March 13, 2013
BY BOBBY JAYARAMAN
REITS are all the rage now. It seems there is an initial public offering (IPO) for a new Reit/business trust every other month, the latest one being that of Mapletree Greater China Commercial Trust (MGCCT), which, predictably, had a strong debut in SGX last week.
Amid this euphoria, it is easy for investors to get caught up with yield investing without doing their homework and understanding fully what they are investing in. My intent here is to take a critical look at this new IPO and raise some fundamental questions for the investor to think about.
Sponsor motivation
First off, it should be noted that MGCCT is not a typical Reit, in the sense that it consists of just two mixed use assets – Festival Walk, a mall in Hong Kong with some office space, and Gateway Plaza, an office building in Beijing with some retail space.
From an investor’s perspective, it is really just one asset – Festival Walk, which makes up 75 per cent of the asset value and gross revenue of the Reit. One cannot help but wonder why Mapletree had to go through the trouble of listing a Reit just to sell a single large asset.
The implication for investors is that their fortunes are tied to the fate of Festival Walk. Given such a high concentration risk, investors had better be sure that they have a good sense of the future earning power of this mall – or they could be in for some nasty surprises down the road.
Festival Walk was a rather quick flip by Mapletree. It had bought it from Swire Pacific, one of Hong Kong’s leading conglomerates, in July 2011 for HK$18.8 billion (S$3 billion) and injected it into MGCCT 18 months later for around HK$20.7 billion, making a profit of around 10 per cent.
It fared much better with Gateway Plaza, its office property which was acquired by Mapletree India China Fund in February 2010 from a Hong Kong-listed Reit for 2.9 billion yuan (S$580 million) and injected it into MGCCT for five billion yuan. This was a more than 70 per cent gain in three years.
Gateway Plaza is now the subject of a lawsuit detailed in the prospectus. As it is, Reit investors have to face enough uncertainties regarding the property cycle, they can surely do without the added headache of a lawsuit.
Anyway, the sponsor has certainly made good returns on these assets. What about investors buying into MGCCT at IPO levels? Will they be rewarded over the medium-long term?
Quality of assets
To understand this better, let us first dig a bit deeper into the quality of the assets, that is, the long-term earning power of an asset under different economic conditions.
Let us start with Festival Walk, a mall built in 1998 in an upscale suburb of Kowloon. This asset is slightly larger than Ion Orchard, well connected and upscale. It is patronised mostly by local shoppers, with tourists making up only 18 per cent of sales last year, said the prospectus.
The shops there include luxury brands such as Rolex, Bally, Piaget and Armani. Investors would thus need to be convinced of the attractiveness of such a positioning, in which the mall will not benefit much from the onslaught of millions of mainland Chinese tourists who go to malls in the tourist areas of Central or Tsim Sha Tsui; the earnings of Festival Walk will also not be as stable as those of suburban “necessity malls” owned by Link Reit (a Hong Kong-listed Reit).
How has the mall performed over the years? The prospectus says its revenues have been resilient through economic cycles. A graph showing Festival Walk’s gross revenue (without citing a source for the data) and retail sales growth since 1999 supports this.
However, the manager, citing a host of reasons, is unable to provide detailed historical statements of financial performance for the past three years as mandated by SGX.
An investor is free to draw his own conclusions. I would personally like to see verifiable hard data on net property income (NPI), rather than high-level gross revenue and sales numbers, which can be increased in a variety of ways without benefiting the bottom line, such as by spending heavily on marketing and promotion to attract tenants.
Another important point to note is that the mall’s lease expires in 2047, or in just another 34 years, similar to that of many industrial properties in Singapore. Investors need to form a view on whether the dividends are in fact part capital repayment.
Finally, the mall was built in 1998, and would need to be refurbished in a major way if it is to remain competitive with newer centres. This would require heavy capital expenditure.
Let us move on to Gateway Plaza in Beijing. The office building is in a good location with high-quality tenants, but with no direct access to a subway station. The nearest one is a 700m walk away – quite a disadvantage for a prime office building, in my view.
The office sector in general is highly volatile and the Beijing office sector more than bears this out. After hitting a trough in 2009, office rents in Beijing have doubled over the past three years. They are now the third highest in Asia after Hong Kong and Tokyo, and command close to a 50 per cent premium over Shanghai.
The Beijing office market today seems to show similarities to the roaring early 2008 Singapore office market. The problem is that office rentals cannot go sky-high. Today’s cost-focused companies show great resistance to paying high rentals and have the option of moving to less centralised locations. Sooner or later, supply comes up to match, and frequently exceed, demand.
Given these realities, investors need to decide what the upside is in this stage of the office cycle. The sponsor certainly got the timing right buying in during early 2010, just when the market was turning, and selling after rentals had doubled. Investors hoping for increased rentals and capital gains from these levels may not be as fortunate. Gateway Plaza is also on a short lease, with just 40 years remaining.
Leverage
Leverage plays a key role in determining a Reit’s level of risk, distribution yield and valuation.
As at IPO, MGCCT had S$4.3 billion in assets (the combined valuation of Festival Walk and Gateway Plaza) and S$1.78 billion in debt (net of S$132 million in cash). That gives it a gearing of close to 42 per cent.
Given the reliance of the Reit on cash flows from mostly one asset and currency risk – the Hong Kong dollar has depreciated close to 20 per cent against the Singapore dollar in the past three years – the gearing looks to be on the higher side.
As a comparison, S-Reits have no currency risk, a more diversified pool of assets and a track record going back several years. As at end December last year, CMT had a gearing of 36.7 per cent; CCT’s gearing was 30.1 per cent, and FCT’s, 30.1 per cent.
In today’s environment of ample and low cost funding, debt levels have taken a back seat to dividend yields, but smart Reit investors would do well to remember that the credit taps are extremely volatile and Reits that are dependent on high debt levels and low cost funding to generate returns will pay heavily when the credit cycle turns against them.
Valuations
Festival Walk and Gateway Plaza have been injected into the Reit at S$4.3 billion. However, there is not much information in the 700-page prospectus on the basis for these numbers.
The valuation reports mention that they use an income capitalisation approach and discounted cash flow (DCF) analysis to value the assets. There are also plenty of standard clauses and disclaimers in the report, but important information such as the capitalisation rates used, the year for which net income is capitalised and the discount rate used for DCF valuations is missing.
More than a decade ago, Singapore’s first Reit CMT put out a 300-page IPO prospectus including this information clearly in a table. It looks like while the IPO prospectuses have been gaining bulk over the years, the quality of meaningful information is decreasing.
Going through the prospectus, it appears that the key operating number is the “projection year 13/14? NPI of S$185.7 million. Dividing this NPI by the asset valuation of S$4.3 billion gives us a property yield of 4.3 per cent. The distribution yield of 5.6 per cent at IPO price is higher than the property yield due to the 42 per cent leverage used.
Over the past couple of years, commercial property cap rates have been compressing all over Asia, with top retail spaces in Hong Kong even trading at cap rates of less than 2.5 per cent.
Investors, however, need to decide whether today’s benign interest rate and credit environment will continue and if such levels of valuation provide a sufficient margin of safety over the long term.
The sponsor makes some optimistic projections on rental increases in the coming years without providing a clear rationale. Investors would do well to test the reality of these projections under conservative scenarios.
Management fee structure
One of the major attractions of MGCCT, going by the press coverage, is the DPU-based fee model rather than the traditional asset based fee structure that most S-Reits use.
There are certainly major drawbacks to an asset based fee model that a DPU-based model avoids. However, it does not mean that a DPU-based fee model completely aligns management and unit holder interests. For starters, investors should keep a close eye on the leverage and debt maturities. Why?
In today’s credit environment, one can borrow at around 2 per cent and make even a 3 per cent cap rate acquisition yield accretive, thereby increasing DPUs and generating higher fees for the Reit manager. The increased DPUs for the investor, however, come at the expense of higher leverage. (MAS rules allow up to 60 per cent gearing if a credit rating is disclosed.)
This method gets even more attractive if short-term debt is used instead of long-term debt due to its much lower cost. Though this would mean having to frequently roll over debt.
Any Reit that employs such methods can earn high fees through increasing DPUs, but set itself up for disaster owing to a deteriorating capital structure.
This is not to suggest that MGCCT or other Reits will behave in such a way. The point is that no fee structure is fool-proof. Ultimately, whether a Reit ends up creating long-term value for unit holders depends on the quality and integrity of its manager.
Conclusion
Investing in Reits is no different from investing in any other asset class. The fundamentals need to be sound and the pricing should be reasonable. Investors get a relatively high yield from Reits because they take on the asset price risk.
The writer is a private investor and author of the local bestseller ‘Building wealth through Reits’.
This article first appeared on http://www.businesstimes.com.sg/specials/executive-money/investing-reits-theres-no-free-lunch-20130313
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