Technology will decide whether UK REITs survive
Copyright: David Lawson - first published Property Week October 2006
The biggest property revolution in modern times has been greeted with almost unnatural calm. After a swift beauty parade sorted out who will switch from traditional listed company to real estate investment trust everyone assumes the bandwagon will continue to roll. But many professionals may not be able to handle the transition.
Technology will play key role in deciding whether REITs survive, say Chris Lees and Stephen Spooner of management consultant Calvis. Sophisticated software will be needed to produce the efficiency and transparency demanded by REIT investors, yet many companies – and surveyors - still have trouble handling even the basics. They could be stranded by the huge change from accumulating assets to enhancing income. ‘Unless property professionals move from deal making to be true managers, the next few years could be a very bumpy ride,’ says Spooner, who has extensive insider knowledge of how the industry works after 10 years as a director at British Land.
Commercial property has been driven for more than 30 years by investors whose main concern is capital value, relying on borrowing to increase returns, he says. Falling yields have flattered overall performance, rewarding those who invest in ‘quality’ low-income assets and innovative finance. This emphasis on balance sheet issues is deeply embedded in the procedures and systems used to manage assets. Spooner acknowledges signs of a slow change, with companies like Workspace which focus on revenue and more effective transaction taxes, particularly SDLT. Big players have also been experimenting with outsourcing.
But REITs will involve a sea change. Some may opt for capital growth, but with yields at historically low levels, this is unlikely to be a major sector of the market, he says. Income in the form of dividends will be the driving force - and the basis for managers’ bonuses - so the focus will shift to the neglected profit and loss account. Managers actually have little influence over yields, says Spooner. The trick is selecting stock that looks like becoming fashionable, but it is notoriously difficult to switch sectors to ‘catch the wave’. Scope for improvement has been based on finding ways to get valuers to take a more optimistic view. This might, for example, mean buying off one tenant to install another on a longer lease or with a better covenant, in some cases with no increase in the rent – which is good for the balance sheet but not the P&L account
Software has been sucked into this trap. ‘Property systems evolved from basic rent collection engines to rent collection engines that can pay loan interest, report historic performance and hold rudimentary property information, which is rarely kept up to date,’ he says. In future, forecasting cash flow must be developed to a higher level of sophistication. Tenants need to be cultivated to reduce voids, the one thing investors will not tolerate. But it will be much harder to justify offering capital payments to tenants, as the P&L will suffer while benefit to the balance sheet may not be as attractive as now.
Even property companies which choose not to switch will need to keep track of future rental prospects, payment records and correct floor areas. ‘Many of the leading players are intending to convert, and sentiment around the market suggests that a raft of new funds could appear. So assets are likely to be bought from or sold to REITs, making their influence considerable,’ says Spooner.
REITs will be heavily regulated. Compliance is hard work and new regimes are harder still. Experience in countries like the US and Australia shows the UK Government may not have got regulation right first time. ‘At best there is likely to be ‘tinkering’ with the legislation and guidance: at worst we could see the kind of seismic events experienced with HIPs and SIPPs,’ he says.
Meticulous record keeping, up to date profit and loss accounting and familiarity with cash flow projections will be crucial. Professionals must evolve from deal makers to true managers. Good information has always been important. ‘Now we are actually going to have to use it,’ says Spooner. ‘Failure to do so could jeopardise bonuses, performance and even the status of the organisation. ‘Who wants to be the first to lose REIT status because they didn’t realise that a sequence of lease expiries or the sale of a property results in falling below qualifying borrowing ratios?’
REITs will expose failings hidden in traditional property companies, according to Chris Lees. Property companies rely on net asset value to impress investors, and rarely state this more than once a year. Trusts will have to expose income to impress shareholders – particularly the small ones anticipated to make up the bulk of investors. This will demand better use of technology, yet almost 20 years after computers began to appear on desks, many surveyors are unable – or unwilling – to handle even basic tasks. ‘They are widely viewed as prima donnas and management dinosaurs,’ says Lees.
The need for fast, accurate information is stymied because many still work on paper. In one firm he investigated surveyors called up documents, printed them, filled in the spaces by pen, scanned them and emailed to the administration department in a different city. They were then printed again and typed into a property management system. ‘The technology was actually making things worse,’ says Lees. ‘We told them it would be quicker and easier to go back to using a fax.’
Such procedures are common. They encourage mistakes each time data is re-entered, delay transactions and prevent up to date information being shared. Agents have got away with such incompetence because fees are almost irrelevant to clients. They are far outweighed by even tiny changes in net asset value - the key indicator for property companies.
Decisions on how much income to pay in dividends are also clouded in obscurity. Switching to a REIT, however, will focus on distributed income. Investors will demand to know how much advisers leach from their returns, so agents and managers will have to justify their activity. Companies themselves also need to grasp the nettle. One firm inspected by Calvis which intends becoming a REIT was blind to the incompetence that could harm chances of success. Its technology takes three months to process invoices. ‘This could drive away the best advisers and mangers, leading to an angry reaction from shareholders,’ says Lees.
Surveyors may be dragging their heels but software is meeting the challenge for change, says Steve Vatidis, Group Managing Director of Raindrop Information Systems. Unrelenting pressure on costs and performance is increasing pressure for greater integration and flow of information. Property investment sections need up-to-date information on financial data and valuations. Operational staff need information and analysis of the cost and performance of facilities and space.
‘Companies need to be able to integrate information from all these sections to optimise the property portfolio from an investment and occupational and operational viewpoint,’ says Vatidis. The challenge will be how to use existing resources and tools to meet this complexity while making life easier for staff who have to deal with it.
Programs such as Raindrop’s Manhattan now enable all information to be extracted from a single system but a new generation of software is emerging using new technology and user interfaces to make it easier and faster for staff to cope with demand for access to masses of additional information and the correlation of vital data. They include second generation web technology such as that developed by companies like Google. All the pieces are in place to make the data-driven ‘Semantic Web’ a reality, according to Sir Tim Berners-Lee, inventor of the World Wide Web. This will enable computers to read the contents of web pages and make connections between data. Technology analyst Gartner says this will reduce costs and improve the quality of content management, information access, system interoperability, database integration and data quality.