Time to revamp insider boards

Is the fate of corporate giants like WorldCom and Tyco looming at the door of some real estate investment trusts across the nation? It may very well be if REITs don't take a few lessons in corporate governance from their publicly traded brethren.

REITs proved to be solid investments in the last couple of years for many investors. USA Today in the summer of 2002 conducted a study that examines what $1,000 invested at the market's peak (March 2000) would be worth today. The study estimated a real estate fund would be worth $1,501, compared with $639 for an S&P 500 fund and $439 for a Microsoft fund.

Although REIT returns have begun to slide a bit due to deteriorating real estate fundamentals, the sector's dividends still are attractive to investors. The interest in REITs is partly a flight to safety driven by the recent spate of high-profile financial restatements in the corporate world and the perception that REITs are less risky investments.

However, there seems to be a misconception that REIT financial statements are relatively simple and are not subject to the accounting intricacies of other industries. In reality, real estate companies are faced with their own unique set of complex accounting standards. The increasingly complicated accounting and reporting requirements mean that REITs need to have independent and financially savvy audit-committee members.

Historically, insiders have dominated REIT boards. Many real estate businesses were family-owned and operated in tight-knit business circles. When private and entrepreneurial real estate developers suddenly found themselves in the public arena, many continued the insider tradition — staffing their boards with individuals possessing close ties to the business.

While this composition may have sufficed in the past, the Sarbanes-Oxley Act of 2002, which addresses corporate governance issues, and the proposed New York Stock Exchange (NYSE) Corporate Accountability and Listing Standards have major implications for REITs, specifically for the auditing committee, which is one of the standing committees of the board.

Call for Action

To ensure guaranteed financial success, REITs must take a critical look at who sits on their boards. REITs should strive toward three main goals:

Independence — Many REIT boards continue to be dominated by company insiders and real estate industry peers. Due to the nature of the formation of REITs, there could well be a conflict of interest involving contributed assets, such as those dealing with tax indemnification issues during the disposition of assets. Having independent board members would help guarantee that decisions are made in the best interests of shareholders.

Additionally, the standing committees within the boards, such as the audit, compensation and nominating committees, should be solely comprised of independent directors. Most regulations governing board independence include a grace period to take into account board election timelines.

Financial literacy — Independent research and analysis of the Securities and Exchange Commission's Form 10K filings revealed that the selection and disclosure of critical and significant accounting policies are quite diverse, even among companies operating in the same property sector. This raises a concern as to the quality of financial reporting. The growing accounting and financial reporting complexities make having significant financial expertise among audit committee members crucial.

In fact, under rules to be developed and published by the SEC, companies will be required to disclose whether or not their audit committees are comprised of at least one member who is a financial expert, as that term may be defined by the SEC. If a company does not meet this requirement, then it must disclose the reasons for its lack of compliance.

Diversity — A REIT's board members should ideally come from a variety of business professions and possess different areas of expertise. This point is particularly important because a majority of REIT board members initially were from the real estate world. A board of directors needs members from various industries who can contribute skills such as financial management and government relations.

REITs can continue their strong track records if they learn a lesson from the corporate scandals of today. By taking the new act and proposed SEC recommendations seriously, REITs can avoid pitfalls in the future.

Susan Cheng is a senior manager at Gleeson, Sklar, Sawyers & Cumpata LLP, a Chicago accounting and management consulting firm.

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