Pressure to bring values in line . FM 22 Feb 2002

Banus van der Walt

Lakeside Mall

Institutional property managers with overvalued portfolios should beware of 'Enronitis' - investor hostility to accounting practices that create fictional values for shares or assets. They could even face legal action from their pension fund members and insurance policyholders who lose out as a result of these practices.

For years, the industry has nodded and winked at the subterfuges some managers have used to pretty up the property portfolios they accumulate on behalf of these policyholders and members. This is dangerous. Especially now that investors are becoming aware that they can hold institutions liable for breaches of duty, says Charles Smith, a partner at the Cape Town office of attorneys Sonnenberg Hoffmann & Galombik.

Consider this: a tenant occupying one half of a building, and paying R65/m², leaves, and a new tenant can only be found at R45/m². Shouldn't the market value of the property immediately drop by 12,5%? Not necessarily: by leaving the premises unlet, the manager can calculate the value on the old rent paid by the remaining tenant and thus maintain its value.

Even if he is forced to rent it for less, the industry has accepted the practice of 'smoothing' the value of the property. This is achieved by using a five-year income stream that assumes rents will rise in the future.

Sanlam property asset management CEO Banus van der Walt argues that most managers have not been cooking the books. The market values of portfolios are lower than the value in the institution books because future income projections have been reduced. This is the result of lower inflation rates. Sanlam, he says, is constantly checking its property values against the market.

But it is generally accepted that the total of R70bn in property amassed by institutions over three decades is mostly more than open-market value. And managers find it difficult to reduce these values because of the damage it could do to the endowments or pensions of their policyholders (and their own reputations) in the short term. A 15% overvaluation could mean that R10bn has to be written off.

These properties were bought so their income streams could meet institutions' policy liabilities far in the future, says Van der Walt. They are called holding portfolios. No thought was ever given to selling them, so they were valued according to the present rate of their income streams rather than on the open market.

Conditions changed seven years ago when some institutions decided to reduce their property exposure. Private investors set up listed and unlisted funds to buy the properties.

Van der Walt says Sanlam has adjusted values where necessary. It has sold R1bn into listed funds - that is, about 7% of its total property portfolio - and another R700m privately, he says.

Private buyers argue that only market value counts and institutional values are unrealistic. This is the reason, they say, that the property sector of the JSE Securities Exchange has a market capitalisation of only R13,5bn instead of R50bn. This despite institutional eagerness to securitise portfolios through the JSE.

But when they have found their way into the hands of hard-nosed companies such as Rand Merchant Bank (RMB) and Investec, portfolio values have been written down sharply. When Momentum Life, part of RMB, took over Southern Life in the merger with First National Bank it wrote values down 'materially', confirms RMB Properties CEO Bryan Jackson.

It could be argued that a buyer always writes down the values to make his own subsequent growth look good. But Jackson says he has since sold 42 properties for R330m, 'a profit on average of 1,5% on our reduced values'.

Similarly, Investec has been at work on Fedsure's portfolio. About R250m of the publicised reduction in the purchase price of Fedsure comes from property. But an unpublicised further R250m was written off policyholder property value - a total of R500m, or 15%, of the Fedsure portfolio. And that does not include the R80m write-down of Lakeside Mall, in which Fedsure has a 55% share, from R340m to R260m. This was done before the takeover.

These reductions have made members of pension schemes poorer. If the value gap remains when they retire, their pensions will fall short of their expectations.

This is a potential class action suit against pension fund trustees who kept the properties overvalued.

Sonnenberg's Smith says this is a new field, but there has been an increase recently in court judgments on the duties of banks, the responsibilities of financial institutions for omissions by their agents and poor advice from attorneys.

'Aggrieved investors could base their actions on delict [damages claims for wrongful acts or omissions],' says Smith. 'Or they could use Section 424, the provision for reckless and fraudulent trading in the Companies Act, which is increasingly being used by creditors against the management of companies that collapse.'

Fund managers argue that they have acted in good faith and that directly held properties have been difficult to value. This is because there have been so few actual transactions in large investments, such as regional shopping centres. Fund managers also claim to follow international practice in valuing their properties by discounting the future income stream rather than by open-market value.

But unless these values are tested by trading the properties, there will always be questions about how they are reached, says property economist Francois Viruly.

Sanlam's Van der Walt says property represents perhaps 8% of current investment portfolios. So even a 30% drop in value would have a 2,4% effect on the entire portfolio.

And even the use of the best independent valuers is not a solution. Adriaan Nieman, CEO of Pareto, which is Eskom's R3,2bn (or is it?) retail fund, cannot list the portfolio. This is because the market would value it at a yield of more than 11,5%, whereas it is valued now at a yield of about 11%. It could mean a loss of R150m for his members.

Nieman does use external valuers. But as no regional shopping centre has been sold in three decades, they have nothing with which to measure theory against reality.

The SA Property Owners' Association recently launched Sapix, a database of institutional properties that allows managers to measure their property performance and valuations against the rest of the industry. This has begun to narrow the gap between book and market value.

Van der Walt says most institutions are members of Sapix and have standardised their valuation methodologies. But some noninstitutional managers argue that Sapix is not enough. 'The most important benchmark for value today is the price paid for properties by funds listed on the JSE,' argues Corpcapital's Marc Wainer.

Van der Walt disagrees. 'The difference between valuing a listed fund and a holding portfolio is so great that they can be treated as different asset classes. The latter must take future income into account [even more].

'It's also a matter of risk. For instance, if a building in the Johannesburg CBD is fully let, it could be valued on the first year's yield at R100m. But what will it be worth if the tenant leaves two years later?'

One of the weaknesses in the way listed funds are analysed is that risk and the underlying properties are not fully investigated, says Van der Walt. 'Some shareholders would run a mile if they knew what they were investing in.'