Understanding Reit structures

The Business Times
Cai Haoxiang
24/2/2014

LAST week, we covered the basics of why investors buy property. To sum up, property investments offer capital appreciation, rental income streams and diversification. Investors also derive pleasure from owning a piece of space.

Buying residential property in Singapore for investment purposes requires a large sum of capital. Properties are generally illiquid and difficult to sell quickly. The multiple measures put in place by the government to cool the market in the last few years also impose costs and limitations on investors. Rental yields, after deducting costs of debt and maintenance, might just amount to a few percentage points a year.

Real estate investment trusts (Reits), on the other hand, offer investors a yield of 5-8 per cent currently. They are easily traded on the stock market. Investors just starting out might find Reits a more attractive proposition than buying their own physical property to rent out.

Before jumping in, investors have to understand the nature of Reit company structures and how they differ from other commonly traded structures such as bonds and stocks.

In Singapore, Reits are divided into shopping mall Reits, office Reits, industrial Reits and others such as hotel, hospital and residential property Reits. The price and yield of each type of Reit are affected by different factors.

Today's article will focus on the Reit structure itself and why Reits have become popular with both buyers and sellers alike.

Why do Reits exist?

While stocks and bonds have been around for hundreds of years and wealthy families have owned land and property for generations, Reits were only first introduced in the US in the 1960s and Australia in the 1970s.

This financial innovation helps investors by breaking up large pieces of property into smaller, easily bought and traded chunks. Reits were introduced in Singapore in 2002, with the listing of CapitaMall Trust. Since then, the number of Reits here have grown. Currently, there are 26 Reits on the market.

Reits allow companies to park their income-generating real estate assets within a financial structure that gives them tax advantages on the rental income received. Individual investors will also not be taxed on the dividend income that they get from Reits. To qualify for these tax advantages, Reits have to distribute at least 90 per cent of their income to their investors.

Essentially, most of the money that a Reit generates from renting out its properties will end up in the pockets of its investors. This is why Reits generally have higher yields than stocks of companies, which generally retain profits for growth purposes. Reits should thus not be looked upon as growth stocks, and investors should not expect them to double in value every year. But they can expect steady dividends.

Companies like to sell their income-generating property assets to Reits. By doing so, they "unlock" or monetise the value of their property, getting a tidy sum from Reit investors to reinvest for their own growth. Companies tend to own a portion of the Reit that they sell their properties to, so they can still enjoy a stable source of income even after they sell their properties.

The relationship between the company that sells the property to the Reit and the Reit itself is important to understand, as conflicts of interest may arise.

One of the hallmarks of a good Reit is having a strong "sponsor" company that can continue to feed the Reit with a pipeline of cashflow-generating properties in years to come. It is a win-win situation for company and Reit: a property developer, for example, can monetise its mature assets while ploughing money back into more development projects; the Reit has a stable growth outlook as investors know which properties might potentially be brought in; if the sponsor is financially strong, the Reit is also more financially stable and can borrow at a lower cost.

What remains to be seen are the terms of the deal, that is, whether a company sells properties to its Reit at a fair price, or whether it is just taking the chance to sell its lower-quality buildings to unknowing Reit investors while holding on to its best properties.

Reit investors look out for "yield-accretive" acquisitions. This means that the costs of debt or equity incurred to pay for the new property will be outweighed by the rental income received, such that the Reit unitholder will see an increase in his or her distributions per unit.

Some Reits in Singapore have sponsors that are developers. Property development giant CapitaLand, for example, is backing the various Reits that bear the CapitaLand name: CapitaMall Trust, CapitaRetail China Trust and CapitaCommercial Trust. Two malls of Frasers Centrepoint Limited could potentially be injected into the Reit it is sponsoring, Frasers Centrepoint Trust, at some point. They are Changi City Point and Centrepoint.

Mapletree Investments, a property group wholly owned by Temasek Holdings that has a property development arm, is sponsoring four Reits: Mapletree Logistics Trust, Mapletree Industrial Trust, Mapletree Commercial Trust and Mapletree Greater China Commercial Trust.

Business park developer Ascendas, formed from a merger of two JTC subsidiaries in 2001, has one Reit, Ascendas Reit, a stapled security Ascendas Hospitality Trust, and a business trust, Ascendas India Trust.

Other Reits have sponsors that are more like landlords instead of developers. The sponsors buy and sell property assets from third-party sellers. Real estate fund manager ARA Asset Management, itself an affiliate of Hong Kong's Cheung Kong Group headed by billionaire Li Ka-shing, partnered logistics firm CWT Limited to list Cache Logistics Trust, a Reit that owns warehouse properties. The Cheung Kong Group also sponsors Fortune Reit here, a Reit that holds retail properties in Hong Kong.

ARA Asset Management, meanwhile, manages Fortune Reit, Cache Logistics Trust and Suntec Reit.

Who runs the Reits?

Reits in Singapore are typically managed by a subsidiary of the sponsor. For example, Keppel Reit is managed by Keppel Reit Management Limited, a wholly owned subsidiary of developer Keppel Land Limited.

The CEO of the Reit manager is responsible for setting the overall direction of the Reit. There is no Reit CEO. This is a point that can confuse people looking at the financial statements and press releases of Reits for the first time, as mentions are always made of the CEO of the Reit management company, instead of the CEO of the Reit.

Responsibilities of the Reit manager, otherwise known as the trust or asset manager, include optimising the Reit's capital structure and identifying assets that can be acquired or sold, as well as planning initiatives that would enhance the value of the properties.

The property manager, meanwhile, is separate from the Reit manager but is also often a subsidiary of the sponsor. SPH Reit, for example, is managed by SPH Reit Management Pte Ltd. But its properties Paragon and Clementi Mall are managed by SPH Retail Property Management Services Pte Ltd.

The property manager provides "on the ground" services such as collecting rental payments from tenants, implementing marketing and promotional programmes, ensuring that floors are swept clean and leaking pipes fixed, and so on.

Fees are charged by the trust manager as well as the property manager. Together with finance costs, utilities costs and property taxes, these charges account for a major part of a Reit's operating expenses.

To get an idea of how much managers charge, let us take a look at the fees charged by the recently launched SPH Reit, which are typical of the industry. The trust manager will get 0.25 per cent a year of the value of deposited property as a base fee, and 5 per cent a year of SPH Reit's net property income in the relevant financial year. In addition, the manager will be paid an acquisition fee of 0.75-1 per cent of the price of properties that it acquires and a divestment fee of 0.5 per cent of properties sold.

The property manager, meanwhile, will get 2 per cent a year of gross revenue of the relevant property, 2 per cent of net property income, and another 0.5 per cent of net property income in lieu of leasing commissions.

Fees can generally be paid in either cash or units.

Aligning incentives

Fees can be a sticking point for unitholders, who argue that incentives of managers are not aligned with them. This is because the more properties are acquired, the higher the revenue and net property income will be and the more fees will rise.

There is no guarantee that additional properties acquired will be yield-accretive and generate a better return for unitholders. In good times and bad, the performance fee will still be paid out as a percentage of net property income.

However, it can also be argued that if a Reit is not managed well, the value of their properties will fall, which will also affect fees.

OUE Commercial Reit (OUE C-Reit) has an interesting way to address the issue that another Reit, Mapletree Greater China Commercial Trust, offered last year. OUE C-Reit's trust manager charges a base fee of 0.3 per cent of the value of gross assets. Then, instead of charging a percentage of net property income for its performance fee, OUE C-Reit charges performance fees based on whether its distributions per unit (DPU) will increase. The performance fee payable is 25 per cent a year of the difference between the DPU of a financial year with the previous year, multiplied by the weighted average number of units in issue for the year. The fee is payable if the DPU of the current year is more than the DPU of the immediate preceding year.

For example, if DPUs increase by one cent, and there are one billion units issued, managers get a $2.5 million performance bonus.

In other words, the Reit manager is only rewarded if the Reit benefits investors with higher DPUs. If distributable income increases but equity is diluted, Reit managers will not be rewarded.

However, this structure might also reward managers handsomely if DPUs plunge one year and recover sharply in the next. They might not get a performance fee for the year that DPUs plunge, but they will get paid for performance in the following year, even if DPUs only recover back to what they were the year before.

To sum up, investors should think about Reits as property assets, not companies. They are not fast-growing companies, but Reits can still grow by increasing their rental incomes every year through various means and by acquiring properties at good prices. Well-run, financially strong Reits will provide steady streams of income for many years to come. They have a place in every portfolio.