in property pricing has positively impacted the Account’s net realized and unrealized gains on its real estate assets and joint venture holdings, the underlying property values are subject to decline prospectively, if capital or real estate market conditions experience adverse changes. Real estate as an investment should be considered from a long-term perspective. The Account’s annualized total returns (after expenses) over the past one, three, five and 10 year periods ended March 31, 2007 were 14.94%, 14.29%, 10.93% and 9.69%, respectively. As of March 31, 2007, the Account’s annualized total return since inception was 9.40%.
The Account’s total net assets grew 33.6% from March 31, 2006 to March 31, 2007. The primary drivers of this growth were the Account’s realized and unrealized gains on its investments, significant net participant transactions, and the Account’s net investment income from its investment portfolio over the last twelve months. Management believes that the net participant transfers into the Account are due to its positive historical performance and its low return volatility relative to other available investment options.
The Account’s net investment income, after deduction of all expenses, was 21.7% higher for the three months ended March 31, 2007, as compared to the same period in 2006. This increase was related to the increase in total net assets, which included a 50.3% net increase in the Account’s real estate properties, joint venture holdings and limited partnerships and a 30.2% decrease in the Account’s marketable securities.
The Account’s real estate holdings, including real estate joint ventures and limited partnerships, generated approximately 83.6% and 81.6% of the Account’s total investment income (before deducting Account level expenses) during the first three months ended March 31, 2007 and 2006, respectively. The 28.4% increase in the Account’s total investment income derived from its real estate holdings was primarily due to an increase in the Account’s income from its real estate, joint ventures and limited partnership holdings. The remaining portion of the Account’s total investment income was generated by investments in marketable securities, including real estate equity securities, commercial paper, government bonds, and an investment in a commercial mortgage loan receivable.
Gross real estate rental income increased approximately 30.0% in the three months ended March 31, 2007, as compared to the same period 2006. This increase was primarily due to the increased number and size of the Account’s wholly-owned property investments, 99 as of March 31, 2006 compared to 108 as of March 31, 2007. Income from real estate joint ventures and limited partnerships was $19,598,193 for the three months ended March 31, 2007, as compared with $10,910,965 for the three months ended March 31, 2006. This 79.6% increase was due to a substantial increase in gross rental income from the increased number of properties owned through the Account’s investments in joint ventures, as well as increased income from limited partnerships. It should be noted that several of the wholly-owned and property investments owned in joint ventures purchased from March 31, 2006 to March 31, 2007 consisted of multiple
properties. Investment income on the Account’s investments in marketable securities increased by 13.9%, from $25,026,788 for the three months ended March 31, 2006 to $28,510,530 for the comparable period in 2007.
Total property level expenses for wholly-owned property investments for the three months ended March 31, 2007 and 2006 were $119,370,607 and $89,097,158, respectively. In the three months ended March 31, 2007, operating expenses and real estate taxes represented 56% and 26% of the total property level expenses, respectively, with the remaining 18% representing interest payments on mortgages. In comparison, operating expenses, real estate taxes, and interest expense in the same period of 2006 were relatively similar at 55%, 27% and 18% of total property level expenses, respectively. Overall, property level expenses increased by 34% from the three months ended March 31, 2006 to the quarter ended March 31, 2007. The majority of this increase (81%) was due to increases in operating expenses and real estate taxes associated with the Account’s larger portfolio of wholly-owned property investments. The increase in the interest expense paid on properties subject to a mortgage accounted for 19% of the overall increase. As of March 31, 2007, there were 12 wholly-owned properties subject to debt, as compared to eight leveraged properties at March 31, 2006.
The Account also incurred expenses for the three months ended March 31, 2007 and 2006 for investment advisory services ($13,142,942 and $6,592,265, respectively), administrative and distribution services ($15,458,222 and $8,996,205, respectively), and mortality, expense risk and liquidity guarantee charges ($2,895,747 and $2,822,385 respectively). The total 71.1% increase in these expenses was a result of the larger net asset base owned by the Account, on which the fees are calculated, and the increased costs associated with managing and administering the Account. In addition, in the fourth quarter of 2006, these expenses were re-evaluated based on the increased net asset base, and the resulting increases in expenses affected the first quarter of 2007.
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 $436,706,627 for the three months ended March 31, 2007, as compared with net realized and unrealized gains on investments and mortgage loans payable of $229,766,395 for the three months ended March 31, 2006. The overall increase was primarily driven by a substantial increase in net realized and unrealized gains on the Account’s real estate properties to $281,007,011 for the three months ended March 31, 2007 from $114,011,393 during the same period in 2006. In addition, the Account had net realized and unrealized gains on its real estate joint ventures and limited partnership holdings of $111,324,143 for the three months ended March 31, 2007, as compared to net realized and unrealized gains of $66,185,795 for the same period in 2006. The increase in net realized and unrealized gains on the Account’s property investments, including those held in joint ventures, was due to the continued liquidity in the commercial real estate markets, combined with healthy real estate market fundamentals, which had the effect of increasing the value of the Account’s existing real estate assets. During the three months ended March 31, 2007, the Account sold one apartment property for total net proceeds, after selling expenses, of $21.7 million, and recognized a cumulative net gain
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of $7.2 million. The Account also posted net realized and unrealized gains on its marketable securities of $23,176,742 for the three months ended March 31, 2007, as compared to $49,231,964 in the same period of 2006. The gains on the Account’s marketable securities in the three months ended March 31, 2007 were primarily associated with the Account’s investments in real estate equity securities, and over 60% of the gains were realized from the disposition of the Account’s investment in EOP.
Liquidity and Capital Resources
As of March 31, 2007 and 2006, the Account’s liquid assets (i.e., cash and marketable securities) had a value of $1,980,061,617 and $2,830,577,299, respectively. The decrease in the Account’s liquid assets was primarily due to its purchases of real estate and joint venture interests in the first quarter of 2007. Net investment income and net positive inflow from participant transfers and premiums, however, continued to flow into the Account, which management believes was in response to the continued strong relative performance of the Account.
In the three months ended March 31, 2007, the Account received $300,544,111 in premiums and $323,088,219 in net participant transfers from TIAA, CREF Accounts and affiliated mutual funds, while, for the same period of 2006, the Account received $264,251,599 in premiums and $321,393,415 in net participant transfers. The Account’s net investment income increased from $117,280,069 for the three months ended March 31, 2006 to $142,777,924 for the three months ended March 31, 2007.
The Account’s liquid assets continue to be available to purchase additional suitable real estate properties and to meet the Account’s expense needs and participant 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 participant transfer or cash withdrawal 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 the loan with one or more of its properties. The Account’s total borrowings may not exceed 30% of the Account’s Total Net Assets. 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 the costs incurred in developing a property.
Effects of Inflation and Increasing Operating Expenses
Inflation, along with increased insurance, taxes, utilities and security costs, may increase property operating expenses in the future. These increases in operating expenses
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are generally billed to tenants either through contractual lease provisions in office, industrial, and retail properties or through rent increases in apartment complexes. The Account remains responsible for the expenses for unleased space in a property as well as expenses which may not be reimbursed under the terms of an existing lease.
Critical Accounting Policies
The financial statements of the Account are prepared in conformity with accounting principles generally accepted in the United States of America.
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 and in accordance with the responsibilities of the Board as a whole; accordingly, the Account does not record depreciation. 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. Real estate properties owned by the Account are initially valued at their respective purchase prices (including acquisition costs). Subsequently, the properties are valued on a quarterly cycle, and independent appraisers value each real estate property at least once a year. TIAA’s appraisal staff performs the other quarterly valuations of each real estate property and updates the property value if it believes that the value of a 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. Real estate properties subject to a mortgage are generally valued as described; the mortgage is valued independently of the property, and its fair value is reported separately.
Valuation of Real Estate Joint Ventures and Limited Partnerships:Real estate joint ventures and limited partnerships are stated at the Account’s equity in the net assets of the underlying entities, adjusted, for the joint ventures, to 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.
Mortgage Loans Receivable:Mortgage loans receivable are stated at fair value and are initially valued at the face amount of the mortgage loan funding. Subsequently, mortgage loans receivable are valued quarterly based on market factors, such as market interest rates and spreads for comparable loans, and the performance of the underlying collateral.
Mortgage Loans Payable:Estimated market values of mortgage loans payable 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 effects of changes in foreign currency exchange rates on portfolio investments and mortgage loans payable are included in the net realized and unrealized gains and losses on investments and mortgage loans payable. 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.
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
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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 risk charge is paid by the Account to TIAA to assume these mortality and expense 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). The Account recognizes a gain to the extent that the contract sales price exceeds the cost-to-date of the property being sold. A loss occurs when the cost-to-date exceeds the sales price. As the Account is fair valued and all properties are appraised quarterly, any accumulated unrealized gains and losses are reversed in the calculation of realized gains and losses. 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 ownership interests in various real estate funds (limited partnerships and one limited liability corporation) and a private REIT (collectively, the “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 financial statements of the limited partnerships.
Income from joint ventures is recorded based on the Account’s proportional interest in the income earned by the joint venture.
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 include the assumptions underlying these forward-looking statements. Forward-looking statements appear in this report, among other places, in “Management’s Discussion and
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Analysis of Financial Condition and Results of Operations.” Forward-looking statements involve risks and uncertainties, some of which are referenced in the sections of the Form 10-K entitled “Item 1A. Risk Factors” and in this report in the section entitled “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 that 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 holdings, including real estate joint ventures and limited partnerships, which, as of March 31, 2007 represented 87.6% of the Account’s total investments, 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 rental and occupancy rates could go down due to general economic conditions, a weak market for real estate generally, or changing supply and demand for certain types of properties;
Appraisal Risk — The risk that the sale price of an Account property (i.e., the value that would be determined by negotiations between independent parties) might differ substantially from its estimated or appraised value, leading to losses or reduced profits to the Account upon sale;
Risk Relating to Property Sales — The risk that the Account might not be able to sell 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 Account losses;
Risks of Borrowing — The risk that interest rate changes may impact Account returns if the Account takes out a mortgage on a property or buys a property subject to a mortgage; and
Foreign Currency Risk — The risk that the value of the Account’s foreign investments, related debt or rental income could increase or decrease due to changes in foreign currency exchange rates or foreign currency exchange control regulations, and hedging against such changes, if undertaken by the Account, may entail additional costs and be unsuccessful.
As of March 31, 2007, 12.4% of the Account’s total investments were in market risk sensitive instruments, comprised of marketable securities and an adjustable rate mortgage loan receivable. Marketable securities may include real estate equity securities, commercial
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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 and mortgage loans receivable are subject to the following general risks:
Financial Risk — The risk, for debt securities, that the issuer will not be able to pay principal and interest when due and, for common or preferred stock, that the issuer’s current earnings will fall or that its overall financial soundness will decline, reducing the security’s value.
Market Risk — The risk that the Account’s investments will experience price volatility due to changing conditions in the financial markets and, particularly for debt securities, changes in overall interest rates.
Interest Rate Volatility — The risk that interest rate volatility may affect the Account’s 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 rate of prepayment 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 increased prepayments. These securities may be harder to sell than other securities.
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.
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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 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 March 31, 2007. Based upon management’s review, the CEO and the CFO concluded that the registrant’s disclosure controls and procedures were effective as of March 31, 2007.
(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.
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.
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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)7 |
| |
| (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.,3as amended effective as of May 1, 2005,4effective April 28, |
| | | | 20066and effective as of May 1, 20078 |
| | | | |
| (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).
7- Previously filed and incorporated herein by reference to Exhibit 3(B) to the Account’s Quarterly Report on Form 10-Q for the period ended September 30, 2006 and filed with the Commission on November 14, 2006 (File No. 033-92990).
8- 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, 2007 (File No. 333-141513).
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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.
| | | TIAA REAL ESTATE ACCOUNT |
| |
| | | By: | TEACHERS INSURANCE AND ANNUITY |
| | | | ASSOCIATION OF AMERICA | |
| |
| DATE: May 15, 2007 | | By: | /s/ Herbert M. Allison, Jr. | |
| | | | Herbert M. Allison, Jr. | |
| | | | Chairman of the Board, President | |
| | | | and Chief Executive Officer | |
| |
| DATE: May 15, 2007 | | By: | /s/ Georganne C. Proctor | |
| | | | Georganne C. Proctor | |
| | | | Executive Vice President and | |
| | | | Chief Financial Officer | |
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