Better disclosure urged for REITS, real estate firms

‘Lack of transparency’ in accounting, distributions, securities watchdogs say

Canadian securities regulators are demanding better disclosures about accounting and distributions from real estate investments, following a review of the sector that includes REITs and real estate operator companies.

“Given strong investor interest in this sector and the inherent pressure on issuers to pay distributions, the sustainability of distributions and the accompanying disclosures are important to investors,” the Canadian Securities Administrators, an umbrella organization for Canada’s provincial securities watchdogs, said Thursday.

“The findings of our review indicate that the quality and completeness of disclosure pertaining to non- GAAP financial measures and distributions in the real estate industry need improvement.”

The CSA review, which included 47 REITs and real estate operating firms, identified “a lack of transparency” when various adjustments are made to financials using non-GAAP (generally accepted accounting principles) measures.

The regulators also found that the non- GAAP measures tend to be presented with “greater prominence” than comparable measures specified under generally accepted accounting principles.

Of the issuers reviewed, six per cent were required to restate the management discussion and analysis (MD&A) section of their financial disclosure, while 62 per cent agreed to “enhance” their disclosure going forward.

“Investors need sufficient information to understand what these measures represent and how they are calculated,” said Louis Morisset, chair of the CSA and chief executive of Quebec’s market watchdog, the Autorité des marches financiers. “Real estate reporting issuers are expected to provide transparent disclosures regarding distributions and nonGAAP financial measures.”

REITs and real estate operating companies pay out the majority of their operating income in the form of distributions to their unit holders or shareholders.

At the conclusion of the CSA’s review, the regulators opted to issue “additional guidance” to ensure these operators provide better disclosure when distributions from the investments exceed operating cash flows.

“Generally, REITs and REOCs provided adequate disclosure about their distributions, except when ‘excess distributions’ were made and in those cases, many issuers did not disclose the sources of cash used to fund the excess,” the CSA said.

Regulators found around twothirds of the issuers in the review did not disclose a description of the sources of cash used to fund the excess distributions, or their description was “boiler plate,” according to Thursday’s missive.

“The risk profile of an issuer that relies on sources other than operating cash flows to fund distributions, such as capital raising, debt financing or sale of properties, is inherently different than an issuer that funds distributions solely through operating cash flows,” the CSA said. “We expect the disclosure about distributions to address these risks.”

Going forward, real estate investment issuers are expected to quantify excess distributions funded by sources other than operating activities, identify specific sources including debt or recent equity raise, and acknowledge if and why distributions are being provided that partly represent a return of capital.

Howard Leung, an analyst at Veritas Investment Research in Toronto, flagged accounting issues at REITs in a report last June. He paid particular attention to the treatment of capital expenditures, AFFO (adjusted funds from operations), and AFCO (adjusted cash flows from operations) at the real estate investment trusts.

Leung said a lack of standard approaches across the sector created a “notable” lack of comparability.

He also expressed a preference for the use of actual capex, rather than “reserves” and estimated maintenance capital that smoothed out volatility, to reduce the amount of judgment in the calculations.

The CSA review, which included interim and annual filings as well as news releases, also focused on adjustments related to maintenance capital expenditures and working capital, and uncovered “deficiencies” in disclosures of these items. “These two adjustments are often material” and subject to “significant” management judgment, the CSA said.

“Furthermore, these adjustments can have a direct impact on non- GAAP financial measures used to describe cash available for distribution … including the related distribution payout ratios.”

Regulators did not name specific issuers, but said they found “diversity in practice” among real estate issuers in how the maintenance capital expenditures is determined and disclosed. The majority opted to deduct an estimate of the capital expenditures using an estimate or reserve, and of the 62 per cent of issuers that went that route only 39 per cent disclosed a comparison to the actual maintenance capital expenditures.

What’s more, the reserve was not well explained and it was often unclear from the disclosure how the reserve was determined, the CSA said.

“We will continue to assess these areas in our continuous disclosure and prospectus reviews,” the regulatory organization concluded.

“We will also monitor certain issuers to ensure commitments to prospective changes and enhancements requested have been made.”

Investors need sufficient information to understand what these measures represent and how they are calculated.