On January 26, 2015, the Ontario Securities Commission issued the results of a staff review of disclosure relating to distributions by Ontario-based real estate investment trusts (OSC Staff Notice 51-724 – Report on Staff’s Review of REIT Distributions Disclosure). The Report highlights several areas where the OSC believes REIT disclosure could be improved.
The OSC and other provincial securities regulators first published National Policy 41-201 – Income Trustsand Other Indirect Offerings in 2004. It was intended to address disclosure deficiencies the regulators had identified on the part of REITs and other income trusts. The Report, in essence, highlights ways in which OSC Staff believe REITs currently are not adequately meeting certain requirements of the National Policy, most particularly in the quality of disclosure around distributions.
The Report was based on the disclosure of 30 Ontario- based REITs. The OSC contacted those REITs whose distributions exceeded cash flow from operating activities and whose disclosure was not considered adequate in this regard. None of the REITs reviewed were asked to refile or restate any of their continuous disclosure documents although a number of them were asked to improve future disclosure. Four principal areas of concern were identified.
Disclosure Around Excess Distribution
The first concern arises in the context of REITs making distributions that exceed their cash flow from operations. The OSC believes that disclosure in this regard needs to more clearly address the increased risk that this entails. By way of example, the source of the cash to pay the distributions (such as incurring additional debt) and the reason for making the excess distributions should be disclosed. If the REIT is saved from over-distributing on a cash basis because of, for example, the effect of a DRIP program, this should also be disclosed.
OSC Staff notes that, with the change from Canadian GAAP to International Financial Reporting Standards, some REITs chose, in preparing their cash flow statements, to report borrowing costs as a financing activity and not as part of cash flow from operations (as permitted under IFRS). This has the effect of increasing cash flow from operations. The OSC takes the position that, if this accounting policy choice is made, and if cash flow from operations less interest expense exceeds distributions, additional disclosure is required.
OSC Staff cited one case where they believed a REIT reduced or eliminated its distributions without providing sufficient advance notice to investors. While the Report addresses timely disclosure obligations generally, the practical response to this (as mentioned by Staff) would appear to be to ensure that the REIT’s management discussion and analysis appropriately addresses risks and events which might affect distributions.
The final item of the Report would apply to most REITs, not just those with excess distribution issues.
When National Policy 41-201 was first written, a commonly used measure of performance was “distributable cash”. This non-GAAP and non-IFRS measure was meant to give investors an idea of how much cash a REIT generated that was available to be paid out to unitholders. Over time, this measure has been largely replaced by “funds from operations” (FFO) and “adjusted funds from operations” (AFFO). The Real Property Association of Canada has published a white paper providing guidance on the calculation of FFO, but there is no uniformity among REITs in how AFFO is calculated.
OSC Staff, after noting this development in what measures are commonly used, also notes that many REITs use AFFO as a measure to determine how much cash they have available to distribute. In these circumstances, where AFFO is used as a measure in the same way as distributable cash, OSC Staff states that REITs should ensure that their AFFO disclosure is consistent with the disclosure expectations for distributable cash under National Policy 41-201. This would include ensuring AFFO is reconciled to cash flow from operations (as the nearest IFRS number) and that it is no more prominent than the IFRS numbers, and disclosing that there is no standard meaning under IFRS for AFFO, that it may not be comparable to other issuers’ AFFO and why it is useful.
Finally, in comparing AFFO from one year to another, REITs need to ensure that they are consistent in the adjustments made. In other words, if a new adjustment is made, then it needs to be reflected in the prior year’s comparative figure.
While the Report is addressed at reporting by REITs, especially those which are over-distributing, other yield-oriented issuers, including those which were formerly REITs or other types of income trusts, may find certain parts of the Report instructive. In particular, the Report contains a number of “before and after” type examples of disclosure which Staff views as deficient together with the improved versions which reflect the Report’s recommendations.