Brian Gaynor: Good day for investors to change rules

Kiwi Income Property Trust's extraordinary general meeting on January 27 is yet another example of New Zealand investors' total subservience to property management companies.

Unit-holders are being asked to approve an increase in the trust's borrowing capacity from 35 per cent to 40 per cent of the gross value of the trust, when the meeting should be addressing the internalisation of Kiwi's management contract.

As with nearly all major decisions put to property trust unit-holders, there is no independent report and no recommendation from parties independent of the management company.

Kiwi raised money from investors in 1993 as a conservative property investor with an external manager and limited borrowing capacity.

The trust deed restricted the amount of borrowings to a maximum of 35 per cent of the gross value of the trust and the amount secured against any particular investment could not exceed 35 per cent of the market value of that investment.

The prospectus said that the trust would use some borrowings to assist the initial growth but, over the longer term, the manager would seek to minimise debt.

In 1997, the trust diversified into property development and established the Kiwi Development Trust, which built the classy Vero Centre in Shortland St, Auckland.

Kiwi Income Property unit-holders had an entitlement to subscribe for Kiwi Development units on the basis of one Development unit at $3 each for every one Kiwi Income Property unit. Directors predicted that the units would be worth $4.05 in December 2000.

The Development Trust had no borrowings restrictions, and the $195 million property was to be paid for by $144 million of equity and $51 million of bank debt.

The Vero development didn't meet expectations as far as investors were concerned.

The project cost $202 million instead of $195 million and, when Kiwi Income Property Trust made a takeover offer for the Development Trust in December 2000, the building had a net realisable value of between $180 million and $190 million.

Development Trust shareholders received three Income Property Trust units for each of their units under the takeover offer.

This valued the bid at between $2.60 and $2.75 a unit compared with the initial purchase price of $3 and a projected value of $4.05.

Kiwi Income Property Trust's next big property development is the 24ha Sylvia Park site in Mt Wellington, near State Highway 1.

The site has a book value of $71.4 million and the trust recently received resource consent approval for the first stage development of the Sylvia Park town centre.

Sylvia Park Stage 1, which will begin in the next few months and be finished in early 2007, will cost about $300 million.

As the trust has about $130 million of spare borrowing capacity under its 35 per cent limit, it could finance the first stage through a combination of $170 million equity and $130 million debt.

(It is not clear whether the trust deed's 35 per cent borrowing limit on any particular investment would apply.)

This equity requirement subjects the trust to investor scrutiny, as it will have to go to the market to raise money.

An increase in the debt limit to 40 per cent would let the trust borrow an extra $55 million and reduce its equity requirement by a similar amount.

The big question unit holders need to ask is do they want the trust to take on a risky development with a large debt component when its previous big development did not meet pre-construction forecasts?

The notice of meeting makes no attempt to answer this question.

It doesn't mention Sylvia Park and gives no indication how the extra debt will be used.

It makes a number of general statements about borrowings being cheaper than equity, that investors have become more comfortable with debt and there is a higher level of gearing in the property sector.

These short statements are not backed by figures or analysis and there is no mention that the extra borrowing capacity will allow the trust to expand and generate more fees for the management company.

Kiwi's management company, which is proposing the extra borrowing capacity, places a great deal of emphasis on industry trends, but makes no mention of the more important development, the internalisation of management.

Across the Tasman, there has been a significant move from external to internal management, and the proposed merger between Macquarie Goodman Industrial Trust and its external management company, Macquarie Goodman Management, is another step in this direction.

Grant Samuel's independent expert's report on the proposed merger had this to say about property trust management:

"The previous dominance of the 'external management' model has been superseded to the point where virtually all of the major trusts are now internally managed."

It says investors appear to have expressed a clear preference for internal management.

Grant Samuel goes on to say: "The move to an 'internalised' management model is arguably a natural evolution and brings important benefits, including better alignment of interests between management and investors and the enfranchising of unit-holders by giving them a direct vote in the governance of the business."

The independent expert believes external management adversely affects a trust's ability to raise equity and increases its cost of capital.

It also believes that trusts with external managers trade close to net asset value whereas those with an internal management structure can trade at a large premium to net asset value. This is because the management contract has greater growth prospects.

Kiwi Income Property Trust unit-holders have an interesting decision to make at the January 27 meeting.

They can lie back and accept that they have no say in running the trust and that their external management company is unbelievably profitable.

Or they can vote against the proposed borrowing cap increase and start a process that should lead to the internalisation of the management contract.

Australian investors have adopted this proactive approach. This has led to a section in the Corporations Act 2001 that allows unit-holders to sack a manager with a simple majority of 50 per cent under an ordinary resolution.

This has encouraged management companies to cash in their management contracts and is one of the main reasons there has been a big switch from the external to internal management in Australia.

External management contracts are entrenched in New Zealand because, under the Unit Trusts Act 1960, unit-holders need a majority of 75 per cent under a special resolution to remove a manager. This is almost impossible to achieve.

New Zealand investors need to take a strong stance on external management and Kiwi's January 27 meeting would be a good place to start. The Australian owners will demand a high price for Kiwi's management contract but the move to internal management will benefit the trust's unit-holders in the longer term.

Disclosure of interest; Brian Gaynor is an executive director of Milford Asset Management.