A new analytical framework for Asian REITs aims to improve corporate governance best practice across the region. Patrick Lecomte explains
As REITs have expanded globally, best corporate governance practices in emerging Asian REIT markets have become a focus for domestic and international investors alike. Idiosyncrasies stemming from the ownership models applied in Asian economies, and the fact Asian REITs are often externally managed ‘captive entities', highlight the importance of corporate governance of the listed real estate sector in Asia.
To assist this, the Asia Pacific Real Estate Association (APREA) has developed an analytical framework aimed at scoring corporate governance practices among externally managed Asian REITs. Initially designed for Singapore REITs (S-REITs), it has been adapted and applied to Malaysian and Japanese REITs.
APREA's scoring framework, known as the R-Index, encompasses 27 governance factors, spanning eight categories of both external and internal corporate governance: fees, board matters, related party transactions (RPTs), REIT organisation, remuneration matters, audit committee, gearing and ownership. The table below lists the main corporate governance issues at stake for each category in the framework.
The R-index accommodates the S-REIT regulatory environment. REITs in Singapore are governed by the Code on Collective Investment Schemes (CIS Code) and the Property Fund Guidelines. The CIS Code is non-statutory; a breach does not of itself lead to legal sanction. However, failure to comply may be relied on in legal proceedings and a breach of the code will be taken into account in determining whether to revoke or suspend the operation of the particular fund. In addition to the CIS Code, REITs are subjected to market authorities' requirements in terms of governance. The Monetary Authority of Singapore (MAS) issued its Code of Corporate Governance in 2005. Compliance with the Code is not mandatory but listed companies are required under the Singapore Exchange Listing Rules to disclose their corporate governance practices and give explanations for deviations from the Code in their annual reports. This comply-or-explain feature of Singapore's corporate governance regulations does in effect give a lot of leeway to S-REITs, and results in a range of practices that the R-Index has to capture.
The unique situation of Singapore REITs pervades all 27 provisions included in the R-Index. Three categories in the R-Index are of particular significance due to the externally managed model used by S-REITs: REIT organisation, fees, and RPTs party transactions.
Figure 1 shows the classic structure of an externally managed Asian REIT. Although this generic model is shared by all sponsored S-REITs, there can be significant differences among REITs both in terms of origin and involvement of the various parties. For instance, the trust manager might be a subsidiary of the sponsor, or an external manager with no links whatsoever with the other parties in the trust. Similarly, the property manager might be related to the sponsor, or in the case of external managers to the trust manager. Classically, the trustee is rather passive. However, the Property Fund Guidelines mention several instances in which the trustee should play a proactive role (for example, RPTs). In such a setting, the entrenchment of the trust manager generates potentially significant agency issues. Conditions leading to the choice of manager as well as provisions for removal (including consequences of termination of management agreements) are essential points covered in the R-Index.
The trust structure generates an array of fees from the trust to the manager, the property manager, and the trustee. Manager's fees are the most important ones among these fees. In the externally managed framework, the REIT itself has no employees. The manager performs all work on behalf of the trust in exchange for fees. Manager's fees include a base fee, a performance fee and, in some cases, acquisition/divestment fees. Base fees and performance fees (whose total amounts to manager's management fees) can take many shapes, from a flat percentage of the asset under management (AUM) to a percentage of net income conditional on a pre-determined benchmark, or any combination in between. The structure and disclosure of all three categories of fees are key indicators of good corporate governance in the R-Index. In a principal-agent framework, the more fees are conditional on manager's actual performance, the better for unit holders. The situation is similar for property manager's fees.
Acquisition and divestment fees paid to the trust manager are particularly controversial. Combined with management fees based on AUM, they might give the wrong incentives to managers and become enmeshed in the broader issues of RPTs and gearing. As a result, the R-Index favours S-REITs, which do not pay acquisition/divestment fees to their managers. If such fees are paid, S-REITs are scored on their level of disclosure.
Finally, the R-Index focuses on the relative level of fees assessed by two operating metrics: manager's management fees as a percentage of deposited properties, and total manager's fees as a percentage of net property income.
The sponsor-satellite ownership model, coupled with relatively narrow and illiquid commercial property markets, puts a special emphasis on RPTs in the context of Asian REITs. This issue, although exacerbated in the case of property transactions, is not specific to the listed property sector. The R-Index does not evaluate the materiality of RPTs on a quantitative standpoint but rather focuses on the disclosure and processes related to RPTs in order to qualify transparency as well as potential misalignment of interests between sponsor, manager and unit holders. The Singapore Code on Collective Investment Schemes requires property funds to make public their policies governing transactions subject to a system of checks and balances as well as to a disclosure process whenever there is a risk of potential abuse. In addition to the scope of RPT (that is, definition of related parties and relevant transactions), other issues are the influence given to non-controlling shareholders (trustee) over the decision-making process, and the role of independent experts.
Scores in the R-Index are based on 99 elements. In addition to 75 core elements, the index encompasses a ‘bonus and penalty' system to account for the comply-and-explain feature of corporate governance practices in Singapore. Data are collected from annual reports and public sources. For each of the eight corporate governance categories in the R-Index, the scorecard provides a sub-score. The higher the score and sub-scores, the better the corporate governance practices of the REIT. The index methodology aims to be objective and transparent.
However, once relevant elements are selected, crucial (and subjective) choices for the macro-relevance of the index have to be made with respect to weighting. The index weights depend on the number of elements in each category. In its current version, the R-Index emphasises fees (24% of total score), board matters (19%), RPTs (16%), and REIT organisation (15%). These weights as well as the scorecard were established after an extensive consultation with institutional investors and experts in Asian REITs, all members of the Asian Public Real Estate Association (APREA).
An extensive consultation took place in 2010 and 2011 to meet with S-REITs and get their feedbacks on the R-Index construction and scorecard. Their remarks were incorporated into the current version of the scorecard. The index therefore reflects extensive industry consultation at a number of levels, and most particularly with a majority of the S-REITs.
APREA considers this project as ongoing. The scorecard will be amended and improved to reflect the requirements of domestic real estate players, the needs of international investors and changing regulation.
The R-Index is not only a way for APREA to promote best corporate governance practices but also a tool that can open the way to in-depth analysis of corporate governance in the Asian listed real estate sector, as has been done in the US and Europe for years. Academic research based on the R-Index shows that S-REITs with the best practices tend to outperform their peers in terms of risk-adjusted returns. These REITs also trade on more liquid, hence more efficient, markets. As a matter of fact, better corporate governance among S-REITs is associated with greater market efficiency, which should serve as a reminder that everyone can benefit from improving it.
Patrick Lecomte is executive director at ESSEC Business School, and a member of the APREA research committee