Horizon.my

We have just included KLCC Property Holdings Bhd in our database. Looking at the Income Statement, the thing that caught my eye was the Fair Value Adjustment.

It seems KLCCP has included the increase in its property value into its profit figure.

OK basically I’m not in favour of such reporting.

Traditionally if property assets go up in value, companies would treat this as an asset revaluation. The increased property value goes into the balance sheet – OK fine. But the corresponding credit should go into an Asset Revaluation Reserve and not into the company’s operating profit.

The company should not be allowed to pay dividends out of the Asset Revaluation Reserve.

We have restated the Fair Value Adjustment as an Unusual Item in our database. It is excluded from our EBIT calculation and as a result KLCCP’s Interest Cover is only 4.0x which is not fantastic. I usually like to see at least 7x Interest Cover in companies I invest in, or in the case of passive property vehicles perhaps 6x. Then again, Petronas is the major shareholder in KLCCP. They are big enough to buy up the lenders.

Back to my point…. it’s great that the property has gone up in value. But they haven’t sold it yet which means they haven’t made a cent profit. Hmmm…. am I missing something here? Why should it be treated as profit and not unrealised gain?

The Australian Property Trust Experience

This reminds me of the recent Australian experience with some of their top REITs. The industry was expanding nicely for a good 10 years since 1995. Investors had a fantastic choice of top quality properties, returns were good and earnings were real.

Sometime from around 2004, the testosterone level of property fund managers began to increase at a rapid and uncontrollable rate. Fund managers were competing to buy properties, often overpaying for them and relying on financial wizardry (eg. income support mechanisms) to justify the high prices paid. To boost their equity returns, they stuck in some debt funding. Here’s a simple illustration:

Total Return = Income Return + Capital Growth

So if your net rental return is 6% and the property goes up in value by 4% – your total return is 10%. Simple enough.

OK let’s stick in some debt funding. Say your borrowing cost is 7%. Hmmm…more than your rental income but never mind, report the profit as 10% and since the funding cost is only 7%, you’re still ahead by 3% right?

Well yes… so long as you can keep increasing your rents return to justify the higher property value. But sooner or later reality catches up and we saw some violent wake-up calls for even the largest property trusts in Australia.

Fair Value Adjustment was the name of the game. Look at GPT, at its peak market cap was more than A$10 billion. Today it is A$1.9 billion.

Here’s another one, a familiar household name synonymous with quality houses in Australia – Mirvac. From a high of A$6.30 its security price is now A$1.30.

I’m not saying KLCCP is headed towards this direction. All I’m saying is that the recognition of “Fair Value Adjustment” as “Profit” in the Income Statement is misleading and shame on the auditor for its unqualified sign off.

Our REIT industry in Malaysia will take many many years to reach the kind of bubble seen in Australia.

And when it does, please remember the “Fair Value Adjustment” bubble!