Croesus Retail Trust

[gzbkel]

Hi Nick, thanks for pointing that out.
After checking, I realized that tax from fair value property gains are only payable when the properties are sold and the gain realized.
Until then, it stays as deferred tax liability, which is non-cash.

[white collar]

Japan has perhaps the most advanced technology quake-proof technology in the world, however, Saizen REIT was the worst J-REIT affected by the 2011 8.9 magnitude earthquake with 15% of its portfolio damaged.

Has anyone previously done an analysis on the implications of a major earthquake on affected J-REITs valuations? Up to what extend will they be able to withstand it? How have investors taken comfort in this?

That said, I am thankful that there are no natural disasters in Singapore. This is something we.. or at least I tend to take for granted.

[gzbkel]

I digged out some info about earthquake risk from public information, and will share it here.
However, I am no expert, so I look forward to any better interpretion.

First, I created a map that marks the location of the malls that CRT owns.
https://www.google.com/maps/d/edit?mid=z...WnvX7hRa0Y

Next, compare the map with the attached image, which shows all the active faults near cities in Japan.
You will notice that out of the 7 properties, 5 are located on active faults.
The two exceptions are ONE'S MALL in Chiba and Aeon town Moriya in Ibaraki. Not very reassuring.

Next, I check this site to find out the strength of the ground that each property is sitting on.
https://supportmap.jp/#14/33.6485/130.4984

AEON Town Moriya: No data (Surrounding is "Normal")
AEON Twon Suzuka: "Weak"
Croesus shinsaibashi: No data (Surrounding is "Weak")
Croesus Tachikawa: "Moderately strong"
Luz Omori: "Weak"
MALLAGE SHOBU: No data (Surrounding ranges from "Weak" to "Normal")
ONE'S MALL: "Normal"
TORIUS: No data (Surrounding is "Normal")

Quite a mixed bag.

Also, as mentioned, Tokyo is overdue for an major earthquake, with some experts predicting a 70% chance occurrence over the next 4 years. Assuming a 7.0+ magnitude earthquake, they estimate 11,000 deaths.
This affects the 3 Tokyo properties as well as the two nearby in Chiba and Ibaraki.

Looking at the AR, I note that all the properties are built after 1981, which means that all conform to the latest major revision of the Japanese building code, the so-called shin-taishin.

According to the following website, this means that 
"For the often occurring mid-size earthquakes (magnitude 5~7), the building should suffer no more than a slight amount of cracks and should continue to function as normal. For the rare and large earthquakes with a magnitude 7 or higher and a Shindo scale of upper 6 or higher, the building should not collapse. - See more at: http://japanpropertycentral.com/real-est...DLcGP.dpuf"

http://japanpropertycentral.com/real-est...-in-japan/

So perhaps we can reasonably assume that none of the properties will collapse in a major quake, but repairs may be necessary. In the worst case, the building may become uninhabitable and need to be rebuilt.

Regardless of the state of the buildings, business will be badly affected for weeks due to traffic disruption.
In the longer term, consumption may be reduced for months as the population get depressed and go into mourning mode like what we see after the touhoku earthquake.

(Not vested but considering)

[sykn]

Wow, this is a known-unknown-known risk. We know that it has happened before, but we don't know when it's going to happen again, and if it happens then we know that the impact on CRT is going to be bad!!!!!
Thanks for sharing your analysis; now what should we do???

[Nick]

It must be noted that bulk of CRT properties are on long term master leases so it is spared from the ebbs and flows of retail demand.

I don't think it is highly likely for an entire building to be destroyed in the earthquake. If there was a high chance, I believe lenders who force them to take up insurance. There is some probability benchmark IIRC.

The interesting bit is that J-REITs are trading at 2-4% yield despite facing the exact same risk.

(Vested)

[tanjm]

Well, if you recall, the actual economic impact to saizen Reit in 2011 was quite small.

[gzbkel]

The interesting bit is that J-REITs are trading at 2-4% yield despite facing the exact same risk.

I find it strange that investors consider 2-4% yield as adequate compensation for the risks. Could be a case of home bias, which Japanese investors are known for.
If we look at the chart on this page, the average yield for Jreits for the past 15 years is about 5%.
http://jreit-view.ares.or.jp/jreit_e/JRV002.html
So the current 2-4% may be considered rather compressed even for Japan standards.

Besides natural disaster, I am also concerned about the effects of rising borrowing cost. It was mentioned that CRT's debt cost is 1%. According to AR2015, the interest cover is 3.8, so if debt cost rises by 1% to 2%, the interest cover will be halved to less than 2.
Granted, CRT fixes borrowing cost using swaps, but that would not help if rates stay high for years.

With Japan's high Debt to GDP ratio, aging population, Feds rising rates, etc, I think borrowing cost will rise.
CRT seems like a good buy now, but the longer term outlook is rather murky.

[gzbkel]

I don't think it is highly likely for an entire building to be destroyed in the earthquake. If there was a high chance, I believe lenders who force them to take up insurance. There is some probability benchmark IIRC.

Found more information about earthquake impact from Prospectus.
None of the properities held during IPO were insured.

The industry practice in Japan is to procure earthquake insurance for retail properties only where
the Probable Maximum Loss for a property is in excess of 15%. None of the Properties have a
Probable Maximum Loss in excess of 10%. As a result, CRT has not procured earthquake
insurance for the Properties.

The prospectus also includes the estimated Probable Maximum Loss (PML) for the initial properties. The value ranges from 1% (AEON Moriya) to 7.2% (AEON Suzuka).

Current prediction of major earthquake (7+) in Tokyo is:
- 70% in the next 4 years
- 98% in the next 30 years

Assuming that the prediction is correct, we can work out the rough impact on the NAV.

A major Tokyo earthquake will affect the following properties:

Aeon Town Moriya. PML=1.0% Value=14,400m JPY
Mallage Shobu PML=2.1% Value=24,500m JPY
ONE'S MALL PML=?% Value=12,000m JPY
Croesus Tachikawa PML=??% 12,800m
Lux Omori PML=?% 3,880m

Unfortunately there are no PML estimates for Croesus Tachikawa, ONE'S MALL, and Lux Omori, so we need to guesstimate.

- Croesus Tachikawa lies on the Tachikwa fault, so I will take PML=7%, which is high end of the range.
- For Lux Omori, lying on "weak" ground, I will take PML=5%, for lack of a better guess.
- For ONE'S MALL, lying on "normal" ground, I will take PML=2%, for lack of a better guess.

So, estimated loss will be: 1,988.5 million JPY.

If your holding period is 4 years or less,
expected loss = probability of earthquake (0.7) x 1,988.5 = 1392m JPY, or 2.19 JPY (S$0.0241) per share

If your holding period is long term,
expected loss = probability of earthquake (0.98) x 1,988.5 = 1949m JPY, or 3.07 JPY (S$0.0337) per share

Doesn't look too bad, but these calculation assume that estimated PML are accurate, which is a very big assumption.
People who want a MOS should use recalculate using bigger values for PML.

Following are not taken into consideration:
- Other losses due to indirect impact (Loss of rental income, compensation, etc)
- Earthquakes near non-Tokyo properties.
- Effects of the numerous after-quakes that happen after a major earthquake, that may further weaken and damage properties that are already damaged.

[sykn]

As I was running through the numbers for the latest 2Q16 financial report, I notice but don't quite understand the JPY 583.5M loss on derivative financial instruments which led to a negative net profit after tax. Would any VB be able to shed some light on what this is as well as its impact on the business? Thanks. (vested)

[tanjm]

As I was running through the numbers for the latest 2Q16 financial report, I notice but don't quite understand the JPY 583.5M loss on derivative financial instruments which led to a negative net profit after tax. Would any VB be able to shed some light on what this is as well as its impact on the business? Thanks. (vested)

This is normal when you take out a interest rate hedge.

Supposing you take a 100 million loan where you pay interest of 2% above 3M Libor every 3 months. Say that Libor is 0.5% now. Then your interest payment is 0.25 x 2.5% x 100 mio. If libor rises to, say 3%, then your interest cost is suddenly 0.25 x 5% x 100 mio.

So you go to the bank and take out a swap. Based on a notional of 100 mio, you receive from the bank Libor and pay 1.5% (for example), and you have now transformed your 100 mio floating rate loan into a fixed rate loan at 3.5% fixed (libor you pay for the loan cancels out the Libor you get from the bank and the net result is 2% + 1.5% = 3.5%).

Now this is not a free lunch. if during the life of your loan, libor stayed at 0.5% or falls, you have ended up paying at least 3.5% - 2.5% = 1% more interest. The fair value of your swap is then the market calculation of the current market expectation of where libor will be during the life of your loan - you can think of it as the amortization of your additional interest losses. On the other hand, if rates rise in general, then your swap will actually gain value. 

Another way to look at it is that when you take a interest rate hedge, you have fixed your interest costs. That is not always a good thing. A classic example is Rickmers Martime which took out interest rate hedges at 5% back in around 2007, but Libor stayed stubbornly low these several years so RM ended up paying much more interest than it would have if it didn't hedge.

This is as simple as I can make it. Hope it suits.