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ACADEMIC PAPERS

Real estate corporations: the quest for value Joseph T.L. Ooi and Kim-Hiang Liow

Academic papers: Real estate corporations 23

Department of Real Estate, National University of Singapore, Singapore Keywords Property management, Real estate, Corportate strategy, Economics Abstract This paper examines the implications of the corporation’s quest for value and the adoption of a new economic performance metric on real estate corporate strategies. The economic profit of 19 Singapore property companies is computed. Overall, the results suggest that most property companies failed to generate enough periodic income to cover their cost of capital. Hence, the companies appear to be destroying rather than creating corporate wealth. The discussion also highlights some reasons why economic valude added (EVA) tends to understate the true economic performance of real estate, both as an investment and as a business unit.

1. Introduction Although the ultimate goal of most corporations is to maximize their shareholders wealth, the management may not always seek to do so due to moral hazard problems (Jensen and Meckling, 1976). Following a growing awareness of the problem of management opportunism, shareholders have increasingly placed more pressure on the companies to create and maximize wealth. Indeed, the proliferation of corporate restructuring, acquisitions and mergers, share buybacks, asset divestments and securitization deals seen recently have been motivated largely by the corporations’ quest to add shareholders value. Real estate corporations are not isolated from the pursuit to create wealth. For example, the mission statement of Land Securities, the largest property company in the UK, is to ``pursue attractive and increasing returns for its shareholders’’. Parallel to this quest for value is the adoption of an alternative metric to measure corporate performance such as the economic value added (EVA), which is a trademark of the consulting firm Stern Stewart & Company. Prominent companies that have adopted EVA include Coca-Cola, Monsanto, Bausch & Lomb, and Toys ``R’’ Us in the USA and Tate & Lyle, Diageo, and Siemens, in Europe. Proponents of the EVA concept claimed that it is a superior performance metric because it eliminates financial and accounting distortions and provides a real measure of a company’s success in creating shareholder value. Applied to the business unit level, EVA is also claimed to provide a powerful management tool for investors and corporate managers to identify where value has been created or destroyed in a business organization. In The authors would like to acknowledge the feedback and constructive comments from the anonymous referee and participants at the RICS Cutting Edge Conference in London, UK in September 2000.

Journal of Property Investment & Finance, Vol. 20 No. 1, 2002, pp. 23-35. # MCB UP Limited, 1463-578X DOI 10.1108/14635780210416246

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contrast, traditional measures of corporate performance such as accounting profits, returns on investment (ROI) and returns on equity (ROE) have been criticized as inconsistent with the goal of wealth maximization. The quest for value and the adoption of the EVA metric have important implications on the attractiveness of real estate as an asset class and as a business entity. From a corporate real estate perspective, ownership of real estate has an unfavorable impact on a company’s financial position because the value of corporate real estate is often hidden from investors and, therefore, not fully reflected in stock prices (Brueggeman and Fisher, 1997, p. 467). The discount to net asset value of quoted property stocks is an issue that has been investigated extensively in the real estate literature (Liow, 1996; Barkham and Ward, 1999). Companies with intensive real estate portfolios also tend to be ranked lowly in comparative studies on corporate performance[1]. In the search for ways to increase wealth, corporations would inevitably have to re-examine the notion that there is a competitive advantage in owning real estate. In Singapore, it has been observed that companies, `àfter nearly a decade of bingeing on an assortment of businesses such as property, are now returning to the `nuts and bolts’ of their core business’’ (Sunday Times, 1999). Even property companies, such as DBS Land in Singapore and Land Securities in the UK, have announced that they would be downsizing their investment portfolio and accelerating their sales programme to boost shareholder value. Are the market activities signaling that real estate, as an asset class and as a business entity, is losing out in the race for value? The primary motivation of this paper is therefore to examine why property companies do not stand up well under the EVA analysis. Is it the case that property assets are simply losing their attractiveness as an investment or business venture, or is it the case that EVA does not reflect fully the economic contribution of property assets? If there are any limitations in the application of the new metric, it is important to identify them so that wrong decisions will not be made. The remainder of this paper is structured as follows: Section 2 provides the background for this study by revisiting the residual income concept. Section 3 reviews the economic performance of property companies listed on the Stock Exchange of Singapore (SES) and offers explanations as to why property companies tend to perform poorly under the EVA metric. Section 4 discusses the broader impact of the quest for shareholder value on corporate real estate strategies and corporations. Section 5 concludes with a summary of our findings and recommendations. 2. Economic profit and the EVA concept Although EVA is relatively new, its conceptual foundation based on the ``residual income’’ concept is not. Intuitively, wealth is created when a company earns more than the cost of investing and running the business. Economic profit of a business is defined as the margin between operating profits and the cost of capital employed to produce those earnings. The relationship is represented in equation (1) below:

Economic Profit ˆ Operating Profit ¡ Cost of Capital Employed:

…1† Academic papers:

Since the cost of capital employed is defined as the company’s total capital invested times the average cost of capital, equation (1) can be expanded as follows: Economic Profit ˆ Operating Profit

¡ …Capital Employed £ Average Cost of Capital†

…2†

Equation (2) shows that derivation of economic profit involves three elements: (1) the firm’s net operating profit after taxes (NOPAT); (2) its total capital invested to generate that income; and (3) its weighted average cost of the capital (WACC) (see Appendix for details on the computation of WACC). Unlike accounting profit which is derived after deducting interest charges, economic profit is derived after subtracting the cost of all capital employed. This includes both equity as well as debt capital. To measure real economic profit, EVA proponents further recommend a series of adjustments to eliminate distortions arising from accounting conventions[2]. Some studies have shown that although there are incremental contributions to the EVA adjustments, the practical gain is found to be too small to be meaningful and that companies may not need to make these adjustments in order to adopt the residual income paradigm (Chen and Dodd, 1997). Higher accounting earnings do not necessarily indicate a more efficient deployment of capital[3]. Since no cost is imputed for the use of equity capital in accounting profit, the real cost of doing business is understated. This may lead to a wrong perception that equity capital is cheap or, worse still, free! Since adoption of the EVA concept helps the management and employees to understand the real cost of equity capital, it reduces the possibility of management misusing free cash flow in unprofitable investments (Makelainen, 1998). Following basic economic theory that cost of capital be stated in opportunity terms, the residual income approach is consistent with the capital budgeting decision rule that a project with positive NPV is to be accepted because it adds value to the firm. Investing in a negative NPV project, on the other hand, signifies value destruction. Furthermore, when compensation is tied to EVA, the goals of employees and managers are aligned with the goals of the entire company. This reduces the conflict of interests between the managers and the shareholders (Wallace, 1997). In contrast, the policy of maximizing ROI (or any other accounting rate of return, such as return on equity, ROE) does not always encourage managers to exhibit decision-making behavior that is congruent with the goals of the company (Brewer et al, 1999). For example, if financial compensation is linked to ROI or ROE, a manager has no incentive to pursue investments that yield positive returns, but at a lower rate than what is achieved currently due to

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Figure 1. All property, property stocks and all equities indices (Singapore, 1990-1999)

potential earnings dilution. Instead, projects with high returns potential may be favoured at the expense of exposing the company to unduly high risk. 3. Economic profit of Singapore property companies The economic profit of 19 property companies listed on the SES are computed based on their historical accounting results extracted from the DATASTREAM (DS) database as well as the Financial Highlights of Companies listed on the SES. Two newly listed companies, namely Allgreen and Ho Bee Investments, were excluded from the study sample due to insufficient market data. An eight-year study period (1992-1999) was chosen to cover the most recent property cycle in Singapore; from market recovery in 1992 through to the peak in early 1996, followed by a sudden slump from mid 1996, and finally the recovery stages in 1998/99. Figure 1 shows the overall property market index and property stock index over the study period. Over the study period, the property price index rose 78.6 per cent, whilst property stocks rose 133.9 per cent. Between 1992 and 1995, property companies grew rapidly in tandem with rapid economic growth and robust performance in the Singapore property market. Market capitalization of property stocks increased by 145 per cent from SGD 9.7 billion in 1992 to SGD 23.7 billion in 1995. The average price-to-earnings ratio (P/E) of property companies also rose from 32.4 to 43.7 over the same period, which reflected the confidence investors had in the direct and indirect property markets. After experiencing years of high profits and strong performance in the early 1990s, the Singapore property market was adversely hit by anti-speculation measures on residential properties introduced in May 1996 and the regional financial crisis starting from July 1997. The average P/E ratio of property stocks declined 40 per cent to 20.7. As of June 1998, the P/E ratio for the sector declined further to 9.7. As of the end of 1998, the market capitalization stood at only SGD 11 billion.

Net interest expense (DS Code 2408) after taxes is added back to published cash Academic papers: earnings (DS Code 2260) to derive the firm’s NOPAT. It does not take into Real estate account unrealized capital gains. Current debt (DS Code 308) is added to total corporations capital employed (DS Code 322) to derive the firm’s invested capital at the end of each year. To compute the company’s rate of return on capital employed, we divide NOPAT by the average capital employed for the particular year (i.e. the 27 beginning capital plus ending capital divided by two). The average balance is employed (instead of the beginning balance as proposed by EVA proponents) to compute the rate of return because new funds may be added to the existing capital base throughout the year. The rates of return of the property companies are reported in Table I. Bukit Sembawang yields the highest average rate of return, 9.26 per cent per annum over the study period. CDL ranked second with 7.33 per cent per annum. Overall, the sample only registered a modest 3.43 per cent rate of return on total capital invested, ranging from a high of 5.1 per cent in 1996 to a low of – 0.9 per cent in 1998. The cost of debt and cost of equity are weighted based on the firm’s capital structure to derive the WACC for each firm, which is tabulated in Table II. WACC of the property companies averaged 7.46 per cent over the study period, ranging between 6.71 per cent in 1993 and 8.08 per cent in 1998[4]. The economic profit of a company is computed by deducting the cost of capital (total capital investment multiplied by the WACC) from the firm’s NOPAT. Since the average rates of return on invested capital (3.43 per cent) are Company

1993 1994 1995 1996 1997 1998 (%) (%) (%) (%) (%) (%)

1999 (%)

1 Bonvest Holdings 3.91 5.89 6.25 4.78 2.67 – 8.99 9.01 2 Bukit Sembawang Estates 27.95 8.09 0.72 8.26 15.03 0.62 4.13 3 Centrepoint Properties 2.99 5.72 7.25 6.66 3.14 1.69 3.24 4 China Everbright Pacific 1.79 4.97 4.52 1.41 2.42 5 City Developments 5.60 6.83 9.34 10.96 8.59 4.91 5.07 6 DBS Land 3.49 4.80 3.70 4.01 3.39 –1.40 1.69 7 First Capital Corporation 7.67 7.66 7.07 6.04 4.65 – 0.65 – 4.60 8 Hong Fok Corporation 0.83 0.92 4.28 2.16 0.63 0.76 – 0.08 9 Jack Chia-MPH 3.63 8.14 6.76 10.16 7.57 3.85 4.73 10 Keppel Land 2.21 2.83 2.52 2.41 2.63 – 6.77 1.84 11 L.C. Development 0.80 – 0.03 0.06 1.13 – 0.16 – 6.63 – 58.36 12 Marco Polo Developments 3.51 2.02 2.42 5.72 8.01 13 MCL Land 2.78 3.37 4.09 4.36 1.83 – 15.64 3.23 14 Orchard Parade Holdings 6.41 6.75 2.25 3.30 2.52 – 8.45 1.36 15 Scotts Holdings 5.73 0.15 1.64 16 Singapore Land 3.03 3.02 2.36 2.23 2.35 2.06 2.91 17 TLB Land Limited 52.88 3.67 2.95 2.96 – 31.95 4.13 18 United Overseas Land 3.73 3.06 3.25 3.57 2.99 1.54 3.91 19 WingTai Holdings 9.11 5.91 7.54 7.44 – 4.33 – 2.96 Average 5.31 7.80 4.16 4.64 4.22 – 3.33 –1.08

Average (%) Rank 3.36 9.26 4.38 3.02 7.33 2.81 3.98 1.36 6.41 1.10 – 9.03 4.40 0.57 2.02 2.51 2.57 5.77 3.15 3.78 3.09

9 1 6 11 2 12 7 16 3 17 19 5 18 15 14 13 4 10 8

Table I. Returns on invested capital of Singapore property companies (1992-1999)

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Table II. WACC of Singapore property companies (1992-1999)

Company

1992 1993 1994 1995 1996 1997 1998 1999 (%) (%) (%) (%) (%) (%) (%) (%) Average Rank

1 Bonvest Holdings 10.60 9.95 11.27 8.19 7.86 8.36 7.54 7.74 2 Bukit Sembawang Estates 6.40 5.33 6.34 5.53 5.38 7.12 7.62 6.96 3 Centrepoint Properties 10.28 7.85 7.29 7.29 7.14 7.89 6.98 7.20 4 China Everbright Pacific 8.54 8.26 8.72 10.42 10.46 10.71 5 City Developments 5.49 5.47 6.69 5.57 5.80 6.89 7.37 7.01 6 DBS Land 6.15 5.66 6.97 6.30 6.66 7.29 7.46 8.34 7 First Capital Corporation 6.12 5.97 7.51 6.16 6.63 6.84 8.35 8.50 8 Hong Fok Corporation 6.64 5.65 7.42 7.26 7.58 6.54 6.64 6.52 9 Jack Chia-MPH 6.67 5.45 6.42 6.32 6.47 7.15 6.59 6.51 10 Keppel Land 7.92 7.50 8.68 7.12 6.79 8.16 8.13 8.28 11 L.C. Development 5.03 4.92 7.11 7.01 6.61 7.56 8.41 6.00 12 Marco Polo Developments 7.19 6.93 6.53 7.59 9.08 8.09 13 MCL Land 8.32 7.78 9.19 7.92 7.75 8.67 12.28 12.10 14 Orchard Parade Holdings 5.72 5.42 5.82 4.94 5.59 6.14 6.05 6.13 15 Scotts Holdings 7.37 7.55 8.28 16 Singapore Land 9.34 8.43 10.17 7.23 7.38 8.76 9.55 9.54 17 TLB Land Limited 5.66 5.28 5.88 7.33 6.42 6.42 18 United Overseas Land 8.95 8.04 6.69 6.75 6.97 7.55 7.56 7.76 19 WingTai Holdings 9.56 7.90 7.58 8.60 8.88 9.18 Average 7.41 6.71 7.68 6.79 6.94 7.82 8.02 7.94

8.94 6.33 7.74 9.52 6.29 6.85 7.01 6.78 6.45 7.82 6.58 7.55 9.25 5.73 7.74 8.80 6.16 7.53 8.61 7.46

17 4 13 19 3 8 9 7 5 14 6 10 18 1 12 16 2 11 15

lower than the WACC (7.46 per cent), it is not surprising that the sector as a whole registered negative residual income over the study period (Table III). Overall, the results suggest that most property companies in Singapore fail to generate enough periodic income to cover their cost of capital. On average, only two companies, CDL and Bukit Sembawang, managed to register positive residual income over the study period. In 1998, the sector as a whole recorded an overall loss of SGD 3.65 billion, with all the companies registering economic losses. The results have important implications on real estate decisions. Based on their poor results, EVA proponents would argue that the property companies stop destroying value and leave the industry! Furthermore, managers of property business should not be receiving any performance bonus if their remuneration is tied to the company’s EVA performance! Why do property companies fare badly under the residual income or EVA metric? Whilst it is possible that the poor performance results from poor management, a more plausible reason is that the actual performance of property, both as an investment asset and as a business unit, has been understated to the extent that capital profit has not been taken into account in NOPAT. In a recent study, De Villiers (1997) demonstrates that companies employing non-depreciable assets will appear less productive than they really are under the EVA metric. It was also shown that the distortion would increase with the life of the asset. Table IV tabulates the decomposition of returns in Singapore by property type. On average, the prices of real estate in Singapore appreciated between 6.5

1 Bonvest Holdings 2 Bukit Sembawang Estates 3 Centrepoint Properties 4 China Everbright Pacific 5 City Developments 6 DBS Land 7 First Capital Corporation 8 Hong Fok Corporation 9 Jack Chia-MPH 10 Keppel Land 11 L.C. Development 12 Marco Polo Developments 13 MCL Land 14 Orchard Parade Holdings 15 Scotts Holdings 16 Singapore Land 17 TLB Land Limited 18 United Overseas Land 19 Wing Tai Holdings Total

Company

(143,798) (71,192) (613,449)

(152,530) (81,801) (711,063)

(70,198) (9,014)

(20,351) 18,957 (49,227) – (20,490) (82,854) 5,858 (56,492) (6,684) (109,251) (7,138) (29,339) (42,797) 1,349

1993

(24,077) 10,862 (76,389) – (24,312) (94,039) (14,280) (4,506) (9,986) (110,620) (7,060)

1992

1995

(21,996) (15,027) 968 (6,705) (20,800) (16,624) (7,493) (6,523) (29,182) 179,813 (138,940) (186,605) (802) (16,381) (96,564) (36,768) 5,356 699 (172,340) (192,254) (7,368) (11,476) (44,748) (52,142) (57,974) (47,039) (6,168) (52,853) (25,963) (269,823) (204,439) 38,711 (2,797) (134,197) (110,616) (58,794) (58,819) (1,022,156) (862,520)

1994

1997

1998

1999

Average

(25,060) (37,059) (94,616) 6,072 (29,014) 3,062 16,997 (14,339) (8,277) 2,691 (39,318) (118,496) (145,235) (108,751) (71,855) (3,799) (7,444) (9,140) (8,798) (7,199) 323,555 105,496 (198,262) (236,741) 12,484 (207,009) (321,278) (616,717) (462,212) (263,707) (18,045) (82,525) (283,826) (361,323) (96,415) (79,887) (82,809) (64,562) (84,231) (63,227) 14,532 424 (11,192) (9,595) (2,056) (224,067) (277,496) (677,364) (318,203) (260,199) (11,769) (17,221) (37,876) (129,954) (28,733) (61,379) (31,015) (7,985) (38,532) (40,657) (98,349) (311,744) (96,542) (95,663) (53,772) (98,047) (246,182) (66,946) (66,454) (44,336) (39,989) (36,762) (220,835) (277,804) (237,016) (210,616) (214,608) (8,754) (11,743) (81,182) (3,749) (11,586) (105,199) (163,567) (172,941) (112,597) (119,014) (13,699) (53,067) (418,402) (352,303) (159,181) (816,435) (1,594,992) (3,628,580) (2,564,766) (1,549,030)

1996

7 2 12 4 1 19 14 10 3 18 6 9 13 11 8 17 5 15 16

Rank


Table III. Residual income of Singapore property companies (1992-1999)

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per cent and 11.9 per cent annually between 1985 and 1998, which is sufficient to bridge the 4.03 per cent gap between the average yield (3.43 per cent) and the average WACC (7.46 per cent). To reflect the true performance of property companies and real estate as an investment, NOPAT should consequently include all valuation adjustments affecting the balance sheet. Recognition of unrealized capital appreciation as earnings would improve the perception that property investment destroys value. However, property revaluation can become a rather subjective and delicate issue in property company financial reporting (Barkham and Purdy, 1992). In contrast, the actual profitability of non-real estate corporations tends to be over-stated. Whilst economic profit should be computed based on current market or replacement values of assets employed, the EVA of most non-real estate companies is computed using the book value of net assets, due to practical and cost reasons[5]. In the presence of inflation, book values lagged behind actual value, thereby understating the capital base of non-real estate companies. Since the capital base of property companies is closer to current market value because of frequent asset revaluations, it is necessary to compute the EVA of non-real estate companies based on current asset valuation (De Villiers, 1997) to provide a more meaningful performance comparison between real estate and non-real estate business units. 4. Implications on real estate corporate strategies If management compensation is linked to economic performance of a company, we anticipate that it will have a significant influence on its corporate real estate strategies. In particular, investment decisions would be made on the basis of whether they would yield positive EVA or not. Equation (2) highlights four ways in which a firm can increase shareholder wealth. First, by utilizing existing resources more efficiently, i.e. making existing capital work harder to yield higher earnings. Second, by injecting more capital into projects which are expected to earn positive NPV. Third, by withdrawing capital from activities and assets that yield unattractive return, i.e. withdrawing from unprofitable projects. Finally, by employing optimal capital structure and exploring alternative sources of finance to reduce its WACC. One likely impact of the quest for shareholder value is that property investment would be viewed unfavorably because of its adverse effect on EVA. Hence, companies may seek to boost EVA by reducing their investment property portfolio and shifting their resources to activities which generate higher profits within a shorter time frame, such as property trading and Property type

Table IV. Decomposition of returns by property type (Singapore, 1985-1998)

Office Residential Industrial Retail

Total return (%)

Price appreciation (%)

Rental yield (%)

12.1 14.5 18.0 13.1

7.4 9.9 11.9 6.5

4.7 4.5 6.1 6.7

development projects. For example, Land Securities in the UK indicated that it Academic papers: would be accelerating its sales programme and focusing substantially on Real estate development projects in areas with greatest opportunity for long-term growth corporations to increase shareholder value. Development and trading activities are of course not invariably profitable. In addition, they may increase the company’s WACC due to higher operating risk. 31 Another implication of the pursuit to increase wealth is that companies would be less eager to diversify for the sake of risk diversification per se. In some instances, the company may decide to refocus its energies and resources on core areas where it has competitive advantage. For example, MEPC sold substantially all their overseas assets in 1998 to concentrate on fewer but larger prime investment properties in the UK. For non-property companies with substantial real estate asset holding, a review of the corporate real estate strategy would be timely to evaluate the comparative advantages of owning real estate. With the pride of real estate ownership becoming less significant, divestment of non-core real estate assets may become a viable option to boost share prices. The quest for value will also put pressure on property managers to boost returns through active management. Hence, asset management will take on a more important and pro-active role. Besides seeking ways to reduce maintenance costs, property managers have to work harder to increase the operating revenue of properties under their care. One possibility of increasing the worth of a property asset would be evaluating the feasibility of converting ``dead’’ space into valuable rental space. Existing assets will also be subjected to more frequent and rigorous evaluation to justify their continual inclusion in the company’s asset portfolio. In particular, their performance will be benchmarked regularly against the cost of capital. Property companies may also prefer certain sectors of the property market (e.g. industrial and retail properties in the Singapore context) because of higher rental yield. Similarly, investment properties in more mature real estate markets such as the USA and the UK may appear more attractive because they offer higher rental yield than properties in Singapore. Furthermore, property companies may be tempted to diversify into high-end property-related services such as offering their asset management or property management expertise. In addition to the attractive fees for the advisory roles, provision of such professional services also involves less capital. Some property companies in Singapore have in the past adopted an aggressive land banking strategy or engaged in development and investment projects in growing markets such as in China and Vietnam to safeguard market shares and to take position in growing markets. Unless the company invests continuously in strategic projects, its ability to continue earning positive EVA over time will be limited by a span of time defined by as the competitive advantage period of the company. This is because as more competitors, attracted by the high returns, enter the market to compete for the same pie, excess profits will eventually be reduced down to the cost of capital

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(Milunovich and Tsuei, 1996). Nevertheless, since the benefits of such strategic initiatives are not enjoyed until very much later, the company will be penalized in the interim period with low EVA. Companies, therefore, face disincentives to pursue strategic ventures with long-deferred payoffs if their stock prices are discounted excessively due to low EVA in the initial years (Brewer et al., 1999)[6]. Timely disclosure of pertinent information is necessary to ensure that the potential benefits of such strategic actions are clearly understood by the investors and shareholders to prevent its stocks from being under-priced in the marketplace. If the strategic information cannot be divulged without compromising the company’s competitive position, it may convey indirect signals of the firm quality through its debt maturity (Ooi, 1999) and ownership structure (Ooi, 2000). In the pursuit to increase wealth, property companies will increasingly look towards financial engineering and alternative sources of financing to drive down the cost of capital. For example, Capital and Income Trust (CIT), a consortium of international investors, raised GBP 343 million through the securitisation of six London office properties in 1998. From CIT’s point of view, the deal improves the owners’ wealth because the average cost of the securitised loans was 130 basis points below the rate the company paid on existing loans (Parker, 1998). In Singapore, DBS Land similarly structured several asset securitisation deals to raise funds at a lower cost of capital (Ong et al., 2000). 5. Summary and conclusions The main strength of EVA and the other economic profit metrics is that they force managers to think about the total cost of capital and shift the managers’ paradigm from accounting profits to economic profits. It provides a valuable measure of wealth creation and can be used to help align managerial decision making with firm preferences. Besides making the managers run faster, EVA also reduces the possibility of misusing free cash flow to unprofitable projects. Despite being touted as ``today’s hottest financial idea and getting hotter’’, EVA has its limitations and it may not be right for every company. There are cases in which a straightforward application of EVA may create more problems than solutions (see Stern Stewart, 1994). In particular, the EVA of property assets and businesses is understated when the capital appreciation component is not taken into account. When ranking economic performance of different business units, conglomerates with diverse business interests should not be deceived by the low or negative EVA recorded for the property unit. It would be myopic for the conglomerates to divest themselves of their property business based solely on EVA. Similarly, property companies should not decide to shift their business from real estate investments to property development and trading purely on the grounds that the low yield from investment properties would drag down the company’s EVA. The acid test is whether their shareholders will benefit from such activities over the long run.

In deciding a company’s business orientation, the management should look Academic papers: beyond EVA and seek to position itself strategically to take advantage of Real estate market trends and future growth areas. As contended in the debate between corporations Ehrbar and Hamel (1997), EVA is merely a measure of capital efficiency and it reveals nothing about a company’s relative capacity to create new wealth within its industry. Indeed, an over reliance on EVA could deter the long-term 33 sustainable growth of a company. Ultimately, investment performance is a function of expected risk and returns and the best way to safeguard and increase shareholder wealth in the long run is to continuously invest in positive NPV projects and monitor the performance of the assets closely. Notes 1. For example, a comparative study by KPMG on the profitability of 85 Singapore manufacturing companies in 1997/98 revealed that the top company in terms of sales, Fraser & Neave, ranked second from bottom in terms of EVA due mainly to the company’s heavy investment in properties. 2. In total, 164 measurement issues that put doubts on the accuracy of using reported accounting results to measure real economic income were identified. Stewart (1994, p. 74) recommends four tests before adjustments to the definition of EVA are made: .

Is it likely to have a material impact on EVA?

.

Can the managers influence the outcome?

.

Can the operating people grasp it?

Is the required information relatively easy to track or derive? Setting a target of maximizing accounting profits can lead to the undesirable outcome of over-investment in low returns projects. For example, the earnings per share (EPS) of a corporation rises with the number of ventures undertaken so long as the new capital investments yield positive accounting returns. The WACC of the sample may seem relatively low in comparison with property companies in other countries. This is due mainly to the low interest rate regime in Singapore over the study period, which averaged an annual rate of 4.44 per cent net of tax. Current market values of individual assets are often either very difficult or costly to estimate for most companies. To circumvent the bias arising from the use of historical costs, Stewart (1994) suggests tying management rewards not to absolute measures of EVA, but to year-to-year changes in EVA. To counter the criticism that EVA focusses on short-term results, EVA proponents advocate keeping strategic capital off the books for internal evaluation purposes and then gradually readmitting it into the manager’s capital account to reflect the expected payoffs over time (Stewart, 1994, p. 77). .

3.

4.

5.

6.

References Barkham, R.J. and Purdy, D.E. (1992), ``Property company financial reporting: potential weaknesses’’, Journal of Property Valuation & Investment, Vol. 11, pp. 133-44. Barkham, R.J. and Ward, C.W.R. (1999), `Ìnvestor sentiment and noise traders: discount to net asset value in listed property companies in the UK’’, Journal of Real Estate Research, Vol. 18 No. 2, pp. 291-311. Brewer, P.C., Chandra, G. and Hock, C.A. (1999), `Èconomic value added (EVA): its uses and limitations’’, SAM Advanced Management Journal, Vol. 64 No. 2, pp. 4-11.

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Brueggeman, W.B. and Fisher, J.D. (1997), Real Estate Finance and Investments, 10th ed., McGraw-Hill, Irwin, Boston, MA. Chen, S. and Dodd, J.L. (1997), `Èconomic value added: an empirical examination of a new corporate performance measure’’, Journal of Managerial Issues, pp. 318-33. De Villiers, J. (1997), ``The distortions in economic value added (EVA) caused by inflation’’, Journal of Economics and Business, Vol. 49, pp. 285-300. Ehrbar A. and Hamel, G. (1997). ``Debate: duking it out over EVA’’, Fortune, Vol. 136 No. 3, p. 232. Jensen, M.C. and Meckling, W.H. (1976), ``Theory of the firm: managerial behaviour, agency costs and ownership structure’’, Journal of Financial Economics, Vol. 3, pp. 305-60. Liow, K.H. (1996), ``Property companies share price discounts and property market returns – the Singapore evidence’’, Journal of Property Finance, Vol. 7 No. 4, pp. 61-74. Makelainen, E. (1998), `Èconomic value added as a management tool’’, Master’s Thesis, Helsinki School of Economics and Business Administration, Department of Accounting and Finance, Universitas Oeconomica Helsingiensis. Milunovich, S. and Tsuei, A. (1996), `ÈVA in the computer industry’’, Journal of Applied Corporate Finance, Vol. 9 No. 1, pp. 104-15. Ong, S.E., Ooi, J.T.L. and Sing, T.F. (2000), `Àsset securitization in Singapore: a tale of three vehicles’’, Real Estate Finance, Vol. 17 No. 2, pp. 47-56. Ooi, J.T.L. (1999), ``The debt maturity structure of UK property companies’’, Journal of Property Research, Vol. 16 No. 4, pp. 293-307. Ooi, J.T.L. (2000), ``Corporate reliance on bank loans: an empirical analysis of UK property companies’’, Journal of Property Investment & Finance, Vol. 18 No. 1, pp. 103-20. Parker, G. (1998), ``Property companies start selling debt’’, EuroProperty, February. Stern Stewart (1994), `ÈVA roundtable’’, Journal of Applied Corporate Finance, Vol. 7 No. 2, pp. 46-70. Stewart, G.B. III, (1994), `ÈVA: fact and fantasy’’, Journal of Applied Corporate Finance, Vol. 7 No. 2, pp. 71-84. Sunday Times (1999), 15 August. Wallace, J.S. (1997), `Àdopting residual income-based compensation plans: evidence of effects on management actions’’, Working Paper, University of California, Irvine, CA. Further reading Bacidore, J.M., Boquist, J.A. Milbourne, T.T. and Thakor, A.V. (1997) ``The search for the best financial performance measure’’, Financial Analysts Journal, Vol. 53 No. 3, pp. 11-20. Biddle, G.C., Bowen, R.M. and Wallace, J.S. (1997), ``Does EVA beat earnings? Evidence on associations with stock returns and firm values’’, Journal of Accounting and Economics, Vol. 24, pp. 301-36. Lee A. and Yeo, G. (1997), `Èvaluating corporate performance’’, SES Journal, pp. 49-54. Modigliani, F. and Miller, M.H. (1958), ``The cost of capital, corporation finance, and the theory of investment’’, American Economic Review, Vol. 48, pp. 261-97. Myers, S.C. (1977), ``Determinants of corporate borrowing’’, Journal of Financial Economics, Vol. 5, pp. 147-75. Sheehan, T.J. (1994), ``To EVA or not to EVA: is that the question?’’, Journal of Applied Corporate Finance, Vol. 7 No. 2, pp. 85-7. Stewart, G.B. III (1990), The Quest for Value: A Guide for Senior Managers, Harper Business, New York, NY. Tully, S. (1994), `Àmerica’s best wealth creators’’, Fortune, Vol. 130 No. 11, p. 143.

Appendix. Computation of WACC WACC is defined as the total returns demanded by debt and equity investors weighted against the proportions of debt and equity employed in the target capital structure of the company. The WACC of the company can be represented as follows: µ ³ ´¶ µ ³ ´ ¶ E D WACC ˆ CE ‡ CD …1 ¡ Tc † D‡E D‡E CEÃ is the cost of equity, CD is the cost of debt, E is total equity employed, D is total debt employed, and TC is the company’s marginal tax rate. Ideally, the cost of debt should be measured for each individual company based on the marginal borrowing rate. Whilst this may be easy for the individual company to establish by seeking a quote from the capital market, it is difficult to determine the marginal borrowing rate because companies do borrow funds from many sources and for different purposes. We, therefore, resort to employing the prevailing prime lending rate as a proxy for the marginal cost of debt across all companies. The company’s after tax cost of debt is estimated by multiplying prime lending rate with one minus the relevant corporate tax rate for the respective year. The cost of equity is computed using the capital asset pricing model (CAPM) as follows: E…Rit † ˆ Rf ‡ it ‰E…Rm † ¡ Rf Š where E…Rit † is the expected cost of equity in year t; Rf is the rate of return on risk-free asset in year t, and it is the systematic risk of the company in year t. The risk free rate is represented by the average interest yield on Singapore Government Securities (SGS) between 1988 to 1999. The annual compounded market return, E…Rm †, is proxied using the SES all share return over the same period. The difference between the annual market return and the risk-free rate, ‰E…Rm † ¡ Rf Š, is the market risk premium. It measures the expected annual compounded return from the market over the risk-free rate. The resulting market risk premium of 4.1 per cent is used for all the years in calculating the cost of equity. The yearly betas of the company are extracted from the Financial Highlights of Companies on the SES, which is computed using a moving window of 60 monthly returns with the return on the SES All Share Index as a proxy of the market index.
