ACCOUNTING
SA 21-1 Jeff Zengel is a financial consultant to Rae Properties Inc., a real estate syndicate. Rae Properties Inc. finances and develops commercial real estate (office buildings). The completed projects are then sold as limited partnership interests to individual investors. The syndicate makes a profit on the sale of these partnership interests. Jeff provides financial information for the offering prospectus, which is a document that provides the financial and legal details of the limited partnership offerings. In one of the projects, the bank has financed the construction of a commercial office building at a rate of 8% for the first four years, after which time the rate jumps to 12% for the remaining 21 years of the mortgage. The interest costs are one of the major ongoing costs of a real estate project.
Jeff has reported prominently in the prospectus that the break-even occupancy for the first four years is 60%. This is the amount of office space that must be leased to cover the interest and general upkeep costs over the first four years. The 60% break-even is very low and thus communicates a low risk to potential investors. Jeff uses the 60% break-even rate as a major marketing tool in selling the limited partnership interests.
Buried in the fine print of the prospectus is additional information that would allow an astute investor to determine that the break-even occupancy will jump to 90% after the fourth year because of the contracted increase in the mortgage interest rate. Jeff believes prospective investors are adequately informed as to the risk of the investment.
Comment on the ethical considerations of this situation.
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