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Towards better protection for REIT unitholders

REAL Estate Investment Trusts (REITs) have been becoming more popular in the global market. The global REIT market has experienced significant growth in the past 20 years, with an additional 20 countries adopting REIT legislation or equivalents.

In 2010, several other countries, including India and China, were considering setting up REIT markets, as was the Philippines, which had legislation in place but was waiting for final governmental approvals before the REITs could officially list and function.

The REIT market in Asia Pacific is the second largest globally, (after North America), and worth approximately US$118 billion (RM357.5 billion), accounting for 21% of the total REIT market capitalisation. North America accounts for about 60% of the global REITs market. However, REITs in Asia-Pacific markets such as New Zealand, South Korea, Thailand, Taiwan and Malaysia, represent less than 1% of the REIT market in Asia Pacific and less than 0.5% globally.

Within the Asia-Pacific region, Australia is the largest and oldest market, accounting for approximately 58% of the region, followed by Japan with 20%, Singapore with 14%, and Hong Kong 8%.

Like the rest of the capital markets, REITs suffered large market revaluations through the global downturn. From the peak in September 2007, the global REIT market has lost about 15% in value. The capital intensive nature of REITs and their reliance on debt financing made them particularly exposed when the credit markets imploded.

A combination of high gearing and falling asset values left many REITs with ballooning loan-to-value ratios and banks knocking on their door because they were in breach of debt covenants. Renegotiating debt terms was difficult because of the lack of liquidity and inflated prices.

Although all markets suffered huge losses, nearly 30% of the value in the Asia-Pacific REIT market was destroyed between September 2007 and October 2010. On closer examination, however, Asia Pacific was heavily influenced by the significant drop in market capitalisation in Australia and Japan. Excluding the negative impact of Australia and Japan from Asia Pacific, the region has in fact increased in value by 38% since September 2007.

Since mid-2009, the REIT market in Asia Pacific has started to pick up steam. REITs in Australia, Hong Kong, and Singapore have been able to renegotiate debt funding, and many, especially in Australia, have recapitalised their balance sheets. Stronger balance sheets and improving credit conditions will put REITs in a good position to benefit from growth opportunities in the future.

Significant potential for growth exists in this region if China and India follow through with their plans to introduce REITs into their markets.

REIT governance issues
REITs in Asia Pacific are predominantly externally managed by a REIT manager. The manager is paid a fee by the REITs in return for its management services. The manager has a fiduciary duty to act in the best interests of unitholders. However, the separation of ownership and control has the potential to create conflicts of interests between unitholders (principals) and managers (agents).

In the case of REITs in Asia Pacific, the REIT sponsor plays an important role because it is the entity that sources the properties that are initially placed into the REITs at the time of listing. More importantly, it usually wholly owns the REIT manager, and to further confuse matters, the sponsor often also holds a large unitholding in the REITs. This inter-relatedness increases the risk that the manager/sponsor will act in its own interests at the expense of minority unitholders, thereby exacerbating the principal–agent conflict. Many of the REIT governance issues identified in this report arise because of these conflicts of interests.

Conflicts arising from the principal–agent relationship can be managed if proper investor protection measures are in place that limit the ability of managers to expropriate the rights of unitholders. Because of their different structure, REITs are usually governed by REIT codes or various legislation that is separate from corporation legislation. Consequently, they are often not afforded the same rights. For this reason, it is important for REITs to have a robust governance structure in place to minimise the risk of expropriation by insiders and to strengthen unitholders' rights.

This report focuses on the four largest REIT markets in Asia Pacific — Australia, Japan, Singapore and Hong Kong — and is intended to be a resource for regulators and industry participants. The objective is to provide a guide on effective governance structures for regulators and industry participants in new or prospective REIT markets and help regulators in existing REIT markets improve their current REIT governance standards with the ultimate goal to improve unitholder protection.

Recommendations for existing REIT structures
Recommendations one to eight provide practical and straightforward ways to improve current governance practices in the near term in externally managed REITs.

1. Board independence of the REIT manager Governance requirements for the REIT manager's board of directors should be included in the licensing requirements for managers. The board's role should be to provide independent review and oversight over the REIT manager and the operations of the REIT. 2. Annual General Meetings Annual General Meetings (AGM) should be mandatory for all REITs.

3. Ownership structure and related party transactions The identities and level of ownership of related parties who have substantial unitholdings should be disclosed, and material related party transactions (RPT) should be reviewed by independent experts, disclosed to the local stock exchange, and approved by independent directors and independent unitholders.

4. Manager entrenchment Trust deeds/management agreements should not contain clauses that in any way entrench the manager or limit unitholders' rights.

5. Removing the REIT manager Unitholders should have the right to remove and appoint the REIT manager.

6. Management fee structure A fee structure needs to be established that aligns the interests of unitholders with those of the manager.

7. Gearing restrictions No need exists for leverage restrictions in regulations as long as proper governance practices are in place and the rights of unitholders are not compromised. Decisions to use debt funding should remain business decisions. To improve transparency, REITs should provide adequate disclosure of relevant information about debt covenants and debt restrictions imposed in their trust deeds.

8. REIT governance Given the trust structure of REITs in Hong Kong, Singapore, and Australia, the best governance structure to minimise conflicts of interests between managers and unitholders and improve oversight is the single responsible entity. Under this structure, only one responsible entity is accountable to investors. The single responsible entity is responsible for holding the assets in custody for unitholders and for the independent oversight of the REITs. Confusion around the roles and responsibilities of trustees is removed and replaced with independent boards and/or independent compliance committees.

Recommendations for an ideal REIT governance structure
The following recommendations describe the governance characteristics of an ideal REIT structure. The structure incorporates many of the earlier recommendations and aims to facilitate growth in new and prospective REIT markets as well as to help guide long-term changes in existing markets.

1. Internalised management An internal management structure better aligns the interests of the manager with those of the unitholders.

2. Board of directors A REIT should have its own independent board of directors and unitholders should be able to appoint or remove directors.

3. Annual General Meetings AGM should be mandatory for all REITs.

4. Approvals for related party transactions Material RPT should be reviewed by independent experts, disclosed to the local stock exchange, and approved by independent directors and independent unitholders.

5. Remuneration In an internally managed structure, the management team should receive salaries, making managers' fees irrelevant.

6. Gearing restrictions No regulatory need exists for leverage restrictions as long as proper governance practices are in place and the rights of unitholders are not compromised. The decision to use debt funding should be a business decision. Increased disclosure about debt covenants and debt restrictions imposed in the trust deed will facilitate transparency and improve investor protection.

7. Controlling unitholders should not own more than 50% of the issued units A unitholding restriction of 50% would not only improve REIT governance practices but also improve tax pass-through benefits for investors.

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