In the current low interest rate environment, yield-hungry investors have been particularly attracted to real estate investment trusts (REITs), which, as tax-efficient, flow-through investment vehicles, aim to pay regular cash distributions to their unitholders. The Ontario Securities Commission (OSC) recently reviewed the disclosure provided by 30 REITs to assess the quality and sufficiency of disclosure provided concerning the sustainability of unitholder distributions. In Staff Notice 51-724 Report on Staff’s Review of REIT Distributions Disclosure (Notice), the OSC identifies four areas where, in its view, improvements are required and for these areas the OSC has provided examples of acceptable disclosure.
CONTENT OF DISCLOSURE WHERE EXCESS DISTRIBUTIONS ARE PAID
When a REIT’s distributions exceed its cash flow from operations, existing guidance in National Policy 41-201 Income Trusts and Other Indirect Offerings (NP 41-201) highlights the expectations of the Canadian Securities Administrators (CSA) concerning the provision of disclosure sufficient for investors to understand the risks relevant to the REIT and its distributions. The Notice specifies that such risks include the unsustainability of financing excess distributions by increasing levels of debt (as opposed to increases in underlying rents).
The OSC found that 33 per cent of the reviewed REITs paid distributions which exceeded cash flow from operations, and that none of these REITs provided adequate disclosure (per the guidance provided in NP 41-201) in their MD&A or annual information forms (in the risk factor section) concerning their excess distributions.
The Notice also provides that disclosure regarding excess distributions should be provided by REITs in situations where distributions would be in excess of cash flow from operations if non-cash distributions (including distributions paid in connection with distribution reinvestment plans) were considered in quantifying the amount distributed, which the OSC found to be the case in 13 per cent of the REITs reviewed. The OSC is concerned that the absence of such disclosure may be misleading to investors in such REITs.
CONSISTENCY OF DISCLOSURE ABOUT EXCESS DISTRIBUTIONS
International Financial Reporting Standards (IFRS) permit REITs to record borrowing costs within either cash from operating activities (reducing cash flow from operations) or cash from financing activities (not reducing cash flow from operations).
The Notice notes that disclosure regarding excess distributions should also be provided by REITs in situations where distributions would be in excess of cash flow from operations if interest paid was classified as an operating activity on the statement of cash flows rather than as a financing activity, which the OSC found to be the case in 10 per cent of the REITs reviewed. The OSC is concerned that the absence of such disclosure may be misleading to investors in such REITs.
TIMELY DISCLOSURE WHERE A REDUCTION OR TERMINATION OF DISTRIBUTIONS OCCURS
In the Notice, the OSC stresses that it is critical for investors to be provided with information on a timely basis in order to understand and assess the risks related to the sustainability of distributions. It is the OSC’s expectation 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—be provided to investors as soon as practicable and that, in the OSC’s view, any such reduction or elimination of distributions may constitute a material change.
PRESENTATION OF COMMON METRICS SUCH AS ADJUSTED FUNDS FROM OPERATIONS
Adjusted funds from operations (AFFO) is a non-IFRS metric commonly used by REITs to represent the resources that have been generated by a REIT’s operations and are available for distribution to unitholders. When AFFO represents a cash flow measure because the adjustments used to arrive at AFFO encompass adjustments for non-cash items, it is the OSC’s view that, consistent with guidance in NP 41-201 and the CSA’s Staff Notice 52-306 Non-GAAP Financial Measures and Additional GAAP Measures , the REIT should provide disclosure that:
- Reconciles AFFO to cash flow from operations, being the nearest IFRS measure
- Presents cash flow from operations with equal or greater prominence than AFFO
- States explicitly that AFFO does not have any standardized meaning prescribed by IFRS and is therefore unlikely to be comparable to similar measures presented by other issuers
- Explains why AFFO provides useful information to investors and how the REIT’s management uses AFFO as a financial measure
- Explains the nature of adjustments included within AFFO and employs the same adjustments con-sistently from reporting period to reporting period.