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A condo development in the Liberty Villiage area in Toronto. Real estate investment trusts are providing poor disclosure to investors when their operating cash flow falls short of the level needed to pay distributions, according to a new Ontario Securities Commission review of the REIT sector.

KEVIN VAN PAASSEN/THE GLOBE AND MAIL

Real estate investment trusts are providing poor disclosure to investors when their operating cash flow falls short of the level needed to pay distributions, according to a new Ontario Securities Commission review of the REIT sector.

The OSC said 33 per cent of REITs it reviewed had insufficient cash flow from operations in a recent period to fully fund payouts to investors, requiring the REITs to find other sources of money – primarily borrowing – to finance their distributions.

None of the REITs with shortfalls provided the "expected disclosures" to investors, the OSC said, although some published a "boilerplate" disclosure noting there was a shortfall.

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"REITs are an important investment vehicle for many investors, and we expect a REIT's disclosure to accurately represent its current risk profile and its ability to sustain distributions at current levels," the regulator said in a staff notice to the REIT sector issued Monday.

REITs are investment funds that own incoming-producing real estate assets and pay distributions or dividends from the income.

They are popular with investors because they can provide a predictable stream of cash flow, and investors often choose to invest in REITs based on their size of their distributions.

However, the OSC said it is concerned that REITs are under competitive pressure to maintain and increase their distributions, pushing managers to seek other sources of funds when the underlying properties are not generating enough cash. In such cases, the distributions are not a return on capital, but a return of capital, the OSC argued, because REITs are using other assets for payouts, decreasing the value of their units.

"We are concerned that investors may be potentially misled if these risks are not appropriately disclosed," the commission said in its staff notice.

Neil Gross, executive director of shareholder advocacy group FAIR Canada, said he is pleased the OSC is telling the REIT sector to give investors plain and clear disclosure when cash flow is not sufficient to cover distributions.

"That's crucial information for assessing whether the distributions are sustainable, and therefore it's also essential for evaluating the overall risks associated with the investment," Mr. Gross said Monday.

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The notice says the OSC sent comment letters to 15 of the 30 REITs it reviewed, and 67 per cent of those letters required companies to improve their disclosures in the future. None of the REITs were required to refile or restate previously published disclosures.

The OSC said it will continue to monitor reporting, and REITs that do not comply with disclosure expectations "will be expected to take corrective action."

The regulator provided an example to REITs of what it considers adequate disclosure about cash shortfalls, saying it should include an explanation of what a shortfall means for investors, how the REIT raised the financing to cover the shortfall, what rate of interest it paid on the borrowing and why the REIT thinks the current distribution level is still sustainable.

Toronto lawyer Stephen Pincus of Goodmans LLP, who specializes in working with REITs, said it is good news that the OSC report found that REIT disclosures were generally good in other areas, and said the REIT sector will be quick to improve reporting on cash flow shortfalls.

"There are a number of areas where a minority of REITs have room for improvement, but I think that would be the case in any sector that is examined," Mr. Pincus said. "And I think that improving disclosure from more general to more specific is always a good thing for investors and for the sector."

He said it is important that the OSC found no disclosures that required restatements.

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"The way I would summarize it would be to say there was nothing fundamentally problematic," he said. "I do think the sector will welcome these comments and will follow them."

The notice also warns REITs that they must make clear disclosures to investors even in cases where their non-cash distributions – primarily payments in the form of additional units under dividend reinvestment plans – exceed cash flow from operations.

The commission said REITs should add non-cash distributions into the totals when calculating whether operating cash flows were sufficient to fund distributions, and should tell investors that non-cash distributions increase the REIT units outstanding, which will cause cash distributions to increase over time.

The OSC also reported that 10 per cent of REITs it studied would have reported a cash shortfall if they had not opted under new international accounting guidelines to classify their mortgage interest costs as a financing item in their financial statements rather than an operating cash flow item.

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