Analysing REITS

[FFNow]

How do you guys analyse REITs?

For quantitative:
I mainly look at NAV, debt/market cap (<0.5), gearing ratio(<0.5)

For qualitative:
I look at ability to maintain dividend payouts for next 3-5 years:
- Quality of properties in portfolio? Diversified?
- Occupancy rate?
- Leases secured till?
- Future growth/plans?
-Ability to increase rental?
Large amounts of debt due only in 3-4 years time?

I look at Price/NAV to see if the REIT is undervalued.

I know DCF can be done on REITs. What starting figure to use for DCF calculation? I know there are FFO and AFFO (similiar to cash flow and free cash flow for companies). How to obtain this FFO since depreciation is accounted for in the income statements?

Hoping someone can shed some light on this.

[Nick]

If you are really kiasu, ask yourself these questions -

1) What will the REIT NAV be when the land lease have matured and returned back to the State freely ? Assuming, there is possibility of extension, where will it get its money from ?

2) How will a REIT pay its debt off eventually ? It doesn't retain any income for debt payment.

3) What is the sponsor relationship with the REIT - partner or atm machine ?

4) Did the REIT cut its distribution during 2008/09 ? If so, can we consider it to be defensive ?

Just some points to share

[FFNow]

Nick, thanks for the questions. How do you do valuation for REITs?

[Nick]

The quantitative aspects of valuation is a lot simpler than its qualitative aspects since great foresight is needed. Here are simple pointers which I would like to share.

Quantitative -

1) Is the business truly defensive ? Has its revenues and distributable income remained consistent throughout the past 3 years ? Is there growth in the DPU ? What is its NPI yield ? Is there an increasing trend ? When does the rental lease expire ? Is it hedged against inflation ? What is its rental security deposit ? What is its occupancy rates - is it volatile ?

2) What is its gearing levels ? Do the debts mature in less than 18 months time ? If so, does the economic conditions allow for easy refinancing ?

3) Is there any unfinanced acquisitions ? Do the REIT meets its loans covenant ? If asset valuation drops by 20%, can its Loan to Valuation covenant still be met ? What is its interest cover ratio ? Is there buffer room in case of interest rates hike ?

4) Do the Management engage in asset enhancement schemes to boost DPU ? Has it been successful in the past ? Has its NPI yield increased ?

5) What is its yield ? Does it make sense for it to be trading at such yield levels (compare with SGS bond yield and peers) ?

Qualitative -

1) Does the Management time its equity fund raising exercise well ie not raising new equity when its unit prices are significantly under-valued ?

2) If the Management is a serial acquirer, has its past acquisitions truly benefited the REIT ? There is a difference between expansion and diversification. Diversification leads to a reduction in the overall risk profile. Expansion doesn't - it just leads to more of the same assets. To test - examine the quality of the tenants, geographical risk etc.

3) What is the sponsor's relationship with the REIT ? Does it function as merely a property developer or does it act as a Tenant as well ? Do the sponsor consistently divest its assets at full valuation or does it divest only at opportune time (bonus: below valuation) ? Does the Sponsor treat its REITs as an ATM machine or as a partner ?

4) What are the REIT plans for the future ? Where does it seek to expand ? How does it intend to do it ?

Essentially, I don't use a lot of maths to derive an exact valuation. I tend to look at the big picture and see whether does the current price make sense ? I guess it isn't as professional as a DCF method etc.

[FFNow]

Nick, thanks for the checklist. Could you explain point 3 under qualitative:

3) What is the sponsor's relationship with the REIT ? Does it function as merely a property developer or does it act as a Tenant as well ? Do the sponsor consistently divest its assets at full valuation or does it divest only at opportune time (bonus: below valuation) ? Does the Sponsor treat its REITs as an ATM machine or as a partner ?

[arthur]

*Thumbs up*

You did not employ any DCF or some precise quantitative measures but the list you have provided is better than any of a number to the 3 decimal places.

Some investors can punch out numbers so precisely that they lost track of the big pictures. Seen this kind of maths "genius" one too many.

Cheers.

[Nick]

Nick, thanks for the checklist. Could you explain point 3 under qualitative:

3) What is the sponsor's relationship with the REIT ? Does it function as merely a property developer or does it act as a Tenant as well ? Do the sponsor consistently divest its assets at full valuation or does it divest only at opportune time (bonus: below valuation) ? Does the Sponsor treat its REITs as an ATM machine or as a partner ?

Sponsor is defined as the property developer which has a significant stake in the REIT Management team and will have a stake in the REIT as well. The sponsor's properties form the REIT's pipelines of assets to be acquired.

In most REITs, the sponsor relationship with the REIT is simply one of divestment. It only seeks to sell its completed properties to the REIT and derive its Management fees - end of story. Examples are CMA selling its Malls or the latest MBFC deals. However, there are cases where the sponsor is also the property tenant. Generally they are in the form of sale and leaseback schemes. First REIT is a good example of that. In this case, the sponsor and the REIT relationship is a little more deeper.

If the sponsor treats its REITs as an ATM machine, it will consistently be selling its assets at full valuation in order to make a profit. The NPI yield may seem pathetic but the acquisition will be financed in a way to make it seem yield accretive. Such REITs tend to raise a lot of rights and highly geared. On the other hand, if the Sponsor treats the REIT as a partner, they wouldn't just dump its assets inside every few quarters. Acquisitions will be rarer and more meaningful. Sponsor may also divest its assets below market valuation since its views the REIT to be part of the family etc. However such REITs (while much lowly geared) don't tend to be as exciting as the serial acquirer REITs hehe !

[FFNow]

Thanks Nick! So I suppose First REIT's relationship with the sponsor is a good one as it's not highly geared and acquisitions are slow but more meaningful like the purchasing of MRCCC and Siloam Hospitals LC.

Anyway just wondering is ur blog ak71?

[Nick]

Thanks Nick! So I suppose First REIT's relationship with the sponsor is a good one as it's not highly geared and acquisitions are slow but more meaningful like the purchasing of MRCCC and Siloam Hospitals LC.

Anyway just wondering is ur blog ak71?

I am not AK71 though his blog contains quite a number of postings on dividend investments so it is a good place to learn about yield stocks haha !

[Musicwhiz]

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