NAVs have been the subject of heated debate and the area remains a minefield for investors. Greater consistency, transparency and dialogue are -required to drive progress and improve market liquidity. Wendy Arntsen reports
Net asset values (NAVs) underpin performance measurement, primary equity issuance and secondary market pricing for indirect real estate funds.
The lack of universal agreement in the calculation of NAVs for non-listed real estate funds continues to pose challenges for indirect investors. One fund investment that we review reports three different NAVs for the same units. The highest NAV uses the fund's own reporting principles and is over 18% above the IFRS NAV. Such a margin of divergence would be seen as unacceptable in the property valuation profession, but can easily appear between NAVs through different accounting conventions used across Europe.
The INREV guidelines for calculating an adjusted INREV NAV have a noble aim: to create a consistent and transparent approach to calculating adjusted NAVs so that performance can be compared across funds. Debate continues, however, over what should and what should not be included in NAVs for performance measurement, and for issuing and trading units in funds. For this reason, managers continue to produce their own adjusted NAVs, sometimes in addition to INREV NAVs and IFRS or local GAAP NAVs.
For pan-European funds two particularly important differences between NAVs include variations in approach to recording deferred tax assets and liabilities and the valuation of fixed-rate debt and derivatives.
Deferred tax assets and liabilities
Put simply, deferred tax assets arise where a company has incurred a loss that can be carried forward and used to offset profit in the future. That loss might relate to several things, although at the moment, for real estate funds, it usually relates to property values having fallen against their book cost. In other cases, however, deferred tax assets can also relate to the negative mark-to-market valuation of swaps.
Accountants should only record such deferred tax assets where it can be expected that a) the losses will be realised and b) there will be sufficient profit against which the losses can be offset. If a) and b) do not hold true then a rational investor would not be interested in paying for the deferred tax asset. Whether both a) and b) actually hold true will likely depend on the strategy for each asset. Hold-period intentions can vary over time and by asset. Clearly this leaves potential for subjectivity in recording tax assets.
Conversely, deferred tax liabilities occur where a company has made an unrealised profit that might be subject to corporation tax in the future. For IFRS this occurs where property values are higher than the book cost of the property. For some local GAAP this occurs where property values are higher than the tax depreciated book cost of the property. Even though European property has fallen 15-25% since its peak, property values might still be higher than the book cost or the tax depreciated book cost. Because large commercial properties in continental Europe are usually sold through special purpose vehicle (SPV) sales, the SPV that a fund owns today might have been sold several times since the property was first put into the SPV, potentially decades earlier. This means that the original book cost dates back a long time.
As long as the properties continue to be sold through the sale of SPV shares as opposed to a sale of the direct real estate out of the SPV, then the property revaluation gain will not be realised and the tax on capital gains will not be paid. Does this remind you of the game involving the exploding water ball on a timer? Perhaps that timer might run for so long that we are all gone by the time the clock stops. Perhaps not.
Investors, meanwhile, are left to argue about appropriate discounts for deferred tax liabilities sitting within SPVs. Likewise investors in funds can choose between a NAV that fully reflects deferred tax liabilities (IFRS), or one (such as an INREV NAV) that makes an adjustment to the deferred tax liability to reflect the likely exit from the vehicle (ie, a share sale) and therefore adds back part of the deferred tax liability.
Ultimately the actual price for secondary market trading will typically depend upon whether it is a sellers' or a buyers' market, and therefore how much demand there is for the particular units/LP interest. The uncertainty however, is not helpful for market liquidity.
Mark-to-market valuation of debt and derivatives
IFRS typically takes a cautious approach with respect to interest rate derivatives in the current market but is less cautious with respect to fixed-rate debt. Derivatives are usually held at fair value (marked to the market) and fixed-rate debt is valued initially at fair value (possibly no adjustment) plus capitalised financing costs.
This initial premium/discount to principal and the financing costs are subsequently amortised. As interest rates have fallen considerably in recent years the negative mark-to-market valuations of derivatives have a considerable impact on NAVs that fully reflect them. As the longer end of the interest rate curve has started to tick up, some of this is starting to unwind and to have a positive effect on NAVs, but only for NAVs that recorded the negative mark-to-market valuation in the first place. Under some local GAAP (such as UK GAAP), neither derivatives nor fixed-rate debt are marked to market.
For closed-ended funds the ‘diluted INREV NAV' uses a mark-to-market valuation of fixed-rate debt and derivatives but the ‘diluted INREV NAV for performance measurement' will de-recognise the mark-to-market valuation of derivatives and debt where the derivatives constitute an ‘economically effective hedge'. The rationale for this is that for a closed-ended fund the value of derivatives and debt at the end of the lifetime of the fund should be nil (that is it assumes that derivatives will expire). Investors therefore need to understand which INREV NAV is being reported.
These are only two of the main differences between accounting treatments. Investors also need to watch for different approaches to the capitalisation of fund formation and property acquisition costs, different approaches to the valuation of properties, to the valuation of joint ventures and to making adjustments for non-recourse debt.
So why does all this matter?
When accounting treatments can make such a difference to NAVs, investment managers have much discretion in reporting their unrealised performance to potential investors and to index performance measurement providers.
The complexity and subjectivity inherent in the calculation of NAVs can cause movements in NAVs that are hard for investors to forecast. Volatility in reported NAVs is, on the whole, rarely welcome in real estate returns.
Furthermore, the lack of transparency around NAV calculations is an additional barrier to secondary trading and investment liquidity.
What needs to happen?
Perhaps there is an additional role for index performance measurement providers to specify what accounting standards they will accept for performance to be included in their indices.
Consistency and transparency are key: the increasing adoption of INREV guidelines and provision of clear reconciliations between NAVs is a very positive step. The ideal situation would be for all fund managers to provide sufficient information for their investors to compare like with like. The need for an open and clear dialogue between investors and managers means that accounting should not be purely a back-office function and teams need to be well enough resourced for dealing directly with investors in relation to financial reporting.
NAV calculations are complex and investors and managers need to be able and willing to put them under the microscope.
Wendy Arntsen, head of multimanager, DTZ Investment Management