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Offers of Unlisted Interests in Commercial Properties - A Review

4.32	We think that the expected financial performance of the issuer is a key factor in determining the rate of return to investors in commercial property investments. We think that equal prominence should be given to such information, whether or not the loss-making position of the company is taken into account in calculating the return.
4.33	Related to the concept of an overall return to investors, a majority of respondents consider that the issuer's anticipated net tangible asset backing per unit of securities should be disclosed. It is considered that preliminary and acquisition expenses have an effect on net tangible assets in the absence of capital growth and/or accumulation of retained surpluses and that this should be disclosed. Others, in supporting the disclosure, consider that it is important information, especially in cases where initial losses will reduce the net tangible asset for each share. The information is considered necessary to enable a potential investor to make an informed assessment of the investment.
4.34	Clause 8(5) of the First Schedule and clause 6(5) of the Third Schedule to the Regulations require the net tangible asset of the securities to be stated assuming that the securities have been allotted. However, this applies only where the actual previous financial statements of the issuer are included in the prospectus. There is no requirement to disclose this information where the issuer has no previous trading record. Notwithstanding this, we think that prospective net tangible asset information would be useful to investors in commercial property investments, particularly as a means of balancing any information that is disclosed about the combined rate of return.
Return type E - Internal rate of return of the project
4.35	A limited number of issuers show internal rates of return (IRR) in addition to the interest rate of return on the bonds and the combined return on the shares and bonds. Where disclosed, the IRR and its principal assumptions are usually stated in the prospectus rather than in the investment statement.
4.36	An IRR is calculated by determining the discount rate that equates total discounted cash inflows with total discounted cash outflows for a project. On the basis of our review we note that IRR is usually shown for ten years. This is unrelated to the stated maximum period of the investment period of 20 years or to the forecast "return on total investment" often stated for only one or two years.
4.37	It seems that little comparison can be made between the IRR and the interest rate of return on the bonds or the combined rate of return as the bases of calculation are different and the periods covered are different. The differences are not highlighted in the offer documents and issuers seem to assume that investors understand the concept of an IRR.
4.38	Some respondents consider that it is useful to disclose an IRR for the total expected period of the investment. This enables investors to assess the impact which up-front costs, unrealised movements in property values and retained earnings have on cash return over the life of the investment. It is considered by these respondents that the disclosure of the IRR and the cash return rate allows investors to compare returns offered not only with other property investments but also with, say, fixed interest rate alternatives. It is considered that the commercial property investments are, by nature, medium to long-term and the effects of the passage of time are fundamental to understanding real returns.
4.39	One promoter considers it desirable to disclose IRR forecast, projected or promised at the end of each prospective financial period, that is, assuming realisation of the investments at those dates. Another considers that as property funds are marketed as long-term, IRR should be calculated over the lesser of the expected period of investment or the first 10 years of its life.
4.40	However, while it was considered by some that an IRR may provide the best measure for comparing the investment performance of different schemes as the calculation takes into account the timing and amount of all cash flows, it is rare within the industry to disclose IRR. The reasons put forward are: most investors would not understand the method or technique used to derive IRR; assumptions are difficult to make and authenticate - as the investments do not have a fixed life span, it may be difficult to make assumptions about the terminal value of assets at the beginning of the investment; assumptions have a significant effect on the calculation of IRR and most investors and their advisors, even if provided with a full set of assumptions, would find the calculation confusing and may be misled about the return they could expect from the investment; as actual IRR cannot be determined until the investment is terminated, it may be difficult to make performance comparisons during the term of investment and there is likely to be significant variation between actual and projected IRR.
4.41	We think an IRR is useful as a means of showing the overall return of a particular project, particularly over the maximum period of the investment rather than for some other arbitrary time period. We think that where an IRR is disclosed, the rate and its basis of calculation must be clearly identified and differentiated from other types of returns to investors. Assumptions used should be clearly stated, in particular, the period, the significant cash flows and the terminal value of the investment.
Return type F - Rental yield from the properties
4.42	One issuer states a rental yield from the properties under offer. This yield was unrelated to the interest rate payable on the bonds or other distributions that were payable.
4.43	In the particular offer, the rental yield of over 12% per annum was prominently stated in its advertisement. This included a statement that the yield was calculated on the purchase price of the properties and that the yield on investment properties was different from the forecast pre-tax return on investment moneys. Investors were referred to the investment statement for further details. The advertisement used the rental yield as a headline rate. There was no other reference to the interest to be paid on the debenture, repayment of capital or other promised dividend returns.
4.44	The investment statement showed the interest rate payable on the debentures at under 5% per annum calculated on the balance of the principal outstanding with the principal being returned over 183 instalments.
4.45	One respondent considers that it is "unacceptable" for rental yields to be used in an advertisement. If the rental yield is advertised without the rate of return to investors also being clearly disclosed, our respondent considered investors may be misled into thinking that the rental yield is the return payable to investors.
4.46	Rental yields can provide investors with useful information about the properties under offer. They are a factor in determining returns to investors. However, the manner in which the rental yield is disclosed is important as it has the potential to mislead investors, particularly where the rate of return to investors is not clearly stated.
4.47	We think that, where disclosed, rental yields should be clearly identified and differentiated from the returns to investors. In addition, we think it is inappropriate to use rental yields as headline rates, given that it is not a generally accepted practice in such offers to express and highlight such yields. Where disclosed, we consider that rental yields should be accompanied by the disclosure of returns to investors.
Alternative returns-related terminology
4.48	Apart from the different types of stated returns, issuers also sometimes use different terminology to describe the returns to investors.
4.49	There is unanimous agreement from respondents that there should be guidance on the terminology used in offer documents to describe and explain forecast, projected or promised returns. It is considered that guidance would contribute to consistency and would benefit investors when comparing alternative offerings. Others consider it helpful if industry standards are established, as this will help all parties involved in the industry - promoters, issuers, investors, their advisers and monitoring agencies. One respondent considers that all technical terminology should be explained or defined in offer documents (perhaps by including a glossary of terms).
4.50	Some terms that are commonly used by promoters are "cash distribution", "per annum cash return", "interest rate", "per annum interest return", "per annum forecast return", "income return", "projected revenue returns", "yield", "forecast yield", "pre-tax equivalent yield" and "forecast per annum yield".
4.51	We endorse the industry's concerns. However, we do not prescribe the terminology that promoters should use in describing returns because schemes may differ in structure. Even so, we think that the use of certain words, particularly "yield", "income return", "revenue return" and "earn", to describe a combined return which relates to only one component of the stapled security, the debt component, may be confusing. If used, such words should be explained. We think that it is up to promoters to ensure that whatever terms are used, they are properly applied in the context and are understandable.
4.52	The term "projection" is also sometimes used interchangeably with the term "forecast", notwithstanding that in the prospectus (and sometimes in the investment statement) forecasts, not projections, are set out. In one instance, while the prospective financial information in the prospectus was labeled a "projection", the assumptions used were best estimate assumptions and the prospective financial information would have better been referred to as a "forecast".
4.53	A forecast is prepared based on best estimate assumptions about future events associated with actions that management expects to take. A projection is prepared based on one or more hypothetical but realistic "what-if" assumptions that reflect possible courses of action. Prospective financial information prepared as a forecast may be significantly different from prospective financial information prepared as a projection.
4.54	Some respondents argue that the legal, financial reporting and disclosure requirements in advertisements, investment statements and prospectuses are too technical and precise. This is seen to undermine the purpose of disclosure as investors struggle to understand what is presented. It is considered that more emphasis should be given to plain language disclosure even if this decreases technical accuracy.
4.55	While many promoters are reluctant to use technical language, it appears that the language currently used in offer documents is also unclear. We think that the appropriate use of technical language is useful where the terminology is already established and generally understood. There is a danger that it will be more difficult, in cases of doubt, to determine what a promoter or issuer intended to state where alternative words are used in place of generally accepted technical terms.
4.56	It should also be noted that the Financial Reporting Standards Board of the Institute of Chartered Accountants has, on issue, FRS-29 "Prospective Financial Information". The FRS sets out guidance for the preparation and presentation of prospective financial information. The guidance and terminology used is generally accepted and understood and serves as a common basis for preparing, presenting and understanding the information.
4.57	We think that confusion arises where offer documents do not comply with the Standard. We think that the guidance in FRS-29 is sufficient and should be applied in respect of all prospective financial information that is included in offer documents. We do not think that it is useful to further prescribe terminology or guidance for the preparation of prospective financial information. Instead, we think that promoters should exercise greater care in choosing words to describe returns and ensuring that these are used consistently throughout the offer documents.
4.58	Where prospective financial information is included in a prospectus, the law requires the prospectus to contain a report on the information by the issuer's auditors. We think the onus is on issuers and promoters and their auditors to ensure that all prospective financial information included in offer documents, including the terminology where appropriate, complies with FRS-29.
Qualifications to the stated returns
4.59	Most offer documents include a qualification relating to the stated combined rate of return to the effect that the returns are based on the interest payment on the mortgage bonds only and do not take into account the deficits and surpluses of the issuer. However, some issuers do not include such qualifications, especially where the rates are used as headline rates on the covers of offer documents and in advertisements.
4.60	It is not always obvious from a stated rate of return whether it has been promised, forecast or projected. Sometimes, while the interest on the bonds may have been stated to be "promised" for the first forecast period by some issuers, the use of words like "intends to pay" and "based on the forecast" makes it unclear if the return will be paid if, for instance, one of the forecast assumptions was not met. In other cases, interest rates on the bonds are stated to be "forecast" rates. Yet, the wording in relation to the return in parts of the offer documents uses words like "will be paid". We find such inconsistencies to be potentially confusing.
4.61	We have already recorded (see para 3.7) that clause 9(1)(c) of Schedule 3D requires an investment statement to include a statement of whether an amount of returns, quantifiable as at the date of the investment statement and enforceable by the subscriber, has been promised and, if so, the amount or a description of how the amount can be calculated.
4.62	Issuers should ensure that there is a clear statement in the investment statement whether or not there are returns that have been promised which is in accordance with clause 9(1)(c). Issuers should also ensure that the wording in other parts of the offer documents clearly and consistently reflects the nature of the returns as stated under clause 9(1)(c).
4.63	We think that, where returns are stated, it should be immediately clear to an investor from looking at the stated returns whether they are promised, forecast or projected returns.
4.64	It is also not immediately obvious from some offer documents that any promised returns are for a limited time period only, usually for the first forecast period, and not for the length of the investment period. This is unsatisfactory.
4.65	The period for which the returns are payable is considered by respondents to be information useful to investors in making an informed investment decision. It is considered that this information should accompany any returns that are disclosed in an offer document. One respondent considers this information an absolute necessity. We agree.
4.66	One respondent thinks that there may be a danger in associating returns with time periods as investors may wrongly assume that their investments would mature on the stated dates and see the investments as substitutes for fixed term investments. We disagree. We think that there is a greater danger, given that property investments are normally associated with being medium to long-term, if forecast periods are not stated. This may imply that the stated returns apply to the term of the investment.
4.67	We think that all rates but, in particular, headline rates should be appropriately and clearly qualified. The qualifications should, as a minimum, state: what the rate relates to (interest rate of return on the bonds, dividend rate etc); whether the rate is promised, forecast or projected; the period for which the rate applies; and where the major assumptions on which the rate is calculated can be found in the offer documents. Assumptions
4.68	Most offer documents for interests in commercial property investments include some information about future returns derived from forecast or projected financial information about the issuer or the scheme that is included in the prospectus. The Prospectus
4.69	As previously noted (see para 3.12) a prospectus for a first issue of equity securities is required to include a prospective statement of cash flows for the issuing group for the first year after the prospectus is issued. In addition, an advertisement (including an investment statement) cannot include prospective financial information unless that information is also included in the prospectus (Regulation 15). When prospective financial information is included in a prospectus the principal assumptions on which the forecast is based must be stated in the prospectus (Regulation 5(4)).
4.70	We found, in most offer documents, including both prospectuses and investment statements, that the major assumptions used in calculating disclosed returns were not always clear or comprehensive, notwithstanding that the law and FRS-29 both require the disclosure of major assumptions underlying prospective financial information.