In October 1995, the National Council of Real Estate Investment Fiduciaries' performance measurement committee made a little-noticed recommendation to real estate investment managers that additional current return performance disclosures be provided to institutional real estate investors.
The reason for the recommendation is simple: The income component of total return is overstated.
If current returns (often called the income component of return) from real estate were restated to equal the cash paid out in dividends each year, institutional real estate current return performance would fall by hundreds of basis points - often to 50% or less of the current return being reported.
The recommendation was made to clarify reporting of current returns. By using distributed cash, just as institutions do for their stocks, actual current returns to investors will be more apparent.
We believe that, at a minimum, both the traditional real estate methodology and the recommended method should be used and displayed with equal prominence.
"Income component of return"
A diligent analysis reveals actual distributed current returns ("distributed cash") from institutional real estate investments typically are far less than the "income" reported by institutional real estate managers. This would not be the case if the Association for Investment Management and Research standards used for reporting returns from equities were used for institutional real estate.
Institutional real estate "income" return reporting often overstates current returns when compared with traditional AIMR return reporting methods used by equity managers.
AIMR reporting methods for equities do not overstate current returns because they avoid the problems resulting from the NCREIF definition of the income component of return, or ICOR. Traditional NCREIF reporting of ICOR does not reflect actual net cash paid out to investors, but rather, much higher gross numbers from property level operations, in contrast to the AIMR method for stock, which reports actual distributed cash dividends.
ICOR is often much higher than distributed cash because property expenses, such as tenant improvements and leasing commissions, are not deducted. To confuse the issue further, ICOR is reported in some cases before, and in other cases after, entity expenses such as management fees. In any case, a large discrepancy can and often does exist between ICOR and distributed cash.
Report distributed cash also
Unfortunately, owners of institutional real estate might be confused by the manner in which traditional NCREIF reporting is used to the exclusion of a more revealing measure, such as AIMR reporting for equities. Such investors, who might not be aware of the nature of the NCREIF income component of return, might believe they are receiving annual distributed cash income hundreds of basis points above the amount actually distributed. Given the unfortunate prominence in many annual and quarterly reports of NCREIF-calculated ICOR performance numbers vs. the distributed cash being buried deep in the financials, it is no wonder confusion exists.
Which is right?
Which is correct: Traditionally calculated ICOR or distributed cash?
Why not include both with equal prominence? Managers will provide valuable information to investors if the actual distributed cash dividends are given at least as much prominence in return reporting as is ICOR and if AIMR equity return calculations are employed for real estate held in entity form such as group trusts, annuities, private real estate investment trusts or limited partnerships. Such clarity will provide a greater understanding of actual entity level performance.
Equity managers and public REITs use the AIMR methodology for equities. Why shouldn't institutional real estate managers do the same?
There are those who disagree with this recommendation. Proponents of exclusively using NCREIF's traditionally calculated ICOR claim it most accurately reflects the performance of institutional real estate as an asset. Perhaps that is true, but using NCREIF's ICOR methodology does not accurately reflect investment performance, as does using AIMR's distributed cash.
Proponents further claim NCREIF's reporting of ICOR is accurate even though some of it is used for capitalized expenses that may or may not add to value.
To be sure, NCREIF methodology does attempt to provide at least a partial reconciliation of this discrepancy by decreasing the annual valuation component of return by annual capital expenditures. This results in confusion because, intuitively, entity level expenses and typical annual capital expenditures such as tenant improvements and leasing commissions reduce the income generated by properties; not the value of the properties. In any event, the amounts of funds available for distribution as well as actual distributed cash dividends are usually much less than reported ICOR. Just how large this gulf can be is often surprising.
The accompanying table summarizes the discrepancy of current returns for seven randomly selected commingled real estate funds. The gap between NCREIF and AIMR reporting of current returns for funds A and B is as wide as 540 basis points. In all cases, stated ICOR exceeded actual distributed cash results because of the use of the traditional NCREIF ICOR calculation.
The table clearly demonstrates there is discrepancy of current returns as a result of the use of traditional NCREIF methodology. Most regrettably, this overstatement typically occurs without clearly identifying, the equal prominence, the distributed cash dividend for the same period.
It is unfortunate the real estate staff of so many institutions have spent time and energy attempting to stay on top of commingled real estate fund performance but suffer from a reporting methodology that is incomplete. Consequently, the institutional real estate industry should adopt wholeheartedly the recommendations made by the NCREIF performance measurement committee. Investors also might wish to inquire as to past period reported income component of return vs. actual distributed cash.
The good news is that the recommendation might be increasingly followed by managers. Examples of managers embracing prominent reporting distributed cash dividends and/or AIMR performance include Heitman/JMB Advisory, which recently has enhanced the prominence of cash distributions, and The O'Connor Group, which already has used AIMR equity reporting standards for its Retail Property Trust, a private REIT.
A clear understanding of returns from real estate investment as well as historically provided nominal property level returns is necessary for the institutional real estate community to move beyond the performance reporting difficulties and other problems created by the last generation of commingled real estate funds. The AIMR solved these controversies long ago with a more straightforward reporting format. This format will make actual investment performance more apparent. Investors deserve to see the performance measurement committee recommendations embraced and distributed cash reported with prominence.
Brent Donaldson is president and Steve Gruber is vice president of Liquidity Financial Advisors Inc., Emeryville, Calif.