Simon Botherway: Governance key property issue

Listed property investment structures have received a great deal of attention of late, culminating in the heated exchanges at last week's Kiwi Income Property Trusts meeting.

The debate has largely dwelt on the merits or otherwise of internally managed (Capital Properties) versus externally managed property investment vehicles (Kiwi).

Some of the commentary has been well informed and constructive but, in some instances, the opinions expressed have been somewhat dubious.

One commentator, John Schellenkens of Ernst & Young (Herald, January 26), asserts that "to some extent unit-holders can control their managers by refusing to participate in capital-raising exercises". Unfortunately, this is fine in theory but, in practice, there is no such control mechanism.

Property trusts have a long history of raising capital at significant discounts to either net tangible assets or the prevailing unit/share price - investors choosing to forgo participation in such capital raisings are not controlling their manager's capital appetites as such issues have regularly been underwritten or have been undertaken by way of institutional placement. Non-participation would be cutting off your nose to spite your face.

If you owned a property directly that was yielding 10 per cent, would you take on a partner to purchase another property if the new partner demanded a 13 per cent return on his money? That is what an investor would be doing by withholding capital.

Such capital raisings have largely been value-destroying (this can be empirically demonstrated) despite the promoters' worn-out claims that pro rata capital raisings are not value-destructive. To begin with, paying out unimputed cash dividends and then asking for the cash back via a capital raising is highly tax-inefficient.

Further, the implied equity cost of capital is usually much higher than the yield offered by the underlying properties.

Surely in order to add value for investors, the property vehicle should be raising capital to increase either the underlying assets per unit/share or (preferably) increasing the prospective distribution per share.

Yet the overwhelming evidence is that this is not the case here, whereas Australia has a much better trade record in this respect.

So why do property vehicles raise capital if not to improve either net tangible assets or distributions per share? The primary concern of many commentators is that the management companies' fees charged by externally managed trusts are based on gross assets rather than on the investment returns to investors.

Surely then an internally managed vehicle such as Capital without the "bigger can only be better" imperative that we'd expect of externally managed vehicles would not have such dilutive capital raisings.

However, Capital has had several deeply discounted, underwritten rights issues and, in at least one instance, the employee investment scheme had first right of refusal on the rights that were not taken up - an apparent conflict of interest.

Despite protestations from this writer to the Capital board, there has been no evidence of an improvement in understanding of corporate finance or corporate governance.

This track record of poor governance was reflected in the company's recent decision to buy a regional shopping mall in need of redevelopment in spite of its assertions to shareholders that its investment intentions were focused on Auckland and Wellington office and carpark properties as well as the retail associated with the office blocks.

Further, Capital has experienced a higher than desirable level of turnover in senior management personnel, indicating perhaps that the relationship between management and board is not as it should be. No wonder Kiwi was able to secure a 19.9 per cent stake in Capital with such ease.

Clearly, there are issues with external management and this was reflected in Kiwi's poor and subsequently rescinded decision to charge a management fee on the trust's investment in Capital.

Kiwi has undertaken to review its fee structure and I would certainly expect to see a better alignment of unit holder and manager interests in the future.

Shareholders need to look at the adequacy of their elected representatives before deciding which is the best investment for their needs.

Capital's knee-jerk response to Kiwi's investment has been to put its own property management contract up for tender. This may entrench the present board and management - an unattractive outcome for Capital's shareholders.

* Simon Botherway is a principal of fund manager Brook Asset Management.