Is there still trust in Reits?

Business Times - 11 Jul 2009

Real estate investment trusts do look attractive in the long term at current prices, but investors must choose carefully and diversify their investments accordingly. By Roger Tan

THE Singapore real estate investment trust (S-Reit) sector has grown remarkably since the first Reit - CapitaMall Trust - was listed in July 2002. Between 2006 and 2008 alone, more than 13 Reits were listed, compared with only seven between 2002 and 2005.

Choices of Reits have also expanded. In 2005, investors could only choose between commercial (retail, office or mixed), industrial and logistics Reits. Today, they can find hospitality, healthcare and residential Reits. There are also Reits that own foreign assets.

S-Reit growth in 2006 was mainly driven by increasing speculative interest in the property sector after commercial rents started to rise strongly. The office rental index was up 30.3 per cent in 2006, compared with 12.7 per cent the year before. This was a stark contrast to a 5.6 per cent increase in the shop rental index in 2006. The median monthly rent for central office space at end-2006 was $6.24 per square foot (psf), compared with $4.24 psf in 2005.

Investors' hunger for Reits grew dramatically. The market capitalisation of the Reit sector at the start of 2005 was $9.4 billion - but it hit $16.9 billion in June 2006. Furthermore, only one new Reit - Allco Reit, now known as Fraser Commercial Trust - was listed in the first half of 2006. The increased demand for Reits pushed their unit prices up and dividend yield down. Average dividend yield in January 2005 was around 6.5 per cent, compared with 5.6 per cent in June 2006. This together, with higher Sibor rates, squeezed dividend yield premiums - the difference between dividend yield and three-month Sibor rates - from 5.2 per cent in January 2005 to a low 1.9 per cent in June 2006.

Although office prices rose 17 per cent on the back of higher rents, the increase was more benign than the 30 per cent rise in rents. This resulted in an increase in median annualised rental yields of office properties from 8.1 per cent in 2005 to 9 per cent in 2006. Rental yields of shop space and industrial properties, on the other hand, remained at 7.9 per cent and 5.2 per cent respectively.

The combination of a lower cost of equities and higher rental yields spawned many new Reits between June 2006 and December 2007. Seven new Reits were listed in second half 2006 and another five in 2007. Reits' assets under management (AUM) grew from $13.4 billion in 2005 to $23.2 billion in 2006. In 2008, AUM were $42.5 billion.

Given the increased competition, Reits started to enhance their yields with debt to attract investor interest. The average debt to total asset ratio of the Reit sector rose from 26.3 per cent in January 2006 to 30.7 per cent in June 2007. A few Reits even pushed this ratio above 50 per cent in June 2007.

Reit investors' high hopes of continued price increases started to shake when the first sign of financial turmoil presented itself in July 2007 and Reit prices started to fall. The situation did not improve into 2008. Between June 2007 and December 2008, the S-Reit index fell more than 66 per cent, as opposed to 50 per cent drop in the Straits Times Index. Although Reit prices have recovered 16.8 per cent for the year, they are still 60.3 per cent lower than in June 2007.

High debt ratios employed by Reits became a concern as Reits started to signal that they would face challenges refinancing their loans - and even paying dividends. Loan-to-value ratios increased in 2008 as Reits revalued their assets downwards - adding more concerns over their survival. To improve the strength of their balance sheets, some Reits issued rights in 2008 and 2009.

There are, however, some positive developments from this debacle. First, dividend yield premiums have increased since July 2007. With lower prices, S-Reits now offer dividend yields of around 12.4 per cent, compared with around 7.3 per cent a year ago and 4 per cent in June 2007. Sibor rates have also fallen, from 2.7 per cent in June 2007, to the current 0.7 per cent. Dividend yield premium has thus improved to 11.9 per cent, from just 1.4 per cent two years ago.

Prices of Reits are also at more affordable levels now. For example, the prices of CapitaMall Trust, A-Reit and Mapletree Logistics Trust were at $1.40, $1.59 and $0.56 respectively as at June 30 this year - around half their prices in June 2007.

Most importantly, the good and bad Reits are now easier to differentiate. The lower 'tide' has exposed Reits that have bad assets and have been poorly managed - making investment decisions easier than two years ago.

Unfortunately, uncertainty still lurks in the sector. Although there are now signs that the economy is bottoming, economic recovery will probably be gradual at best. Furthermore, the Singapore economy is dependent on foreign demand, and therefore recovery will lag the developed nations.

Vacancy rates of offices and shops in March 2009 increased to 10.0 per cent and 6.6 per cent respectively from 7.7 per cent and 6.4 per cent a year earlier. Only industrial properties bucked the trend, with the vacancy rate falling from 7.6 per cent to 7 per cent.

Between March 2008 and 2009, rents for office space and industrial property were down 12.9 per cent and 6.5 per cent respectively, while shop space was up a marginal 0.5 per cent.

Even though developers have been holding back new projects, the chances of significantly higher rental and lower vacancy rates this year is not high. Reits may, therefore, have to reduce their dividends.

Reits do look attractive in the long term at current prices, but investors must choose carefully and diversify their investments accordingly. Here are a few important factors to consider:

A Reit's ability to raise funds, especially in times of turmoil, will determine its ability to thrive and survive. This is an important factor. In good times, most Reits will enhance their yields through higher leverage, but only well-managed Reits will be able reduce this leverage in challenging times. Without this ability, badly managed Reits will find it difficult to refinance or raise sufficient equity to repay their loans, putting them in danger of liquidation.

The quality of assets is another important factor, and Reits that own properties beyond just Singapore would be a plus. Too much emphasis has been put on dividends and too little on assets. Investors must bear in mind that they are buying the underlying assets when investing in Reits - the dividends are the result of the ownership and management of the assets.

However, good assets can produce poor returns if poorly managed. The quality of the managers is therefore another important factor. Good managers will continuously enhance the yield of the assets and use an appropriate debt-equity mix at all times. A sudden fall in rental revenue, rental collection issues and below average rental yields are some signs of poor management. Such Reits should be avoided.

Last but not least, investors must check if a counter is a Reit, such as CapitaMall Trust, or a business trust, such as IndiaBulls Property Investment Trust. Business trusts and Reits are created to allow unit holders to receive dividend payments from operating cash flow instead of accounting profit. However, only Reits are required to pay 90 per cent of distributable income to unit holders. There is no such requirement for business trusts. Investors should therefore look closely at what they are picking, to ensure the counter they choose is in line with their investment intention.

The writer is vice-president, SIAS Research