Emirates REIT, the Fee Machine

The Emirates REIT (EREIT) IPO took place with fanfare in late spring of 2014, marking the first IPO since the 2009 financial crisis. It was also the first ever UAE REIT, offering investors exposure to Dubai’s commercial property market in a more liquid format.

There are plenty of aspects of EREIT worth covering in due course, such as how it was formed, its liquidity since it started trading and its actual performance. This article however primarily focuses on EREIT’s fee structure.

If you’re familiar with EREIT or wish to jump into the details, you can skip the following sections and begin at Fee Summary.

It’s worth mentioning that REITs came into existence to allow investors a tax-efficient structure to invest in real estate. In most cases, REIT regulations require that 80% to 90% of Net Income generated by a REIT has to be paid out to REIT unit holders as periodic dividends. According to DIFC regulations, REITs must pay out 80% of their annual audited Net Income.

 

Timeline

At IPO in 2014, EREIT had 5 properties in its portfolio with an occupancy rate between 80-90%. Post IPO, using funds raised during the process, EREIT acquired Le Grande Community Mall and Index Tower (Index) office, retail and car parking spaces.

By Year End (YE) 2014, EREIT owned 7 properties, Net Leasable Area (NLA) had increased by around 42% and the occupancy rate had dropped to 67% (94% if you exclude Index). Index was now around 30% of total NLA of the portfolio, and the single largest asset.

Fast forward to June 2016, Index has grown to 40% of portfolio value and is one of 8 properties that collectively have a total occupancy of 77%.

 

The REIT and its Manager

The operations of EREIT are managed and executed by a REIT Manager. The REIT Manager is engaged in a Management Agreement (MA) with EREIT to essentially source, evaluate and acquire properties and subsequently manage and sell them when required. The REIT Manager was formerly Eiffel Management Limited which then re-branded to Emirates REIT Management (Private) Limited. In return for providing these services, EREIT pays the REIT Manager a variety of fees.

 

Fee Summary

The REIT Manager charges an annual management fee of 1.5% of EREIT’s gross assets, which is calculated and paid quarterly. The REIT Manager also charges a performance fee, which accrues and is paid annually on the anniversary of the date on which EREIT shares were publicly listed. The performance fee is set at 3% of any increase in Net Asset Value (NAV) of EREIT. The performance fee has a high-water mark feature, which means that the fee is accrued only when the current NAV is above previous NAVs.

EREIT also has General and Administrative (G&A) expense accounts. G&A includes custody, board, valuation, legal, branding & marketing and other types of fees.
The REIT Manager does not charge any explicit transactions fees to EREIT, which are usually encountered when an asset is either bought or sold.

 

Fee Analysis

The Management Fee. The 1.5% management fee that the REIT Manager charges EREIT is on the high-side compared to global REITs considering the Value-Add strategy. Seeing as EREIT pays no transaction fees, the management fee essentially covers sourcing new properties, performing diligence, evaluating, structuring any financing and making the purchase. Assuming EREIT was to sell assets, management fees would also cover the REIT Manager’s efforts in the sales process.

As of Q2 2016, with property assets of $765.5mn, this fee generates $11.5mn for the REIT Manager per year.

The biggest issue we have with this management fee is that it’s calculated on Gross Assets which includes not just the Investment properties, but also cash and receivables.

As EREIT’s occupancy grows, so too will its cash flows and receivables. As EREIT receives rents every month, management fees will apply to Investment property values (which we consider fair), but also to a growing cash and receivables balance (which we consider inappropriate).

A rough calculation for FY 2015 suggests the REIT Manager likely received an additional $160k, just from fees on rent received.

EREIT’s average Current Assets (Cash & Receivables) balance at the end of every quarter for 2015 was around $32.2mn. This implies a total of $480k of fees paid to the REIT Manager for non-property assets on its balance sheet. The actual figure paid to the REIT Manager is likely somewhere between $160k and $480k for 2015 (we believe toward the higher end of the range).

For the H1 2016 period, management fees earned on Current Assets alone are around $330k, implying a FY 2016 payment north of $600k, for literally, doing nothing.

The Performance Fee. Performance fees should reward a management team for achieving exceptional results due to their efforts. Performance fees are usually calculated on an out-performance above a benchmark. In the Private Equity industry, it’s common for fund managers to charge a 20% performance fee above an 8% hurdle rate, i.e. performance fees are charged only once performance exceeds 8%. Private Equity funds may have a different risk profile to a REIT, so the selection of a benchmark must consider the investment strategy and market in which a REIT Manager is participating.

In EREIT’s case the performance fee is a flat 3% on any increase in NAV.

The EREIT NAV is calculated as Total Assets minus Total Liabilities. Conceptually this arrangement rewards the REIT Manager 3% of any increase in the value of EREIT’s Net Assets. It’s worth noting, performance fees are calculated at the NAV level, which takes a portfolio approach and are not tied to the individual performance of a specific property.

The EREIT NAV can change as a result of the following:

1. The value of the properties increase/decrease due to broad changes in Dubai’s real estate market valuations.
2. The properties are acquired at a discount to fair value, and are subsequently re-evaluated higher.
3. The REIT Manager makes changes to properties that result in those same properties being awarded a higher or lower valuation (improvements, fit-outs, demolition etc).
4. Income or Expenses encountered by EREIT (rental income, maintenance, financing costs etc).

Evaluating each of these factors in isolation allows us to appreciate the underlying drivers of value creation and assess how they should be compensated for:

1. The REIT Manager is currently paid performance fees on Dubai real estate “market beta”. The average Dubai office selling price moved from $260 psqft in 2011 to $346 in 2015, a 33% increase. EREIT has seen revaluation gains in every year since inception, amounting to a cumulative $126mn of unrealized gains by 2015 end. Adjusting for the growing size of the portfolio’s NLA between 2011 and 2015, EREIT’s portfolio has seen a 32% price increase. These are rough calculations (as we aren’t taking into consideration the portfolio is not purely office space); however it appears that EREIT has pretty much tracked the office market over the same period. The REIT Manager however, has been getting paid performance fees. There should be a differentiation between Alpha (Manager skill) and Beta (Market factor) components of property revaluations and the REIT Manager paid only for the Alpha component (when positive). 
2. This element is an Alpha component. If the REIT Manager is able to source undervalued properties for EREIT, we regard that as a value-adding skill set that deserves reward.
3. This element is also arguably an Alpha component of return. The REIT Manager’s capacity to increase the value of a property through modifications and improvements is value-creating and warrants a performance fee. However, the REIT Manager is not clear about the expenses associated with explicitly improving asset values. A look at the financial statements implies that these expenses are paid for by EREIT itself, and shows up under Property Operating Expenses. Assuming this, the REIT Managers performance fee for improving the value of the properties is purely a reward for the decision to undertake this process, i.e. the performance fee doesn’t go to cover any design or fit-out costs. EREIT pays for these, yet the REIT Manager takes a performance fee for the results.
4. Here there’s potential for good alignment between the REIT Manager and EREIT shareholders. The REIT Manager takes performance fees on any positive difference between of income from properties minus the costs of owning and maintaining them. This driver of performance is arguably the one which is “purest” performance linked.

To summarize so far, much of the NAV increases have been driven by EREIT’s revaluation gains. Most of these revaluation gains have been driven by Point 1) above, i.e. market beta. Arguably anyone can achieve these gains, therefore a blanket 3% Performance fee on NAV increases is not justifiable.

This analysis brings to the fore the topic of unrealized vs realized gains.

Rental income from Property Investments are realized gains, i.e. cash is received when the income is accounted for. Cash from Revaluation gains of Property Investments however, is only ever realized when those same properties are sold, thereby crystallizing the gain. Currently, if properties in the portfolio increase in value, Performance fees are accrued and paid to the REIT Manager on the way up. There is no clawing-back on the way down however, if prices should subsequently fall.

In a hypothetical scenario where properties have to be sold below peak price, or worse, acquisition cost, the REIT Manager is not obliged to pay back any of the performance fees it has received. We regard these revaluation-linked performance fees as being highly asymmetric in the REIT Manager’s favor and therefore very inappropriate.

Potential for conflict of interest also exists for the REIT Manager. In a scenario where: 1) a property is acquired. 2) the property price rises and performance fees are paid. 3) the property value for some reason starts to decline. The REIT Manager, knowing that the there is limited opportunity to collect further performance fees over a period in which the property is valued below “peak”, decides to sell. The decision to do this may be influenced by the REIT Manager being able to redeploy the sales proceeds in a new property which has a more immediate prospect to increase in value, and hence generate new performance fees.

These issues could be resolved simply by either linking performance fees solely to Rental Income, or Rental Income plus accrued revaluation gains which are regularly recalculated and only crystallized (paid), when Investment Properties are actually sold at a gain.

When evaluating investment management fees, it can sometime be helpful to ask the question: What kind of behavior does the fee structure encourage?

 

The Fee Machine at Work

Modelling the financial statements, we can evaluate the actual fees that EREIT pays and make some observations. All figures in $000’s.

Note that the following accounting conventions are used in EREIT’s Income Statements.

Property Income = Rental Income + Service Fee + Other Income 

Net Rental Income = Property Income – Property Operating Expenses 

Net Property Income = Net Rental Income + Revaluation Gains 

Operating Profit = Net Property Income – Management Fees – G&A –  Other fees

Net Profit = Operating Profit – Finance Costs

 

Property Income 

Property Income has been increasing yoy as properties gain occupancy, rents are revised higher and new properties with their associated rents are added to the portfolio. This has slowed down in recent years to a more normal, organic growth rate (i.e. EREIT’s balance sheet is getting closer to being fully deployed).

Cash on Cash yields are attractive.
Cash on Cash Yield = Property Income/(Investment Property – Property Financing).

If we adjust this for financing costs, we can see the impact of financing costs on yields.

If we further adjust Cash on Cash to consider Financing costs and Property Operating Expenses, 2015 yields drop by around 47% to 5.3%, illustrating the true cost of operating the property portfolio.

Property Operating Expenses

Total Property Operating Expenses are broken down in detail from 2013 onward and have a material impact on yields. When we dissect Property Operating Expenses we note that EREIT pays its own Property Management and Facility Management fees. These are not paid for out of the REIT Manager’s management fee, but by EREIT shareholders.

This raises the question of what exactly is the separate 1.5% management fee the REIT Manager charges EREIT actually paying for, seeing as these costs are borne by EREIT directly?

Net Property Income

This line item on EREIT’s Income Statement has an outsized impact on a lot of things. Through a combination of Dubai’s commercial property market price increases, and we assume the REIT Managers’ efforts to increase the value of the properties, EREIT has seen revaluation gains in every year since inception. These gains total around $145mn to H1 2016, which is a big number to apply to the previously mentioned 3% performance fee.

We stress that these are unrealized gains, and should the commercial property market in Dubai turn lower, we will see unrealized losses, however the performance fees would have already been paid to the REIT Manager.

We can see just how outsized an impact these revaluation gains have had on Net Property Income, amounting to 65% in 2015. Another way of reading this is over half of income derived from the EREIT portfolio is unrealized gains, a non-cash accounting entry.

The REIT Manager’s Fees 

These fees are 1.5% and 3% that get paid quarterly and annually, respectively for managing EREIT’s operations. The REIT Manager has collected around $23.4mn in management fees since inception, and a further $5.7mn in performance fees making a total of $29.3mn over 5 years. Of that, $11.9mn was earned in 2015 alone. We can’t evaluate the profitability of the REIT Manager as it is a separate legal entity and is not obliged to report its financial statements.

The Rest of EREIT’s Fees

Note that EREIT pays a host of other fees to various services providers, including $1.5mn in General & Administrative (G&A) expenses in 2015 alone. The single biggest component of G&A for 2015 was Branding/Marketing. We wonder, if EREIT is also paying to market its own properties, then again, why is EREIT paying 1.5% and 3% to the REIT manager? Getting paid $11.9mn in 2015 just for coordinating everything seems like a sweet deal.

On another note, we noticed in the 2015 annual report that the Fund Administrator, Maples Fund Services (Middle East) Limited charges EREIT a sliding fee based on the fund’s value, capped at 0.045% of NAV. Total fees paid to Maples were around $240k, however our calculations suggest this figure should be closer to $220k assuming that Maples’ fee is calculated after all other service providers. We’ll discuss the order in which fees are charged, and their implications later.

Note that these G&A fees are in addition to the Property Operating Expenses mentioned earlier and the REIT Manager’s management and performance fees. Fee machine indeed.

 

REIT Performance Measures

In evaluating REIT performance, it’s industry standard to use Fund From Operations (FFO) and Adjusted Funds From Operations (AFFO) measurements.

An explanation as to their composition can be found here

AFFO gives us a clear look at what a more realistic net cash yield is to EREIT shareholders, a paltry 1.75% in 2015. In P/E equity parlance, the P/AFFO ratio implies that EREIT is trading at a 40X NAV to earnings.

EREIT’s shareholders received an $8.25mn realized return, and the REIT Manager was paid $11.9mn.

The REIT Manager’s paid out fees have been increasing as a % of Net Rental Income and AFFO (gross of the manager’s fees) since inception.

 

Dividend Implications

The most alarming aspect of this table is the payout ratio (div/AFFO) which has climbed above 100% in the past two years. Using AFFO as a free-cashflow metric it’s obvious that the current dividend is being supported by unrealized property revaluations. If dividend distributions continue to outstrip AFFO, and no property revaluation gains are crystallized, then EREIT will essentially be distributing NAV back to shareholders as cash.

Another way of thinking about this is that EREIT is essentially self-liquidating in a slow, orderly manner.

 

Index

The REIT Manager took quite a bet with its acquisition of Index, its single largest asset. It warrants highlighting a few key points about this asset as its obvious this has impacted performance metrics. A low occupancy rate that has essentially remained flat since the end of 2015 has been a drag on EREIT.

As well as office space, EREIT also owns the retail area and many underground parking spaces at Index. After long delays, the retail area is likely to open in coming quarters which will help boost rental income. Currently Index suffers from a decisive lack of F&B offerings, with the only go-to being a pop-up coffee counter. The potential for increased parking space take-up is largely correlated to office occupancy. Although EREIT doesn’t publish a breakdown, recent site visits confirm many unoccupied bays.

Another challenge that Index faces is the disconnect from the central DIFC areas that have the highest density. It takes around 15 minutes to do the 600m walk from Index to the Gate area, trivial in December but for half the year, between late May and October, it’s suicide.

The DIFC sponsored “spine project” has just started and promises to offer an indoor walkway stretching the length of the financial centre. Expected completion is winter 2017 and is a potential catalyst for Index to perform.

Generally, however, the landscape for commercial office space in the DIFC is rather competitive. Emirates Financial Towers enjoys much higher occupancy rates and offers lower rents. Burj Daman is arguably the best located DIFC asset located just across the road from the Gate, the Gate Village and Al Fattan Currency Towers which have the highest density of occupiers today and the most popular F&B offerings. The newly opened Central Park Towers have also increased supply in a weak market, with asking rates below those the REIT Manager expects for EREIT’s Index inventory.

Just to rub salt in the wound, Investment Corporation of Dubai (ICD) and Brookfield Property Partners are building a $1bn 54-storey commercial skyscraper designed by Foster + Partners, the same architects that worked on Index. Completion and occupation is slated for Q1 2019, less than 3 years away.

 

All Fees Aren't Created Equally

Getting back to fees, seeing as this is the focus of the article, we mentioned that the timing and order in which fees are applied matters. For example, in calculating the management fees on Gross Assets, is this done before or after deductions are made for accrued administrator or board fees? Calculating this before deductions overstates management fees. The same can be asked of when performance fees are calculated, is the increase in NAV used in that calculation net of accrued management fees?

Another potential for conflict also arises with the management of the Trade and other Payables liability account. As EREIT encounters operating expenses, if payment is delayed then the Cash balance stays elevated, and instead the Trade and Payables liability increases. When calculating a management fee on Gross Assets, this inflated Cash account will result in a higher management fee.

The same scenario exists when we look at how Tenants deposits are handled, a debt of the Cash account and a Credit of the payables account. We are not implying that the REIT Manager is doing this, however there is nothing stopping them.

EREIT doesn’t disclose the process and ordering of how fees are calculated. One would hope the Oversight board members are aware of these processes and protect shareholder interests. Details of its relationship with the REIT Manager however are probably outlined in it’s MA.

 

Conclusion

The REIT Manager took in $8.8mn in fees over 2014, $12mn in 2015, and around $6.4mn in H1 2016. This equates to 32% of Net Rental Income in 2014, 42% in 2015 and 34% in H1 2016.

We believe that the fees that the REIT Manager is receiving are grossly inflated for the service they are performing. As we showed, all operating expenses of EREIT are paid for by EREIT shareholders, including maintenance, facility management and actual marketing of the properties. What is more, it appears that much of the work in managing EREIT is carried out by third-parties, appointed by the REIT Manager but paid for by EREIT.

We believe that the structure of the management fee needs to be adjusted to exclude cash and receivables balance and apply solely to Investment Properties.

Performance fees are being accrued and collected on unrealized gains, and there is no claw-back mechanism. The REIT Manager should have greater alignment with EREIT shareholders and only collect performance fees when revaluations are crystallized in the event of a sale, or instead, link performance fees to the growth in Net Rental Income or AFFO.

Performance fees are also not differentiating between market beta and manager alpha. EREIT should not be paying the REIT Manager for beta (they will get paid on this somewhat by management fees anyway).

We understand that the REIT Manager expects Index will perform better in coming quarters, however the issues addressed in this article relate specifically to the financial relationship between the REIT Manager and EREIT. EREIT shareholders should seek to rectify these inappropriate fee structures and mitigate the scope for the conflicts of interest that we’ve described. We hope this article helps.

Further Reading:

PREA: An Overview of Fee Structures in RE Funds

CFA Institute: Asia-Pacific REITs