"This is the publication I recommend
when people ask me what I read"

— Norbert Lou

On Deferred Income

I sometimes entertain myself by reading about businesses associated with the Old World. My latest project is the Crown Estate, which as its name implies, is owned by the reigning monarch of the United Kingdom. The Crown Estate’s chief asset is a large property portfolio in the heart of London, centered around one of the world’s great shopping destinations, Regent Street.

If prostitution is the world’s oldest profession, property ownership may be the world’s oldest business. It certainly is one of the simplest—in its most basic form, everyone agrees that a certain piece of dirt belongs to somebody, who is allowed to charge others to use it for a temporary period of time, according to a contract called a lease, in exchange for payments called rent. The right to earn rental payments in the future gives a piece of property a market value today, although you must also adjust for the expenses associated with owning the property. You can also own a building that sits on top of the piece of dirt, but the same idea applies. Take this basic logic and apply it to some of the most sought-after dirt and buildings in human history, and you have the business model of the Crown Estate.

In its annual financial statements, the Crown Estate marks its property portfolio to its prevailing market value as of each balance sheet date, as determined by an independent property appraiser. I like this practice, because if I were to enter a reverie in which I imagined myself ascending to the throne and assuming ownership of the Crown Estate, I could easily see my wealth as of the end of each year. This process is made even easier by the fact that the Crown Estate is forbidden by law from incurring debt, which means the market value of the assets of the Estate will approximate the value of its equity.

If I were to extend my reverie to imagining my monarchical self as a shrewd investor—I know monarchs are not supposed to spend time thinking about investing; they have others to do that for them—I’d want some sense of how well the value of my ownership might grow over time in the future. To answer this question, I’d first assume that I bought the Estate as of a certain date at its then-market value. Then I’d decompose the analysis of its expected return on investment into three parts:

a) Suppose you bought a bond for its par value of 100 and received annual coupons of 5 until maturity. Your initial yield would be 5 percent, as would your total annual return on the investment (assuming a discount rate of 5 percent). I’d start out by thinking of my property in exactly this way. The purchase price of the property is analagous to the par value of the bond, and the net rental payments after expenses correspond to the coupon payments on the bond. Divide the latter by the former and you have the total return on your “property-bond.”

b) Now suppose this bond you just bought had a magic coupon; rather than staying fixed at 5 every year, it grew a little bit every year. Real estate is like a bond with a magic coupon, because as a general rule, rents do go up a little bit each year. So I’d now think of my property portfolio as a “property-bond” with a magic coupon. It’s easy to see intuitively that the addition of a magic coupon increases the total return of your investment over and above that of a regular bond. And it can be shown mathematically that if your magic coupon grows at a constant rate forever, then the total return on your magic bond would equal the total return on a regular bond plus the annual growth rate of the coupon.

c) Finally, suppose that your magic bond also had a magic par value, which increased over time until its maturity date. Again, real estate works like this too; the value of the capital asset tends to grow as well. Again, the addition of a magic par value also increases the total return on the investment.

To sum up, the expected return on a real estate investement can be decomposed into its initial yield, the growth rate of the annual “coupons”, and the growth rate of the capital asset itself. I’d apply the same thinking to the purchase of any individual property too. I’m sorry if you already know all of this; I need to write down all the steps in order to keep everything straight in my head.

My reverie would be progressing rather nicely at this point. In real life I’m sitting at my computer, reading through the annual report of the Crown Estate. But in my mind’s eye, I’m His Majesty, presiding regnant over my estate as the world’s greatest landlord, and contemplating the future growth of my wealth. A bit feudal, I admit. But just as I’m really getting going, inevitably some accounting wrinkle will show up in the annual report. The arrival of this wrinkle, and my inability to understand it, will annoy me so much that not only does it wake me violently from my reverie, but it will force me to sit there and think hard about it—another thing monarchs are not supposed to have to do—until I figure it out.

The accounting wrinkle in question arises from the fact that the Crown Estate will often lease its properties not for one or two years, which is what most people think of when they think of a property lease, but rather for 99 years—usually in exchange for a large up-front payment called a lease premium. I can get my head around the idea of a 99-year lease and lease premiums. The annoying wrinkle is how these leases are treated for accounting purposes. On page 100 of the Crown Estate’s annual report we’re told the following:

Where a premium is received in exchange for the grant of a long leasehold interest, the premium is taken to deferred income…

What is this deferred income, and why is it created here?

According to Wikipedia, deferred income (also, and perhaps more accurately, known as unearned revenue) is defined as money received for goods or services which have not yet been delivered. It is recorded as a liability until delivery is made, at which time it is converted into revenue. We see deferred income most often nowadays in subscription businesses like magazines and software, in which customers pay up front for something for a year’s worth of the service in question. But it also makes sense in this context. When the Crown Estate leases a property for 99 years, it receives cash today (the lease premium) for a service (the right to use the property) to be delivered in the future, so deferred income is created.

Why is deferred income a liability? The International Financial Reporting Standards Foundation defines a liability as

“a present obligation of the enterprise arising from past events, the settlement of which is expected to result in an outflow from the enterprise of resources embodying economic benefits.”

Applied here, the Crown Estate’s deferred income is its present obligation to provide the right to use its properties in the future, arising from the past event known as the signing of the lease, the settlement of which will result in an outflow from the Estate of the right to use the properties, which right embodies economic benefits.

That’s the accountant’s way of defining a liability. From an investor’s perpective, I’d add that the presence and classification of a liability answers two questions:

1) How did a given asset now owned by the enteprise come to be owned by the enterprise? In other words, who financed this asset? Or more precisely, who besides the equity financier financed this asset, since by tautology assets financed by equity financiers give rise to equity as opposed to a liability.

2) What does this financier-who-is-not-an-equity-financier want in exchange for financing the asset that the enterprise now gets to use?

In most cases the answer is, the financier wants money. But in this case the financier wants the service promised, the right to use the property.

I’d also add that from the perspective of an equity investor, the purpose of a liability is to substitute for equity capital as the financier of an asset of a business. Put another way, the purpose of a liability is to increase an owner’s leverage—defined most simply as the ratio between the assets of an enterprise and its equity capital. Deferred income is a source of “free” leverage. It puts more assets to work for owners’ benefit than they themselves had to invest to create, without requiring anything from them other than to ensure that a product or service is provided in the future. In the insurance business, no-cost float serves the same purpose as deferred income: to leverage the productive assets controlled by an equity investor at low or no cost. Someone figured that out once and did well. Leverage, along with asset turnover and profit margins, is one of the components of return on equity, so all else equal, more leverage produces a higher return on equity.

Although the presence of deferred income, and the free leverage it provides, is generally good for equity investors, you must be careful not to double count. If you’re trying to value a software company, you can count cash financed by deferred income towards your value—as long as you realize you’re borrowing it from the future’s income statement. The Crown Estate represents a special case of this idea, because here all of your future revenue will come directly from capital assets currently carried at their market value on the balance sheet. When you look at the balance sheet, in other words, you’re roughly seeing all future income statements transformed, through the alchemy of finance, into a value as of a certain moment in time. It follows that when the Estate leases a property for 99 years, it’s carving out the first 99 years’ worth of that market value and turning it into cash. The deferred income liability incurred as a result of the lease can therefore be seen as an encumbrance on the market value of the property in exchange for cash. Rather than create leverage, it simply reshuffles asset value from one form to another. This is a somewhat imperfect way of looking at it—an unexpected increase in rents, for instance, would increase the encumbrance without increasing deferred income liability, so a property’s balance sheet value would overstate its true encumbered market value. But for the purpose of my reverie, simply subtracting deferred income from the market value of the property portfolio—treating deferred income like debt, in other words—produces a good rough estimate of the value of the Estate to its owner as of that balance sheet date.

That felt good, but we’re not done yet. Let’s continue that sentence from page 100 of the Estate’s annual report:

Where a premium is received in exchange for the grant of a long leasehold interest, the premium is taken to deferred income and released to revenue in the capital account column over the life of the lease.

I understand the “released to revenue part”—the deferred income balance is amortized over time as the service that gave rise to it is provided by “releasing” it to revenue. But what is this “capital account” business?

It turns out that while the Crown Estate is formally owned by the monarch of the United Kingdom, it is structured as a trust. The “corpus” of the trust—the productive assets of the Estate—is owned by the monarch. But, the annual income generated by those productive assets is considered the property of the British people, and is paid out annually to the treasury (although some of it does finance the annual expenditures of the monarchy). According to this logic, if the Estate sells an asset, the cash proceeds are considered part of the corpus, and must be retained by the Estate and reinvested in new property, while net rental income, as well as interest earned on cash balances, must be paid out to the people.

I think this trust structure serves two purposes. It allows Britons to preserve the idea of themselves as a people who respect private property and would never stoop to nationalizing it like some other countries love to do, even if said private property can never actually be monetized by the monarch who “owns” it. And, perhaps more importantly, it does what trusts are designed to do, which is prevent the present from stealing from the future. By forcing sales proceeds to remain in the trust and be reinvested for the benefit of future Britons, the trust structure prevents a wholesale liquidation of the estate for the purpose of spending in the present.

In order to keep track of what belongs to the people and what belongs to the monarchy, the Crown Estate divides its accounting statements into an income account and a capital account. All activities in the income account bear on the amount that will be paid to the treasury in any given period, while all activities in the capital account bear on the reshuffling of assets belonging to the monarch.

So far so good, but here comes another accounting wrinkle. On page 99 of the annual report we’re told that

any sum received by way of premium on the grant of a lease shall be carried to the income statement if the lease is for a term of 30 years or less and to the capital account if the lease is for a term exceeding 30 years.

Why are short-term leases treated as income and long-term leases treated as “reshuffling assets”?

Recall our earlier idea that a property business, in its simplest form, is a legally defined piece of dirt that others will pay for the right to use, and that the asset value of such a property is simply the present value of the future payments.

Conceptually, you can “cash in” the value of such a property in one of two ways: you can either wait for a given rental payment to occur at its appointed date and pocket it, or you can bring forward a future payment into the present, through the alchemy of finance, and pocket it. Or you can do some combination of both. There is, in other words, a kind of cash-time continuum.

(One interesting property of this cash-time continuum is that as you own a property through time, its asset value does not decrease even though it’s constantly throwing off its rental payments at their appointed time. These rental payments are like solar flares. (You can also invert this idea by saying that in order to maintain its value over time, an asset must continuously throw off these solar flares, or else asset value will diminish).)

If you do the former—ie wait for rental payments to occur—this accords with what we humans think of as “income,” a flow of payments in time. At the other extreme, if you bring all future rental payments forward into the present, that corresponds to what we think of as a “sale.” The tricky part is: what do you do with something in between? What if you bring forward some but not all of the future rental payments via a lease premium?

The answer, it seems to me, is that there is no “right” answer. There is no magic moment at which “income” turns into “sale.” There is, as I said above, a continuum. So accounting rules sort of split the baby at 30 years.  The specific rule is less important than the spirit of the trust, which is to ensure that the present does not rob from the past, and that value is paid out from the trust only at its proper time and not before. In other words, if the Estate were allowed to enter into 29.999-year lease for a large lease premium, and then dividend all of the lease premium amount right after signing the lease, that would violate the spirit of the trust—it would be a ” premature sale” of a chunk of the asset, some of the cash flows of which rightfully belong to the future. But I don’t think the Estate is allowed to do this in reality, even if according to the accounting rules such lease premium is taken to the income account.

Thus ends the lesson. I’ll confess I spent a lot of time thinking through these issues, perhaps too much time when I consider how rare it is to encounter things like 99-year leases and capital accounts out in the wild. But upon some reflection, I don’t think I wasted my time. It’s been said that in investing, all knowledge is cumulative, and I certainly agree with that. I’d add that all knowledge is also connected, so that if you get smarter about one little area, you’re getting smarter about everything else, even if you don’t realize exactly how at the time. Finally, I’d venture to say that most new knowledge in investing proceeds remarkably easily from about 20 or so piece of “old” knowledge—technical concepts that you have to force yourself to learn and then master, but which form the foundation of everything else you’ll learn—indeed, you’ll see that everything new is actually an application of something old, wearing slightly different clothes.

Based on my experience, this last point is underrated. I sometimes think investors spend too much time increasing the breadth of their understanding—”Today I’ll learn about the oil industry, tomorrow I’ll learn about the banking industry, the next day I’ll learn about China, etc., and then when I put together the Powerpoint presentation describing my hedge fund, it will say ‘extensive experience investing in oil, banking, and China’”—and not enough increasing the depth of their understanding, especially of these fundamental concepts upon which everything else depends. I’ve yet to see anyone advertise how much time they spent figuring out the purpose of a liability from the perspective of an equity investor, or that they came up with this thing called the “cash-time continuum” (I’ve yet to see anyone else advertise this, I should say!). But I think it’s worth doing nonetheless. One of the paradoxes of brainwork is that if you want to go wide, the best thing to do is often go deep.

Another paradox is that the best way to end up wise and profound is to start out foolish and silly, even if it means pretending to be the King of the United Kingdom. Hard thinking is hard work; these little reveries are the spoonful of sugar that helps it go down.