Re: Comments on Key Issues with the Proposed Addition of Real Estate Provisions and Guidance to the GIPS Standards

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Lisa Lyons
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1 December 31, 2001 Association for Investment Management and Research Professional Standards & Advocacy Department P.O. Box 3668 Charlottesville, Virginia Re: Comments on Key Issues with the Proposed Addition of Real Estate Provisions and Guidance Dear Sir/Madam: PricewaterhouseCoopers LLP wishes to thank the Association for Investment Management and Research (AIMR) for this opportunity to comment on the addition of real estate provisions and guidance to the GIPS TM Standards. We strongly support the addition of real estate provisions to the GIPS standards and are pleased to offer our views in support of the initiative. Notwithstanding the considerable thinking that has undoubtedly been part of the current draft, we believe the guidance does not go far enough to address the following significant matters: Comments on Section 6. Real Estate Introduction 6 We believe unlisted, private placement securities issued by private real estate investment trusts and real estate operating companies should be included in the list of investment-types not considered real estate. The returns for these types of investments are generally better measured by a dollar-weighted return as opposed to a timeweighted return. Alternatively, it may make more sense to include these investment types in a separate section that addresses private placement and venture capital investments so that the presented returns better meet the needs of the advisors and investors.

2 Professional Standards & Advocacy Dept. December 31, 2001 In addition, we urge the committee to reconsider the requirement to present only time-weighted returns for all real estate investments, as such returns may not provide the most meaningful measure of investment advisor performance. In certain circumstances, a dollar-weighted return will provide a measure that is just as or more meaningful than a time-weighted return. This may occur, for illustration, in certain separate accounts and close-ended commingled funds where the advisor controls the timing of draws on capital. Additionally, certain short-term investments that are managed to an internal rate of return are meaningless when presented using only a time-weighted return. For these types of private equity real estate investments, we recommend that a dollar-weighted return be required to be presented in addition to a time-weighted return. The comment that the GIPS carve-out provisions be applied when a portfolio contains a mixture of private equity real estate and other investments that are not equity real estate is likely to result in confusion in application unless additional guidance is provided. How, for example, should a composite that contains an account that invests in public real estate securities, private real estate operating companies, fixed rate mortgages and participating mortgages (each without separate cash allocations) present the performance results? Should a sub-composite carve-out be created that contains the performance results of just the public real estate securities and fixed rate mortgages from the account? Should four return columns be presented in the main composite for the real estate income and appreciation returns, the total non-real estate return and the total composite return? Additionally, how should this account s presentation be addressed beginning January 1, 2005, when GIPS requires that carve-out returns not be included in single asset class composite returns unless the carve-outs are actually managed separately with their own cash allocations. Disclosure Requirements 6.A.4.c. Inasmuch as the GIPS are designed to provide a global standard for performance presentation, we believe the issue of inconsistency between valuation methodologies between different countries also needs to be addressed. Stating the valuation method used does little to provide global (2)

3 Professional Standards & Advocacy Dept. December 31, 2001 consistency when the actual procedures applied in that valuation method may vary significantly between different countries. We recommend that AIMR provide definitions and accepted assumptions for the various valuation methods, and disclosures should be required when the procedures applied do not align to those definitions and assumptions. Disclosure Requirements 6.A.5 Separate disclosure requirements for direct and indirect real estate may create confusion and inconsistency, particularly when composites contain accounts that invest in both direct and indirect real estate. Further guidance should be provided on how to address presentation requirements in such instances. Input Data Recommendations 6.B.2 Separate appraisal recommendations for direct real estate may create unnecessary costs, administration and compliance maintenance requirements for advisors, particularly when certain accounts invest in both direct and indirect real estate. Definitions The definitions for direct and indirect real estate do not provide sufficient clarity for investments where the owner has less than a 50% interest or has joint, but not absolute control over property decisions. We also offer additional comments on the proposed guidance in the accompanying appendix. (3)

4 APPENDIX Comments on Executive Summary Independent Appraisals for Real Estate Assets Para. 1 It is stated that the provisions recommend firms implement the twenty-four month independent appraisal before Under Recommendations, item 6.B.2 states, Direct real estate investments should be valued by an external valuer or appraiser at least once every twelve months. As written, these statements contradict each other. We support a recommendation to implement the twenty-four month independent appraisal before Comments on Section 6. Real Estate Introduction 6 We recommend the first sentence be restated to say, These provisions apply to all investments where returns are generated from the management of private equity real estate through holding, trading and development. Comments on Section 6.A. Requirements Input Data Requirements 6.A.2. We agree that the party responsible for engaging valuation services should take the necessary steps to ensure that only well-qualified property valuers are utilized. To help ensure that this occurs, we recommend that a required disclosure be added to state the professional designation of the valuer or the relevant qualifications of the valuer should they not hold any professional designation or government certification or license.

5 Disclosure Requirements 6.A.4.d. We recommend that this requirement be expanded to state, The range of performance returns when there are five or fewer individual accounts in the composite. 6.A.5. See 6.A.2. above. Presentation and Reporting Requirements 6.A.6. The proposal requires the presentation of income and capital appreciation component returns in addition to total return. This requirement is not consistent with other asset classes that report only total return. We believe that consideration should be given to concerns raised against the bifurcation of income and appreciation returns from total return which are partly based on the following: (1) it provides little value to a potential investor as a means of distinguishing the performance between investment advisors without a detailed understanding the investment portfolios and the local markets where they are invested; (2) it adds to the perception that real estate is uniquely different than other investment classes, which is opposite to the goal of establishing consistent investment performance standards; (3) over time, real estate investments do not generate funds equivalent to the income reported, primarily, because most recurring capital expenditures are never deducted from the income return measure; (4) proposed accounting standards in the United States of America may cause a significant reduction or volatility in income returns even with no changes in the underlying economics of the real estate; and (5) different accounting standards between countries may result in inconsistencies in arriving at net investment income. While we do not have a strong preference whether disaggregate returns are presented, we recommend that AIMR carefully consider such concerns in addition to providing further guidance in this area to ensure that the presentation of disaggregate returns have a defined purpose. (2)

6 Comments on Section 6.B. Recommendations Section Comment Input Data Recommendations 6.B.1. AIMR-PPS TM currently requires that real estate values be reviewed quarterly. The proposal recommends that real estate investments be valued quarterly. It is unclear as to whether AIMR still requires real estate values to be reviewed on a quarterly basis. 6.B.2. See comment on paragraph 1 of Independent Appraisals for Real Estate Assets above. Presentation and Reporting Recommendations 6.B.3. We recommend that this item be restated to say, When available, the benchmark s income return and capital return should be presented in addition to the total return. Comments on Definitions Section Definitions Comment The definition of Total Return, Capital Return, and Income Return do not distinguish between the investment level and the property level as discussed in AIMR-PPS. As the return formulas between the property level and the investment level have different assumptions, we recommend that additional guidance be provided on whether there is an intention to distinguish between the two levels, and whether there is a preferred level of presentation. General Comments Section Comment (3)

7 General AIMR-PPS currently addresses the allocation of the various sources of interest income to either the income or appreciation component returns, particularly in the case of participating and convertible mortgages. This requirement has not been addressed in the proposal. If the final release does not address this issue, the allocation required by the various countries generally accepted accounting principles will be applied and may lead to inconsistencies among advisors. Guidance might also be helpful in areas such as how interest payments on mezzanine debt should be accounted for in the performance results, particularly where different partners have different performance results within the same composite due to separate funding mechanisms. Currently, many real estate advisors manage accounts for clients that do not require financial reporting on a fair value basis and have historically reported financial results using historical cost accounting. In many cases, these accounts comprise a significant percentage of the firm s assets under management, particularly in cases where the advisor manages the general account for certain insurance companies. Guidance would be helpful to provide direction to those advisors that are attempting to become compliant with their Country Version of GIPS, but have not been required to appraise the value of their properties under management agreements nor maintain fair value records for their clients. Certain considerations would be whether these companies have to (1) retroactively convert the historical cost accounting records to a fair value basis to enable proper time-weighted performance calculations; and (2) develop fair value accounting records on a prospective basis to enable time-weighted performance calculations. For retroactive conversions, guidance would be helpful on how often property appraisals should be obtained and in what periods they should be reflected in the fair values. For prospective conversions, guidance would be helpful on whether any accounts with historical cost records should exclude those assets from the total firm assets if proper time-weighted returns cannot be calculated. Although the requirement to have independent appraisals creates a perceived integrity in the underlying real estate appraisals, AIMR should consider an alternative for those situations where an advisor manages a portfolio with a large number of real estate assets and the client advisory agreement does not mandate independent appraisals. The cost of maintaining compliance with the GIPS standards may exceed the benefit to the advisor if the advisory client will not bear the cost of the appraisals. (4)

Proposed Guidance Statement on Calculation Methodologies

Proposed Guidance Statement on Calculation Methodologies Professional Standards and Advocacy Association for Investment Management and Research PO Box 3668 Charlottesville, Virginia 22903 United States of America Re: GIPS Guidance Statement October 30, 2002