Sarbanes-Oxley compliance: benefits for the private firm.

With sound reason, the Sarbanes-Oxley Act has extended beyond the public arena to envelop the private firm, including the privately held and privately/publicly funded real estate concern. The Act, which, among other things requires firms and their auditors to attest to the effectiveness of controls over financial reporting, offers tangible benefits to every real estate investment constituent including the advisor, financer, investor, lessor, lessee, transaction processor and acquirer among others. It has become a "stamp of approval" that communicates to this constituent community a firm's commitment to ethical and moral business practices from transaction processing all the way through to financial reporting. Today, compliance is less of an option; it is a business imperative with many benefits.

Benefits of compliance may include:

* Premium on Firm Value: Whether an IPO, sale, or buyout, firms with a defined control environment leave less room for operational and financial scrutiny. These firms create opportunity to place a value premium on infrastructural improvements related to Sarbanes-Oxley compliance.

* Greater Access to, and Lower Cost of, Capital: Private firms seeking public capital are at a loss. Public sources are increasingly requiring operational and financial transparency a la Sarbanes-Oxley. Further, systems of accountability and control reduce overall firm risk, and provide leverage in negotiating with lenders and investors to drive down the cost of capital.

* Lower Insurance and Risk Costs: A by product of Sarbanes-Oxley compliance is accountability at all levels of the firm. This transparency can reduce costs such as Directors and Officers Insurance and litigation expenses.

* Stronger Strategic Relationships: Integrity and trust in any relationship is tantamount. This includes relationships with lenders, lessors, property managers, custodians, data processors, regulatory agencies and others.

* Process Improvement: The Sarbanes-Oxley compliance exercise highlights transaction and reporting inefficiencies. The savvy firm reengineers inefficiencies, layers in controls, thereby creating overall process improvements.

* Fraud Detection: The control environment is designed to detect unscrupulous activity. Detection is proactive and leads to mitigation; mitigation leads to profit retention and higher returns to the constituent group.

* Access to Top Management Talent and Directors: If nothing else, the threat of incarceration has left an indelible mark on the conscience of leadership. Present and future leaders will be comforted by and attracted to the firm that voluntarily undertakes measures to protect constituents.

* Competitive Advantage: Achieve the former, and you have established a higher performance firm. Costs are lower, capital is cheaper, transactions occur quicker, talent is better, and returns are higher. For the private firm, Sarbanes-Oxley is a differentiator and an overall value driver.

The following describe high-level steps that a real estate firm should take to ensure compliance:

* Follow the Act: To the extent possible, adhere to the same government-mandated rules and regulations that public companies must follow.

* Consult with an Advisor: Sarbanes-Oxley can be time consuming and costly even for the small firm. The average publicly traded company, with revenues less than $1 billion, has spent $1.6 million annually on compliance. While it is likely that every process owner at every level in the company--from the leasing agent up through the CEO--will play some role in the implementation of Sarbanes-Oxley, retaining the expertise of a qualified professional or group of professionals is critical to ensuring accuracy and attention to detail. Additionally, external resources can leverage efficiencies and best practices learned during prior compliance projects.

* Map Financial Statement Accounts to Specific Processes: Companies may have dozens of financial systems and processes running enterprise-wide, and every one of them merits scrutiny. Begin with the one that has the most significant impact on the company's financial statements, and work your way down the list in order of its risk-factor. This can include anything related to the negotiation or management of a lease, facilitation of a sale or other financial transaction, hiring of a broker, tracking of payments and assets, or other miscellaneous operating procedures. As a general rule, companies should focus on accounts with balances greater than 5% of net assets or 5% of net income.

* Document Processes: Once prioritized, the Sarbanes-Oxley team should work hand-in-hand with the process owners to document the financial process and identify the related controls, thus creating a "process map," chronicling every step of the process and the parties that are involved with it. At this point, the key controls will need to be identified. These controls are critical to assuring accurate financial reporting. Leading practices include the development of flow charts, and control matrices that identify key controls.

* Walk-through Processes: Once processes are documented, it is important to observe the process, thereby confirming that it has been documented accurately and that the controls are in place and effective. Variances identified during this process should be corrected or remediated before formal testing is conducted.

* Test Controls: Key controls identified for each process should be tested at a minimum on an annual basis. Testing is an assessment to determine if controls are working as designed and that evidence exists to confirm control effectiveness. An example is a monthly review of firm budget against actual results. The reviewer must make notes of variance explanations, probe variances beyond a quantified threshold as well as initial and date the report evidencing their review.

* Monitor the Control Environment: Compliance is an ongoing process, not a one-time project. In addition to testing controls annually, many companies are taking a closer look at their processes and controls following their initial compliance efforts to identify opportunities for process efficiencies and reduce the volume of key controls. Many firms choose to automate controls via technology, centralize operations and re-design processes.

Whether looking to raise money or to drive performance improvement, voluntary Sarbanes-Oxley compliance is a smart idea for private real estate firms.

Taking steps to strengthen internal controls and reporting systems make the organization more appealing to investors and the greater constituent community, and has a positive impact on the business.

HUNT C. HOLSOMBACK AND SCOTT HILEMAN

MANAGING DIRECTORS, ALVAREZ & MARSAL REAL ESTATE ADVISORY SERVICES