Although REIT as an asset class is often viewed as somewhat less risky for their bond-like nature when compared to equities in the more general sense, that is not to say that investing in REITs come with little or no risk. To best illustrate this point, I will show you 2 separate charts extracted from Google, showing the share price performance of both First REIT and Parkway Life REIT over the last 5 years.
On one hand, the share price of First REIT, an Indonesian-focused healthcare REIT has collapsed by over 80% since its height in 2016. On the other hand, the share price of Parkway Life REIT, also a healthcare REIT but with a portfolio predominantly focused on Singapore and Japan has doubled over the same period. The point I am trying to drive at here is that REITs aren’t entirely low risk investment products and you could potentially lose all of your capital. The question is, “What can explain for the differing fortune of the two REITs?”
Personally, I have came across many resources online discussing about the key metrics (e.g: rental reversions, gearing, interest coverage ratio, WALE, etc) to look at when determining the right REIT to invest in, but in my honest opinion, the one and most important thing is the strength of the REIT sponsor. Just to clarify, I am not trying to say that the aforementioned metrics are not important, but rather, I believe that if a REIT has a good backing in the form of a sponsor, the metrics will naturally take care of itself. Hence, as opposed to going through the metrics to focus on when determining if REIT A is a better investment than REIT B, I would flip it around and explain why and how a REIT with a strong and reputable sponsor, will ultimately be able to manage these metrics effectively over the long run to deliver superior returns for its unitholders.
Before diving straight into the details, it is important that you first get familiarised with the structure of a REIT. In case you have no idea or would like a recap on the structure of a REIT, you can refer to this article from REITAS on how the typical structure of a REIT looks like.
Source: FCT FY2020 Annual Report
For the ease of explanation, I have extracted the REIT structure of Frasers Centrepoint Trust (FCT) from its latest FY2020 Annual Report for our reference here. The key thing I would like to zoom in on is the REIT manager (“Frasers Centrepoint Asset Management Ltd”) and the property manager (“Frasers Property Retail Management Pte Ltd”). If you did not already know, both the REIT manager and property manager are wholly-owned subsidiaries of the sponsor, Frasers Property Limited. The REIT manager effectively sets the strategic direction of the REIT according to its stated investment strategy while it appoints the property manager to manage the daily operations of the assets owned by the REIT. As such, it is not difficult to see that the sponsor has a strong influence on how the REIT is being run given its control over the REIT manager and property manager as established above. With this framework in mind, I would move on to explain why the sponsor plays such a crucial role in the long term performance of a REIT. To make it more digestible and relevant for readers, I would include anecdotal evidence in the form of mini case-studies so as to better link what I have explained in theory to real-life actions executed by REITs.
Strong Acquisition Pipeline
One of the key ways for a REIT to grow is via the acquisition of new properties. In general, REITs typically have Rights Of First Refusal (ROFR) on the assets held by the sponsor. It is thus crucial that the assets held by the sponsor are good quality assets since most of the acquisitions done by the REIT are likely to be acquired from its sponsor. Hence, having a strong sponsor is important as a strong sponsor will give the REIT access to high quality assets.
A good asset is typically one that is strategically located i.e. in a location that is close to key transportation nodes and/or in a location that is likely to benefit from a growing population in the catchment area. In the context of real estate, it is almost always the case that being close to key transportation nodes and having an increasing footfall is always good for the asset, be it for a retail mall, an office building or a hospitality asset.
A strong sponsor is thus one that has good market knowledge and the right contacts to give itself access to assets in strategic locations. A classic example of a strong sponsor with good quality assets is Mapletree Investments Pte Ltd (“MIPL”). If you look at the chart below which I had extracted from the recent investor presentation slides of Mapletree Commercial Trust (MCT), you could see that the anchor asset of MCT, VivoCity, has enjoyed a CAGR of 3.0% in its tenant sales since its injection into the REIT.
Source: MCT Investor Presentation Slides
For readers who aren’t familiar with the asset, VivoCity is a retail mall located on the fringe of the Central Business District (CBD) in Singapore, within the Alexandra precinct. It is surrounded by offices such as HarbourFront Tower 1 and 2 and Keppel Bay Tower in the immediate vicinity and also a state-of-the-art Business Park, Mapletree Business City further down in the Labrador Park area. I have extracted a map from MCT’s investor presentation slides released in June 2020 just to give you a rough idea of its relative positioning.
Source: MCT Investor Presentation Slides
Tourists who have visited Sentosa would probably have visited the mall as the Sentosa Express Monorail Station that gives you direct access to Sentosa is located on level 3 of the mall. Not only is the mall a go-to destination mall for residents and office workers in the surrounding catchment, it is a must-go for tourists who are visiting Sentosa. Add on the fact that the mall is located right above the Harbourfront MRT station, a key interchange station, it is not difficult to see why this asset is of superior quality. There are many more factors that I have yet touched that make this asset such a valuable one but I will not go into it in case I bore you out. Nonetheless, I hope the above explanation is sufficient to convince you that this is in fact a good quality, best-in-class asset. All these key qualities have allowed the mall to grow its footfall and tenant sales as seen from the chart above.
Hence, a strong sponsor is important as it provides the REIT a good pipeline of assets for future acquisitions to further grow the REIT. Having established that a good sponsor would offer the REIT a platform to grow inorganically through acquisition of good quality assets, I would now move on to my next section to explain why having a strong sponsor also entails having good operational expertise that will allow the REIT to grow organically.
After a REIT has grown inorganically via the acquisition of an asset, it has to run the asset optimally to maximise the potential of the asset. The point here is an asset with a favourable locational attribute will only be as good as how well it is being managed. If the asset manager (a team within the REIT manager that adopts a portfolio view and executes strategic decision with respect to the operational aspect of its assets) and property manager fails to deliver and curate the tenant mix in such a way to optimise footfall to the mall, the asset will never be able to live up to its potential.
In the earlier chart on the trend of the tenants sales at VivoCity, I had pointed out that Pre-COVID, MCT had successfully grown the tenant sales at VivoCity year-on-year at a CAGR of 3.0%. While it is easy to attribute this to the strategic locational attribute of the asset as explained in the earlier section, this is not entirely the case. In the realm of the retail asset class, the asset manager and the property manager needs to work hand in hand to adapt to the fast changing retail landscape and optimise the tenant mix of the mall so as to constantly attract people to visit its malls.
Taking reference from MCT once again, it had recently completed its 5th Asset Enhancement Initiative (AEI) to date since VivoCity became operational. In the screen grab below from its recent investor presentation slides, we could see that it has successfully brought in NTUC FairPrice to take up c.91,000 square feet of space spanning across 2 floors. This is Fairprice’s largest and most innovative FairPrice Xtra hypermarket and Unity pharmacy, as well as Cheers convenience store to date. This AEI was expected to deliver positive rental uplift and an ROI of ~40%.
Source: MCT Investor Presentation Slides
Just like FCT, the REIT manager and property manager of MCT are subsidiaries of the sponsor, MIPL. In the above case, MCT is able to leverage on the operational expertise of both its asset manager and property management team to execute such a major AEI to boost the relevance of its asset in a fast changing retail landscape. I had personally been down to the NTUC FairPrice Xtra at VivoCity a couple of times and I had seen first hand the ability of the store to consistently attract a substantial amount of footfall with its new to market concept such as in-door farming, specialty coffee corner and live seafood display. Such operational expertise is crucial for the REIT to grow organically as it will help to drive positive rental reversions and hence DPU. With its ability to constantly drive positive rental reversions, this will help to drive up the valuation of its property over time which in effect helps to grow its NAV per unit. Assuming all else is constant, this will bring down the gearing of the REIT and increase its debt headroom which will in turn give the REIT more flexibility to carry out acquisitions to further grow the REIT inorganically.
From the above, it is thus not difficult to see that the strength of its metrics such as rental reversions, gearing, etc are ultimately linked back to the strength of the sponsor. These strong metrics will then give the REIT a good foundation to carry out acquisitions to grow the REIT inorganically. It is important to note that the reputation of a sponsor takes time to build and in the case of Mapletree, it has time and again managed to deliver growth for its shareholders across its 4 REIT vehicles.
Now that you have a clearer picture of why a strong sponsor is a prerequisite to allow the REIT to grow both organically and inorganically, I will move one step further to discuss about the capital management side of things.
As with all types of business, the assets of a business are often funded by a mixture of debt and equity. It is thus important to manage the cost of financing efficiently, be it debt (in the form of interest payments) or equity (in the form of dividend payments for a dividend paying stock) as these are all costs to the business. In essence, the lower the cost of financing, the better it is for the business and hence shareholders.
As REITs are quite highly geared (usually with a gearing of anything between 30% to 50%), it is very important for it to manage both its cost of debt and cost of equity efficiently.
I have extracted a table from DBS’ latest research report on AIMS APAC REIT to illustrate the point about why the strength of a REIT sponsor matters when it comes to the management of financing cost. The table above offers a snapshot of the various annual coupon rates of perpetual securities that have been issued by various REITs in the last couple of years. Just to clarify, perpetuities are classified as equities and thus does not increase a REIT’s gearing. The annual coupon rate are usually set based on a premium with respect to the SOR (Swap Offer Rate) i.e. SOR + premium. If you look at the fourth column in the above table, you could see that the REIT with the most favourable cost of funding is Mapletree Logistics Trust (“MLT”). Its premium for its SGD 180 million perpetual securities is only 1.815%! This is in contrast with the premium of 5.207% for AIMS APAC REIT’s most recent perpetual securities issuance done last year. The reason why MLT is able to raise proceeds from perpetual issuance at such a cheap cost is owing to the credibility and track record of its sponsor, MIPL. A lower interest expense would effectively increase the Distributable Income all else equal, thereby boosting the distribution per unit of the REIT.
Often, REITs with a low cost of debt also have a low cost of equity (but this is not always the case). The dividend yield of a REIT is essentially its cost of equity. The dividend yield offers an indication of the returns that investors expect to receive for the risk associated with holding the REIT. REITs with good sponsors such as MIPL often have a lower dividend yield (~4% to 5%) as investors perceive them as less risky relative to its peers while also believing that they will provide capital upside in the long run. For a REIT to grow via acquisition, it will often have to raise debt and/or equity to do so, especially if the target property is sizable. With a lower cost of equity, it gives the REIT an additional avenue to raise capital to expand its portfolio when the right opportunity comes up.
For a REIT that has a high cost of equity, it is often difficult to raise equity to fund its acquisition without diluting its existing shareholders. As such, REIT with a high cost of equity is usually limited in its ability to expand its portfolio via acquisition as it is often not conducive for them to do so. To give you a real life example, I have extracted the pro forma financial impact of ARA LOGOS Logistics Trust (“ALOG”) regarding its latest proposed acquisition of a portfolio of logistics assets in Australia in October 2020 for a consideration of S$441.2 million. It had proposed to acquire the target properties with a combination of equity (~70%) and debt (~30%), resulting in its gearing rising from 40.4% to 42.9%
Source: ARA LOGOS Logistics Trust
At the time of the proposed acquisition, it’s dividend yield was around 8%, much higher than comparable blue chip logistics REIT such as MLT which was trading at a dividend yield of ~4%. Given the inverse relation between dividend yield and its share price, a high dividend yield also implies that its share price (relative to its book value) is relatively low. To confirm this, at the time of the proposed acquisition, MLT was trading at close to 1.5x P/BV vs ALOG’s P/BV of ~1.0x. With a lower share price relative to its book value, it has to issue a lot more shares to raise the required capital to acquire the new assets. The depressed share price of ALOG means that it is not optimal for it to issue equity to fund this acquisition, causing it to resort to raising about 70% of the total acquisition outlay via external borrowings. The combined effect of this is a reduction of its Pro Forma DPU by 1.9% with a deteriorating gearing ratio.
From the above, it can be seen that it is very difficult for a REIT with a high cost of equity to raise capital through issuing more equity to fund its acquisition without diluting its existing shareholders. In order not to dilute its existing shareholders, it will have to either raise the funding predominantly via debt, or acquire a property with a higher NPI yield. In case you do not know what NPI yield is, you might want to check out my Valuation 101 article here. Often, assets that have a high NPI yield are often perceived as riskier investments or are of comparatively lower quality. As such, these assets tend to be traded at a more depressed valuation, thereby resulting in a higher NPI yield. In essence, a REIT that is trading at a more depressed valuation has a smaller pool of potential acquisition targets and have to resort to purchasing lower quality assets.
At around the same time as when ALOG announced the proposed acquisition of its Australian assets, MLT also announced its proposed acquisition of a portfolio of logistics assets in China, Malaysia and Vietnam. As mentioned earlier, MLT was at that time trading at ~1.5x P/BV. At such a premium valuation, it makes perfect sense to fund this acquisition using equity. In the extract below taken from MLT’s presentation slides on its proposed acquisition of 9 logistics assets in China, Malaysia and Vietnam, it can be seen that almost the entire acquisition outlay of S$1 billion is funded via equity issuance. Consequently, this has allowed MLT to lower its gearing from 39.5% to 36.8%. At the same time, this transaction is both DPU and NAV accretive!
Source: Mapletree Logistics Trust
The above case study is a perfect example to show why having a favourable cost of equity is so important for the growth of a REIT. In essence, the strength of the sponsor meant that the REIT was able to generate consistent growth in DPU over time and this has allowed the REIT to enjoy a lower cost of equity as investors push the prices of the REIT up. A lower cost of equity will then allow the REIT to have greater flexibility in terms of its capital management to undertake equity fund raising to lower its gearing while at the same time acquiring new properties that can further boost its DPU and NAV, thereby generating further growth for its unitholders.
Having the backing of a strong sponsor has multiple benefits. From the ability to have ROFR over good quality assets to enjoying a lower cost of equity, I hope that my above explanation has allowed you to understand that a strong sponsor is one of the most (if not the most) important factor in determining the long run performance of a REIT.
Before I end off my article, I would just like to leave you with some food for thought. If a REIT is trading at way below its Book Value, it does not necessarily mean that it is undervalued while the converse is true as well. Always remember that the market is “not stupid”, mispricing may occur occasionally, but over the longer term, the invisible hand will cause prices to adjust and reflect its fundamentals. The P/BV is often strongly correlated to its historical DPU performance and the ultimate factor that determines its DPU is the strength and credibility of the sponsor.