REITS: \'Please weigh the risks!\'

REITS: \'Please weigh the risks!\' By Mephisto I HAVE been asked many a time by friends to explain my pessimistic outlook on Singapore REITs. My starting point is that local analysts have not experienced a collapse of REITs before. Hence, they do not understand fully the inherent risks of REITS. Here, I hope to explain the risks that one should examine prior to investing in a REIT. A REIT, or Real Estate Investment Trust, is a company that derives most of its income from the rental of properties. It raises funds from the public and uses it to acquire, own and manage real estate. To qualify as a REIT, it has to pay out 90% of its taxable income as dividends to shareholders. Other characteristics of REITs listed in Singapore include: * At least 70% of assets invested in real estate; * 75% or more of income to be derived from rents; * Leverage limit is 35% of deposited properties, or 60% if a credit rating is obtained and made public. The first Singapore REIT, CapitalMall Trust, was launched in 2001. In the US, since its beginnings in 1960, when the Congress created this investment tool to allow the public to invest in large scale commercial properties, the industry has grown dramatically. By end 2007, there were over 180 REITs in the US with assets totaling USD 375 billion. Benefits of REITs REITs allow investors to hold a diverse portfolio of properties, without having to buy physical real estate. This diversification can be easily achieved through an allocation of investments in mixed portfolios of properties and geographical markets. There are REITs that invest in Indian industrial properties, Japanese commercial properties as well as the different types of properties in Singapore. Unlike common stocks, REITs are taxed on an individual basis only. In Singapore, this is less of a problem as retail investors do not face double taxation. Risks of REITs I have seen many research reports highlighting high distribution yields as the key selling point of a REIT / Shipping Trust, without explaining in detail the risks that lurk. Distribution yields, for one, are a function of REITs’ unit prices, so yields could be high simply because unit prices have dropped dramatically. Refinancing Risk The first risk that all REITs / Shipping Trusts face today is refinancing risk. Not many investors understand that refinancing is now the biggest headache faced by the senior management of REITs. But the challenge of refinancing was highlighted by Mr John Lim, CEO of ARA Asset Management, who has openly asked banks to relax their lending to Singapore REITs. He was quoted in the Business Times recently as saying: “In 2009 alone, you have S$4.6 billion of debt for refinancing. In the next four years, it may be close of S$20 billion, including rollover debt. The issue is very real.” The worst case scenario is bankruptcy, as exemplified by a recent REIT case in Japan. New City Residence filed for bankruptcy protection on 9 October in a decision prompted by difficulties relating to financing a recent acquisition and the scheduled repayment of borrowings. If no sponsor is found, New City is expected to be liquidated with its debts to be repaid from the proceeds of all properties to be sold. Any outstanding funds would be distributed to investors. Over the weekend just past, you would have read that Frasers Commercial Trust (FCOT) has taken a $70 million loan from parent company Fraser and Neave (F&N) to repay debt. The money has been used to repay $70 million of loan notes issued to Australia\'s Commonwealth Bank. Other than the $70 million loan, FCOT also owes Commonwealth Bank a further $400 million and $150 million, due in July and December 2009 respectively. You would also recall that FCOT is actually ex-Allco REIT. In July 2008, Frasers Centrepoint bought 17.7 per cent of Allco Commercial Reit and 100 per cent of the trust\'s manager for $180 million and renamed Allco REIT as FCOT. If F&N have not stepped in to refinance this $70 million loan, do you think Allco REIT could be the first REIT casualty in this financial tsunami? Dividends will be cut in 2009 It is my belief that the Singapore REITs / Shipping Trusts would have to cut their Dividend Per Unit (DPU) in 2009 to preserve their cash holdings. Distribution yields will be adjusted downwards subsequently. And since, the REITs are mainly valued via a Dividend Discount Model (DDM), doesn’t it make sense to downgrade the REITs if the dividends are cut?Some REITs are taking the innovative approach of offering units as dividends instead of cash. Kudos to the management! Going forward, REITs would be valued more as a bond, rather than a hybrid of debt and equity, given their inability to sustain capital appreciation. Look at the AA-rated bonds trading in the US and you would know roughly how much yields you would be expecting from the REITs. Reduced Rental & Lower Occupancy Rates In the past, REITs made acquisitions of properties based on assumed rental rates and occupancy levels. In this current economic downturn, I would be surprised if the REITs are still optimistic about those assumptions. They would be more concerned about keeping their tenants rather than talking about increasing rental next year. Occupancy levels are also likely to take a hit as tenants either reduce their demand for space or source for cheaper alternatives. Supply Side of the Equation Having stated the demand side of the equation, I now take a look at the supply portion – which is essentially the strength of the Singapore banking system. Goldman Sachs in a November report said: “In our view, the market seems to be focused on the demand side of the equation, i.e. demand for financing/refinancing, and market participants appear to have simply extrapolated the blanket of tight liquidity from the US and European banking systems onto Singapore. However, we believe that it is equally important to look at the supply side, i.e. the health of Singapore’s banking system and overall system integrity.” Goldman has noted that there are funds available for lending (should banks choose to do so), although banks have become more selective in extending credit. The level and recent progression of SIBOR rates underscored the assertion of continued system liquidity. According to Goldman Sachs, a snapshot of Singapore’s banking system (Domestic Banking Units, DBU) shows a comfortable level of loans to deposits of about 80% as of August 2008, while loans to total assets stands at 41%. There is a significant amount of assets tied up in interbank funding which can easily be moved to higher yielding loans if required (most interbank loans are conducted at SIBOR vs. non-bank loans at SIBOR plus a margin). 2 REIT picks by Goldman Sachs So are there any good REITs that one can keep a lookout for? Goldman Sachs’ Nov report highlighted CapitaCommercial Trust (CCT) and Suntec REIT (SUN). In its view, CCT’s chances of refinancing are strong given its prime commercial office portfolio and the strength of its sponsor, CapitaLand. CCT (Moody’s Baa1 credit rating) has S$656m of debt due by end Dec-09, the bulk of which comprises S$580mn of CMBS due in Mar-09. CCT’s gearing (total debt to assets) is 36.3% as at September 30, 2008. The company has advised that it has undrawn facilities of S$225mn and it intends to complete the refinancing well in advance of the debt maturity date (Mar-09). SUN’s refinancing risk is limited but definitely higher than CCT. In the relative sense, although SUN’s asset portfolio is also of prime quality, its shareholding is fragmented and it lacks a “committed patron” (such as CapitaLand in CCT’s case). However, Goldman Sachs also noted that Cheung Kong is a major shareholder in SUN’s REIT manager (ARA Asset Management). SUN (Moody’s Baa1 credit rating) has S$125mn in short term financing, though of more significance is the S$700mn of CMBS due in Dec-09. As at September 30, 2008, SUN’s gearing stood at 34.8%. Management has stated that it has started negotiations with its bankers on refinancing its debt that is due in Dec-09, and has further advised it has no plans for equity financing in the foreseeable future. In conclusion, the report highlighted CCT and SUN’s debt refinancing chances are strong, and prime location commercial space landlords like CCT and SUN will be able to sustain their core operations in an environment of declining rental rates.

Quote from CIMB report today Feedback from Investors We held meetings with 58 investors during an 8-day roadshow to the UK, Europe, Singapore and Kuala Lumpur in November. Themes discussed included REITs’ refinancing issues, the implications of breaching the 60% gearing limit as well as the degree of occupancy and rental declines that could be expected in a downturn. While most REITs seem able to maintain general debt covenants with their bankers with safe gearing levels of under 45% (vs. the regulatory 60% limit) and interest cover exceeding 3x, short-term refinancing looks daunting for a number of them. From the refinancing deals announced over October-November, we conclude that REITs with strong sponsors, particularly government-linked sponsors, low leverage and quality portfolios are more likely to secure bank loans, which are the preferred refinancing option. While some sceptical investors felt that there was more room for rents and occupancy to fall, most agreed that REITs have been oversold and even if yields deteriorate moderately from here, the REITs remain highly attractive, by any measure. Top Pick -- CCT Will it get cheaper? Most clients agreed that at 0.2x P/BV, falling rents and occupancy levels have been priced in and yields of 18% certainly look attractive. We contend that CCT’s low average rent base (under $8psf/month), long leases, rental caps for some of its leases, rental support from CapitaLand for One George Street and a master lease structure with the hotel operator RC Hotels within Raffles City would provide buffers despite falling office spot rents and occupancy levels. Investors’ apprehensions about a falling topline were somewhat assuaged. However, refinancing issues remain the main worry and three possibilities were discussed: (1) Bank loans secured but at a high cost. Refinancing via bank loans is the most preferred solution for CCT at this point. On 28 Nov, Reuters reported that CCT verbally mandated four banks (Bank of Tokyo-Mitsubishi UFJ, DBS Bank, Standard Chartered Bank and UOB) to handle a S$580m 3-year bullet refinancing deal, which is equivalent to its short-term debt coming due in Mar 09. Interest cost, which was reported at 250bp above LIBOR, is in line with the 3-year cost of debt in Singapore (we earlier estimated at 200-300bp above SIBOR or SOR). However some investors are concerned that the indicative rate is significantly higher than CCT’s portfolio property yield, which is below 4%. Even though the cost of debt has yet to be finalised, we have assumed a cost of debt of 5% for CCT in 2009. Most investors conceded that an increase in cost of debt would still be preferable to a dilutive rights issue. We are of the view that banks remain willing to extend credit to CCT, given its quality portfolio and strong sponsor CapitaLand (CAPL SP, S$2.49, Underperform, target price S$2.30). A direct bank loan remains the most possible and positive outcome for CCT. (2) Bank loans not secured; rights issue forced. More sceptical clients were worried that CCT may resort to a rights issue if bank loans cannot be secured, causing dilution for existing unitholders. Additionally, if take-up is poor, sponsor CapitaLand could end up absorbing the bulk of the issue, resulting in a highly illiquid REIT. This would be negative for both CCT and the REIT sector. We are of the view that this option would be given low priority, and that bank financing would eventually be made available to CCT. Before deciding on a rights issue, a loan from the parent might be an alternative, and would be received more positively than rights. (3) Convertible bonds redeemed at put date. Short-term financing woes aside, Singapore-based investors were particularly concerned that CCT’s S$370m convertible bond due to mature in 2013 would be redeemed earlier at its put date in May 2011. This would cause a spike in CCT’s debt profile in 2011 and increase its allin cost of debt.

Avoid ALL REITs. They have a uphill task to manage their refinancing as well as to grow the DPS. Anticipate ALL REITs to spend 2009 consolidating their balance sheets, writing down their overly valued assets and de-leveraging from over zealous acquisitions in 2007/2008. :laugh: :laugh:

Morpheus\' earlier article was superb. Single best post in this forum so far!

Thanks Danielxx... You had some very impressive articles too. Care to share with us a few recent stories? You read about TT International?? A real pity that a Singapore Brand is going bust.... So many years of hard work going down the drain. :ohmy: :ohmy:

Traded TT in 2004 period .... heard about Akira and thought it had some potential, plus the company seemed to be growing profits steadily. But I was aghast at how its capital structure had become so geared when I looked at it again recently after the news reports. How the hell did they overdo things so much? Recent stories all appear to be on the global macro side: tight credit, writedowns, collapse of business and consumer spending. My prediction is that financials will never be the same again, and institutions will avoid putting too much weightage on them in their portfolios once they come around to this structural development. It is incredible if you examine the previous portfolio allocations of unit trusts. Most allocated close to or >30% of their stock portfolio to financials. It will change. The gilded age of finance is over; it will be heavily regulated from now on. Consequently, high ROEs built on high financial leverage will undergo a structural downshift.