Brought to account

Alex Catalano looks at how an accounting requirement to show current market value for borrowings, due next year, could spotlight net asset values per share

Property companies tend to make a big play on the plus side of their balance sheets – the value of their assets, and how that goes up or down according to the market. Rather less attention focuses on the minus side: financial liabilities. These are stated at historic cost.

But this is changing. Come next January, a new accounting standard will require quoted companies to show the current market value of their borrowings as a note in their annual accounts. Moreover, managements will have to explain how this affects them.

Dry stuff – but it will put the spotlight on those companies that are carrying big loads of expensive long-term debt or that are involved in pricey swaps or other derivatives.

With long-term bond yields hitting a 30-year low, repricing debt to today’s value could imply significant knocks to net asset values per share – as the tables below show.

The question is, will investors take differential debt costs into account and start re-evaluating companies’ net asset values, and, hence, share prices? A handful of property analysts and others think that they should – and that the changes will lead to a re-ranking in the sector. Property companies are less convinced. Some argue that the current value of debt is already taken into account by analysts and investors; others say it is not a significant factor.

The new rules are likely to follow the lines laid out in Financial Reporting Exposure Draft 13 – Disclosure of Derivatives and other Financial Liabilities (FRED 13).

Chris Turner, a director of Henderson Investors and manager of TR Property Investment Trust, has looked at how a FRED 13-type approach might adjust the way the market values a company. Using published information on debt, he has estimated what a market pricing of borrowings would imply for net asset values per share.

For most of the larger companies, marking their existing liabilities to market does imply a rethink of net asset values per share: the downgrades range from 7% to 17%.

Brixton and Great Portland Estate are the two worst affected because of their relatively greater load of debentures paying coupons in the 9.5%-11.75% range.

But it is in the smaller companies that commitments to high-coupon borrowings have a more dramatic impact.

Take Hampton Trust. It has£100m-worth of mortgage debenture, paying 10.5% until 2020. Today’s pricing of that debt implies it is worth not £100m, but £133m. This means about 29p a share off the NAV – or knocking nearly two-thirds off the value.

Similarly, Raglan took on a £70m debenture paying 11.25% when it took over LETINVEST in 1994. Today this is worth more like £96m. The adjustment would see Raglan’s NAV per share down 33%.

Does marking to market matter? Chris Turner argues that it does (see box).

Raglan’s chief executive Alan Fosler is relaxed about the impending regime. “From a personal point of view, I have no problem with it. Analysts do make adjustments, so in terms of the professionals, that’s taken into account,” he says.

In fact, Raglan did make a capital adjustment when it brought the debt onto the balance sheet, pricing it at £77m to compensate for the differential interest rate. “We were one of the few to do that at the time. Interest rates have moved since then,” says Fosler. He sees some benefit in the new disclosure rules. “Now the company makes the assessment, rather than someone who may not fully understand the detail.”

Fosler also thinks that the additional information will change the market’s view of some companies. “If companies acquire overpriced debenture, they take cognisance of the present value of that situation,” he notes.

“But others have historical situations. They may not fully recognise the change in situation, and not draw people’s attention to it. It’ll affect certain companies that have a position of expensive long-term debt.”

Others pooh-pooh the view that the changes will make a difference to the way investors value their companies. “Some analysts have been calculating the value of debentures and long-term bonds for years, so it is not news to the property equity sector as such,” says Steve Owen, finance director at Brixton Estate.

“If a property investment company issues a £100m debenture for 25 years, it knows, and the shareholders know, that it has to pay back £100m only at year 25. If yields fall, that debt might cost £130m today – is that the market value of the debt to the company? If you are looking to take over the company it is significant, but if you’re buying a stake, it’s not really,” Owen argues.

Land Securities’ finance director Jim Murray also thinks that investors have already taken the issue on board. “In one sense, shareholders or investors have been aware of the current value of debt anyway, especially when there is a quoted price, like ours.”

He believes the downside is that some shareholders may find the ups and downs of debt pricing difficult to understand, given that the company is intending to hold the loans to maturity.

“Provided it is shown only by a note in the accounts, it’s a limited problem. A next stage – if we have to show it in the accounts – may give much more of a problem.”

HOW THE MAJORS MIGHT LOOK
Company	Last published NAV/share	FRED 13 adjustment (p/share)	Adjusted NAV/share(p)	Impact on NAV/share %
Brixton Estate	208	-35	173	-17
Great Portland	262	-38	224	-15
MEPC*	497	-55	442	-10
British Land	586	-54	532	-9
Land Securities	910	-78	832	-9
Slough Estates	340	-27	313	-8
Hammerson	438	-29	409	-7
Source: Henderson investors *The mepc figures are after pending preference issue and share consolidation

HOW THE SMALLER FRY MIGHT LOOK
Company	Last published NAV/share	FRED 13 adjustment (p/share)	Adjusted NAV/share(p)	Impact on NAV/share %
Hampton Trust	46	-29	17	-63
Hemingway	51	-18	33	-35
Raglan	43	-14	29	-33
Evans of Leeds	151	-41	110	-27
Bourne End	74	-18	56	-24
Town Centre	133	-29	104	-22
Scottish Met	109	-22	87	-20
Source: Henderson investors

IDENTIFYING RISK

The new accounting rules will identify potential areas of risk more clearly, says Jim Murray – “this is what the standard originally intended”.

Today, many companies – including some in property – try to manage their exposure to interest-rate swings by using caps and swaps.

But these are not always spelt out in detail in the accounts, and it is rare for the financial implications to be discussed.

In some cases, investors will realise that a company has locked into what in hindsight is relatively expensive debt only when the arrangements are unwound.

For example, in the late 1980s and early 1990s, when MEPC had a large development programme planned, it swapped part of its variable-rate debt into fixed-rate over the medium and longer term. But projects were cancelled and, by 1997, thisfixed-rate debt was looking expensive. MEPC decided to unwind 19 of its swap agreements.

The cost of cancelling them was £73.4m. The company said that the move would save £44m in interest between 1997 and 1999, with further savings flowing through to 2010.

If the new standard follows the draft, all quoted companies will be expected to discuss the main financial risks they face, and what strategies they have to manage them. Indeed, the more sophisticated – such as MEPC and British Land – have already started doing this.

DOES MARKING TO MARKET MATTER?

Should investors seek to assess the effect of marking debt to market when evaluating property share prices? Should not share prices reflect the wide variations in debt costs across the property share sector?

Our view is that they should for two primary reasons. First, expensive debt increases a company’s weighted average cost of capital and therefore decreases its likely return on capital relative to the sector. Second, the true extent of a company’s liabilities are understated if expensive debt is held at par in a balance sheet.

Thus, the stated net asset value per share could be giving an exaggerated impression of the genuine open market value of the company on a per share basis.

For example, two identical properties are marketed for £20m each, both having an attached debt package of £10m of 20-year fixed-rate debt. If the interest rate on the debt package for the first property is 6.5% throughout the term and the interest rate on the second is 10%, would the properties sell for the same price? In our view, it is obvious that they would not.

To apply the same measure to assessing the real value of property companies seems entirely logical.

Obtaining the current value of fixed long-term debt is not hard. Pricing for all quoted debentures and loan stocks is available from the bond market, and unquoted debt can usually be assessed by reference to open market prices.

Where convertibles are in issue we generally use the fully diluted equity capital and ignore the convertible coupon. Measuring the potential liability in caps and other rate-fixing instruments is difficult unless full details of deals are spelt out in the accounts.

Chris Turner, Henderson Investors