Analysing REITS

[pianist]

how to calculate replacement cost of a business

[Nick]

A very well-written summary on REIT investment. A prospective investor should look beyond NAV and the dividend yield of any REIT. I often feel that the defining feature of any REIT/Trust is the quality of its Management but sadly there is no scientific or mathematical formula for that. Poor Management will lead to poor returns.

Business Times - 25 Dec 2010

How much is a Reit worth?

We look at the determining factors and valuation measures for a Reit, but bear in mind that valuing a Reit is far more art than science. By Bobby Jayaraman

DONALD Trump started off in real estate developing residences in Manhattan in the 1970s when New York was on the brink of bankruptcy. Li Ka Shing scooped up property dirt cheap during the 1967 riots in Hong Kong. The late Ng Teng Fong of Far East Organization was the king of Orchard Road in the 1980s.

All these tycoons made fortunes when the value of their investments grew multiple times. However, it is unlikely they invested on the basis of a valuation from a property consultancy! So what is it that drives growth in asset values? And is it possible to value assets accurately?

The noted economist John Maynard Keynes was thought to have observed that it is better to be vaguely right than precisely wrong. Investors would do well to keep this in mind when reading reports by analysts and valuers. Their neat Excel spreadsheets make it appear that valuing a Reit (or real estate investment trust) is a perfect science. In reality, it is far more art than science.

Following are the common measures of valuing a Reit:

1) Discounted cash flow: A discounted cash flow (DCF) analysis assumes a certain rate of growth in cash flows over a certain period. This is then discounted back to their present value at an appropriate interest rate that reflects the weighted average cost of capital (WACC) of the Reit.

2) Book value: This method attributes a certain discount or premium to a Reit's book value (book value or revised net asset value is the latest valuation of all the properties owned by the Reit minus its liabilities).

3) Cap rate or yield: The annual net property income (NPI) is capitalised at a certain yield thought to be appropriate for the Reit.

While all the above methods are intellectually correct, they are not of much use to an investor if the fundamentals behind the assumptions are not clearly understood. I believe it is far more important to understand the factors that drive valuations rather than obsessing about precise values churned out by financial models. The long-term value of a Reit is driven by the following fundamental factors:

- Potential for capital value growth

- Sustainability and growth of rental income from the properties

- Capital structure of the Reit and the calibre of its managers

Let's delve into each of these factors in greater detail.

Capital values

Let's say you bought some units in CapitaMall Trust (CMT) and are wondering whether the asset values will keep appreciating the way they have mostly done since the Reit was listed in 2002.

If the Reit's assets appreciate in value, that would increase CMT's book value and thus its unit price. The question then is what factors would make CMT's portfolio of suburban malls worth more in the next 10 years.

There are several factors that need to be in place for the malls to appreciate in value. A key factor is whether the trend of suburban shopping will continue since this is what has driven strong demand from retailers for mall space. It was the high occupancies and rentals at suburban malls that drove up capital values in the past decade.

Is it likely that this trend would diminish in the years to come? No one can answer this with certainty, so the investor needs to form his own opinion.

On the supply side, the investor would need to form a view on the potential for new supply and the government policy regarding releasing land for malls in the suburbs.

This question can be answered with a good degree of conviction if an investor does his homework, ie, studying the potential land marked for commercial development in the suburbs, and history and pattern of commercial land released in the past. Were there cases of over-supply in the suburbs in the past? If so, what led to it? Was the catchment area not large enough? Can this happen in the future?

Another factor is replacement cost. Can a new mall be built in the future at a cheaper rate? Unlike the high-tech industry where new technology has historically led to lower costs for components and gadgets, real estate is a fairly staid industry where construction costs usually trend upwards, driven by the increasing cost of labour and materials. So the cost element is unlikely to lead to big surprises in the future.

This is not an exhaustive list and there might be several other factors depending on the specific Reit. However, the general principle is the same: Understand the factors that lead to capital appreciation and you will gain good insight into the valuation of a Reit.

It also makes sense for an investor to keep tabs on transacted values of properties not only in Singapore but globally at different stages of the economic cycle. When comparing valuations keep in mind that the specific nature of the transaction - whether a competitive bid or a forced sale, etc - will have a major impact on the transacted values.

Rental income

Many investors own property for its ability to generate steady income whatever the economic cycle. The ability of the property to attract tenants is directly linked to its valuation.

The capitalisation rate (or cap rate) is the annual net operating income divided by the capital cost. The cap rate denotes the income-generating ability of the property. It depends on: a) the risk-free rate which, for Singapore, is the 10-year SGD bond; b) the risk premium investors assign to real estate, which is heavily influenced by macro conditions and the prevailing market sentiment; and c) the income growth that investors hope to achieve through real estate.

The cap rate can thus be depicted as (a+b)-c. The trouble with this formula, as you might have already guessed, is that both risk premium for real estate and income growth potential are highly subjective and can change by the day.

In the early 1980s, when the US was suffering from high inflation, the cap rate of 8-8.5 per cent was even lower than the 10-year US government bond rate of 10-12 per cent as investors anticipated strong capital gains due to continued inflation.

In contrast, cap rates in 2009 had moved up to about 10 per cent even in a sub-one per cent interest rate environment reflecting the high risk premium that investors were placing on real estate. This illustrates the highly cyclical nature of cap rates.

The average cap rate in the US historically has been around 7.5 per cent and the average spread over the 10-year bond has been around 250 basis points. In Singapore, the 10-year bond yield over the past decade has been about 3 per cent and cap rates have been in the 5-6 per cent range.

These benchmarks are important to keep in mind. If you are buying a high- quality asset at cap rates of 5-6 per cent it is a fair bet that you are not paying too much. What if you are buying at a 3 per cent yield? In this case, you are banking on income growth which is much riskier.

Calculating cap rates using next year's NPI only works if the rentals are sustainable, so an investor needs to understand the factors that drive the sustainability of rentals. This assessment requires a good sense of supply and demand for the type of property that a Reit owns as well as an understanding of global benchmarks and trends in the particular sector.

For example, office rentals of around $6 per sq ft per month (psf pm) in 2009 made Singapore the 24th most expensive office location globally (as per Colliers second-half 2009 survey of 154 cities globally) while Hong Kong was the most expensive.

Given that Singapore is a major Asian financial centre, this certainly made the city very competitive and one could have made a reasonable assumption that office rentals of $6 psf are sustainable (if not close to bottoming out).

In the case of retail Reits, occupancy costs (rental costs divided by sales turnover) are also a good indicator of sustainability. A good level is around 12-15 per cent, and the lower it is the better.

Similarly in the hotel sector, Singapore's current deluxe hotel rates of US$150-US$170 a night compare well with those in other global cities and a healthy increase from current levels looks to be quite sustainable.

One mistake investors should avoid is to blindly extrapolate current rentals into the future. For example, rentals for Orchard Road malls peaked in 1990 at $60 psf pm. Twenty years on, despite strong GDP growth, rentals today are around the $30-$35 psf level!

The main reasons for this were the emergence of suburban malls and slow growth in tourist spending. This underscores my point: Focus on the fundamentals and trends and not on predicting precise numbers.

Reit capital structure and management

Asset values and rental growth can be quantified and directly impact a Reit's valuation. However, that does not mean one should ignore qualitative factors just because they cannot be put in a financial model.

Keep in mind that a Reit is not just a collection of physical assets but is operated by managers. It is precisely the ability of management to add value to the assets that makes the Reit model attractive.

Three qualitative factors in particular are important in valuing a Reit:

Leverage and interest coverage: We discussed this in an earlier article, so all I will say here is that one should tread carefully if a Reit has low interest coverage as it can easily run into trouble if rentals drop. An investor should be convinced that rents are sustainable before committing to such a Reit.

Ability to raise financing: Reits that can raise financing from a variety of sources deserve a premium, as you can sleep peacefully knowing that banks and investors believe in the Reit.

Management calibre: If the management is able to consistently increase values through asset enhancement, prudently acquire assets, and consistently deliver growth in distribution per unit (DPU) without taking undue risks, then it also deserves a premium.

What about acquisition-led growth? Doesn't that also deserve a premium? Yes, a truly yield-accretive acquisition is a big positive, but my advice to investors is not to pay for this beforehand.

Don't buy a Reit which has already priced in acquisition-driven growth. This is one of the most frequent causes of disappointment as growth through acquisitions is the most risky route and only works during depressed times.

A particularly risky time for acquisitions is the current period where interest rates are abnormally low. This tempts many Reit managers to borrow cheaply to acquire. However, the 'yield accretion' in such cases comes from low interest rates rather than attractively priced assets. As such, the accretion will likely disappear with the next refinancing.

To conclude, there is no single formula or model where you can plug in all the variables and get a precise valuation. One needs to understand a variety of factors to get a sense of a Reit's valuation.

This article first appeared in the December 2010 issue of Pulses
jbobby@singnet.com.sg

[Musicwhiz]

Dec 31, 2010
Reits still a good bet in 2011
Analysts point to good distributable income growth, acquisitions
By Yasmine Yahya

SINGAPORE-LISTED real estate investment trusts (Reits) are shaping up to be among the top choices for investors in the new year.

Thanks to the improved economy and low interest rates, Reits have refinanced their debt and made aggressive acquisitions this year. Their overall business has also strengthened on the back of rebounding rental rates.

The FTSE ST Reits index, which measures the value of 17 Singapore-listed Reits, has jumped 10 per cent since the start of the year, outperforming the real estate developers' index's 6 per cent gain.

Almost every sub-sector of the Reit market was represented among the five highest-yielding trusts of the year, which is topped by Lippo-Mapletree Indonesia Retail Trust and followed by health-care trust First Reit, office space supplier Ascendas India Trust, industrial Reit AIMS AMP Capital and Frasers Commercial Trust.

Looking to next year, Reits are viewed as being in a strong position to continue this success story, the only fly in the ointment being the fact that their prices have increased and yields have fallen.

DBS Vickers analyst Derek Tan thinks Reits will deliver distributable income growth of 10 per cent on average next year. Debt financing should not be a problem, he said, as economists expect interest rate hikes to occur only towards the end of next year.

OCBC Investment Research analyst Ong Kian Lin agreed, noting that many Reits are taking advantage of the existing low interest rates to refinance their debt and are seeking longer debt tenures of more than three years.

'Overall, debt profiles remain healthy with an average gearing of 29.6 per cent and average borrowing costs of 3.8 per cent,' he added.

According to Kim Eng analyst Anni Kum, exciting acquisition announcements are on the horizon.

The trend of looking overseas for purchase targets is set to grow - especially in the health-care sub-sector, where the number of properties available in Singapore is limited.

Chief executive of Parkway Trust Management, the manager of Parkway Life Reit, Mr Yong Yean Chau, is confident that next year will be a good year, with Asia's ageing population and growing affluence boosting the need for a solid health-care infrastructure.

'With the growing health-care pie, we are seeing good opportunities for growth, as health-care operators increasingly adopt asset-light strategies to channel their precious resources to their core activities,' he told The Straits Times.

'This represents an enlarged pool of properties available in the market and more opportunities for Parkway Life Reit to grow via acquisition.'

After being sidelined this year, many analysts single out hospitality Reits as the ones to watch because of the expected strengthening of Singapore visitor numbers.

DBS Vickers' Mr Tan forecasts that the distributable income of hospitality and health-care Reits will rise 33 per cent next year. His top picks for hospitality Reits are CDL Hospitality Trusts (CDL HT) and Ascott Residence Trust.

Analysts from DMG & Partners Securities, JP Morgan and Credit Suisse also expect CDL HT to outperform the market, while Ascott is a favourite at Credit Suisse and OCBC Investment Research.

On office and industrial Reits, analysts are more divided.

Nomura's South-east Asia head of equity research, Mr Lim Jit Soon, believes office Reits will be the leading performers among all sub-sectors as job growth drives up demand for office space.

But others, including DBS Vickers' Mr Tan, are more sceptical.

He believes distributable income of office Reits will actually shrink by 3 per cent next year, with such trusts facing topline pressure from renewing rents that were signed during the peak of the previous office cycle in 2007 and 2008.

yasminey@sph.com.sg

[Musicwhiz]

Jan 23, 2011
How about real estate investment trusts?

Real estate investment trusts (Reits) - which invest in a portfolio of properties and get income from rents - also offer investors access to the industrial and commercial market without buying bricks and mortar.

Reits may have a portfolio of offices or malls, such as CapitaCommercial Trust, K-Reit Asia, CapitaMall Trust and Suntec Reit. They are listed on the Singapore Exchange.

Experts said, however, there are significant differences between investing in a listed industrial or commercial Reit and a physical property of that type.

Colliers International director of research and advisory Tay Huey Ying said that the advantages of investing in a physical property include property rights ownership and pride of ownership.

A physical property is a visible asset and would give the investor a better sense of stability and security. It is also the preferred form of bequeathing wealth to the next generation in traditional families, she added.

'By owning the property, the investor is given the exclusive right to use the property while Reit investors hold only a share of the portfolio of properties and do not have exclusive rights to it.'

There is, however, a downside to the investment involving the larger capital needed to be stumped up and the more active role needed in the property's management and repair, said Mr Ong Kah Seng, Cushman & Wakefield's senior manager for Asia-Pacific research.

Direct property investment usually requires a higher investment sum owing to the indivisibility of properties, unlike Reits, and higher transactional costs such as legal and agency fees, experts added.

There is also less potential for diversification. The high investment outlay and location-specific characteristics mean that retail investors can afford to purchase only a limited number of properties, Colliers' Ms Tay said.

She added that Reits, however, allow the manager to acquire a variety of properties in different locations - including cross-border locations - allowing it to diversify the Reit's risks more effectively.

[Musicwhiz]

Business Times - 16 Mar 2011

Can Reits weather the turbulence?

By MICHELLE TAN

REAL estate investment trusts (Reits) have grown increasingly popular over the years due to their attractive tax-exempt dividend income and greater liquidity as compared to physical property assets.

With more people starting to plan for their retirement earlier, many look to Reits as a form of 'annuity' that will see them through their golden years.

Even global fund managers have now set up dividend funds to tap the rise of the dividend culture, with Asia taking centrestage.

Notably, recent times have brought about an increased trend among Reits to acquire yield-accretive overseas assets to diversify their earnings base. This acquisition trail tends to be focused more on developed countries, such as Japan, where yields are perceived to be more 'stable'. But is this really a wise move or a lack of foresight, from a risk management angle? More importantly, are Reits really that resilient to capital downside in times of turmoil while staying capable of sustaining dividend payouts indefinitely into the future?

Let us evaluate this in the context of the latest natural disaster that has hit Japan.

When news of the recent 9.0-magnitude earthquake and tsunami hit newswires last Friday, investors scurried to sell off positions in a broad range of equities, including the once-believed safe-haven Reits.

This led Reits with income and asset exposure to Japan such as Saizen Reit, Parkway Life Reit (P-Life), Mapletree Logistics Trust (MLT), Frasers Commercial Trust and Starhill Global Reit to shed 16.1 per cent, 5.3 per cent, 4.4 per cent, 6.2 per cent and 2.4 per cent respectively since last Friday.

Some feared fluctuations in the Japanese yen may trigger translation losses for Reits. But, in the first place, the more pertinent question to ask is: is the yen more likely to appreciate or depreciate in such a scenario?

Our guess is the yen may appreciate against the greenback in the short term as Japanese investors repatriate funds back to Japan. With hefty insurance payouts also looming on the horizon, the yen could be further boosted as insurance companies quickly liquidate foreign assets to raise cash.

We borrow confidence that this trend will persist in the short term as the yen's advance last Friday was similar to that experienced after the 1995 Kobe earthquake. As such, income impact - if any - will be more positive than negative for now.

On the asset front, overall damage was also in check as verified by most of the affected Reits. Besides, most Japanese assets tend to be insured against natural disasters. This being so, any fears arising from the need for excessive capital expenditure are probably unwarranted although insurance premiums are likely to increase going forward - an item that is unlikely to materially dent a Reit's bottom line.

All in all, most of the Reits walked away relatively unscathed, except one: Saizen Reit. It took a hard knock as the trust's entire asset portfolio consisting of 146 properties is located in Japan, of which 22 properties are situated in worst-hit Sendai. The lack of diversification of its earnings base sent the Reit reeling, with its units plunging a sharp 16.1 per cent or 2-1/2 cents to 13 cents since tragedy struck last Friday.

Fortunately, most of the other Reits with exposure to Japan have diversified portfolios where income streams come from a mix of geographical locations. Analysts reckon income streams for most Reits are not likely to be materially impacted going forward.

Interest rates-wise, the recent disaster that destroyed much of north-east Japan's infrastructure is more likely to deflate interest rates than inflate them in the short to medium term as the government attempts to keep interest rates near zero while rebuilding the nation.

Our view is further supported by the Japanese central bank's recent move to inject 15 trillion yen (S$232.4 billion) into the nation's money markets to promote financial stability and boost overall liquidity.

Reits with debt arising from Japanese assets are therefore likely to continue operating in an 'idyllic' low-interest-rate environment, at least in the short to medium term.

Interest rates could, of course, become firmer in the longer term. After all, they are ruled by a function of demand and supply for funds. For instance, if infrastructural demand increases, increased competition for funds may drive up interest rates.

That said, interest rates are unlikely to be able to escalate very much before triggering government intervention as the Japanese government tends to favour less stringent monetary policies that promote liquidity in the nation's money markets.

To highlight a couple of Reits that could potentially be affected by interest rate movements in Japan, let's examine P-Life and MLT - the two Singapore-listed Reits with the greatest amount of Japanese borrowings within the Singapore Reit universe.

Both Reits currently still draw bullish ratings from analysts despite their debt exposure to the stricken nation. In particular, P-Life has held up exceptionally well despite a meltdown in regional markets. So far, P-Life has eased 2.4 per cent year-to-date as opposed to the benchmark Straits Times Index (STI), which has declined 7.6 per cent since the beginning of the year.

Analysts such as Janice Ding from CIMB also remain positive on both Reits' outlook in the times ahead as reiterated by her 'outperform' calls on both stocks and target prices of $1.98 and $1.05 for P-Life and MLT respectively - this translates to 23 per cent and 20.7 per cent upside potential for P-Life and MLT respectively, based on yesterday's closing prices.

So what are our key takeaways from this?

Diversification of earning streams is perhaps one of the key imperatives from a Reit's risk perspective as reflected in the case of Saizen Reit. Even though Japan is seen as a developed nation that could provide stable yields from its assets and mature economy, too much of a good thing may be bad after all.

Reits that had other sources of income - such as P-Life and MLT - weathered this round of 'turbulence' much better than counterparts that did not.

In fact, sharply discounted prices make such Reits look increasingly attractive from a yield perspective. Not only are they resilient in trying times like these, they 'fill our wallets' on a regular basis too.

[soros]

I notice the average yields for S Reits is 7.21% compared to 5.78% for Hong Kong Reits .

Are all dividends on S Reits paid to shareholders free of withholding tax ? ( like in Hong Kong where no tax deducted on dividends )

Singapore Stock Exchange include 2 reit companies having indonesian assets ( First Reit and LippoMapleTree offering 8.8% and 8.22 % yield). Is the higher yield on these shares is due to currecy exchange risks ? ? Do Singaporean Investors view the Indonesia assets as being more risky ?

[Nick]

Hi Soros,

There is no taxation on dividend income or capital gain for investors in Singapore equities.

The 2 Indonesian REITs are traded in SG$ and they pay their distribution in SG$ as. Individually, they may have their own set of currency risk. First REIT gets its rental income from Lippo in SGD so there is no forex risk to speak of in terms of rental income. LMIR on the other hand has to hedge its rental income which is paid Rupiah. The higher yield is due mainly to the Indonesia label - emerging countries have higher risk. I think we have to consider natural disaster risk as well.

Most retail and hospitality S-REITs trade at 4-6% yield. However, industrial REITs tend to trade at 8-10% due to the cyclical nature of their business. Foreign REITs also trade at a premium. There is also an HK REIT here as well. I think the REIT market in Singapore is pretty robust compared to the rest of Asia ex Japan.

Hope this helps

(Vested in First REIT)

[tonylim]

Hi Nick,

Have few doubts, hope you can help to clarify.Thanks.

1. Why reits need to pay out atleast 90% of the income then it is eligible to enjoy free tax ? I thought they have already paid the corporate tax ?
What if they only pay out 80% to unitholders ?

2.Why there are mentioning of TAX EXEMPT and LESS TAX ? What is the difference.

3.Why there is 'return of capital' which inclusive in the 100% payout to unitholders, like the case of Starhill Global Reit in its last Q DPU ( 0.0022 ).
What is that return of capital meant ?

[Nick]

Hi Tony,

1) REITs do not pay corporate tax if and only if they pay out at least 90% of their distributable income to unit-holders for the financial period. If they fail to do so, then they will be taxed accordingly at the corporate level. But note that this only applies to rental income derived from local properties. It doesn't impact REITs with foreign assets since they will still have to pay tax to that particular country. I believe Saizen has to pay taxes no matter what level its payout ratio is so there was no de-incentive to cut its dividends for 2 years. First REIT pays taxes for its Indonesian assets. Cambridge REIT and CMT pays 0 tax. Shipping trust pays no tax as well irregardless of their payout policies.

2) First REIT website has a pretty comprehensive write-up here - http://firstreit.listedcompany.com/singa...tions.html - on the capital distribution definitions.

[tonylim]

Hi Nick,

Thanks for your speedy reply.

How about point 2 and 3 . Hope you can help to enlighten also.