By Phillip Britt
How Small-Cap REITs Are Handling the Financial Squeeze From Sarbanes-Oxley and Other Regs
Due in large part to the Sarbanes-Oxley Act of 2002 and other stringent regulations, the cost of being a public company has significantly increased, and those expenses will rise further as Section 404 of Sarbanes-Oxley takes effect with fiscal years ending after June 30, 2004, according to Robert Lehman, partner in the real estate practice of Ernst & Young.
The costs, estimated to be anywhere from $150,000 to $500,000 for smaller public companies (including REITs), are primarily
for additional accounting and legal fees for auditing, monitoring and testing of accounting systems. Director's fees and director
and officer insurance are also increasing, although not at the same rate, as a result of Sarbanes-Oxley.
Smaller companies, including some REITs, tend to be the
most impacted because they don't have large accounting and
legal staffs to handle some of the additional requirements of the law. The costs also tend to be a higher percentage in terms of
funds from operations (FFO), than for larger REITs due to the lower overall FFO base.
While this change might cause some small private REITs to
re-think the decision to go public, those that expect continued
growth in the equity markets will likely still tend to go public, according to several executives of small-cap REITs. Those companies that recently went public expressed no regret with their decision (see sidebar). In addition, the rising costs aren't likely to lead to a wave of smaller public companies going back to private status due to complexities and costs associated with the conversion, Lehman says.
"The only companies that would likely (go back to being private) are the ones that see little or no future growth and would need to cut costs, like Sarbanes-Oxley compliance costs," Lehman says.
However, Lawrence Jones, partner with PricewaterhouseCoopers, says that small companies, including REITs, don't have excess general and administrative funds to use for the additional Sarbanes-Oxley and
related costs, so some may return to private ownership.
Sarbanes-Oxley Background
Sarbanes-Oxley is the Congressional Act designed to prevent some of the financial scandals like those at Enron, WorldCom, etc. Those scandals also gave rise to new rules at the New York Stock Exchange (NYSE) and the Securities Exchange Commission (SEC) that affect public REITs and all other public companies.
The Sarbanes-Oxley law itself amended the regulatory provisions of the Securities Commission Act of 1934. The SEC is the governing body charged with making the rules to enforce the Sarbanes-Oxley changes. In addition to new stipulations for financial literacy, disclosures and board member rules, the law requires strict auditing and monitoring measures that are adding to the cost of operating a public company.
Sarbanes-Oxley is expected to add as much as $500,000 to the cost of running a public company, according to a survey by CFO Magazine. Nearly half of those surveyed said they already had spent that amount to comply with Sarbanes-Oxley. That amount doesn't include the cost of NYSE-issued and other new rules regulating legal, accounting and overall governance.
Jon Grisham, vice president for investor relations for Acadia Realty Trust (NYSE: AKR), says that the costs of Sarbanes-Oxley and other regulations are difficult to quantify because they're difficult to separate from other costs of doing business. However, Grisham adds that Acadia is spending "several hundred thousand dollars" for a third-party firm to assist with some of the Sarbanes-Oxley and other compliance issues. Even with that expense, however, the costs don't significantly affect funds from operations.
Grisham adds that most of the costs of compliance are scalable, so a small REIT will pay on a percentage basis, the same amount as larger REITs, so he doesn't see a lot of impact for Acadia Realty.
Yet executives of some other REITs say they've seen costs rise significantly as a result of Sarbanes-Oxley and other regulations. The small REITs don't have in-house financial experts with free time available to work on
Sarbanes-Oxley issues, they say. No one knows the exact amount of the costs of Sarbanes-Oxley because Section 404, the portion of the law that could be the most expensive for some REITs, hasn't taken effect yet. As a result, some REITs have yet to conclude how they'll comply with that part of the statute.
Requirements of Section 404
For some smaller REITs, Section 404, which requires a complex "internal control report," will require additional personnel as well as hiring outside legal and accounting help.
More specifically, the internal control report must:
- State the responsibility of management for establishing and maintaining an adequate internal control structure and procedures for financial reporting; and
- Contain an assessment, as of the end of the issuer's fiscal year, of the effectiveness of the internal control structure and procedures of the issuer for financial reporting.
The amount of the increased cost for complying with the requirements depends in large part on the REIT's internal structure. For example, Correctional Properties Trust (NYSE: CPV) saw its administrative overhead increase by 50 percent as a result of the new regulations imposed by Sarbanes-Oxley and the NYSE, according to CEO Charles Jones. The REIT, which operates correctional facilities, had only three total employees pre-Sarbanes-Oxley and now has five—one just to handle Sarbanes-Oxley and other regulatory issues.
Cornerstone Realty Trust (NYSE: TCR), Richmond, Va., has also seen higher personnel costs as a result of the new regulations, according to Mark Murphy, senior vice president, corporate services.
"The internal controls portion of the act seems to be quite broad," Murphy says. "That is taking a lot of time and effort. We have initiated additional hiring to handle the requirements, and we have moved employees from other areas of the company to help out. The internal control and monitoring is a very laborious process."
So the REIT's general counsel, J. Philip Hart, and other employees are spending more time with Sarbanes-Oxley and other regulations, Murphy says.
Hart adds that the REIT is still calculating the costs of Sarbanes-Oxley, though the $150,000 to $500,000 estimate of Lehman is probably a good range. About half of that will be needed to pay an outside auditor to ensure Sarbanes-Oxley compliance. Compliance with strict NYSE and SEC rules add only marginal incremental costs, Hart adds, because they build on the Sarbanes-Oxley rules.
Most of the increased costs are due to the monitoring and information technology concerns, according to Murphy and Hart. Information technology systems are part and parcel of financial reporting systems, so the technology needs to be monitored and tested to ensure compliance with Sarbanes-Oxley rules.
Sorting the Implications
Joe Green, president and chief financial officer of hospitality REIT Winston Hotels, Inc. (NYSE: WXC), agrees that
Sarbanes-Oxley and some of the other new rules are needed to help ensure that large, multi-division companies don't commit accounting fraud.
"We feel like we've always complied with the rules," Green says. "We're a small REIT with only 15 to 20 employees. We've been working together a long time."
Jones says that many small REITs, with small administrative staffs, are used to working less formally than Section 404 requires. So most have relatively little of the documentation or controls already in place.
As evidence that Winston Hotels was already in compliance with the spirit of Sarbanes-Oxley, Green points to the company's own procedures. The company has changed a committee charter and has added an additional committee, but to date has had to change little else to abide by the new rules.
However, the requirements of Section 404 will change all of that. The problem isn't so much the procedures themselves, but the documentation of the procedures, according to Green. The rules, as interpreted by the financial firm that has worked with Winston Hotels on accounting issues, requires documentation via a series of check boxes of accounting procedures and controls in very minute detail.
"We've always had [accounting] controls in place," Green says. "We're doing the same things now that we've done for the last 10 years."
Green likens the rules to documenting what someone does every day: Getting up, taking a shower, brushing teeth, eating breakfast, walking (insert distance) to car, turning key, depressing gas pedal, etc.
Winston Hotel officials are still weighing the benefits of using or hiring additional employees to handle the auditing and other Section 404 requirements versus using an outside firm. Whatever decision the company makes, the cost to Winston Hotels should be near the bottom of Lehman's range, according to Green. Green expects Winston Hotel's Sarbanes-Oxley costs to remain relatively low because the company was already following the spirit of the law.
Control Costs Via Internal Processes
Executives at several small-cap REITs agree that the best way
to attempt to rein in these costs beyond previously established policies and procedures is to have internal staff handle as much of the compliance issues as possible, either with current or new staff members. However, many smaller REITs don't have the internal expertise to handle these duties and are weighing the prospects of hiring a third party against adding internal staff.
Beyond monetary costs, the new regulations also cost managers and directors more time to ensure they are in compliance, Correctional Properties' Jones says. Preparation and board meetings themselves take much longer than before. Whereas a board meeting might have been a few hours before, now the meetings last most or all of a day.
Even with the higher cost of doing business, Jones sees positives from the new regulations, particularly the accelerated filings of financial reports.
"Going public provides you with access to liquidity and capital," Jones says. "If you need that, you need to accept the costs and move forward."
Despite the expense, Sarbanes-Oxley brings about good standard operating procedures as well as better governance for public companies, including REITs, Grisham says. "It ultimately benefits the shareholder."
Large shareholders and institutional investors understand that the new regulations mean higher costs, Jones adds.
It's incumbent on management to handle as much of the added duties as possible, Lehman agrees. The more work that has to be outsourced, the higher the costs will be. Lehman recommends that someone with experience in internal auditing handle Sarbanes-Oxley related duties.
Town & Country Trust (NYSE: TCT), a REIT specializing in multifamily buildings primarily in the Mid-Atlantic states, is another one of those at the bottom end of the $150,000 to $500,000 estimated cost range, according to James Dolphin, executive vice president and co-chief operating officer.
If the final cost does turn out to be $150,000, that will represent one cent per share, which Dolphin terms as "significant, but not material." The SEC defines material costs as those exceeding 3 percent. The final cost isn't known yet because "the meter is still running."
The company hired a third-party firm to handle the requirements of Section 404 and other portions of Sarbanes-Oxley because the work was too much for the internal staff, Dolphin explains. Even with the third-party firm, however, Sarbanes-Oxley and other regulations mean more work for Town & Country employees.
"Even though we hired a third party, they're not doing everything themselves, so it's still a drain," Dolphin explains. The third party knew little about Town & Country, so it had to learn about the company's accounting systems and procedures from the REIT's employees.
The costs could have been higher, Dolphin adds. As part of a change to a new accounting software in 2002, Town & Country reviewed its systems, located potential weaknesses, etc. So that didn't have to be done internally (or by paying a third party) to abide by the Sarbanes-Oxley rules.
"We included auditors in our entire planning process, so we have them identify our critical systems," Dolphin says.
Phillip Britt is a freelance writer based in suburban Chicago.
