The glory of REITs

You probably have heard or read about REITs (Real Estate Investment Trusts) before? If you haven’t, you don’t know what you’re missing out! So for the benefit of those who don’t know about REITs, they are basically just like stocks trading on SGX, but instead of referring to them as “stock” the proper term is called “units”. REITs receive special tax considerations and typically offer investors high yields, as well as a highly liquid method of investing in real estate.

Individuals such as you and me can invest in REITs either by purchasing their units directly on an open exchange or by investing in a mutual fund that specializes in public real estate (Etc Lion Fund, they invest into a group of China related REITs)

So let's just touch a bit on the "sciences" of valuating a REIT.

1) Many people I know in the industry, uses the Discounted Cash Flow (DCF) model to value a REIT. This model 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, for those who attended MIP advance would be well aware of this model. But perhaps in my opinion, a better valuation model for valuating REITs, is to use dividend discount model (DDM), due to the fact that REITs in Singapore are required by law to pay off 90% of their earnings back to unit holders. Wouldn’t then this be a clear indication of using DDM instead of DCF, since dividends is the one that unit holders are getting back instead of cash flow? This is debatable, nevertheless I shall move on. 

  

1) Many people I know in the industry use the Discounted Cash Flow (DCF) model to value a REIT. This model 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, for those who attended MIP advance would be well aware of this model. But perhaps in my opinion, a better valuation model for valuating REITs, is to use dividend discount model (DDM), due to the fact that REITs in Singapore are required by law to pay off 90% of their earnings back to unit holders. Wouldn’t then this be a clear indication of using DDM instead of DCF, since dividends is the one that unit holders are getting back instead of cash flow? This is debatable, nevertheless I shall move on.   

2) The Book Value method is another way to value a REIT, 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), so some people just use the BV as a signal to buy when the unit price fall below the BV by a certain percentage and likewise sell when the unit price rises above the BV by a certain percentage.

3) Cap rate or yield, the third way to value a REIT, which is the annual net property income (NPI) is capitalized at a certain yield thought to be appropriate for the REIT. Some analyst uses the yield as indication to buy or sell. For example, In 2004 to 2007 when the stock market was booming, many of the REITs were trading at a high valuation and had yields that were quite low

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 than obsessing about precise values churned out by financial models.

So without further ado let’s look at the “art” side of valuating REITs

The main pointers are 

+The potential for capital value growth (CVG)

+Capital structure of the REIT and the caliber of its managers

Capital Value Growth (CVG)

There are several factors that need to be in place for the a REIT to appreciate in value, let's use Capital Mall trust to illustrate. A Key factor is to ask yourself whether the trend of suburban shopping activities will continue to go up since such activities will result in high occupancy rates and increase rentals at suburban malls, in turn driving up the capital value of the REIT. A reasonable investor would then need to make intelligent guesses (supported by industry research/ expert opinion) and form his or her own opinion on the industry trend for that particular REIT. 

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 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 (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 labor 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.

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.

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 caliber  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 "yield accretion" in such cases comes from the low interest rates rather than attractively priced assets. As such, the accretion will likely disappear with the next refinancing. 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

But hold on a minute!

According to Ms Teh Hooi Ling, senior correspondent of Business times,

The high yields of real estate investment trusts (Reits) are tempting. And indeed, they have been touted as a relatively safe and stable instrument to own if one is looking for a steady stream of income. As such, many investors see Reits as a good asset class to have in one's retirement accounts.

But you know what? That Reits are good income-yielding instruments is but a myth. The thing is, whatever they pay out in dividends, they will take back - all and more - a few years later in the form of rights issues.

Here's what I found. Of the 17 Reits which have a listing history of at least four years on the Singapore Exchange, only three have not had any cash calls or secondary equity raising. The remaining 13 have had cash calls, and many had raised cash multiple times. One had a few rounds of private placement of new units which diluted the stake of existing unitholders somewhat.

For many of these Reits, the cash called back far exceeded the cash received. So, the myth of Reits as almost comparable to a fixed income instrument is really busted.

Take CapitaMall Trust (CMT) which was listed in July 2002. Assuming that Ms Retiree bought one lot or 1,000 units at the initial public offering (IPO) for a total sum of $960. For the whole of 2003, she received $57 in dividends. However in that year, CMT also had a one-for-10 rights issue. To subscribe for her entitlement, Ms Retiree would have to cough out $107.

In 2004, she would received $89 for the total number of CMT units she owned. That year, CMT had another rights issue, also one-for-10. The exercise price was higher at $1.62. To subscribe, Ms Retiree would have to fork out $178.

In 2005, CMT again had another fund raising exercise via rights issue. Ms R would pocket $124 in dividends but in that same year, had to return $282 back to the Reit.

In the next three years - 2006 to 2008 - Ms Retiree felt rich and happy. She merrily banked in her quarterly distributions which amounted to $404 for her holdings of CMT. Her one lot, after three rights issues, had grown to 1,331 units.

In the following year, another $175 was distributed. But CMT wasn't going to let Ms R be happy for long. It launched a big one - a 9-for10 rights issue. To fully subscribe for her entitlement, Ms R had to empty her bank account of a whopping $982.

And you know what, the cash call came in March 2009, when the Straits Times Index fell below 1,600 points, and many retirees were dismayed to see their investment portfolios plunge by half or more. Many fret if they would have enough left in the pot to sustain their lifestyle. Having to cough up more money for a Reit was the last thing that they wanted to do!

Negative cash flow

And here's the final tally. Since its IPO until today, a holder of one lot of CMT would have received $1,264 in cash distributions. However, in all, he or she had to return $1,549 back to the Reit so as to subscribe to their entitlement of new issues. That's a net outflow of $284 per lot.

It's the same story with K-Reit Asia, Capitacommercial Trust, Frasers Commercial Trust, Mapletree Logistics, First Reit, Lippo Malls Indo Retail Trust, AIMS AMP CAP and Saizen REIT in that what was taken back from investors was more than what was given out.

K-Reit has been one of the most aggressive fund raising Reits. Had you started with just one lot when it was listed in April 2006, you would have to dish out $8,399 to subscribe to your rights issue. Distributions amounted to $1,110, resulting in a net outflow of $7,289.

For Reits with at least four years of track record, only Fraser Centrepoint, Parkway Life and CapitaRetail China have not had any cash calls.

Instead of a rights issue, Suntec Reit raised funds by issuing new units to some institutional investors at a slight discount. Existing unitholders don't have to cough out additional cash, but they would have their share of earnings diluted somewhat

Misalignment of interests

Reits are managed by managers, and managers are paid based on the size of the portfolio that they manage. So the incentive is for the managers to continue to raise money and expand the portfolio size. Sometimes this is not done in the best interest of unitholders.

The most recent controversy was over K-Reit's purchase of Ocean Financial Centre (OFC) from its sponsor Keppel Land. K-Reit has launched a 17-for-20 rights issue to pay for the purchase which was deemed by the market to be expensive at a time of uncertain outlook and when office rental is expected to ease.

BT reader Bobby Jayaraman argued that rather than be compensated based on factors such as the value of assets, net property income and acquisition fees, Reit managers should be paid based on a combination of growth in distribution per unit and market valuation of the Reit.

'If Reit managers were paid on the basis of distribution per unit and market valuation growth, would K-Reit have bulldozed its way through the OFC acquisition like they have done?

'The day K-Reit announced the OFC acquisition, its stock price fell close to 10 per cent and has continued sliding. Yet, its Reit manager will take home significantly increased management fees while shareholders would have lost a good chunk of their capital even as they bear significantly more risk in the form of higher leverage and potential property devaluations given the uncertain environment,' he wrote to BT.

Misalignment of interests aside, there are also unitholders who clamour for growth.

But while Reits may not be the perfect income yielding instrument that they are made out to be, they have proven their capacity for capital appreciation. Relative to the capital ploughed in, CapitaMall Trust has rewarded its unitholders with a return of 127 per cent. Most Reits have yielded positive total returns.

Instead of buying Reits for yields, some savvy investors only buy them when they see those with good quality assets trade at sharp discounts to their book value. For example in the first half of 2009, CMT was trading at 50 per cent its book value.

Hence, valuation metrics which apply to a typical asset heavy stock would apply to Reits as well.