OSC Publishes Results of Review on REIT Distribution Disclosure; Excess Distributions, Non-IFRS Metrics Among Key OSC Concerns
On January 26, 2015, the Ontario Securities Commission published OSC Staff Notice 51-724 – Report on Staff's Review of REIT Distributions Disclosure. The Report presented the findings of the OSC's recent review of the disclosure practices of 30 publicly-listed REITs, primarily in the area of distribution sustainability and accounting disclosure. As investors expect REITs to provide predictable and regular distributions, the OSC is concerned that REITs may not always be providing their investors with a complete picture of the stability and sustainability of distributions. Though Staff's review found the disclosure of the subject REITs to be generally satisfactory with respect to distributions, Staff did note that many REITs are falling short of the OSC's expectations for disclosure set out in National Policy 41-201 – Income Trusts and Other Indirect Offerings. In particular, Staff found that certain REITs were deficient in their disclosure of distributions paid in excess of cash generated by operating activities, and in their disclosure relating to the use of certain non-IFRS measures.
Common Disclosure Deficiencies Relating to Distributions
The Report outlined several key concerns surrounding the payment of distributions by REITs in excess of their operating cash flow, a practice that Staff noted is relatively common, particularly among REITs in the process of adjusting to the impact of a recent financing, major acquisition, or contractual and/or seasonal fluctuations in operating income. Of the REITs surveyed, 33 percent had paid distributions in excess of cash flow from operations during the review period, and in turn, 70 percent of these had paid distributions equal to or in excess of 10 percent of available operational cash flow. Of the REITs surveyed, 13 percent had paid non-cash distributions (such as distributions paid pursuant to a distribution re-investment plan or DRIP) that, if paid in cash, would have been in excess of operational cash flow.
Additionally, the Report noted that, while the intent of NP 41-201 is to require REITs to report interest paid on long-term debt—typically a crucial REIT expenditure—as an operational expense, IFRS gives REITs the accounting choice to report this expense as a financing expense not required to be deducted from operational cash flow. For approximately 10 percent of the REITs surveyed, distributions would have exceeded cash flow from operations had these REITs elected to treat interest as an operating expense. Staff stressed that REITs whose cash distributions would exceed operating cash flow but for the accounting election should, nonetheless, provide the prescribed excess distribution disclosure pursuant to NP 41-201.
Return on Capital vs. Return of Capital
Staff also stressed that that the impact of a REIT's decision to fund distributions from sources of cash other than operating activities, such as debt or other new financing, cash reserves or non-cash distributions, is not being adequately communicated to investors in many cases. Staff expressed a particular concern that paying distributions to unitholders in such circumstances, commonly referred to as a return of capital as opposed to a return on capital, can significantly alter a REIT's risk profile and should be appropriately disclosed.
Several suggestions were provided by Staff for improving the disclosure in the case of a return of capital distribution, including describing the material terms of any borrowing required to finance such distributions, the expected impact on the REIT's operating performance of additional interest expense or the issuance of additional units pursuant to a DRIP (upon which distributions must subsequently be paid) and generally increasing transparency surrounding management's distribution payment strategy, all as contemplated by NP 41-201.
Changes to Distributions that Trigger Timely Disclosure
Staff's concerns were heightened during the course of its review in the case of one REIT that suspended payment of distributions to unitholders as the shortfall from operational cash flow had made continued distributions unsustainable. The Report confirmed Staff's view that any suspension or elimination of a distribution by a REIT constitutes a material change under securities law, which should be immediately disclosed under National Instrument 51-102 – Continuous Disclosure Requirements. The Report notes that "sufficient advance notice of any prospective distribution reduction, either to conserve capital for use in future projects or because current distribution levels have become unsustainable, should be provided to investors as soon as practicable. It is critical that investors receive information required in order to understand and assess any risks related to the sustainability of distributions on a timely basis."
The Report also highlighted a concern of Staff relating to the practice by REITs of disclosing performance metrics typical to the real estate industry (and REITs in particular) but which do not have standardized meanings under IFRS or US GAAP. Most common among these are net operating income, distributable cash, funds from operations (FFO) and, of most concern to Staff, adjusted funds from operations (AFFO). The Report found that AFFO is not always presented as a cash flow measure with appropriate adjustments, which is necessary for it to be an adequate metric of a REIT's cash available for distribution to unitholders. The Report also found that REITs often fail to present the nearest IFRS or US GAAP metric more prominently and include proximate disclosure about the non-standard nature of the metrics used, all as required by NP 41-201.
Although the Report found that the disclosure by REITs surveyed was generally adequate, common disclosure deficiencies identified in the Report underscore Staff's broad concern with investors' ability to assess the risk profile of distribution-paying securities. For roughly half the REITs surveyed, the OSC felt the disclosure deficiencies warranted a comment letter, though ultimately no REIT was required to refile or restate any of its continuous disclosure documents. REITs should take particular note of the highlighted deficiencies and prospectively address Staff's concerns in future disclosure.