Inês Pinto ERES 2010 – Doctoral Colloqium SDA Bocconi – School of Management, Milan, Italy 23rd-26th June 2010 Supervisor: Professor João Duque Managerial Discretion in the Real Estate Sector: An Empirical Evidence

22 RESEARCH OBJECTIVE The aim of this study is to analyse if managerial discretion is associated with management incentives to avoid negative fair value changes. On the other hand, we also attempt to determine which fund-level factors can influence such behaviour.

33 RESEARCH OBJECTIVE In order to determine the value of the property for subscriptions or redemptions, fund managers may choose any value between the acquisition cost and the average of the appraisal values attributed by two independent appraisers with a minimum periodicity of two years. We predict that fund managers have the opportunity to control the financial information throughout the timing of the recognition of the unrealized gains that arise from fund assets.

44 MOTIVATION/CONTRIBUTIONS Portuguese real estate investment funds represent an opportunity to investigate the executive behaviour regarding accounting choice in a sector particularly sensitive to managerial discretion. The results enhance our understanding of the concept of conservatism in a different context. Managerial discretion may incentive fund managers to have a less conservative attitude regarding accounting choices. This research examines the importance, quality and attributes of financial information in the real estate sector. This research can also supply relevant evidence to the question of transparency of non-listed real estate vehicles compare to the public real estate sector.

55 PRIOR RESEARCH Managerial discretion is defined as the latitude of options that top managers have in making strategic choices with impact on organizational outcomes (Hambrick and Finkelstein, 1987). Managerial discretion is influence by three sets of factors: task environment, the organization's internal forces and the managerial characteristics of the executive himself. Despite some limitations, our work seek to represent an empirical application of managerial discretion in a specific context.

66 PRIOR RESEARCH Conservatism principle is captured by the accountants tendency to recognize “bad news” more quickly than “good news”, being the unrealized losses typically recognized earlier than unrealized gains. (Basu, 1997). Earnings management literature suggests that managers strategically exercise managerial discretion in order to avoid earnings decreases, earnings losses or negative earnings surprises (Burgstahler and Dichev, 1997; Degeorge et al., 1999; Matsumoto, 2002 and Burgstahler and Eames, 2006).

77 HYPOTHESIS DEVELOPMENT Hypothesis Development Managerial discretion in real estate investment funds (REIFs) is associated with management's incentives to avoid the recognition of negative fair value changes of properties.

88 RESEARCH DESIGN In order to test our hypothesis, we develop a research design similar to Burgstahler & Dichev (1997) and Degeorge et al. (1999) based on the analysis and comparison of the distributions of asset value changes fixed by fund managers and those recommended by appraisers. Therefore, we develop a variable called RDIF – Return Rates Difference in order to estimate the discretionary behaviour of fund managers: RIMP it is the annual rate of return implicit in two sequential appraisals at the beginning of the year for property i. RA it represents the annual property market value rate of return fixed by fund managers for year t for the same property i.

99 RESEARCH DESIGN If the value of RDIF is negative, then we can conclude that the market value increment fixed by fund managers is higher than the return estimated by appraisers. Negative values of RDIF indicate situations where fund managers are less cautious or prudent in unrealized gains recognition than appraisers´ recommendation. Therefore, if our hypothesis hold, we expect to observe a high frequency of negative RDIF.

10 RESEARCH DESIGN To verify if fund managers effectively use their discretion to avoid the recognition of properties depreciation recommended by appraisers, we conduct a regression of RA on RIMP in line with Basu (1997) model for accounting conservatism. Properties depreciations recommended by appraisers (RIMP<0) are classified as “bad news”, while properties appreciations are recognize as “good news”. RA it represents the asset value change fixed by fund manager; RIMP it is the asset value change recommended by appraisers; DRIMP it is a dummy variable with the value of 1 when there is a bad news (RIMP<0).

11 RESEARCH DESIGN According to our hypothesis, the slope coefficient from regression of RA on RIMP is expected to be lower in the case of bad news sample because managers will be less sensitive to this type of appraisers recommendation. 11

12 RESEARCH DESIGN Finally, in order to investigate which fund characteristics can influence the managers discretion, we seek to conduct a logit regression modeling the probability of our variable RDIF being negative for a specific property: NEG is a dummy variable with a value of 1 for observations with a negative RDIF and 0 for other observations and X is a set of factors that could potentially influence the probability of RDIF being negative (rented vs not rented, type of fund for example).

13 PRELIMINARY RESULTS Sample, Data and Variables –Real estate investment fund data was obtained from Portuguese Securities Market Commission (CMVM – Comissão do Mercado de Valores Mobiliários); –The final sample includes property-year observations between 2003 and 2008; –14 open-end REIFs and 137 closed-end REIFs

14 PRELIMINARY RESULTS Descriptive Statistics: Both the annual return fixed by fund managers (RA) and the annual returns implicit in appraisal estimates (RIMP) present a relatively stable distribution during the sample period, being the sample mean of RA (0.73%) slightly lower than the sample mean of RIMP (0.70%). Appraisal estimates register a higher variability with an inter-quartile range of 2.67% vs 0.47% for property annual returns, suggesting that appraisers seem to adjust their estimates more quickly than fund managers. In 2008, we can observe a substantial decrease in both returns, being the sample mean return implicit in appraisal recommendations of 0.12%, evidencing the ongoing period of turbulence of financial markets.

15 PRELIMINARY RESULTS (ii) Incentives of managerial discretion If fund managers use their discretion to strategically manage asset value changes, we expect that manager’s asset revaluations exceed appraisal estimates. Histogram for Return Rate Difference – RDIF

16 PRELIMINARY RESULTS We can observe more frequent negative scores of RDIF (positively skewed). Statistical test similar to Burgstahler & Dichev (1997) evidences that negative scores of RDIF occur more frequently than would be expected given a smooth distribution (the standardized difference for the two intervals immediately to the left of zero is 4.0 and 2.6). Therefore, we have some evidence that the asset value changes fixed by fund managers seem to be higher than appraisers´ recommendations in the intervals near zero.

17 PRELIMINARY RESULTS To examine the distribution of RDIF conditional on annual return implicit in appraisal estimates (RIMP), we sort observations on the variable RIMP to form equal-sized portfolios of 475 observations per portfolio. Some of the results can be observed in the following table: Descriptive Statistics of RDIF´s portfolios formed by the sign of variable RIMP We can observe that for the first portfolio to the left of zero, despite the negative valuations of appraisers (mean of RIMP is -0.15%), the mean of RA is of 0.61%. 17

18 PRELIMINARY RESULTS We also computed the percentage of negative values of our variable RDIF for each of the years of our sample, together with the annual capital growth of the Portuguese IPD index. We report the results in the following table: Despite the low number of observations available, we observe a negative correlation between the percentage of negative RDIF and the Portuguese IPD index. 18 Temporal trend of the percentage of negative RDIF

19 PRELIMINARY RESULTS The results from the regression about the asymmetry of timeliness in asset value changes recognition are presented in the following table: Pooled Regression of RA on RIMP According to our expectation β 3 is negative. This coefficient measures the impact of bad news relative to good news in the property capital return fixed by fund managers (RA). 19

20 PRELIMINARY RESULTS (ii) Incentives of managerial discretion We predict that managerial discretion become stronger for properties that are not rented. We conduct similar tests dividing our property sample into two subgroups: property rented and not rented. Histogram for Return Rate Difference – RDIF for Rented and Not Rented Properties 20

21 PRELIMINARY RESULTS Nevertheless, results do not confirm our prediction. We also conducted splitting the sample into open-end and closed-end funds. However, we were not able to see any significant difference in fund managers´ behaviour. The weak evidence in finding factors that can motivate fund managers´ behavior can be related to other determinants not included in this first analysis. Therefore, we seek to perform the logit regressions in order to modeling the probability of RDIF being negative. 21

22 CONCLUSIONS Our results suggest that fund managers are less cautious or prudent in unrealized gains recognition than appraisers´ recommendation. There is evidence of an asymmetry in the timeliness of asset value changes recognition. When appraisers recommend depreciating a property (“bad news”), fund managers seem to postpone the recognition of this information.

23 FURTHER RESEARCH Investigate if fund managers use this discretion opportunistically in order to increase fund performance. Based on a fund-held sample, we test different hypothesis to examine if fund characteristics as fund type, dimension or fund vacancy rates can stimulate the management of net asset value. After modeling how annual revaluations increments of funds properties would be reported in the absence of earnings management, we estimate a discretionary accrual proxy as the difference between the reported revaluation increment and its expected value obtained by the model. Analyze the possible economic implications of fund managers behavior. Compare the use of this hybrid accounting system with the adoption of a fair value method.