In search of good governance
Corporate governance is one of the key factors to be integrated in a credit rating analysis. Good governance not only helps speed the resolution of strategic or operating problems but, more importantly, it helps to stop them from arising in the first place.
With REITs gaining in number, scope and size around the world, governance is fast becoming a key topic for property investors in debt and equity alike.
We evaluate governance at property firms on two levels: the quality of governance practices, and the degree to which the board and management team have shown that they are able effectively to balance shareholder and creditor interests.
Real estate firms have several distinct governance characteristics, many of which reflect their origins as creations of entrepreneurs that have brought together what are often disparate real estate holdings.
We have seen significant improvements in REITs’ governance practices in recent years, although room for enhancement remains.
Directors are bringing a renewed level of commitment that is having an effect on oversight, controls and risk management. Boards and key committees are meeting more frequently and for longer. They are more involved at earlier stages of strategic planning, are less likely to rubber-stamp corporate acquisitions and large investments, and have instituted more formal procedures for reviewing themselves and management.
Once the backwaters of the board, audit committees are now home to the most experienced and dedicated directors.
Boards are also reaching beyond their traditional networks and utilising search firms to recruit “independent” directors, to strengthen their audit committee’s financial expertise and to strike a finer balance between a need for property expertise and a diversity of perspective.
Executive and director compensation has begun to shift from
stock options to restricted stock, which we believe fosters a greater focus on long-term growth and the downside potential of risky strategies. For REITs, executive pay is often heavily weighted towards restricted stock (not surprising, given the high-yield
nature of these vehicles), which we view as positive from a creditor perspective.
Transparency of governance policies has improved significantly through the utilisation of the internet as a communications medium.
Despite these changes, though, there remains room for improvement.
A lack of clear succession planning, or concerns about ability to execute such plans, have been cited for one out of every four property companies we have reviewed to date. In part this is due to the ‘big man’ phenomenon common at many REITs. This continues to be an area of director dissatisfaction.
Executive compensation that is either excessive or is not aligned with long-term growth and the interest of bondholders is another significant factor. Although many boards have adjusted compensation policies to offer less-leveraged opportunities to executives, there is also pressure to increase “pay for performance” awards tied to share price and earnings per share, which can encourage more risk-taking than creditors might prefer.
There are few signs that elevated executive pay levels of recent years—which many critics cite as evidence of weak boards—have come down.
A significant minority of REITs still face material challenges on board composition, including a lack of independence, a lack of sufficient financial expertise on the audit committee, a lack of women and minorities, turnover, and/or directors who are stretched thin by other commitments.
Although REITs have been improving their governance practices, some sections of the real estate sector are lagging behind.
This highlights the fact that although real estate firms are often considered to be financial institutions, the sector does not face regulatory-driven governance requirements like most other financial service firms.
As a consequence, governance standards have often evolved
in line with stock exchange standards, and not faster, or better
Moody’s Investors Service has seen general governance improvements by leading real estate firms along the lines outlined above. In many cases, we believe this reflects a generational shift in management across the real estate universe. Often, this is via the appointment of younger family members or professional managers to the CEO position.
This new generation is more focused on building the necessary control structures and management systems than their entrepreneurial predecessors ever were.
The typical governance strengths we see in real estate firms include:
l large, founding shareholders providing stability and a long-term view;
l the fact that split chairman/
CEO roles are more prevalent in REITs than in many other sectors – however, the chairman is rarely independent;
l high levels of experience of real estate and capital markets on most boards.
Nevertheless, the manner in which many real estate firms were founded creates a backdrop in which some clear governance challenges remain, especially in REIT structures.
Takeover defences can be significant, although some are now being removed. The presence in the business of founders can limit boards’ role in succession planning. Control functions – such as internal
audit – are still being developed. Related-party transactions among directors and executives are a common feature. Management
teams are given significant discretion to make major investments
and, finally, the UPREIT structure (umbrella partnership real estate investment trust) that operates in the US creates potential conflicts among the REIT, shareholders and operating-unit holders.