Who moved my REITs? Part 2

It's been 2 years since Feb 21st 2009, i wrote my very first article on REITs and had many people emailing me with questions. This time around, i'll have gather some very interesting research on REITs again and hopeful it will be clearer this time around. Now with the help from Bobby Jayaraman, let us look at the determining factors and valuation measures for a Reit, the art and science of it.

Li Ka Shing & Ng Teng Fong. People born before 1980s should be very familiar with these two names, young dudes born before 1990s kind of have an idea who they are and younger hollows born in this century should be completely ignorant. Well, just some general about these two men, Li Ka Shing bought properties during the 1967 riots in Hong Kong at dirt cheap prices and Ng Teng Fong was the King of Orchard Road in the 1980s having done similar property investments like Mr Ka Shing. Both of them are property tycoons who made fortunes when the value of their investment grew multiple times, having bought them at crazily low prices. However it is unlikely they invested on the basis of a valuation from a properly consultancy, hence this got me thinking, what is it that drives growth in asset values? And is it possible to value assets accurately without the help from "professional consultants"?

The famous economist John Maynard Keynes (founder of the key-'sian' cross and many other crosses that burdens uni students when they are studying economics)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 spread sheets make it appear that valuing a Reit is a perfect science. In reality however it is far more art than science , so it is good news for those who don't really like to pour over theory books and academic doctrines.
So let's just touch on some of the "sciences" of valuating a Reit.

1)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 (PV) at an appropriate interest rate that reflects the weighted average cost of capital (WACC) of the Reit. What the heck is WACC? is basically finding the cost of equity, using CAPM (Capital Asset Pricing Model) and the interested rate charged for loans, when weight it accordingly to the amount of percentage in each form of capital. Sounds confusing? Ya, but it's not important, cause this WACC is usually given.

2)Book Value 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 third way to value a Reit, which is 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 such assumptions are not clearly understood. Hence i believe it is far more important to understand the factors that drive up value of a Reit rather then 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.

So these three pluses are the "arts" that derives value of a Reit. So let's delve into each of these factors in detail

Capital Value Growth (CVG)
Let's say you bought some units in Capita-Mall Trust and are wondering whether the asset values will keep appreciating (going up in value) 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 becomes what is it that would make CMT's portfolio of suburban malls (Think of IMM, the upcoming new Jurong East mall etc) 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 ahead? No one can tell with 100% certainty, if they can , they are playing God =], so a reasonable investor would then need to make intelligent guesses and form his or her 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 then answered with a good degree of conviction if the reasonable investor does his homework,like studying the potential land marked for commercial development in the suburbs and history and pattern of commerical 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 (the area and population from which a facility or region attracts visitors or customers) 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 on the other hand is a fairly staid (fixed, settled, or permanent) 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 insights 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 buy 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 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 the follow 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 capitalisation rate is therefore (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 capitalisation rate was 8-8.5% , it was even lower than the 10-year US government bond rate at that time which was 10-12% as investors anticipated strong capital gains due to continued inflation.

In contrast, the capitalisation rates in 2009 had moved up to about 10% even in a sub-1% interest rate environment reflecting the high risk premium that investors were placing on real estate. This illustrates the highly cyclical nature of the capitalisation rate (cap).

The average cap rate in the US historically has been hovering around 7.0-7.5% and the average spread over the 10-year bond has been around yield over the past decade has been about 3% and the cap rates have been in the 5-6% range.

These benchmarks are important to keep in mind. If your are buying a high quality asset at cap rates of 5-6% it is a fair bet that you are not paying too much. What if you are buying at a 3% 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 the reasonable 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 foot per mth in 2009 made Singapore the 24th most expensive office location globally, while Hongkong was the most expensive according to Colliers second half 2009 survey. Given that Singapore is a major Asian financial centre, this certainly made the city very competitive and one could have made reasonable assumption that office rentals at $6 is not sustainable (if not close to bottoming out), which is one of the main reasons why i bought CapitaCommerical Trust at $0.72 and made loads thereafter.

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%, and the lower 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 the global cities and a healthy increase from current levels look 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. 20 years later, 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 precis numbers.

Lastly 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.

Kepp in mind that a Reit is not jut 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.

I give you three most important qualitative factors out of the many i have discovered in valuing a Reit:

1) Leverage and interest coverage: One should tread carefully if a Reit has low interest coverage as it can easily run into trouble if rentals drop (etc Fraser Commercial Trust). A reasonable investor should be convinced that rents are sustainable before committing to such a Reit.

2) 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 the big boys (investors with large pockets, or funds) believe in the Reit.

3)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 with out taking undue risks, then it also deserves a premium.

Don't buy a Reit which has already priced in acquisition driven growth. This is one of the most frequent cases 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 "yeild accretion" in such cases comes from the low interest rates rather than attractively priced assets. As sucj, 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. And that is not all, given now that you have read this article and perhaps many other more in the future, with this knowledge... the question becomes , what are you going to do with it? Take action and start investing in Reits!