account. Please refer to the section entitled “Statements Regarding Forward-Looking Information.”
Risks of Real Estate Investing
General Risks of Acquiring and Owning Real Property:The Account is subject to the risks inherent in acquiring and owning real property, including:
- Competition for real estate investments and any resulting delays in the acquisitionof investments may increase the Account’s costs or otherwise adversely affect theAccount’s investment results.
- The Account’s property values or rental and occupancy rates could go down due togeneral global economic conditions, a weak market for real estate generally, changing supply and demand for certain types of properties, natural disasters, terroristattacks or other man-made events.
- A property may be unable to attract and retain tenants, which means that rentalincome would decline. This situation could be exacerbated if a concentration oflease expirations occurred during any one period.
- The Account could lose revenue if tenants don’t pay rent, or if the Account is forcedto terminate a lease for nonpayment. Any disputes with tenants could also involvecostly litigation.
- A property’s profitability could go down if operating costs, such as property taxes,utilities, maintenance and insurance costs, go up in relation to gross rental income,or the property needs unanticipated repairs and renovations.
- The Account may experience periods in which its investments are geographicallyconcentrated, either regionally or in certain markets with similar demographics. In this event, the Account’s income and performance may be adversely impacteddisproportionately by economic conditions in those areas in which the Account’sinvestments are geographically concentrated.
General Risks of Selling Real Estate Investments:Among the risks of selling real estate investments are:
- The sale price of an Account property might differ from its estimated or appraisedvalue, leading to losses or reduced profits to the Account.
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- Because of the nature of real estate, the Account might not be able to sell a property at a particular time for its full value, particularly in a poor market. This mightmake it difficult to raise cash quickly and also could lead to Account losses.
- The Account may need to provide financing to a purchaser if no cash buyers areavailable.
Risks of Borrowing:Among the risks of borrowing money and investing in a property subject to a mortgage are:
- The Account may not be able to make its loan payments, which could result in adefault on its loan. The lender then could foreclose on the underlying property andthe Account would lose the value of its investment in the foreclosed property.
- If the Account obtains a mortgage loan that involves a balloon payment, there is arisk that the Account may not be able to make the lump sum principal paymentdue under the loan at the end of the loan term, or otherwise obtain adequate refinancing. The Account then may be forced to sell the property or other propertiesunder unfavorable market conditions or default on its mortgage.
- If the Account takes out variable-rate loans, the Account’s returns may be volatilewhen interest rates are volatile.
- The market valuation of mortgage loans payable could have an adverse impact onthe Account’s performance.
Regulatory Risks:Government regulation at the federal, state and local levels, including, without limitation, zoning laws, property taxes, and fiscal, environmental or other government policies, could operate or change in a way that hurts the Account and its properties. For example, regulations could raise the cost of owning, improving or maintaining properties or make it harder to sell, rent, finance, or refinance properties due to the increased costs associated with regulatory compliance.
Environmental Risks:The Account may be liable for damage to the environment caused by hazardous substances used or found on its properties. Under various environmental regulations, the Account may also be liable, as a current or previous property owner or mortgagee, for the cost of removing or cleaning up hazardous substances found on a property, even if it didn’t know of and wasn’t responsible for the hazardous substances. If any hazardous substances are present or the Account doesn’t properly clean up any hazardous substances, or if the Account fails to comply with regulations requiring it to actively monitor the business activities on its premises, the Account may have difficulty selling or renting a property or be liable for monetary penalties. The cost of any required cleanup and the Account’s potential liability for environmental damage, including performance under indemnification obligations to third parties, to a single real estate investment could exceed the value of the Account’s investment in a property, the property’s value, or in an extreme case, a significant portion of the Account’s assets.
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Uninsurable Losses:Certain catastrophic losses (e.g., from earthquakes, wars, terrorist acts, nuclear accidents, floods, or environmental or industrial hazards or accidents) may be uninsurable or so expensive to insure against that it is economically disadvantageous to buy insurance for them. If a disaster that we haven’t insured against occurs, or if the insurance contains a high deductible, the Account could lose both its original investment and any future profits from the property affected. In addition, some leases may permit a tenant to terminate its obligations in certain situations, regardless of whether those events are fully covered by insurance. In that case, the Account would not receive rental income from the property while that tenant’s space is vacant.
Risks of Developing Real Estate or Buying Recently Constructed Properties:If the Account chooses to develop a property or buys a recently constructed property, it may face the following risks:
- In developing real estate, there may be delays or unexpected increases in the costof property development and construction due to strikes, bad weather, materialshortages, increases in material and labor costs, or other events.
- Because external factors may have changed from when the project was originallyconceived (e.g., slower growth in local economy, higher interest rates, or overbuilding in the area), the property, if purchased when unleased, may not operateat the income and expense levels first projected or may not be developed in the wayoriginally planned.
- The seller or other party may not be able to carry out any agreement to provide certain minimum levels of income, or that agreement could expire, which couldreduce operating income and lower returns.
Risks of Joint Ownership:Investing in joint venture partnerships or other forms of joint property ownership may involve special risks.
- The co-venturer may have interests or goals inconsistent with those of theAccount.
- If a co-venturer doesn’t follow the Account’s instructions or adhere to the Account’spolicies, the jointly owned properties, and consequently the Account, might beexposed to greater liabilities than expected.
- The Account may have limited rights pursuant to the terms of the joint venture,including the right to operate, manage or dispose of a property.
- A co-venturer can make it harder for the Account to transfer its property interest,particularly if the co-venturer has the right to decide whether and when to sell theproperty.
- The co-venturer may become insolvent or bankrupt, which could expose theAccount to greater liabilities than expected.
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Risks with Purchase-Leaseback Transactions:The major risk of purchase-leaseback transactions is that the third party lessee will not be able to make required payments to the Account. If the leaseback interest is subordinate to other interests in the real property, such as a first mortgage or other lien, the risk to the Account increases because the lessee may have to pay the senior lienholder to prevent foreclosure before it pays the Account. If the lessee defaults or the leaseback is terminated prematurely, the Account might not recover its investment unless the property is sold or leased on favorable terms.
Appraisal Risks:Real estate appraisals are only estimates of property values based on a professional’s opinion and may not be accurate predictors of the amount the Account would actually receive if it sold a property. If an appraisal is too high, the Account’s value could go down upon reappraisal or if the property is sold for a lower price than the appraisal. If appraisals are too low, those who redeem prior to an adjustment to the valuation or a property sale will have received less than the true value of the Account’s assets. Further, the Account generally obtains appraisals only on a quarterly basis, and there will be circumstances in which the true value of a property is not reflected in the Account’s daily net asset value calculation.
Risks of Mortgage Loan Investments
General Risks of Mortgage Loans:The Account will be subject to the risks inherent in making mortgage loans, including:
- The borrower may default, requiring that the Account foreclose on the underlyingproperty to protect the value of its mortgage loan. Since its mortgage loans areusually non-recourse, the Account must rely solely on the value of a property forits security. The larger the mortgage loan compared to the value of the propertysecuring it, the greater the loan’s risk. Upon default, the Account may not be ableto sell the property for its estimated or appraised value. Also, certain liens on theproperty, such as mechanic’s or tax liens, may have priority over the Account’ssecurity interest.
- A deterioration in the financial condition of tenants, or the bankruptcy or insolvency of a major tenant, may adversely affect the income of a property, which couldincrease the likelihood that the borrower will default under its obligations.
- The borrower may not be able to make a lump sum principal payment due undera mortgage loan at the end of the loan term, unless it can refinance the mortgageloan with another lender.
- If interest rates are volatile during the loan period, the Account’s variable-ratemortgage loans could have lower yields.
Prepayment Risks:The Account’s mortgage loan investments will usually be subject to the risk that the borrower repays the loan early. Prepayments can change the Account’s return because we may be unable to reinvest the proceeds at as high an interest rate as the original mortgage loan rate.
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Interest Limitations:The interest rate we charge on mortgage loans may inadvertently violate state usury laws that limit rates, if, for example, state law changes during the loan term. If this happens, we could incur penalties or may not be able to enforce payment of the loan.
Risks of Participations:Participating mortgages are subject to the following additional risks:
- The participation element might generate insufficient returns to make up for thehigher interest rate the loan would have obtained without the participation feature.
- In very limited circumstances, a court could possibly characterize the Account’s participation interest as a partnership or joint venture with the borrower and the Accountcould lose the priority of its security interest, or be liable for the borrower’s debts.
Risks of REIT Investments
Investments in REIT securities are subject to many of the same general risks associated with direct real property ownership. In particular, equity REITs may be affected by changes in the value of the underlying property owned by the trust, while mortgage REITs may be affected by the quality of any credit extended. In addition to these risks, because REIT investments are securities, they may be exposed to market risk — price volatility due to changing conditions in the financial markets and, in particular, changes in overall interest rates.
In addition, REITs are tax regulated entities established to invest in real estate–related assets. REITs do not pay federal income taxes if they distribute most of their earnings to their shareholders and meet other tax requirements. As a result, REITs are subject to tax risk in continuing to qualify as a REIT.
Risks of Mortgage-Backed Securities
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. In particular, these types of investments may be 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, since the original price paid by the Account is based in part on assumptions regarding the receipt of interest payments. The rate of prepayments depends on a variety of geographic, social and other functions, including prevailing market interest rates and general economic factors.
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 prepayments.
These securities may be harder to sell than other securities.
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Risks of Liquid Investments
The Account’s investments in securities and other liquid investments may be subject to:
- 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 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.
Risks of Foreign Investments
In addition to other investment risks noted above, foreign investments present the following special risks:
- Foreign real estate markets may have different liquidity and volatility attributesthan U.S. markets.
- The value of foreign investments or rental income can go up or down fromchanges in currency rates, currency exchange control regulations, possible expropriation or confiscatory taxation, political, social, and economic developments, andforeign regulations.
- The Account may (but is not required to) seek to hedge its exposure to changes incurrency rates, which could involve extra costs. Hedging might not be successful.
- It may be more difficult to obtain and collect a judgment on foreign investmentsthan on domestic ones.
No Opportunity for Prior Review of Purchase
Investors do not have the opportunity to evaluate the economic merit of a property purchase before the Account completes the purchase, so investors will need to rely solely on TIAA’s judgment and ability to select investments consistent with the Account’s investment objective and policies. Further, the Account may change its investment objectives, and pursue specific investments without the consent of the Account’s investors.
Risks of Registration Under the Investment Company Act of 1940
The Account has not registered, and does not intend to register, as an investment company under the Investment Company Act of 1940, as amended (the “Investment Company Act”). Management intends to continue to operate the Account so that it will not have to register as an “investment company” under the Investment Company Act.
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Generally, a company is an “investment company” and required to register under the Investment Company Act if, among other things, it holds itself out as being engaged primarily, or proposes to engage primarily, in the business of investing, reinvesting or trading in securities, or it is engaged or proposes to engage in the business of investing, reinvesting, owning, holding or trading in securities and owns or proposes to acquire investment securities having a value exceeding 40% of the value of such company’s total assets (exclusive of government securities and cash items) on an unconsolidated basis.
If the Account were obligated to register as an investment company, the Account would have to comply with a variety of substantive requirements under the Investment Company Act that impose, among other things, limitations on capital structure, restrictions on certain investments, compliance with reporting, record keeping, voting and proxy disclosure requirements and other rules and regulations that would significantly increase its operating expenses and reduce its operating flexibility. To maintain compliance with the exemptions from the Investment Company Act, the Account may be unable to sell assets it would otherwise want to sell and may be unable to purchase securities it would otherwise want to purchase, which might materially adversely impact the Account’s performance.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
The Account’s real estate and real estate-related investments, which as of September 30, 2006 represented 78.46% 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 differ 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.
- 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.
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As of September 30, 2006, 21.54% 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 topay 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 earlier or later than anticipated. If the underlying mortgage assets experience faster than anticipated repayments of principal, the Account could fail to recoup some or all of its initial investment in these securities since the original price paid by the Account was based in part on assumptions regarding the receipt of interest payments. 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 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
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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 September 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 September 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.
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PART II. OTHER INFORMATION
Item 1. LEGAL PROCEEDINGS.
There are no material legal proceedings to which the Account is a party, or to which the Account’s assets are subject.
Item 1A. RISK FACTORS.
The contents of the section entitled “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Risk Factors,” contained in Item 2 of Part I of this Quarterly Report on Form 10-Q, are hereby incorporated into this Item 1A by reference.
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.
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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) |
| | | | | |
| | (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 |
| | | | | |
* Filed herewith1- 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).
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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 14, 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: November 14, 2006
| | By: | /s/ Georganne C. Proctor |
| |
|
| | Georganne C. Proctor |
| |
| | | Executive Vice President and |
| | | Chief Financial Officer |
| |
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