“Risk off the Table” – A Window for Asian REITs
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Recently I attended a real estate conference in the Lion City of Singapore and participated on the panel of one of the sessions. Fifteen years ago there was no more than a small handful of conferences in the region dedicated to the real estate sector. Now they seem to be popping up in considerable numbers all over the region. In the early days these conferences seemed to be little more than gatherings of somewhat “spivvy” real estate sales folks flogging their wares. Yes, the real estate community does have more than its fair share of somewhat flambuoyant characters whose main aim in life is to sell you something you didn’t know you wanted . The sorts of folks who preface their pitch with remarks like – “You have to be in real estate – it always goes up”. I shudder every time I hear one of these enthusiasts launching forth on that tack.
But the conferences have improved a lot over the years with much more solid content and good speakers who have deep knowledge of their subject and often lashings of good experience. There is much more thoughtful and intellectually meaningful commentary coming from the speakers, panelists, participants and organizers. These events are still very much a “meet and great, press the flesh”, industry networking opportunity, and that is still a major raison d’etre for their existence. But the content has definitely improved.
At this recent conference the opening speaker was the inimitable Marc Faber, author of the famous Gloom Boom and Doom Report. Marc gave his usual tour de force of the global economy and a fair dose of contrarian thinking. Highly enjoyable and very informing. Other luminaries included Tim Bellman, a friend from way back and now Global Head of Research and Strategy with ING Real Estate Investment Management. Erwin Stouthammer founder of Composition Capital, a long time real estate fund manager originally operating in Holland but now investing in Asian real estate. Justin Chiu, long term veteran of the Asian real estate scene as Executive Director of Cheung Kong Holdings, the second largest listed real estate company in the world. Ben Sanderson, Director of International Investment from UK based Hermes Real Estate Investment Management. Mark Ebbinghaus, Managing Director and Global head of Real Estate for Standard Chartered Bank, another 25 year veteran of the real estate industry. The list goes on and on.
Apart from the much improved content of these conferences, the attendees tend to be much more international than in the past and from many different parts of the real estate universe. The real estate investment industry has definitely become a more global industry over the past decade or so, with considerable skills and technology transfer having taken place over this period.
While the expected bevy of real estate agents, valuers, and property developers are still very much in evidence, the conferences now seem to attract increasing numbers of private equity real estate funds, specialist real estate investment bankers, real estate finance specialists, lawyers, real estate research analysts, sovereign wealth funds, mainstream fund managers, hedge fund managers. This tends to make for very much more varied inputs, and more valuable interaction.
For this particular conference I was invited to sit on one of two panels discussing the subject of REITs (Real Estate Investment Trusts). The panels consisted of CEO’s and the like from various regional REITs, real estate banking specialist, specialist real estate fund manager, real estate investment banking specialist, and myself – a bit of an odd man out perhaps! Most real estate conferences in the region have at least a slot or two devoted to the REIT space. Ten years ago that would have been zero.
The Recent “Risk Off the Table” Trade Plays Well to REITs as an Investment Medium
In the recent pullback in equity markets, and the “risk off the table” mindset that has pervaded investment thinking, the role of the REIT in reducing some risk in portfolios, and still maintaining some exposure to real estate perhaps warrants a little thought. The “search for yield” trade also plays well into the REIT universe, where reasonably secure dividend yields of 4% to as much as 8%-9% (and more) can be found without going out too far on the risk curve. REITs also have the advantage of some security of income over the coming few years, and a degree of predictability of earnings and dividends that is generally much greater than for mainstream publicly listed stocks.
While REITs may not provide the ALPHA that many investors come to emerging markets for, they can provide some security of income, they can prove less volatile instruments than many others in the region, and provide access to underlying structural changes in the urban framework of fast growing cities. As such they can form a valuable part of a diversified portfolio in the region.
REITs a New Entrant to the Asian Listed Securities Universe
REITs are a specialized listed vehicles that invest in and hold real estate assets (or mortgages held against real estate assets). They are normally traded on stock exchanges just like any other publicly listed security. They are usually governed by a different set of rules (they are established as trusts) that amongst other things require them to pay out all, or most of their rental income profits to unit holders in the form of dividends or distributions. Normally REITs receive tax breaks that most listed companies do not.
There may be a number of restrictions placed on the REITs operations such as:
- Limits to leverage that can be used.
- No ability (or restricted ability) to undertake property development.
- Limits or bans on holding of foreign assets.
- Limits to assets other than real estate that may be held, including shareholdings in associated companies.
- Limits to ability to retain profits.
- Rules on distributions of capital gains.
There may be a range of other accounting and taxation rules applied to REITs that may be different from other listed vehicles.
Rationale for REITs – Gives Smaller Investors Direct Access to Large Scale Real Estate Assets
The first major market for the establishment of REITs was the US in 1960. The idea behind the legislation, which is essentially what most other countries have followed, is to make investment in large scale, income producing real estate assets available to small and large investors alike. It is impossible for most of us to own a shopping mall, an office building, or an industrial complex independently. The REIT allows investors to own an equity interest in such assets in a way that is similar to owning shares in any other company. The unit holder (shareholder) receives the benefit of rental income from the assets as well as any growth in the value of the assets over time.
Pretty much all jurisdictions that have introduced REIT legislation have granted investors tax concessions that may not be available to other forms of investment and therefore add to the attractiveness of the vehicles for investors.
Personally I have been a supporter of the development of the REIT industry in Asia for a number of reasons.
- They allow large and small investors direct access to asset classes that would not be available to them otherwise, and to target specific types of assets quite closely. Buying shares in a typical Asian listed property company gives the investor exposure to mainly development properties, and often a range of property asset classes, sometimes in multiple jurisdictions.
- The asset is liquid, being traded on the local stock exchange.
- It provides a high dividend yield, much higher normally than other listed securities, as the REIT is required to distribute all or most of the net income to shareholders.
- REITs can provide good diversification to a property specific portfolio or a wider portfolio. Even if I were able to buy an office building, my risk is very concentrated. Owning a portfolio of office buildings via an investment in a REIT should reduce the concentration risk.
- Investors can target specific asset classes and specific countries or markets quite closely because most REITs focus largely or even exclusively on a specific property type and/or a specific country or market. “I like Singapore’s office market, but not so keen on the retail market”. Therefore I buy an office focused REIT.
- In theory REITs should be a lower risk asset class than most listed securities, and most other forms of property companies. Regulations typically proscribe maximum gearing levels. Absence of development properties reduces development and market risk. Rental incomes should be a less volatile source of earnings than development earnings, and they are typically more predictable source of income.
- The investor should see some increase in share price over time if property markets rise. Other things being equal (which they rarely are!) share price should broadly track movements in net asset value (NAV) of the REIT.
REITS should be desirable investment vehicles for individuals and funds that want to have or need to have a steady, reasonably reliable and predictable income stream. They suit pension funds, superannuation funds, insurance companies and the likes of you and me who might need a reliable cash flow to sustain us in our dotage!
Pension funds and their ilk build actuarial models that allow them to identify what their pay out liabilities are likely to be over the coming few years, and being able to identify reliable cash flows that help meet those liabilities can clearly be very helpful and reduce risk of not being able to meet obligations.
REITs as a halfway house between stocks and bonds
I liken REITs to being a halfway house in the spectrum between the universe of listed securities and bonds. Listed securities may provide greater growth potential, but less earnings predictability, probably greater earnings and share price volatility, and greater financial risk in many instances. Bonds have the advantage of great predictability of earnings (the coupon), but little potential for value enhancement of the underlying instrument.
So the broad case for REITs is not too difficult to grasp, but there are negative aspects to the REIT as an investment instrument.
REITs Are Not Typically High Growth Vehicles
Because they have limited or no development properties, and cannot retain earnings for application to new assets to grow portfolios, growth of earnings and asset backing is likely to be restricted. It is often likely to be somewhat lower than the great bulk of Asian property companies that are more development focused.
Income is based almost solely on rental income, which may grow in line with rentals in a particular market or sector, but due to the typical three year lease cycle, it takes some time for growth in spot rentals to get reflected in income. This lagged effect also works to advantage on the downside, when rentals may be declining mode.
Limits on gearing also can impede the ability of a REIT to grow its asset base.
Some investors might argue that they come to Asian markets to benefit from the high growth in the region, so why lock in to an inherently lower growth asset class? A valid point, but increasingly Asia is developing its own pension funds, and middle income/high net worth investors who DO want lower volatility, higher dividend yielding investments. In today’s low interest rate environment that may be an added advantage of the REIT markets.
Debt and Financial Crisis Often the Catalysts for REIT Industry Formation and Growth
A cursory look at the formation and growth of the REIT industry around the world reveals that it has often been spawned or grown rapidly out of a debt crisis and a collapsed property market.
For example, the REIT industry in the US enjoyed its major growth spurt in the wake of the S&L crisis of the late 1980’s’early 1990’s. US financial institutions were saddled at the time with legions of non-performing loans, backed (surprise surprise!) by real estate. A good way to get them off the books was to inject into REITs that were bought by the public.
Japan’s JREITs – Born Out of Crisis
Japan’s property market suffered the mother of all crashes in the early 1990’s, and for the most part has never got back even close to the values of the peak period in the late 1980’s. It took some time, but the Japanese created the REIT legislation in 2000 which provided a source of new capital and a venue to off-load real estate assets that may have been a major drag on their owners and the banks. There is even today, a nagging suspicion on the part of the Japanese investing public that REITs are a dumping ground for less than great real estate assets.
Figure 4: Japan REITs – Core Metrics
|Sector||Market Cap. (US$ Mil.)||Yield Range % (2011 E)||Gearing Loan to Value % (avg)||Prem. (Disc.) to NAV %|
|Office||14,978||3.1 – 6.1||42||+5 to -53||Retail||3,857||5.6 – 5.7||35||-2 to -27|
|Office/Retail||6,666||5.7 – 7.3||45||+35 to -46|
|Residential||4,669||4.4 – 6.8||50||-2 to -41|
|Residential/Office||2,788||3.7 – 7.3||51||-17 to -50|
|Others*||7,546||4.1 – 6.8||52||-9 to -55|
*Others contains multi-sector REITs, hotels, logistics, infrastructure.
Source: Reuters, Citibank, Portwood Capital
Hong Kong – REIT Sponsors Appear to be Cynically Exploiting Investors/Shareholders
That mentality very much pervades the Hong Kong REIT industry, which has not grown anything like the way it has elsewhere. The REIT industry has queered its own pitch in Hong Kong. Some of the initial REITs used dubious financial engineering techniques to enhance the appearance of near term returns in a way that was clearly designed to boost the price of the injected assets for the REIT’s sponsor. This apparently cynical exploitation of investors has not gone down well, and probably stunted the potential growth of the industry. There is also a fairly widely held view, probably valid, that REIT sponsors have injected the dregs of their portfolios – sometimes perhaps one decent quality asset and a bunch of less than stellar bits of real estate. Again, providing ammunition for skeptics.
Hong Kong’s REIT industry was NOT born out of debt crisis or distress.
The Clean, Green Singapore Machine – Driven by Government Backed Companies and Assets
Singapore’s REIT industry was in fact born out of an environment of high leverage, but not distress. Many property companies were grappling with quite high debt levels in the wake of the Asian financial crisis that broke in 1997. Gearing levels of 80% – 120% were not uncommon in the listed property companies at that time, very high compared with the average of less than 35% in Hong Kong’s major listed property companies.
While the Singapore REIT industry was not born out of distress, there was certainly a motivation to reduce gearing at major property companies, and selling assets into REITs could help achieve that end.
This has meant that the industry’s corporate governance is probably the best in the region in the REIT space. These are in essence clean, straightforward vehicles which are sponsored ultimately by government. Yes, there may be management mistakes from time to time, but there is less of the cynical exploitation of shareholders that we have seen in the Hong Kong context.
Moreover the good example set by the government backed entities encourages other non- government sponsored REITs to behave in like manner.
Figure 5: Singapore REITs (As of August 10th, 2011)
|Sector||% of Local REIT Market||DPU Yield EY 2001||Prem. (Disc.) to stated NAV %||Debt/Total Assets %||Total Market Cap. (US$ Bn.)|
*Other REITs includes REITs specializing in residential, healthcare and hospitality.
Source: Bloomberg, Reuters, UBS, JP Morgan, Portwood Capital.
Growing REIT Portfolios is Not Always Easy
It is not easy for REITs to grow property portfolios. It can only really be done by raising new debt or new equity. It cannot typically be done through retained earnings. Typically property development companies in Asia may pay out around 20% – 30% of net income as dividends to shareholders, often leaving substantial funds to buy additional properties or land. REITs are required to pay out around 90% at least. If a REIT is close to its proscribed debt ceiling, its ability to grow its asset base through debt is limited. Sales of existing assets may free up cash or new assets.
Raising new equity may also not be possible or sensible. If the REIT shares are trading at a big discount to underlying NAV, as many were in 2009 after the onset of the global financial crisis, and many still are today, then raising equity at today’s share price will likely be dilutive to existing NAV and probably to earnings per share and dividends per share. Why raise new equity at 75 cents per 100 cents of existing underlying value to buy assets at “market” price. This will only dilute existing shareholder’s asset value, and earnings per share.
For example, if shares are trading at say 25% discount to NAV and the company issues 10% more shares at the current share price to buy additional properties, then there will be dilution to NAV per share of about 2.3%.
This limited ability to grow assets and earnings is largely behind the moves in Australia to combine development businesses with the REIT business, all under the same listed vehicle. In this mechanism, development businesses are “stapled” on to the REIT structure, allowing the overall business to grow assets and earnings. The development business may provide the assets that eventually end up in the REIT structure, but shareholders of the REIT, in theory, get to share in any development profits made by the development company.
This stapled structure is not used in other parts of the region.
An important factor for the REIT investor is to be sure that the REIT manager is growing the portfolio, and earnings potential without dilution to existing shareholders. If there is near term dilution, can the manager demonstrate how the asset value and rental income can be enhanced through various means such as refinancing more cheaply, repositioning, asset upgrading, additional floorspace, renovation, uplifting rentals, filling vacant space etc.
REITs Are Not all Created Equal
While the legal structures of REITs around the region are quite similar, there is marked differences in the “character” of the vehicles from country to country and investor perceptions of them as an investment vehicle.
Australian REITs Sophisticated, Complex, but Often Lacking in Transparency and Not Always Shareholder Friendly
The Australian REIT industry is the oldest and most sophisticated in the region, having been around since the early 1970’s. REITs find ready buyers in the deep and sophisticated pension and superannuation industry. Australia has reputedly the 6th largest pension industry in the world as all employees are required to contribute a significant part of their pay-packet to superannuation plans. This has fueled the growth of the REIT industry. But the drive for growth has created certain features of the industry that are not always in the best interests of shareholders.
We have mentioned above the device of “stapling” development activities on to the REIT vehicle. This may provide a ready source of new assets to inject into the REIT vehicle, but there can also be some concern about the pricing of these assets as they pass from the developing entity to the REIT. It can also give rise to increases in debt, and potential conflicts of interest.
The Australian REIT industry has developed the device of “warehousing” properties. There are various forms of this but it essentially involves the manager acquiring assets within a vehicle that might be funded in part by outside investors, typically pension funds or superannuation funds. Such assets may be held for some time by this entity and then may be injected into the REIT, typically at a capitalization rate somewhat lower than that at which the assets were originally acquired. i.e. the REIT, which is owned by Mr. and Mrs. Joe Public ends up paying a “full” price for the assets from the REIT sponsors vehicle.
Because the vast majority of institutional grade commercial real estate is already owned by REITs or pension vehicles, there is limited opportunity for growth within Australia. Hence the Australian REITs have been world leaders in the internationalization of their businesses. North America and Europe have been the major hunting grounds for Australian property entities. Many of these foreign forays have proved to be less than friendly for shareholders. Westfield’s strong presence in North America and now Europe (UK) are a notable exception.
Finally, Australian property vehicles have been frequently tempted to grow by acquiring oodles of debt, and in the recent financial crisis, a great deal of debt proved to be “off balance sheet”. Analysts and shareholders had a real mission understanding clearly where the debt obligations really lay – transparency in this regard proved severely lacking in a good many cases.
Japan – The Name of the Sponsor is Critical to Valuation
Within Asia proper, Japan was the first country to launch a REIT industry and now has more than 35 listed REITs. Some are single asset class REITs while many have a mix of real estate types. There has been little to no growth in the sector since the onset of the global financial crisis and many REITs, although not necessarily highly geared, found themselves in financial difficulty in the aftermath of the Lehman debacle.
Typically borrowing by REITs in Japan is relatively short term. As banks closed their doors to lending in 2009 many REITs had trouble refinancing their credit lines and were forced to sell assets or seek other forms of debt, often more expensively. There has developed a marked divide in Japan’s REIT market between REITs that are sponsored by a top drawer household name and those whose sponsor may be more local or much less well known. This divide is reflected in access to and price of capital and trading price of the listed vehicle. Many of the REITS of lesser known sponsors trade at significantly deeper discounts to NAV and higher dividend yields.
Hong Kong – Has Stalled in its Tracks
The REIT market in Hong Kong has stalled. There is little impetus for the establishment of new REITs. Companies do not have stretched balance sheets which might encourage sales of portfolios into REIT vehicles. Those who might wish to do so have had the market tainted somewhat, I believe, by the less than appropriate manner of the listing of some of the first entrants to the market.
There are some private equity real estate funds that have created sizable portfolios of investment properties in China. Normally, Hong Kong would be a natural place for such funds to achieve a “liquidity event” perhaps by listing as a REIT. Given the somewhat negative reputation that the sector brought upon itself, I would not be surprised to see potential new REIT listing with China properties consider Singapore as a preferred listing jurisdiction.
A Time and Place for Everything – It is Distinctly Possible to Build an Asian REIT Portfolio Offering Around 6+% Dividend and With Relatively Low Risk
The world of investment has slipped back into “risk off” mode in recent weeks, in response to, amongst other things, sovereign debt and potential bank problems in Europe, the US debacle over budget deficit reductions, and the general view that the economies in these regions are likely to weaken in the short term, leading to potentially slower global growth, and possible a double dip recession.
Without making any judgments on the outcomes on our part, it is clear that there is an asset allocation shift in many markets to lower risk assets, including bonds and gold.
While REITs do not provide the lower risk profile that sovereign bonds may do, they may well be lower risk than traditional equities, and provide the comfort of reliable and predictable dividend yield. There is also the prospect of some growth in income and asset values in the Asian region in our view.
To quickly summarise the underlying fundamentals that underlie the REIT industry in the Asia region:
- Asian economies are likely to slow in the coming months, but will generally likely post much higher growth than is the case in many western markets.
- Asian countries are still “savers” and have the capacity to ramp up domestic consumption to support domestic economies and local economic growth.
- Corporate (and government) balance sheets are largely in good shape in most parts of the region – probably because companies did not have time to get into trouble after fixing the problems of the Asian financial crisis that commenced in 1997!
- Broadly speaking real estate markets are in solid condition in most parts of the region, so much so that many central banks and governments have put in place financial and administrative measure to temper “animal spirits” in local real estate markets, particularly residential markets.
- For the most part, and certainly in the countries that have sizable REIT exposure, there has not been a blow-out of supply of real estate, and in fact the opposite is often the case – supply is tight.
- Some inflationary pressure is leading to higher interest rates in some countries, but for markets like Japan and Hong Kong in particular these are likely to remain close to record low levels, and will probably be “on hold” in markets such as Australia and Singapore in the short term at least.
Commercial real estate in tight supply:
Office markets are far from oversupplied and in fact will face a big slowdown in new supply in Hong Kong in particular. Vacancy rates are heading down in both Hong Kong and Singapore, and rentals are rising – very sharply in Hong Kong’s case, a bit more modestly in Singapore. Vacancies have probably peaked in Japan, and also Australia/New Zealand. It remains to be seen if and when rentals start to edge up again in these markets.
Retail real estate enjoying domestic consumption and tourism boom:
Both Singapore and Hong Kong retail property markets have been enjoying booming conditions in tourism, with sharp upward momentum in prime retail rentals and prices. For Japan and Australia/New Zealand the prospects are more muted, but have probably pretty much run their course on the downside for the most part. In Australia, domestic spending on consumer staples remains robust.
Residential real estate has seen very rapid recovery in some markets:
Housing prices have shot off their 2009 lows very sharply in Hong Kong and Singapore, so much so that measures have been put in place to cool residential markets. However, there is very little residential exposure in REITs in these markets. In Japan, residential markets are not showing much sign of rental growth, and may not do for some time. In Australia, housing in some major cities has recovered quite soundly, but again, housing is not a big part of the Australian REIT scene.
A list of suggested names to consider in an Asia-wide REIT portfolio would include:
Japan: Nippon Building Fund (8951:JP), Japan Retail Fund (8953:JP), Japan Prime Realty (8955:JP), Frontier Real Estate (8964:JP), Kenedix Realty (8972:JP), Astro Japan Property Group (AJA:AU).
Singapore: Mapletree Industrial Trust (MINT SP), Capitamall Trust (CT SP), Capita-Commercial Trust (CCT SP), Suntec REIT (SUN SP), Ascendas REIT (AREIT SP).
Hong Kong: Fortune REIT (FRT SP 0778.HK), Link REIT (823:HK), Prosperity REIT (808:HK).
Australia/New Zealand: GPT Group (GPT.AX), Westfield Group (WDC.AX) Challenger Diversified Property Group (CDI.AX), Stockland (SGP.AX), Charter Hall Group (CHC.AX), AMP NZ Office Ltd (ANO:NZ), Kiwi Income Property Trust (KIP:NZ).
|First REIT Listed||1971||2005||2001||2002|
|1. Legal Structure||Two common REIT Structures:
1. Standalone unit trusts
2. Listed stapled security (company and trust)
|Unit Trust||Unit Trust or Corporate (all listed on stock exchanges are corporate)||Unit Trust or Corporate (generally trusts in practice)|
|2. Management Structure||Internal/External||Internal/External||External||External|
|3. Single Responsible Entity (RE)?||Yes. RE has ultimate responsibility of the trust||No. Trustee and manager must be functionally independent of each other||No. Asset management responsibility lies with external manager of the REIT’s assets||No. Separate trustee and manager|
|4. Mandatory Listings on the Exchange?||No||Yes||No||No|
|5. Publicly and/or privately held||Mostly public||Public only||Public and private||Mostly public|
|Income and Asset Requirements|
|1. Percentage of Real Estate||No specific asset limits. However, to be eligible for pass-through taxation it must invest only in “land for the purpose of deriving rent” or other eligible investment activities||Only allowed to invest in income-generating real estate. The contract value should not exceed 10% of the total net asset value||At least 70%||At least 75% of the fund’s deposited property should be invested in income-producing real estate|
|2. Property Development||No. In a stapled structure, the active “trading” business is carried out by the company and the trust is not affected||Not allowed||Not allowed||The fund should not undertake property development activities unless the fund intends to hold the developed property upon completion. Total contract value should not exceed 10% of the portfolio’s deposited property value|
|3. Geographical Restrictions||No||No||No||No|
|4. Leverage||No restrictions for domestic REITs||Aggregate borrowing cannot exceed 45% of gross asset value at any time||No restriction||35% of total assets, capped at 60% if REIT is rated, and the credit rating is disclosed|
|5. Distribution Rules||No Restrictions||At least 90% of annual net income after tax||At least 90% of taxable income||At least 90% of taxable income arising from Singapore assets|
|REIT||REIT is not taxable as long as unit holders are entitled to 100% of net income. The trust will be taxed at the highest marginal tax rate on income that is not accessible to unit holders||REIT is subject to either property tax or profit tax depending on whether an SPV is holding the assets||REIT is subject to corporate tax on amount un-allocated to unit holders||17% corporate tax on the undistributed taxable income|
|1. RPT Regulations||Yes||Unit holders’ approval is required when total consideration or value of the transaction is equal to or greater than 5% of the latest net asset value of the scheme||No||If transaction is equal to greater than 5% of the fund’s NAV, it must obtain majority vote in participants’ meeting (interested parties not allowed to vote)|
|2. Do Members have the right to vote on the removal of the manager?||Yes||Yes||Yes||Yes|
|3. Typical Fee Structure||No particular regulations||Must adopt the “high-on-high” principle||No particular regulations||No particular regulations|