Sinking fund 2012 - KPMG - MRMA

Sinking Fund in the context of Real Estate Investment Trusts (“REITs”)

Abdullah Abu Samah

3rd July 2012

What is Sinking Fund?

Application of Sinking Fund

Sinking Fund vs. Real Estate Investment Trusts (“REITs”)

Matters to consider

2 © 2012 KPMG, a partnership established under Malaysian law and a member firm of the KPMG network of independent member firms affiliated with KPMG International

Cooperative (“KPMG International”), a Swiss entity. All rights reserved. Printed in Malaysia.

What is sinking fund?

A fund set up for the purpose of covering the costs of future capital expenses. As a building ages, parts need to be replaced and without a sinking fund, it will deteriorate.

Sinking Funds are commonly set-up and used by developers and owners’ corporations of property such as condominium. ? ? ?

Sinking fund is used to meet major liabilities of a strata estate. Some developers collect this fund by way of governing documents, such as a Deed of Mutual Covenants, prior to the establishment of a management corporation for the development, while others rely on the provisions of legislations. Unit owners in a strata title development must contribute to this sinking fund, which is kept as a reserve fund to meet major replacement of parts of the common property. The collection of the sinking fund should not be confused with service charges, which are meant for the general maintenance and management of the common property and for the other services the developer has agreed to provide.



Sinking Fund vs. Real Estate

Investment Trusts (“REITs”)

Matters to consider



Application of sinking fund

In the case of a sinking fund set-up by the owners’ corporation of a condominium, the amount collected from the owners is treated as a liability in the books of the owners’ corporation or developer, while the owners would typically record it as an expense.

1. • Painting or repainting any part of the common property, which is a building or other structure

2. • Acquisition of any movable property for use in relation with the common property

3. • Renewal or replacement of any fixtures of fittings in any common property and any movable property vested in the body

corporate

4. • Any other expenditure, not being expenditure incurred where the repairs or work were wholly or substantially the liability or the

responsibility of the proprietor of a parcel or some of the parcels only

For strata property, legislations (Strata Titles Act and Housing Developers Regulations) require that a sinking fund be set u p for:




Matters to consider




Sinking funds are not commonly used by REITs and tenancy agreements drawn up generally do not include a clause for the collection of sinking fund. One of the challenges faced by REITs is the obtaining of funding for major refurbishments. Income from operations is almost fully-distributed (at least 90%) in order to enjoy the tax incentive applicable to REITs. The creation of a “provision” to set aside funds for future refurbishments is not allowed by the accounting standards as it would not meet the criteria under FRS137.14: A provision shall be recognised when:

1. • an entity has a present obligation (legal or constructive) as a result of a past event

2. • it is probable that an outflow of resources embodying economic benefits will be required to settle the obligation

3. • a reliable estimate can be made of the amount of the obligation

If these conditions are NOT met, NO provision shall be recognised




FRS137.14 (a) is difficult to prove as there is no obligation for the REIT to refurbish the building and in any case, the age of the building together with its wear and tear would be reflected in the books of the REIT in the fair value adjustments as the properties would be measured under the fair value model. However, from a business perspective, regular refurbishments are necessary for the properties to continue attracting good rentals.




Matters to consider



Matters to consider

A possible consideration for REITs would be to set aside funds progressively based on its expectations of future funding required for major refurbishments and reducing it from the income distribution (lower income distribution while still meeting the 90% threshold), which will have to be explained to the Unitholders to get their support.

Alternatively, the REIT could obtain legal advice in drawing up tenancy agreements which include a clause which stipulates a portion for sinking fund in the monthly rental payments; or to clearly state its responsibility to maintain the properties, including, the replacements of parts so as to support the need to create a provision in relation to the future costs to be incurred.



Matters to consider

The life cycle of all of the long-term elements will have to be calculated together with a replacement cost for each on the basis of building up enough funds to meet these long-term costs. This is will then have to be reviewed regularly to ensure the fund is not falling behind at the level predicted for the future.

How to obtain a reliable estimate of the costs for the refurbishment

Utilisation of the sinking fund in REITs is not governed under any laws (it does not come under the Strata Titles Act or the Housing Developers (Control and Licensing) Regulations)

Even under current legislation, there is not much guidance provided on the collection and use of the sinking fund, and unfair practices as well as unintended results are emerging, as seen from the frequent grouses of strata property owners. The lack of legislations in the case of sinking funds set up by REITs could prove to be a bigger challenge.

Regulatory compliance

There is also a need to consider other regulatory requirements, such as the Securities Commission’s Guidelines on REITs whether the setting up of such sinking fund is allowed.

Role of REITs vs. role of Trustee

A clause within the tenancy agreement that describes a sinking fund contribution could end up putting the REIT in the role of trustee of the sinking fund. In the case of housing developers, Clause 20 of Schedule H stipulates that the money accumulated in the sinking fund is to be held by the vendor in trust for all purchasers until a management corporation for the property is established. The vendor or his agent shall be obliged to provide purchasers with a copy of the annual audited accounts for services paid for with this fund. The sinking fund is, in fact, a trust fund that is entrusted to a trustee, who plays the role of "stakeholder". This could be difficult to administer and may not be the intention of the REIT.

Challe

nges

Thank you

Abdullah Abu Samah, Partner +603 7721 3388 [email protected]

© 2012 KPMG, a partnership established under Malaysian law and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved. The KPMG name, logo and "cutting through complexity" are registered trademarks or trademarks of KPMG International Cooperative ("KPMG International"), a Swiss entity.

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