Reporting the REIT way
However, after digging deeper into the recent accounts of a number of A-REITs, I believe that there are serious questions to be raised about the changing focus of profit reporting, the gearing levels emphasised in media releases, and the actual asset valuations adopted.
Transactional databases, such as those maintained by Commercial Property Monitors, have recorded significant expansions of capitalisation rates during the year to date. Softening of 50 to 150 basis points has not been uncommon in the sales of retail, industrial, and office assets when compared to mid- to late-2007 transactions.
In an August research bulletin, the unlisted AXA Wholesale Australian Property Fund released July valuations for a number of its domestic assets. Compared to previous valuations, the value of these assets fell by 8.9 per cent, from $222.3 million to just $202.6 million. Of particular note was a North Sydney office asset purchased in late 2007, which suffered a 100 basis point capitalisation rate expansion to 7.25 per cent, resulting in an 11.1 per cent decline in value.
In comparison to these results, the listed market has reported far more sedate drops in asset prices in the order of 20 to 30 basis points on average.
It is a concern to find similar graded properties being valued quite differently between various funds. A number of the listed counterparts appear to be adopting a more optimistic approach to the capitalisation rates used, whereas the unlisted sector has generally taken a more conservative approach. Given that the general rise in capitalisation rates has occurred largely in response to a macro event – the global credit crisis – it's of concern that some of the capitalisation rates used by certain REITS are too low.
Throughout the recent property boom period, profit growth was almost exclusively publicised by A-REITs in terms of headline earnings growth. As required by adopting the Australian equivalent to International Financial Reporting Standards (A-IFRS), in many instances these results included substantial unrealised gains based on asset revaluations.
However, in this current reporting season, many A-REITS have focused on the 'operating number' when publicising results in media releases, which excludes adjustments for asset valuations, rather than the actual headline results.
Steep tightening of capitalisation rates through to December 2007 translated into rocketing earnings results well above previous comparable periods. However, these growth figures were not indicative of sustainable performance and now, due to flat or declining valuations, net profit numbers for a number of A-REITS are recording steep declines year on year.
Listed stapled Trust Stockland booked 10.3 per cent growth, tagged as 'operating profit', as the first item of their recent media release. However, the actual net profit result was a 59 per cent decrease. Where was this result in the Stockland media release?
Having reported on 14 August, Stockland quoted a gearing figure of 28.9 per cent in both its financial year media release and presentation. Adviser Edge has calculated the gearing of Stockland, based on look-through liabilities to assets, to be approximately 45.4 per cent. This is significantly higher than that quoted by the company itself and widely published in the media. I believe that using the look-through method provides a much clearer picture of a fund's debt position.
The calculation for Stockland is based on look-through liabilities of $6,507 million and tangible look-through assets of $14,339 million, as provided in Stockland's released accounts. The method Adviser Edge has used to calculate the gearing is identical to proposed standards, due to be adopted in October 2008, for unlisted property schemes.
A July 2008 discussion paper released by the Australian Securities and Investment Commission (ASIC) proposed that gearing should be defined as look-through total liabilities to total tangible assets. This also means taking into account the underlying gearing of equity accounted investments, the effects of which many A-REITs are failing to report due to their preferred 'gearing' calculations.
Given the varying definitions and accepted calculations of gearing, Stockland's quoted figure of 28.9 per cent does meet existing accounting standards. However, there needs to be much greater transparency surrounding the method and disclosure of the calculation adopted by a number of A-REITs to quantify debt levels.
Retail giant Westfield provides a further example. Westfield reported gearing in its half year June 2008 results of 32.9 per cent. The methodology used for this calculation appears to have remain unchanged since December 2007, where gearing was stated to be 31.7 per cent.
Appearing quite conservative, this ratio has been widely publicised and met with acclaim from analysts and commentators during the continued slide of domestic A-REITs prices. Using the ASIC definition of gearing, and based on Westfield's published accounts, Adviser Edge estimates Westfield to have been geared at 46.9 per cent based on look-through liabilities of approximately $24,303 million and look-through assets of $51,818 million.
It seems that the listed market is now lagging behind that of unlisted property schemes, many of which are already acknowledging and implementing these new disclosure principals proposed by ASIC. Intended for finalisation as of September 2, ASICs issuance has specifically targeted debt related disclosures in the wake of the US sub-prime credit crisis.
Although it does not explicitly apply to listed structures, the principles of disclosure contained within the paper relating to gearing ratios, interest coverage, valuation policies, and distribution practices are especially relevant to investors currently exposed to the A-REIT stock holdings. The principles, should they be enforced, would bring unlisted property schemes in-line with global best practice for debt-related disclosure and ahead of their listed counterparts.
One of the ramifications of adopting the look-through approach is that a number of A-REITs currently have loan covenant thresholds based on gearing levels. For those that have disclosed the covenants, it is apparent that banks do largely base their gearing calculations on total liabilities to total assets on a look-through basis. So while the 'gearing' result stated in media releases appears to place the entity in a conservative position, the actual debt position on a look-through basis may be quite different, and could lead to breaches of banking covenants in some instances.
It is also interesting to note the divergence between the disclosures of the various entities within the market as provided in the table below. For example, the Macquarie Office Trust reported a gearing ratio of 51.3 per cent in its June full-year results. The ratio was calculated as look-through total liabilities to total assets (less cash). Excluding the cash adjustment, this figure looks to be largely accurate. Further to this, the financial statement issued provided full disclosure of applicable covenants, based on maximum look-through liabilities to assets ratio of 60 per cent, with minimum interest coverage ratio requirements also listed.
Valuations used by a number of real estate investment trusts still appear to be very aggressive and do not appear to have taken into account the softening of capitalisation rates, which has been demonstrated by recent transactional evidence and the valuations adopted by unlisted property schemes.
Further to this, there has been a shift away from reporting profits in media releases, including revaluations, to now reporting 'operating earnings', which exclude valuations. This has conveniently hidden increasing weaknesses occurring in the underlying property assets.
And finally, of particular concern is the reporting of gearing ratios by a number of major listed A-REITs. The accounting standards used in reporting allow A-REIT managers to present a far more conservative picture of debt exposure to the marketplace. This shifts the focus away from a more concerning reality, especially given the current environment of falling commercial asset values.
Adviser Edge advocates that all A-REITs should adopt best practice standards in their reporting, including consensus calculations for gearing and full disclosure of loan covenants. In doing so, it is believed that these actions would foster a return of investor confidence and reduce the uncertainty present in the marketplace.
Failure to do so could lead to continued poor performance, and a long period of sluggish growth stemming from ongoing doubts over the true state of affairs of the A-REIT sector. This situation doesn't even touch on the issues surrounding proper disclosure to investors.
Louis Christopher is head of property at AdviserEdge
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