Background

1. The Department of Defence (Defence) operates one of the largest real estate portfolios in Australia, comprising both owned and leased property. Leased property has significant expenditure implications for Defence. Defence leases approximately 350 properties with annual rental commitments in the order of $80 million. Lease rental commitments over the initial lease term for those properties are in the order of $1 billion (exclusive of Goods and Services Tax (GST)). Ten of these leases have resulted from the sale of property from the Defence Estate with leaseback arrangements to the Government, represented by Defence. Properties sold and leased back comprise five office properties, two industrial properties, two residential properties and one training college.¹

2. The sale and leaseback of Defence property commenced in 2000-01, following a joint review of the Defence Estate by Defence and the Department of Finance and Administration (Finance). Sales from the Defence Estate were pursued to contribute to the Budget outcome and to accord with Government policy on property ownership.²  Proceeds from property sale and leaseback transactions, up to a target set through the Budget process and based on estimated sale proceeds, were required to be returned to the Budget. The first two sale and leaseback processes were managed by Finance. Subsequent sale and leaseback processes were managed by Defence.

3. Sale proceeds from properties sold and leaseback by Defence amount to $594 million, of which the six properties reviewed in the audit account for $472 million. In 2003-04, Defence paid $46.4 million in rent for these six properties which amounted to approximately 60 per cent of Defence's property rental payments in that year. The rental commitment over the initial lease period for the six properties reviewed in this audit is $604 million. Should Defence exercise the option periods in the six leases then the rental commitments would amount to $1.2 billion.

4. The range of responsibilities retained by Defence in the leases for properties sold and leased back by Defence, are broader than those assumed under standard expenditure leases where Defence is lessee of the property. This is particularly the case for the three leases reviewed covering whole of land and building, namely Campbell Park Offices, the Defence National Storage and Distribution Centre (DNSDC) Moorebank and the Australian Defence College (ADC) Weston Creek. Property management services, including for leases, are outsourced to an external provider under the Property Services Contract.

Audit approach

5. The objective of the audit was to examine Defence's management of leases that have resulted from property sale and leaseback transactions. Leases subject to review were for a period of ten or more years and included the following six properties: the Defence Plazas in Sydney and Melbourne; the Hydrographic Office Wollongong; DNSDC Moorebank;³ Campbell Park Offices in Canberra; and ADC Weston Creek in Canberra.

6. The audit examined the process for identifying the properties for sale and leaseback and the sale approval process. The audit sought to determine the basis on which the properties were proposed for sale and leaseback and the financial impact for the Government. The audit also reviewed the lease terms and conditions to determine whether they protect the Government's interests, and examined Defence's management of commitments arising from the leases.

Key findings and conclusions

Financial management

7. The decision to approve complex financial transactions should consider the component parts of the transaction. The transactions reviewed in the audit comprised both a decision to sell property and a decision to enter into a contract for a long-term leaseback arrangement with commitments spanning 10 to 20 years.

8. Following the identification of properties for possible sale and leaseback from the joint review of the Defence Estate by Defence and Finance, Defence undertook to base the sale and leaseback program on cost-effective business cases over time. The outcome of the review commissioned by Defence and completed on 6 March 2000 was that the Government would be better off retaining ownership of the properties in all cases. The review report to Defence did not apply the principles endorsed by Government on property ownership as it stood at the time. The Government had decided in 1996 that the Commonwealth should retain ownership of property if it met a hurdle rate of return of 14 to 15 per cent, or if it was otherwise in the public interest to retain the property. Finance engaged a consultant on 8 March 2000 to review the report to Defence. The report to Finance applied Government policy on property as it stood at the time and supported divestment of all of the properties for the preferred lease terms by applying the higher hurdle rate of 14 to 15 per cent included in the Commonwealth Property Principles (CPPs) in its analysis.⁴

9. The Government agreed in April 2000, in the context of the 2000-01 Budget process, to the sale and leaseback of the Defence Plaza properties in Sydney and Melbourne, the Hydrographic Office Wollongong and DNSDC Moorebank.⁵ The business case methodology supporting the submission to Government by Finance and Defence to the properties proposed for sale and leaseback in 2000 01 was an assessment of the consistency of the transaction with the CPPs.⁶ Defence's objective was to implement the Government's property disposals program and to meet revenue targets. Defence advised ANAO that it ‘implemented the sale and leaseback of the properties in line with these Government decisions.'

10. The Government's financial framework provides that financial transactions should represent efficient and effective use of resources in addition to complying with Government policy. Where these two requirements are, or may be, inconsistent it is sound administrative practice to inform Minister(s) of the inquiries undertaken and seek their consent before proceeding with the transaction.

11. The business case analyses prepared for the properties were based on hypothetical lease terms and commencing rentals, prior to the approval of actual lease terms and conditions to be put to the market. The analyses were not updated by Defence to reflect actual rental and estimated sale proceeds prior to the sales and Defence did not make due inquiries required under legislative provisions of the Financial Management and Accountability Act 1997 (FMA Act).⁷

12. In the absence of such analysis, ANAO examined the value for money of the transactions by comparing rental payments with sales revenue. ANAO determined the implication of selling and leasing back property on a long-term basis was that, at the point of execution of the sale and leaseback transaction, the Government would be paying more to lease four of the properties than it could gain from applying the sale proceeds to paying off debt or from investing the funds in Reserve Bank of Australia (RBA) term deposits. This applied to the leases for the Defence Plaza Melbourne, the Hydrographic Office Wollongong, Campbell Park Offices and ADC Weston Creek.

13. Significant rent increases have since resulted from the application of market related rent review processes for the two Defence Plaza properties in the context of buoyant commercial property markets, and a redefinition of the area leased at the Defence Plaza Melbourne property for security reasons. Two years into the lease terms, the rent had increased by 23 per cent from the commencing rental for the Defence Plaza Sydney, and by 43 per cent for the Defence Plaza Melbourne. The major component of the increases arose from the 1 July 2003 rent review to market which resulted in rent increases of 19 and 33 per cent respectively for the Sydney and Melbourne office properties. Analysis taking account of the actual rent review outcomes to date for the Defence Plaza properties indicated funds invested from those sales are likely to be exhausted by the rental commitments during year 10 in the case of Defence Plaza Sydney and year 8 in the case of Defence Plaza Melbourne.

14. In October 2004, Defence implemented a revised process for the disposal of Defence property requiring detailed business case analyses to form the basis of disposal decisions. Future sale and leaseback transactions will require a value for money assessment by Defence officials to arrive at a detailed business case. This process will accord with sound administrative practice for the sale of property and the entering into contractual commitments under a lease.

15. ANAO did not find evidence within Defence of approval for the commitments arising from expenditure payable under the six leases. Documentation reviewed indicated that Defence considered its financial exposure in property sale and leaseback arrangements would be mitigated by the provision of Budget supplementation for rental commitments and statutory charges payable under the leases. Defence advised ANAO in March 2005 that procedures have now been put in place to ensure that statutory approvals are formally obtained and documented.

16. Five of the six property leases reviewed in the audit have been classified by Defence as operating leases for accounting purposes. Subsequent to the sale process, Defence reclassified the lease for the ADC Weston Creek property as a finance lease in the reporting of Defence's financial position for 2003 04.

Lease management

17. Payments transacted in 2003-04 under the leases for the six properties reviewed were assessed by ANAO to be consistent with lease obligations, including rental commitments which accorded with rent review provisions.

18. Benchmarking activities documented in the 2003-04 and 2004-05 Business Plan for Property Management Services have progressed slowly. The Property Management Contractor undertook to benchmark the Defence property portfolio against comparable properties within its client base which has yet to occur. ANAO considers the establishment of appropriate benchmarks for property operating costs would serve as a useful comparator for the costs of occupying leased property by Defence.

19. The management of the breadth of lease responsibilities assumed by Defence in the leases reviewed is spread across a number of areas within Defence, with some of the services provided in-house and some outsourced via service contracts. ANAO considers there is a need for lease management responsibilities to be clearly defined within Defence.

20. The Property Services Contract was market tested by Defence through the conduct of a competitive tender process in 2002-03. The incumbent service provider was awarded a new contract commencing from 1 July 2003 for a term of four years with options for extensions of up to a further four years. ANAO found that the tender process was effectively managed and the resulting contract addressed problems identified in the previous contract and reported in ANAO Audit Report No.58 2000-01, Defence Property Management.

21. The current Property Services Contract has improved linkages between the assessment of Contractor's performance against Key Performance Indicators (KPIs) and the payment for services. However, the review of Contractor performance for 2003-04 had not been finalised at the time of the audit to determine the Contractor's eligibility for incentive payments. While the contract includes performance criteria that have been developed down to a task level, those measures were found by ANAO to have little utility given that performance reporting is based on general high-level KPIs. ANAO did not evidence the conduct of audits or spot checks of processes performed by the Contractor or of documentation held by the Contractor, as provided for under the contract.

Commitment management

22. ANAO found that a comparison of the terms and conditions of the Commonwealth National Lease (CNL)⁸ with the lease for Campbell Park Offices highlighted the extent of the lease obligations Defence has committed to as lessee. Under the CNL the only lessee obligation for repair and maintenance relates to the interior of the property occupied. In the Campbell Park Offices lease, Defence has assumed the additional obligation to maintain building services, plant and equipment. While not commercial office properties, the leases for ADC Weston Creek and DNSDC Moorebank also impose similar repair and maintenance obligations on Defence. It is not common practice for Defence to assume such repair and maintenance commitments in expenditure leases negotiated by Defence. In addition, Defence has assumed responsibility for environmental remediation over the lease term for the DNSDC Moorebank property.

23. The Defence Estate Management System (DEMS), which stores information on lease repair and maintenance commitments, has not been entirely effective in assisting in the ready identification of lease related responsibilities of Defence and property owners. Defence advised ANAO that an upgrade to that system is scheduled to commence in March/April 2005.

24. The property leases reviewed do not include performance standards for completion of property owner repair and maintenance obligations. Defence has advised that the absence in the leases of required turnaround times for the owner's completion of referred works has been noted for future improvement.

25. The leases provide for Defence to notify the property owners of its requirements relating to security and confidentiality at its absolute discretion. The owner is required to comply with those requirements, thereby providing Defence with adequate control over security of the properties. The security arrangements in place prior to sale generally did not change with the passing of ownership of the properties to the private sector. As well, the lease terms and conditions provide for any revised arrangements to be put in place if required by Defence and for those requirements to be followed by the owner. A shortcoming in security at the Defence Plaza Melbourne property has been addressed through a lease variation. The variation revised the definition of the space leased by Defence to include additional space on the ground floor, and necessarily resulted in an increase in rental payments for the property.

26. ANAO found that there was a lack of effective administration by Defence of the insurance for properties sold and leased back by Defence, to ensure that insurance coverage remained consistent with the terms and conditions of the leases. Neither Defence nor the Contractor for property management services held copies of current insurance policies for the properties reviewed.

27. Procedures were not followed by Defence for the inclusion of indemnities in lease documentation resulting from property sale and leaseback transactions. There was no evidence that indemnities provided in the leases were taken into account in considering value for money of the sale and leaseback transactions. Risk assessments were not performed prior to execution of the leases; and legal advice was not obtained as to whether risks covered by those indemnities would be included in the general indemnity insurance held by Defence with Comcover. Following audit review, Defence has now recognised in the Defence Indemnities Register its liabilities for indemnities arising from these leases.

Overall audit conclusion

28. The sale of the six properties reviewed was consistent with annual Defence property sale programs approved by the Government through the Budget process. ANAO analysis indicates that the Government's total rental payments over the lease terms, and the opportunity cost of making those payments, in relation to four of the six properties reviewed, could be greater than the return that could be generated from investing the sale proceeds over the lease terms. For all properties other than the Defence Plazas in Sydney and Melbourne, the annual rent increase is 3 per cent over the term of the lease. A combination of percentage rent increases and market rent reviews have imposed significant rent increases for the Defence Plazas, Sydney and Melbourne. Since commencement of the leases, annual rent for these two properties has increased by 23 per cent and 43 per cent respectively.

29. ANAO assessed that the tender process for the provision of outsourced property management services from 1 July 2003 was effectively managed; and sound contractual arrangements have been put in place for the financial management of expenditure leases and the management of performance by the contractor. ANAO identified scope for improvement in the measurement of contractor performance.

30. ANAO found that Defence's management of leases resulting from property sale and leaseback transactions has generally been effective. Defence has implemented revised procedures, effective from October 2004, requiring business case analyses to be prepared as part of the property disposal process, including for properties to be sold and leased back.

31. The terms and conditions of the leases for properties sold and leased back by Defence were generally found by ANAO to be more extensive than those included in standard Defence expenditure leases based on the CNL in the case of three properties where Defence leases the whole of land and building. To varying degrees across the properties, Defence has retained responsibility for repair and maintenance and other property related costs including for energy and insurance. Defence has not effectively managed, nor reported on, the risk exposure assumed by the Government from indemnities included in the leases.

Agency response

32. The ANAO made three recommendations aimed at improving Defence's management commitments arising from long-term property leases. The Department of Defence agreed with those recommendations.

Footnotes

1 Office properties include: Defence Plaza Sydney; Defence Plaza Melbourne; Hydrographic Office Wollongong; Campbell Park Offices; and the Royal Edward Victualling Yard Pyrmont. Industrial properties include the Defence National Storage and Distribution Centre Moorebank and the Logistics Facility Winnellie. Residential properties include Lady Gowrie House Bondi and Endeavour House Coogee. The training college is the Australian Defence College Weston Creek.

2 Properties considered to contribute directly to Defence capability are retained on public interest grounds. Surplus property, not required for capability purposes, are considered for disposal.

3 DNSDC Moorebank is the largest single warehousing and distribution centre for Defence inventory.

4 A hurdle rate is the minimum return an investor requires from holding or acquiring an asset. A hurdle rate of 14 to 15 per cent was included in the CPPs in July 1996. The hurdle rate has subsequently been revised down to 11 per cent in May 2002 and to 10 per cent in July 2004.

5 The Government agreed in the context of the 2001-02 Budget to the sale and leaseback of Campbell Park Offices and ADC Weston Creek.

6 In relation to the sales managed by Finance, Internal Rate of Return (IRR) calculations were performed prior to approval of the sale of the Defence Plazas in Sydney and Melbourne to determine consistency with policy. An IRR is the discount rate at which an asset has a net present value of zero. The IRR is compared to the CPP hurdle rate to determine whether a property should be sold or retained.

7 Under FMA Regulation 9, a decision to spend public money must not be approved unless the approver is satisfied, after making such inquiries as are reasonable, that the proposed expenditure:

a) is in accordance with the policies of the Commonwealth;

b) will make efficient and effective use of the public money; and

c) if the proposal is one to spend special public money, is consistent with the terms under which the money is held by the Commonwealth.

8 The CNL was developed by Australian Government Solicitor (AGS) to provide a benchmark for the acquisition by lease of commercial office accommodation for Government agencies. The CNL has been designed to produce a balanced allocation of risk between the property owner and tenant. Defence has developed a standard lease based on the CNL.