Newcomers up the ante in governance index for trusts

NetLink NBN Trust debuts in GIFT 2019 at No.1. Its overall score of 90 puts it well ahead of all the other trusts. It has adopted most of the practices that we consider to be “best practice” in the governance area, including that of allowing unitholders to endorse the directors of the trustee-manager before they get re-appointed at the annual general meeting (AGM) of the trustee-manager.

Another debutant, Keppel-KBS US Reit, has also done well, with an overall score of 78.5, making it joint sixth with Manulife US Reit and Far East Hospitality Trust.

Excluding the four new trusts, the overall average score for those trusts that were in both last year’s and this latest edition increased by just under one point.

Far East Hospitality Trust showed one of the greatest improvements, gaining 15 points from last year and moving up from last year’s 29th place to joint 6th this year. It was able to do so through improvements in many areas, including appointing independent directors with relevant experience to replace non-executive directors who retired from the board (83 per cent of independent directors on board, highest of all trusts).

In addition, the trust was more prompt in releasing its financial results and posted minutes of its AGM – simple gestures that go a long way to improve engagement with unitholders.

Compared to 2018, the average business risk score in GIFT 2019 has remained relatively flat, although the average governance score has improved.

Areas of improvement

The greatest area of improvement in 2019 is the posting of detailed meeting minutes on the website of the trusts. Last year, we found the CapitaLand-related and Mapletree-related Reits doing so. This year, 29 of the 46 trusts have done so. Overall, communication with unitholders continue to be the area where the trusts fare particularly well.

Some other areas where there have been improvements include having nominating and remuneration committees (or a combined NC/RC), and disclosure of non-executive director (NED) fee structure.

In the business-risk section, trusts have reduced their refinancing risks as more have average debt maturity of more than three years, fewer have more than 25 per cent of their debt expiring in 12 months, and more have locked in at least 70 per cent of their interest costs. These have provided more stability to the trusts and improved the visibility of cash flows and financing costs.

Going backwards

Some trusts have, however, gone backwards. One stopped the practice of allowing unitholders to endorse the appointment of directors because it deemed that it has complied with the requirements for half the board to be independent and endorsement was no longer required by the rules. This suggests a minimum compliance mindset.

Another stopped disclosing the remuneration of each individual director, the chief executive and top five executive officers on a named basis, whether in exact quantum or in bands of S$250,000, and the total remuneration paid to the top five key management personnel.

This contributed to it suffering one of the biggest falls in score of 11 points, compared to 2018.

Some trusts justify the independence of certain directors when these directors have certain relationships with the manager, the trust, substantial shareholder of the manager or substantial unitholder of the trust. Some independent directors who retire from a trust after having served for nine years promptly joined another related trust as independent director. Hypothetically, if there are four related trusts, such directors can still be independent after 36 years!

While extensive justifications are given for such cases, we believe these trusts should just cast their net wider when appointing independent directors.

In cases where directors have other business relationships with the substantial shareholder of the manager and/or the substantial unitholder of the trusts, we have re-designated the independent directors from independent to non-independent in our assessment and this could affect a number of items in GIFT.

For trusts that fared less well in GIFT 2019, it is usually due to corporate actions related to the sponsor and/or controlling unitholder and less favourable business conditions, such as a drop in the weighted average lease expiry and higher refinancing risks.

Fewer isolated showers but four seasons in Singapore?

In past reports, we highlighted some trusts that had faced various types of challenges. The good news is that this year has been less eventful in this regard. Two trusts that showed large improvements in their GIFT scores appear to have put their worst behind them as they resolved their governance and operational issues.

That being said, the operating conditions and the structure of certain trusts continue to put downward pressure on their distributions to unitholders and unit prices.

A Reit that languished in the bottom three in all the GIFT editions cut its distribution per unit by 40 per cent in the past year. A business trust lost more than 70 per cent in value at its lowest point in the past year when it reduced its distribution by 80 per cent.

Rather than isolated showers last year, four seasons may be upon us in Singapore as more foreign trusts choose to list here and Singapore-based trusts with strong local sponsors venture overseas.

Before unitholders apply for units in a new listing, including foreign ones, in what seems to be assumed to be a “sure-win” Reit sector, they may want to ask themselves why certain foreign trusts are listing in Singapore especially when the sponsor is not local and the assets are overseas.

Of course, this may reflect the success of the Monetary Authority of Singapore (MAS) and SGX in making Singapore a major international listing destination for Reits. Today, this asset class accounts for about 10 per cent of the total market capitalisation of SGX – a larger percentage than in key markets such as Australia, Japan, UK and US, and Singapore is now the second largest Reit market in Asia after Japan.

Nevertheless, we believe it is important for investors to understand what they are investing in under our largely disclosure-based caveat emptor regime.

As for local Reits, their risk profile may change as they acquire assets overseas. Investors should consider whether these Reits are operating outside their core competence and their network and knowledge of the local market. Even if managers take out loans in foreign currency and forward-hedge their expected distributions, unitholders still retain significant exposure to foreign-exchange risk associated with these foreign investments.

Bigger, but are they better for unitholders or for the managers/sponsors?

In the past year, there were consolidations and mergers in the market, including several mergers that are in the works.

Unitholders are asked to foot the “acquisition” fee for the “merger” upfront, even if the assets being acquired come from a related trust. Unitholders need to question if there are real operational synergies that would translate into tangible benefits for them. On paper, merging a hospitality trust with a commercial real estate trust can be justified by various textbook reasons. Ultimately, it is up to the manager to execute it well, based on a good strategy to deliver returns to unitholders.

As long as a trust is externally managed, issues of alignment of interests between unitholders and the manager are more likely to arise, given that the manager has its own financial considerations and ultimately accounts to a different set of shareholders (which are not the unitholders of the listed trust).

Leveraging up

Reits are well-regulated and the MAS has taken a prudent approach in ensuring that any relaxation in operational flexibility for Reits which may increase their risks is accompanied by stronger governance safeguards.

In recent years, we have seen the leverage limit for Reits raised from 35 per cent (and 60 per cent for those with a credit rating) to a flat 45 per cent, which is still relatively conservative compared to other markets.

There was also an increase in the property development limit from 10 per cent to 25 per cent.

Last month, the MAS issued a consultation paper with a view to allowing a higher leverage limit of 50 per cent or 55 per cent, subject to Reits meeting or exceeding certain interest coverage ratio thresholds or having demonstrated strong financial discipline.

These changes, if approved, may lead to further changes in the risk profile of Reits. In line with earlier relaxation being accompanied by enhancements in governance safeguards, the MAS may wish to consider enforcing stricter standards on Reits, such as in how the independence of directors is assessed, or prodding trusts to have independent directors with strong financial, investment or real estate experience.

Out of the 46 trusts included in GIFT 2019, 14 currently issued hybrid securities in the form of perpetual or convertible securities.

Perpetual securities are classified as equity under current accounting standards, even though they have debt-like features. We found that those trusts which have issued perpetual or convertible securities have higher average leverage of 37.5 per cent, compared to other trusts, which have average leverage of about 34 per cent. This is consistent with trusts turning to hybrid securities as an alternative source of financing when their leverage increases.

In fact, for the nine pure Reits that have issued perpetual securities, two of them would have exceeded the 45 per cent leverage limit if the perpetual securities were reclassified from equity to debt. Three other Reits would have adjusted leverage above 44 per cent and be just a whisker away from the 45 per cent cap.

The MAS may wish to take into account whether trusts are using hybrid securities when determining the leverage limit that should be imposed.

What’s in store for GIFT 2020?

We are encouraged by the continuing strong interest in GIFT as 34 out of the 46 trusts – or nearly three-quarters – took up our invitation to submit a voluntary self-assessment.

This compares with 29 out of 43 – or two-thirds – which did so last year. We look forward to continuing engagement with the trusts to improve governance in the sector.

For next year’s GIFT, we plan to measure weighted average lease expiry (WALE) using Gross Rental Income (GRI) rather than Net Lettable Area (NLA).

We will also be looking for more clarity on long-term remuneration incentives/plans for key management, and examining more closely the competencies of directors and key management as trusts expand their operations overseas. We may also focus more on the use of perpetual securities, especially if the limit on aggregate leverage is raised.

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Mak Yuen Teen is an associate professor of accounting at NUS Business School. He has been involved in developing several governance rankings in Singapore and the region. Chew Yi Hong is an active investor and researcher in corporate governance, who holds an MBA with Distinction from the London Business School.