PFA Research Report Net Tangible Assets Review of Industry Standard and Usage October 2014
The PFA wishes to acknowledge Atchison Consultants who have contributed to the preparation of this report, and Deborah Upton, its author. Deborah Upton is the Managing Director of Envisager Securities Limited, a boutique fund manager in the unlisted property space. She has been a long term supporter of the Property Funds Association having chaired and spoken at its conferences and educational events, been involved in the administration of the organisation and supported its conferences through the Events Committee. Deborah has worked in the listed and unlisted property industries for over 20 years and has observed and analysed the nexus between NTA and value over many years. She has now contributed to this report on NTA and hopes that it will be the beginning of an ongoing fruitful discussion which will lead to best practice in this sector.
Contents Executive Summary 4 Conclusion 5 Recommendation 5 1 Introduction 6 2 NTA Current Practice - Survey Outcomes 7 3 Net Tangible Asset Definition 10 4 International Guidelines 12 4.1 Investors in Non-listed Real Estate Vehicles 12 4.2 Asian Association for Investors in Non-Listed Real Estate Vehicles 12 4.3 European Public Real Estate Association 12 4.4 APREA 12 5 Australian Direct Property Investment Association 13 6 One Proposed Measure 13 6.1 Valuation of Investment 14 6.2 Application and Redemption Value 14 6.3 Performance 14 7 Conclusion 15 Appendix 1 PFA Survey 16 2
Executive Summary Discussion about the use, let alone the calculation, of Net Tangible Assets (NTA) raises debate, disagreement and some division amongst those in the Australian Unlisted (and Listed) Property Funds Sector. The Property Funds Association of Australia (PFA) has worked in conjunction with Atchison Consultants to undertake a survey of participants in the unlisted property funds sector. In addition, the PFA has held discussion groups evaluating the results of the survey and refining the conclusions. The results of the survey and discussions have highlighted the need to clearly define what NTA is, and what it is not. In addition, when defining what NTA is, we need to understand the implications that any variations in methodology can have on funds and the perception of them in the marketplace. This paper does not seek to be prescriptive, but to highlight issues for further discussion. The NTA of a fund is the measure of value of equity invested in a fund. Once calculated this figure can be used as the basis for further calculations, namely: Unit price or current unit value (CUV), i.e. the basis for application and redemption unit prices in a fund The measurement of fund performance This paper will primarily focus on the calculation of NTA but will also touch on issues such as: How does a fund manager create fairness between all investors? Are the needs of an open-ended fund and a closed-ended fund the same? Sitting in the background of the discussions are regulatory guidelines from Australian Securities and Investments Commission (ASIC), best practice guidelines from international associations representing unlisted property funds as well as Australian Accounting Standards. ASIC guidelines provide a great deal of room for interpretation of how an NTA calculation could be made. International associations best practice guidelines lack consistency with respect to their adherence to International Financial Reporting Standards (IFRS) while Australian Accounting Standards are equivalent to IFRS. A review of these standards and best practice guidelines is included in this report. While adherence to Australian Accounting Standards preclude too many options with regard to the calculation of NTA, there is still room for interpretation. As a consequence Australian unlisted property fund managers have variations in their approach to the calculation of NTA. This paper is not a best practice guideline, it is an analysis of the results from the survey of industry participants. It is an exploration of the key methodologies used by fund managers, and where they differ, an analysis of why, particularly in light of the issues above. This paper seeks, however, to provide a thought leadership piece for fund managers to review their practices and to make an informed decision as to how they could calculate NTA. 4
Conclusion Results from the survey participants show that: There is not a uniform method of calculation used by all fund managers to calculate NTA, particularly with respect to the timing of the first write-off of acquisition costs These different methodologies lead to inconsistency in the representation of information to investors and their understanding of the value of funds and their potential performance The manner in which unit pricing is calculated, using the NTA as a base, also differs between fund managers (though a more thorough examination of this issue is beyond the scope of this paper) The position of the fund managers (who participated in this survey) on NTA can be summarised as follows: Group 1 Group 2 Those who interpret the accounting fair value concept for valuation as being the first revaluation after acquisition typically between 3-12 months. Those who interpret the accounting fair value concept for valuation as being the first valuation upon acquisition and write-off all acquisition costs at fund commencement. Recommendation As an industry we need to recognise and respect that there are different views as to how an NTA should be calculated. The industry also knows that it is subject to an international accounting regime which is not ideal for understanding and interpreting property investment vehicles. Indeed, these standards have been overruled in recommendations from international property fund industry bodies. However, lack of uniformity in the reporting of NTA creates some issues. 1. It makes it more difficult for investors to make investment decisions based on reported numbers alone 2. It makes comparison between investments more problematic 3. It makes it more difficult for the industry to present a unified front as it competes with other asset classes for investment funds As it stands, it would appear unlikely that the industry will achieve uniformity in its reporting of an NTA. Even if it does not, full declaration of the methodology used is important for transparency in the sector. In the meantime, it is helpful to keep the debate open and to contribute ongoing information and analysis. The PFA trusts that this thought leadership piece provides such a contribution. 5 PFA Research Report October 2014
1Introduction The basis upon which an unlisted property fund NTA is calculated has been a point of discussion and debate for many years. The unlisted property funds management industry in Australia neither has a benchmark standard nor a best practice guideline for such a calculation. This paper seeks to supply neither of those, but to re-examine the issue in the light of industry feedback for the purpose of giving a framework to the debate in the current market. There exist a number of regulatory and accounting related standards that are applied in the calculation and reporting of NTA, even though NTA itself is not a separately defined term in accounting. However, the interpretation of these requirements and their application to the concept of NTA varies across fund managers. The NTA of a fund is the measure of value of equity invested in a fund. Once calculated this figure can be used as the basis for further calculations, namely: Unit price or current unit value (CUV), i.e. the basis for application and redemption unit prices in a fund The measurement of fund performance As ASIC is the primary regulatory body for fund managers, the disclosure of NTA per unit in an unlisted property investment fund should adhere to the guide disclosure principles set out in ASIC RG 168: Disclosure should be timely Disclosure should be relevant and complete Disclosure should promote product understanding Disclosure should promote product comparison Disclosure should highlight important information Disclosure should have regard to consumers needs In addition, each component of the calculation should be: Objective Transparent Equitable Quantifiable Identifiable Traceable Repeatable While these principles underline the desirability of a consistent measure of the value of equity in an unlisted property fund investment, the interpretation of principles such as Disclosure should promote product understanding and Disclosure should have regard to consumers needs, means that the outcome from the application of those principles is varied. A survey of unlisted property fund industry participants with regard to the basis of calculation of NTA has been conducted. The responses demonstrated a range of practices, interpretations and adoption techniques of the calculation of NTA. A copy of the survey form is included at Appendix 1. The survey covered the following industry groups: Institutional investors (2) Property fund managers (16) Service providers (13) Research houses Accounting/Auditing firms Asset consultants 6
2NTA Current Practice - Survey Outcomes The results of the survey of unlisted property fund industry participants demonstrated that there is some divergence in the method of calculating NTA. The area which has the single most impact upon the value of the NTA is the treatment of acquisition costs and stamp duty. This is because stamp duty is typically the largest cost associated with the acquisition of property. Stamp duty ranges between 5% and 6% of the acquisition price. Other acquisition costs include due diligence costs directly related to the acquisition of assets. These will include legal fees, technical, structural and taxation expert reports, valuation and professional advice regarding town planning and zoning and environmental considerations. Analysis of Fund Manager Results Notwithstanding Australian Accounting Standards allow investment property to be subsequently measured at cost or fair value, all fund managers adopt the fair value model. The major distinction between the Fund Managers was: 1. Those who wrote off acquisition costs immediately (assuming a valuation at acquisition) 2. Those who wrote off at first revaluation (timed from the first quarter to the first anniversary after acquisition) The results from this aspect of the survey, pertaining to fund managers, are as follows: Treatment of Aquisition Cost and Stamp Duty for Calculation of NTA Write off Immediately 0% 10% 20% 30% 40% 50% 60% 70% Write off at First Revaluation Australian Accounting Standards require that acquisition costs, including stamp duty, are capitalised at acquisition and written off at the first revaluation. Some 38% of respondents follow this practice, but the majority, 62%, choose an immediate write-off. Reasons cited for the policy of immediate write-off of acquisition costs revolve around the desire to express to investors the true value of the fund. Comments (gleaned from the survey, discussions and publicly available documents) contain the following elements: An approximate measure of the risk of capital loss to the investor if the fund were to be liquidated, and a desire to be open with investors regarding what would be the realisable value of the fund if it were to be closed down A measure of the amount of capital gain needed in the underlying assets in order to offset the acquisition and establishment costs The difference between these two methodologies can be quite significant in the interval between the acquisition and asset revaluation dates. The following scenario is a simple example which highlights the difference. 7 PFA Research Report October 2014
Scenario: Two funds purchase a property for $100m with 6% acquisition costs to be written off. Gearing is 40% of the property value. Fund 1 writes off costs at inception, Fund 2 after first revaluation, a 12% increase in value. Units have been issued at $1. Sources and Applications of Funds At acquisition After 1st valuation Source Fund 1 Fund 2 Fund 1 Fund 2 Equity (70m units @$1) Debt Application $m $m $m $m 70 Investment Property 100 110 Investment Property 112 40 Debt -40-40 Debt -40 110 Net assets 60 70 Net assets 72 $m 112-40 72 Investment property 100 Acquisition costs 6 No. Units (m) 70 70 No. Units (m) 70 70 Working capital 4 NTA per unit ($) 0.86 1.00 NTA per unit ($) 1.03 1.03 110 Investment property after first revaluation 112 While, in this simplistic scenario, the NTAs are equalised at first revaluation, the first revaluation could be up to 12 months away or more. There could be a significant period of time in which the representation of the same acquisition is quite different. It is also a demonstration of the paradox of including expenses paid as assets, regardless of their capability to neither generate income nor be exchanged or divested for valuable consideration. The incorporation, or not, of other potential assets or liabilities in the NTA, as per the survey questionnaire, are not as clear due to many of the items being irrelevant to many of the managers. See Appendix 1 for a description of these items. However, one item which did receive more significant attention was the mark to market of hedges. This was considered important as it demonstrates any liability the fund may have as a result of the instrument being out of the money. In addition, the issue of having rolling valuations on debt break costs should be raised as this also can have a significant impact on the reported NTA. Further Survey Analysis A significant area of discussion which arose from the survey was the relevance of an accounting NTA to unit holders as a means of providing an understanding of the value of their units. This is particularly highlighted in the different needs of open ended and closed ended funds. For fixed term, closed ended funds the proposition is simpler. The NTA calculated to represent the fair value of the fund under Australian Accounting Standards, typically aligns with the wind-up value of the fund subject to any fund specific wind up items. All participants in the fund have equally borne the costs of the transaction through the initial write-off of costs (either at inception or at first revaluation after purchase) which is reflected in the NTA. The objective of the manager over the term of the fund is to increase the value of the underlying assets such that the NTA upon wind up of the fund (taking into consideration any performance fees, selling costs etc.) is above the issue price. 8
The manager of an open-ended fund has the responsibility of ensuring that there is a fair distribution of costs between unit holders, particularly between those who enter and exit the fund at different times. The manner in which this fair distribution of costs was represented by survey participants fell into two main categories: Creating a separate buy/sell spread which embedded the up-front and other costs Creating what might be called a current unit price based on the NTA to which up-front costs have been recapitalised then amortised over a period of time, say 5 years. There may be an additional buy/sell spread to represent other selling costs associated with the transaction. For any funds which acquire property during the term of the fund, particularly relevant to open-ended funds, the difficulty of fair representation of value for unit holders does not end there. With the acquisition of new properties during the life of the fund, Australian Accounting Standards require acquisition costs to be reviewed at first revaluation but the timing of that valuation can have a critical effect on the unit pricing of the fund. Those funds which choose to write-off at acquisition may produce an NTA (hence current unit value) which declines with the write-off of costs. This effect is demonstrated in the example scenario above, having the same effect on NTA as occurs on initial acquisition of properties. Those funds which choose to write-off at the next valuation date, may be able to smooth the NTA, hence unit price, with offsetting gains from other properties which have revaluation increases. Both practices can produce quite different outcomes, in the short term, for the funds. In turn, new investors entering the funds during this period may have different entry prices therefore a different value proposition. This highlights the need for funds to differentiate the reporting of NTA from unit pricing, recognising that the NTA is limited in reporting fair value for unit holders. To this end, the following options are either implemented or being considered by fund managers: Provide an NTA for accounting purposes Provide separate pricing for units which may - Include acquisition costs which are amortised so that current unit holders are not disadvantaged and future unit holders carry some of the costs of acquisition - Provide for acquisition costs in a separate buy / sell spread account - In addition, bring to account rent as received rather than straight lining rent as for accounting standards Analysis of Service Provider Results Not surprisingly, research houses encapsulated their responses through a perspective of risk. Essentially, they addressed the question, what is the greatest risk to the investor? The answer is, that the fund is dissolved today and investors receive what is available upon sale of the assets. To this end, research houses favour the immediate write-off of all costs and the mark to market of all financial instruments. Moreover, some have sought to provide uniformity for their own analysis by: Creating a bespoke calculation to reflect their analytical framework rather than relying on the NTA provided by a fund manager Requiring that the fund manager report their results to them in a specified calculation framework rather than from their own calculations In this way, a measure of uniformity in value and performance between fund managers is able to be reported by these research houses. 9 PFA Research Report October 2014
Accounting firms focussed on Australian Accounting Standards as the framework for NTA. It was acknowledged in the responses that NTA was not necessarily appropriate for unit pricing which serves a different purpose and should take into account transaction costs. It was also acknowledged that the use of an accounting NTA with immediate write-down of costs is hard for unit holders in small funds. 3Net Tangible Asset Definition Having discussed how fund managers and others view NTAs, it is worth understanding a definition of NTA using Australian Accounting Standards as a guide. NTA is a statement of value of net assets being total assets less total liabilities and total intangible assets such as goodwill. Net asset value (NAV) is used in some countries rather than NTA. NTA or NAV may also mean NTA or NAV per issued security (as used in the above scenario). Net assets has a defined meaning in accounting standards as set out by the Australian Accounting Standards Board (AASB). Net assets is total assets less total liabilities. NTA is not an accounting construct and is not specifically defined by standards or regulation. NTA will generally reflect the fair value of the fund. The AASB defines fair value as the amount for which an asset could be exchanged between knowledgeable, willing parties in an arm s length transaction. Changes in fair value are recorded through the profit and loss account according to AASB standards. Regulatory guidance published by ASIC dated March 2012 (RG 46: Unlisted Property Schemes Improving Disclosure For Retail Investors) sets out at RG 46.109 the components for the calculation of NTA being total assets less intangible assets and liabilities. AASB defines an intangible asset as an identifiable non-monetary asset without physical substance. Intangible assets may include: Technical knowledge or design Implementation of new processes or systems, licences, intellectual property, market knowledge and trademarks Patents and copyrights Customer lists, customer or supplier relationships Customer loyalty, market share and marketing rights Goodwill ASIC notes the expectation that fund managers comply with all relevant accounting standards and RG 94: Unit Pricing Guide to Good Practice. ASIC acknowledges that the formula is open to interpretation as it stipulates that fund managers should disclose the methodology and set out the adjustments used to calculate NTA. RG 46.109 requires that the responsible entity of a closed-end fund should disclose the value of NTA on a per unit basis in pre-tax dollars. According to accounting standards, acquisition costs for investment property are to be capitalised on the balance sheet. Upon first revaluation of the property, the valuation is adopted in the balance sheet. Where the valuation is less than purchase price plus acquisition costs the acquisition costs are thereby written 10
down. Where the valuation is higher than the purchase price plus acquisition costs, the acquisition costs are absorbed into the higher valuation. Notwithstanding the fact that accounting standards allow investment property to be carried at cost, overwhelmingly investment property is carried at fair value. Thereafter, valuation increments and decrements will be recorded as fair value adjustments in each reporting period, as stipulated by accounting standards. Property acquisition costs comprise any or all of the following: Property acquisition contract price Legal fees and expenses relating to acquisition Government stamp duty and registration fees on acquisition Property due diligence costs and expert reports Responsible entity s initial fee for establishment of the scheme Accounting standards stipulate that borrowing expenses including application fees, legal fees and mortgage stamp duty should be capitalised and written off over the term of the loan. Interest rate hedges and other financial derivatives are used to manage interest rate exposure. The value of a financial derivative will vary through the term due to changes in interest rates, amongst other variables. Fair value accounting changes in the mark to market valuation of derivatives such as interest rate hedges will be recorded in the profit and loss account (where hedge accounting is not applied) and on the balance sheet for inclusion in the NTA calculation reflecting the value of that derivative contract. This would identify structures where there is a clear economic relationship between the hedged item (e.g. loan) and the hedging instrument (e.g. interest rate swap). A deferred tax asset may arise from income or expenses timing recognition difference. It may also arise from carry forward unused capital losses for tax purposes only to the extent that it is probable that future capital profits will be available against which the unused losses can be offset. Most property funds are not taxable entities. Accounting professionals differ in their views as to how deferred tax assets and liabilities are include or excluded in NTA calculations. Performance fees are accrued by a fund as a potential liability. The fee should be recognised only when 4the obligation through the fair value of the assets is recorded. Any fee for outperformance is a liability and should be included in the calculation of NTA. International Guidelines In contrast to a definition of NTA heavily reliant on the application of accounting principles as largely used in Australia, the following review of best practice guidelines published by other property investment professional bodies indicates that a number of them recommend a more commercial and fair to unit holder rather than fair value methodology. 4.1 Investors in Non-listed Real Estate Vehicles The European association for Investors in Non-listed Real Estate Vehicles (INREV) publishes a voluntary best practice guide for the estimation of NAV based on IFRS guidelines. INREV acknowledges that the fair value option of IFRS requires acquisition expenses to be capitalised as part of the property and charged to income as fair value changes in the first year. 11 PFA Research Report October 2014
INREV policy is that acquisition expenses are capitalised and amortised over the first five years of the term of the fund. According to the INREV best practice guide, the treatment of acquisition costs, such as transfer taxes, lawyers', agents' and accountants' fees, should be amortised over five years to create a consistent smoothing. 4.2 Asian Association for Investors in Non-Listed Real Estate Vehicles ANREV is the Asian Association for Investors in non-listed real estate vehicles. At the end of 2009, ANREV entered a co-operation agreement with INREV, its sister organisation in Europe and endorsed the INREV Guidelines in Asia. Thus its policy mirrors that of INREV. 4.3 European Public Real Estate Association In 2011 a best practice guidance note was issued by European Public Real Estate Association (EPRA) regarding NAV. EPRA considers that NAV reported in the financial statements under IFRS does not provide the most relevant information on the fair value of the assets and liabilities within an ongoing real estate investment fund. Assets and liabilities that are not expected to crystallise in normal circumstances such as the fair value of financial derivatives and deferred taxes on property valuation surpluses are excluded. This includes the mark to market adjustment to the value of financial derivatives which are used for hedging purposes and where the fund has the intention of keeping the hedge position until the end of the contractual term. Under EPRA s NAV measure revaluation of the asset should be to fair value in accordance with the valuation option under IAS 40. The basis of valuation should be disclosed. 4.4 APREA Contained in its Best Practice Handbook, APREA has produced an adjusted NAV measure which provides regional comparability. APREA NAV involves minor adjustments to the standard IFRS NAV. A summary of the guidance from relevant professional bodies is set out in the following table. Comparison of International Guidance Factor INREV ANREV EPRA APREA Investment properties are accounted for at fair value Yes Yes Yes Yes Acquisition costs written off at first revaluation date No No Yes Mark to market of financial derivatives No Yes 12
5Australian Direct Property Investment Association The Australian Direct Property Investment Association (ADPIA) was the predecessor to the PFA. In December 2002, the ADPIA Accounting Standards Sub-Committee issued a proposal for the uniform treatment of initial expenses in the acquisition of real estate assets into a managed investment scheme structure. This report was prepared in the regulatory environment prevailing at the time which predated the IFRS regime. It was proposed that the manager s initial fee and due diligence costs related to the acquisition of the property specific to the fund be capitalised and amortised over the life of the fund with a maximum write down period of ten years. Transaction costs including stamp duty, conveyancing legal costs, valuation fees and property due diligence costs were to be capitalised and written off over five years. Borrowing costs including mortgage stamp duty and associated legal fees were to be written off as an expense in the financial year in which they were incurred. 6One Proposed Measure While a number of funds adopted this methodology no best practice guideline was formally issued by ADPIA at the time. The subsequent introduction of IFRS and its influence upon Australian Accounting Standards appears to have largely replaced this line of thinking. In its contribution to the report, Atchison Consultants has proposed one way forward for the industry which combines some of the elements discussed by fund managers. It is presented as one option which may be used in future discussion. NTA per unit of a property fund is calculated by deducting from total assets, intangible assets and liabilities and dividing by the number of securities on issue. This will involve either annual external valuations or clear disclosure of which properties are subject to director valuations. As a result the following conclusions are drawn. NTA calculation should follow Australian Accounting Standards (equivalent to IFRS) which results in the following: - Acquisition costs should be capitalised on the balance sheet - Property acquisition costs should be written off to the profit and loss account as an expense to the extent that the purchase price plus acquisition costs exceed the initial valuation of the properties - Mark to market valuation of financial derivative contracts should be recognised on the balance sheet and reflected in the profit and loss accounts (unless hedge accounting is applied) for fair value accounting - Costs associated with establishing a debt facility should be amortised over the term of the debt - Performance fees should be included in the calculation of NTA - Deferred tax assets which can reasonably be realised should be included in NTA Fund managers should disclose their NTA calculation methodology 13 PFA Research Report October 2014
There are three key applications for which the calculation of NTA can be used as the basis of the calculation. 6.1 Valuation of investment This calculates the fair value of a fund which is required by investors for inclusion in financial statements. Fair value is the amount for which an asset could be exchanged between knowledgeable willing parties in an arms length transaction. This will be derived from a market valuation. 6.2 Application and Redemption Value Unit pricing provides a basis for a transaction price. A unit price is based on the NTA. A transaction price represents an equitable balance between unit holders with respect to the impact of the costs of a property transaction. A buy/sell spread is the difference between the application or redemption unit price. The spread reflects the transaction costs of assets. These costs will include any transaction costs which are incurred when buying and selling assets. The spread is applied to the unit price resulting in application and redemption unit prices. It is inequitable if new equity capital into a fund does not incur a portion of acquisition costs. This is dealt with in the buy/sell spread in unit prices, not through NTA. Transaction costs include: brokerage government charges bank charges stamp duty registry and administration fees 6.3 Performance Changes in an evaluation based on NTA are a component of measurement of performance of a fund. Fair value requirements under Australian Accounting Standards require investment property to be revalued annually, either by an independent valuer or the directors. 14
Conclusion The NTA of a Fund is the measure of value of equity invested in a fund expressed in financial statements. Once calculated this figure can be used as the basis for further calculations, namely: Unit price or current unit value, i.e. the basis for application and redemption unit prices in a fund. The measurement of fund performance. It is clear from the results from the survey participants that: There is not a uniform calculation which is used by all Fund Managers to calculate NTA, particularly with respect to the timing of the first write-off of acquisition costs These different methodologies lead to inconsistency in the representation of information to investors and their understanding of the value of funds and their potential performance. The manner in which unit pricing is calculated, using the NTA as a base also differs between fund managers (though a more thorough examination of this issue is beyond the scope of this paper) The position of Fund managers on NTA can be summarised as follows: Group 1 Group 2 Those who interpret the accounting fair value concept for valuation as being the first revaluation after acquisition between 3-12 months. Those who interpret the accounting fair value concept for valuation as being the first valuation upon acquisition and write-off all costs up front. While the typical practice is to revalue property at least annually, it is possible for valuations to be delayed for up to three years, thus making comparative judgements between funds even more problematic. 15 PFA Research Report October 2014
Appendix 1 PFA Survey In 2013 a survey was conducted of representative industry practitioners to assess methodologies used in calculation of NTA. A summary of the survey questions follows: Components of the calculations: How should net assets be derived? Are any or all of these included in NTA construction? Capitalised acquisition costs Carried forward performance fees Fee obligations Capitalised interest Prepaid interest Stamp duty What is a liability? Convertible notes Warrants Hybrid securities Debt Adjustments Timing differential for asset valuations What role might the AASB or AIFRS standards play in the methodology? Where is NTA calculated? Internal accountant Custodian Auditor 16
PFA would like to acknowledge its 2014 annual sponsors:
Level 9, 500 Collins Street Melbourne VIC 3000 Phone: 03 9603 5250 pfa@propertyfunds.org.au www.propertyfunds.org.au