09 Jul REIT’s, IFRS 9 and COVID-19 – much more than an alphabet soup
By Laurence Milner
COVID-19 has had a significant impact on IFRS 9 with ECL% spikes by between 3-6 times in certain categories in the last few months. This has impacted the property industry in the key areas of rental arrears, intra-group loans, guarantees and loan covenants. In this article i9 Partners look at the new challenges relating to trade receivables and some appropriate solutions.
REIT’s and other commercial property owners have up until now not had to pay too much attention to trade receivables when considering IFRS 9. COVID-19 is changing all that as rental deferrals and arrears result in new categories of receivables on their balance sheets. These may now be material and carry very different credit risks from the past.
What new challenges does the property sector face?
Rental arrears and deferrals and the strain on tenants’ businesses are resulting in receivables becoming a much larger balance sheet item and their risk rising too. By their nature they are past-due, high risk and will require material Expected Credit Losses.
The debtors are new, and the cause of the debts is new. This means that history cannot be relied upon as an indicator of current and future risk. IFRS 9 requires that ECL’s are measured with reference to internal history or external models that have been created on relevant data – in other words if you do not have a relevant internal history, which very few are at the moment, you need to rely on a model that has been created using data that is applicable to your population.
To meet this challenge i9 Partners has developed a methodology to measure the ECL’s on rental debtors. It makes use of a combination of measuring the risk on specific tenants with larger exposures and the application of industry and sectoral risk measures to the remainder. These are then converted to forward looking ECL’s using credible credit risk models and macro-economic forecasts that include the impact of COVID-19.
How to measure the credit risk on a loan or tenant’s balance
The tools we apply include a Moody’s Analytics model that quantifies probability of default and loss given default from a company’s financial statements. This model was built on a database of over 100,000 South African companies’ financial statements, many with several decades of history. The model includes Moody’s Analytics experience in many major shock events across the world over the past decades and their impact on credit risk.
As part of the rental reduction and deferral process, some landlords have been able to, or can still, request financial statements from tenants. A company’s financial statements provide a very meaningful basis to measure their credit risk. We also have access to credit risk measurement on listed companies and sector average credit risk scores which can form a justifiable basis from which judgemental adjustments can be made.
The use of verified macro-economic forecasts and a model of their relationship to credit defaults and losses.
The final piece of the toolset is a verified set of macro-economic forecasts and multiple scenarios produced by Moody’s Analytics as well as their proprietary credit risk models to convert historical loss information into the forward-looking measure of an ECL.
A single factor, like GDP or interest rates, very seldom explains changes in credit risk by themselves and attempts to do so often result in materially incorrect ECLs. That is why the Moody’s Analytics’ multi-factor model with their vast SA and global database of default history is so widely used by major banking institutions, and trusted by auditors, to perform this function.
In these times of uncertainty, measuring future expectations is fraught with the risk of material inaccuracy. Our approach to measurement of ECL’s on rental debtors is based on minimising subjective judgements and using sound and justifiable principles which result in a defendable result. As more REITs go through this process with us, it broadens and strengthens our anonymised benchmark data at property sector, tenant industry sector and geographic risk level which increases certainty and reduces the ECL measurement cost.
Want to know more?
We have extensive experience working in the REIT and property industry and will be happy to discuss any questions you have. Contact us on email@example.com or complete our online assessment form for a no obligation assessment on which financial assets should require ECL calculations and their impact on your financial statements.