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Offers of Unlisted Interests in Commercial Properties - A Review

4. SURVEY RESULTS AND OUR COMMENT

4.1 We have identified matters for comment in each of the following areas:

returns;

assumptions;

risks: and

charges.

Returns

4.2 Our review of offer documents shows that "returns" and "rates of return" are disclosed in a variety of ways by issuers. We note that they are sometimes disclosed in more than one way in a set of offer documents. We do not suggest a "best" method of disclosing returns. That is a matter for individual promoters to decide. However, where returns are disclosed, we would like promoters to take into account our comments in this report.

4.3 In this section, we discuss the following returns-related information:
(a) return type A - interest rate on the bonds;
(b) return type B - "combined" rate of return on bonds and shares;
(c) return type C - dollar value of cash distributions;
(d) return type D - interest on the bonds plus principal repayments;
(e) return type E - interest on the bonds plus change in net tangible assets;
(f) return type F - internal rate of return of the project;
(g) return type G - rental yield from the properties;
(h) alternative returns-related terminology;
(i) qualifications to the returns.
Return type A - Interest rate on the bonds

4.4 The interest payable on the bonds that is forecast, projected or promised is usually expressed as an interest rate per annum on the investment in the bonds. Usually, it is expressed as the only return for the investment as dividends are not provided for. All offer documents that we reviewed stated a percentage rate of interest payable on the bonds.

4.5 In general, most promoters consider it important that the interest rate payable on the bonds should be disclosed:

they believe it allows investors in cash return investments to compare the rate of return on the amount invested in the bonds with the rate of return from alternative investments;

they believe it is an appropriate benchmark for comparison as promoters have tended to emphasize this as a key feature and have marketed their investments on this basis;

often, they assert, the key purpose of commercial property investments is to provide regular income and this reflects the main purpose of the investment;

they believe the term "return" here better aligns with the concept of a distribution or interest payment rather than "change in asset value";

they believe cash distributions are what investors expect to physically receive.

4.6 We think that this information is useful as the interest payable on the bonds represents the rate of return on the debt component of the stapled investment. We think that it is information generally expected by the investor. However, as the security is a stapled security, we think that it is not sufficient to provide this information to investors without also providing information about the returns (if any) on the equity component of the stapled investment.

Return type B - Combined rate of return on bonds and shares

4.7 In addition to the rate of interest payable on the bonds, issuers generally also state a "combined" rate of return based on the interest payable on the bonds calculated as a percentage of the total investment in bonds and shares. It is this combined rate that is usually highlighted in the offer documents as the return on the commercial property investment. The combined rate will be lower than the rate of interest on the bonds as returns are seldom, if ever, payable on the shares.

4.8 Most promoters tend to consider the combined rate of return on the total investment to be the most appropriate rate of return to disclose to investors. The reasons put forward are that:

the investments tend to be promoted as cash return investments and, as such, investors are interested in the amount of cash that they will receive as a percentage of their total investment;

investors tend to view returns from a total investment perspective and, as such, to relate to a combined rate that represents a return based on their total investment;

property is a long-term investment and, over the term of the investment, the initial losses resulting from the write off of preliminary expenses should be recouped through increases in the value of the property.

4.9 Reason (c) is usually used to justify the use of a combined rate that does not take into account the expected performance of the issuer in the initial forecast period. Issuers usually incur operating deficits in the initial forecast period, the result of the immediate write-off of preliminary expenses.

4.10 In nearly all cases reviewed, issuers explicitly state that they do not take into account the net deficits of the issuer in calculating the combined return. Most issuers, in quoting a combined rate incorporating the interest payable on the bonds, state that the rate does not allow for any profit or loss accruing to shareholders through the trading operations of the company or any increase or decrease in the value of the properties or any preliminary or issue costs. This appears to be a standard feature in most of the offer documents, in the nature of a disclaimer.

4.11 The calculation of the combined rate is relatively straightforward and is used in a consistent manner by issuers. Our impression is that promoters assume this combined rate is generally accepted and understood by investors in these types of securities.

4.12 However, we think that where the combined rate of return which purports to show an overall return on the total investment is disclosed, the issuer should also disclose specific information about the amount of deficits that the issuer expects to incur in the forecast period.

4.13 While most issuers assume no increases or decreases in property values during the forecast periods, the effect of the immediate write off of preliminary expenses, which in most cases is unavoidable, will be that the issuer will show deficits in the initial forecast periods. If these deficits are taken into account, as some respondents suggest should be done, then the overall rate of return on the investment in the initial forecast period is likely to be lower than the combined rate and could well be negative (as illustrated in para 2.7).

4.14 We think that it may be misleading to highlight the combined rate of return on the investment in that initial forecast period without also giving information in an equally prominent manner to any deficits that the issuer expects to incur.

Return type C - Dollar value of cash distributions

4.15 Some commercial property investments describe the returns in terms of the cash payments to be made to investors over a set period. There is no "rate" of return quoted. Frequently, these cash amounts comprise an interest component and a repayment of principal component.

4.16 Stapled securities tend to be promoted as cash return investments. However, few issuers show the dollar value of cash distributions (preferring to emphasise rates of return). One promoter shows the dollar value of cash distributions by way of an illustration of the returns that will be received from the investment with a description of how the "combined" returns are calculated. Another shows a schedule of cash distributions from the securities, showing the amount of interest and amount of principal repayments that are to be made by the issuer for the forecast periods.

4.17 Some respondents consider that investors are interested in the dollar amount of cash distributions, that is, the amount of cash that will be credited to their bank account from each distribution. They consider the amount of cash distribution to be useful as many investors rely on regular cash flows from the investment. They consider that sufficient information should be provided to identify the elements making up the dollar amount of cash distributions.

4.18 However, most respondents consider that the dollar amount of cash distributions should not be disclosed (as the primary indication of returns to investors). The reasons for this include:

it does not immediately link the distribution to the amount invested, investors will have to determine the amount of their own distributions if the amount they have invested is different from the base;

it does not allow comparisons with other investments;

it is not the standard method of disclosing returns;

it would require investors to determine the percentage rate of return.

4.19 One respondent considers that investors should be informed of the returns on the bonds (interest distribution) as well as total returns, including any principal repayments and returns on the shares.

4.20 We think that whether or not the dollar value of cash distributions is disclosed should be up to the individual promoter. However, there is considerable scope for confusing investors because of the mixing of "income" payments and principal repayments. For this reason, we think where cash distributions are disclosed they should clearly differentiate between interest returns, principal repayments and returns on the shares. In addition, the sum of these "mixed" cash distributions is not a proper basis for expressing a rate of return to investors and should not be used for this purpose.

4.21 We have ignored the influence of taxation in this report, both on the performance of the issuer and in relation to the payment of returns to investors. However, we note that some commercial property investments that pay "returns" on the bonds which are part interest and part principal repayment describe the principal component as "tax free" and then proceed to "gross up" the component to a "pre-tax" level, even though no tax is payable. Incorporating the principal repayment at a "pre-tax" level in calculating returns gives the appearance of a higher rate of return.

4.22 One consequence of making regular principal repayments is that as the debt component of the investment is progressively being repaid, the proportion of the investor's equity stake in the issuer increases. At the maturity of the investment, the investor's claims on the company will have changed from being substantially a debt security holder to that of an equity claimant. For this reason, the change in value of the issuer is a key factor determining the returns, particularly long-term returns, to investors.

Return type D - Interest on the bonds plus change in net tangible assets

4.23 The writing off of preliminary expenses invariably means that issuers show an operating deficit in their first forecast reporting period. If the deficits incurred by the issuer, which are usually not highlighted in offer documents, are taken into account, the returns on the total investment will be lower and may even be negative (see para 2.7). In addition, the net tangible asset per share at the end of the first forecast period is usually less than the $1 issue price for the shares.

4.24 Some respondents consider that the rate of return disclosed in offer documents should take into account the performance of the issuer. They consider this can affect the calculation of the stated returns. It can also affect the issuer's ability to maintain interest payments on the bonds. It can provide investors with a more realistic expectation of the rate of return and the viability of the investment more generally. It can make investors aware of the potential for variation in future cash flows and information that actual returns are dependent on the financial performance of the issuer. The information will also show how preliminary expenses are expected to be recovered over time.

4.25 Only in one instance did a promoter show detailed forecast financial statistics in its prospectus which reflected the financial performance of the issuer. The information was shown notwithstanding that most of the statistics reflected negative figures.

4.26 Most promoters, however, do not disclose a rate of return taking into account the financial performance of the issuer. It is argued that the information may be misleading unless there is also disclosure about the long-term nature of the investment. It is thought that the initial negative impact of up-front costs on net tangible asset may inappropriately focus an investor's attention on short-term effects when in fact investors are committed to a long-term investment. It is said that focusing on such a return distorts the true nature of the investment. It is said that it will mislead investors, deter them from investing and lead them to forgo the expected benefits from investing in property.

4.27 One respondent considers that if there was a requirement to disclose this rate it may lead promoters to use other methods or adopt different assumptions to calculate rates of return. Another considers that, while the financial performance of the issuer affects the underlying value of an investor's contribution, it only becomes a "return" if the investment is wound up and gains/losses realised. The promoter considers that this issue is better dealt with under "risks" rather than by complicating the issue of "returns".

4.28 This argument assumes that "returns" in the Regulations (see para 3.18 earlier) comprise only "payments". As pointed out earlier (see para 3.19), the Regulation 2 definition of "returns" is not exclusive and does not define the meaning of the term.

4.29 We think the Regulations clearly envisage that the investor may receive several types of returns on a single investment. These could comprise returns of interest, an earning concept, returns of principal, a capital concept, and returns of services, a benefit concept.

4.30 The main argument put forward for not disclosing a rate of return taking into account the performance of the issuer seems to be that promoters are reluctant to direct attention to the performance of the issuer in the initial periods. This is notwithstanding that issuers are free to explain the reasons for the short-term deficits.

4.31 Promoters tend to argue that the investment should be considered as medium to long-term and that to disclose a rate of return taking into account the initial loss-making position of the issuer is potentially misleading. Whatever merit this argument has, it is our impression that promoters for the most part adopt the apparently inconsistent practice of focusing on the short-term cash returns of the investment, excluding information about the medium to long-term nature of the investment. This is worrying.

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