Introducing the R-Index of Corporate Governance for Externally Managed Asian REITs
Apr 18, 2012
As the REIT regime has been expanding 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. The framework presented in this article was introduced in 2010 at APREA’s Property Leaders Forum and adapted to Sing-apore and Malaysia, where the first scores were disclosed in spring 2011. APREA’s goal is to publish on a yearly basis a list of top Asian REITs in terms of corporate governance, starting with Sing-apore, Malaysia, Hong Kong and Japan.
CORPORATE PROVISIONS IN THE R-INDEX
The 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, REIT organization, remuneration matters, audit committee, gearing and ownership. The table on page 24 lists the main corporate governance issues at stake for each category in the framework.
The R-Index was initially designed to accommodate the S-REIT regulatory environment. REITs in Sing-apore are governed by the Code on Collective Investment Schemes (CIS Code) and the Property Fund Guidelines (Appendix 6 of the CIS Code). The CIS Code is non-statutory, i.e., a breach of the CIS Code 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 Sing-apore (MAS) issued its Code of Corporate Governance in 2005. Compliance with the code is not mandatory, but listed companies are required under the Sing-apore 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 Sing-apore’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 S-REITS
The unique situation of Sing-apore 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 organization, fees and related-party transactions.
REIT organization — The figure on page 25 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 (e.g., related-party transactions). 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.
Fees — The trust structure generates an array of fees from the trust to the manager, the property manager and the trustee. Managers’ 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. Managers’ fees include a base fee, a performance fee and, in some cases, acquisition/divestment fees. Base fees and performance fees (whose total amounts to managers’ management fees) can take many shapes, from a flat percentage of the assets 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 managers’ actual performance, the better for unitholders. The situation is similar for property managers’ fees.
Acquisition and divestment fees paid to the trust manager are the subject of debate. Combined with management fees based on AUM, they might give the wrong incentives to managers and become enmeshed into the broader issues of related-party transactions and gearing. As a result, the R-Index favors S-REITs that 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.
Related-party transactions — The sponsor-satellite ownership model coupled with relatively narrow and illiquid commercial property markets puts a special emphasis on related-party transactions in the context of Asian REITs. This issue, although exacerbated in case of property transactions, is not specific to the listed property sector. The R-Index does not evaluate the materiality of related-party transactions on a quantitative standpoint but rather focuses on the disclosure and processes connected to related-party transactions in order to qualify transparency as well as potential misalignment of interests between sponsor, manager and unitholders. The Sing-apore Code on Collective Investment Schemes (Appendix 6, Section 5: Interested-Party Transactions) requires property funds to make public their policies governing transactions subject to a system of checks and balances as well as a disclosure process whenever there is a risk of potential abuse. In addition to the scope of related-party transactions (i.e., definition of related parties and relevant transactions), other issues are the influence given to non-controlling shareholders (i.e., trustee) over the decision-making process and the role of independent experts.
SCORECARD OF THE R-INDEX
Scores in the R-Index are determined 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 Sing-apore. Data are collected from annual reports and other public sources. For each of the eight corporate governance categories covered in the R-Index, the scorecard provides a subscore. The higher the score and subscores, 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 emphasizes fees (24 percent of total score), board matters (19 percent), related-party transactions (16 percent) and REIT organization (15 percent). These weights as well as the scorecard were established after an extensive consultation with institutional investors and experts in Asian REITs, all members of 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 available on APREA’s website (see the white paper “The R-Index of Corporate Governance”). 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 an ongoing project. 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 United States 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, according to Patrick Lecomte and Joseph Ooi’s 2010 paper, Corporate Governance and Performance of Externally Managed S-REITs, which was presented at the American Real Estate Society 26th Annual Meeting. 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, if necessary, that all can benefit from improving it.
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