Japan REITs Step Up ESG Initiatives, but Governance Still Lags
Links between the manager of the REIT and its major shareholder (sponsor) spark management fee and related party-transaction debate. Invincible defends its stance.
REIT AsiaPac asked Invincible about their dilutive offerings. To read their response, please click here.
While companies such as GLP J-REIT, Ichigo Hotel REIT, and Kenedix Retail REIT have focused on improving their Environmental, Social and Governance (ESG) standards, others have remained less prominent in their efforts in integrating these factors into their investment process.
Among J-REITs, developments in the environmental aspect have seen rapid progress, in part because of the establishment of government guidelines and the ease with which companies can set up green schemes. The Ministry of Environment of Japan published its Green Bond Guidelines in March 2017. In FY2017, no green bonds were issued for the funding of green buildings, but in 2018, there were as many as ten issuances. Among them were offerings by Japan Real Estate Investment Corporation (JRE), Japan Excellent Inc (JEI) and Nippon Prologis REIT (NPR). The net proceeds of these bonds have been used to finance buildings or projects that meet the green eligibility criteria. Such issuance has also helped to expand the REIT’s investor base.
“Green initiatives have been the easiest for J-REITs to tackle and many companies have pursued energy saving and protective environment initiatives within their property portfolios,” says Rico Kanthatham, Managing Director and Portfolio Manager at Barings.
Management Fees Should Be Aligned With UnitHolders’ Interest
However, the industry’s effort in governance is lagging, particularly concerning related-party transactions and management fee structures.
The management fee structure of a REIT has been contentious. REITs in the Asia Pacific are predominantly externally managed by a REIT manager, who is usually appointed by the sponsor. In most REITs, the sponsor is also a major shareholder. The REIT pays the manager a fee in return for management services. The manager has a fiduciary duty to act in the best interest of unitholders; however, links between the sponsor and the manager increase the risk that they will act in the sponsor’s interest at the expense of minority unitholders. The fee structure should align the interest of the unitholders with those of the manager to ensure fair governance.
Most REITs in Japan follow this fee structure, which isn’t illegal. However, three REITs—Kenedix Retail REIT, GLP J-REIT and Ichigo Hotel REIT—have voluntarily changed their management fee structure to be aligned with share price performance or Distribution Per Unit (DPU).
Kenedix Retail REIT has introduced a DPU-linked management fee structure since its initial public offering in 2015. To link the asset management fees even more closely with unitholder interests, it started “investment unit performance fee” in 2018. This new fee will be paid if the total return on Kenedix Retail’s investment unit exceeds the total shareholder return of the Tokyo Stock Exchange (TSE) REIT Total Return Index.
GLP J-REIT implemented performance-linked fees and management incentive bonuses for the asset manager. Around two-thirds of the fees received by the asset manager are linked to Net Operating Income and Earnings Per Unit (EPU), while the bonuses for major executives are based on EPU and to the relative unit price performance against the Tokyo Stock Exchange’s REIT Index.
“ESG is getting bigger in the J-Reit universe, and we are have made great strides in the E and G, and there is still some way to go on S,” says Yoji Tatsumi, President of GLP Japan Advisors Inc.
Finally, Ichigo Hotel REIT became the first J-REIT to have no fixed fee for managers. Managers are remunerated based solely on the performance of the assets. “Our directors are independent of our sponsor, and bound by well-established related party transaction rules,” Hiroshi Iwai, Statutory Executive Officer, Head of the Hotel REIT division, tells REIT AsiaPac.
REITS’ Tendency to Issue Dilutive Equity for Acquisitions Hurts Shareholders
Another controversial issue concerns related-party transactions. Potential asset acquisitions are sometimes introduced by parties connected to the sponsor. In most markets in the Asia Pacific, REITs are required to hold Extraordinary General Meetings (EGMs) to allow shareholders to vote on any significant events including the acquisition of assets from the sponsor. With the sponsor as a major shareholder, he or she has a greater influence on the vote. In Japan, the problem is further complicated by the fact REITs are not required to hold EGMs for related-party transactions. In general, non-independent directors also dominate the number of board seats at J-REIT asset management companies, with most board members coming from the sponsor. This arrangement will inevitably lead to outcomes where decisions made benefit the sponsor at the expense of other shareholders.
“An example is a tendency for some J-REITs to issue dilutive equity to fund property acquisitions often under the influence of heavy-handed sponsors,” explains Rico Kanthatham, Managing Director and Portfolio Manager at Barings. Because some J-REITs trade at a discount to their Net Asset Value (NAV), the acquisition of assets through equity issuance is dilutive to their earnings, erodes their intrinsic value, and financially hurts their existing shareholders.
“In such situations, shareholders have virtually no voice in the matter, no way of expressing their displeasure for such decisions or effecting what they perceive as necessary changes into the management structure. The only recourse for investors is to sell shares of the company in question.”
Japan’s Silent Partnerships
Asset managers have also raised issues relating Japan’s so-called “silent partnership” arrangement, known as Tokumei Kumai (TK), which is aimed at allowing investors to profit from the purchase, management, and sale of the real estate in a tax-efficient manner. It is an arrangement where an investor makes a financial contribution to an operator, and the operator conducts business under its own name. The identity of the TK investor is not disclosed to third parties who engage in transactions with the TK operator.
Some REITs have stake investments in such silent partnerships. A proposed tax reforms announced on 14th December included the requirement that a REIT does not own 50% or more of the equity of another corporation, through investments in silent partnerships.
Fund managers with whom REIT AsiaPac Media spoke say Invincible Investment Corporation is one example of with a track record of sponsor-driven dilutive issuances, which has led to investors abandoning the J-REIT, causing the discount to NAV for the company to worsen. This, in turn, makes it more difficult for the REIT to fund future acquisitions.
One of the cheapest J-REITs, Invincible Investment Corporation’s shares trade at a 7.4% dividend yield – 350 basis points (bps) wider than the J-REITs’ average and 260 bps higher than the Hotel J-REIT average.
“The wider than average spread is in part due to concerns regarding a significant ramp up in Japan’s hotel supply. However, the bulk of the excessive risk premium for Invincible is the result of poor handling of conflicts of interest by the company’s management,” says one fund manager.