Mapletree North Asia Commercial Trust – In A Precarious Situation

Mapletree North Asia Commercial Trust (SGX: RW0U)  is one of the four listed REITs under its sponsor, Mapletree Investments Private Limited (“MIPL”). With its recent acquisition of a 50% stake in a South Korea office tower, the REIT’s investment mandate has been expanded to include the acquisition of commercial properties (both retail and/or office purposes) across the Greater China Region, Japan and South Korea. For readers who are familiar with the REIT industry in Singapore, you would know that most of the REITs managed by Mapletree have outperformed the wider S-REIT market as a whole in the last couple of years. However, the same cannot be said for Mapletree North Asia Commercial Trust. It’s share price has taken a huge hit due to the double whammy of the Hong Kong SAR protest that broke out sometime in 2019 and the COVID-19 pandemic that swept across the world in 2020. Just to give you some context about its performance over the last couple of years, I have extracted a chart showing its share price movement over the last 5 years. 

Source: Philips Securities

From the above chart, it is apparent that prior to mid-2019, Mapletree North Asia Commercial Trust’s (MNACT) share price had been advancing steadily and had risen by slightly over 80% between early-2016 to mid-2019, reaching a high of $1.48 on 10 July 2019. However, it’s share price has tumbled by 35% since, closing at $0.96 on 26 February 2021. The first wave of its downtrend in the second half of 2019 was due to the escalation of the Hong Kong protest that had ultimately led to protestors stomping into its anchor asset, Festival Walk and damaging the property. It’s subsequent plunge in the first quarter of 2020 was due to the market crash triggered by the COVID-19 pandemic. In today’s article, I will be sharing my thoughts on this REIT and whether it is effectively a “gone case”.

Before diving straight into the analysis, I will first have a quick run through on the portfolio of assets held by the REIT which will help set the stage for my subsequent analysis. 

Source: Mapletree North Asia Commercial Trust Q3FY20/21 Business Update

Based on the above extract of its portfolio breakdown by Net Property Income (“NPI”) taken from its latest Q3FY20/21 business update, we can deduce that the REIT derives close to half of its NPI from its anchor asset, Festival Walk in Hong Kong SAR. It’s Chinese office assets, Gateway Plaza in Beijing and Sandhill Plaza in Shanghai collectively make up close to 30% while its Japanese Office properties make up 23% of its NPI. Finally, its sole South Korea office asset in Seoul acquired in 4Q2020 accounts for about 1% of its NPI. 

As such, it is obvious that the performance of the REIT is heavily dependent on the performance of Festival Walk. Please do note that as the South Korea asset was only acquired in 3QFY20/21 and since the above chart takes into account the performance from 1QFY20/21 to 3QFY20/21, the contribution of the South Korea asset is under-represented. In actual fact, it’s contribution to the portfolio NPI should be approximately 3%. Despite this, it does not change the fact the performance of the REIT is highly dependent on the performance of Festival Walk. 

Festival Walk is a territorial retail mall and lifestyle destination with an office component, comprising a seven-storey retail mall with a four-storey office tower and three underground car park levels. In terms of its location, it is located in the upscale residential area of Kowloon Tong, Hong Kong SAR. 

Source: Mapletree

It is one of the top 10 retail malls in Hong Kong SAR by GFA. In terms of its valuation, it is valued at HKD27 billion (~SGD4.7 billion) as at 30 September 2020. To put things into context, even the mega integrated development Raffles City Singapore that includes the office, retail and hotel spaces is only valued at SGD3.3 billion, 30% less than Festival Walk. The property even has an ice rink within the development! 

As I personally have not been down to the mall before, I am not able to give you my first-hand opinion of the mall’s positioning. However, based on my research, I do believe that Festival Walk is more akin to a suburban mall that caters to the mass market rather than a “tourist mall” and hence derive a majority of its tenant sales from locals. I arrived at this conclusion after digging through the IPO prospectus of Mapletree Greater Commercial Trust (before it became Mapletree North Asia Commercial Trust) and found the below charts.

Source: MGCCT IPO Prospectus

In essence, the above charts show the gross revenue performance and retail sales trend of Festival Walk for the period between 1999 to 2010. During that time, Hong Kong SAR had undergone two major crisis, the SARS epidemic in 2003 and the Global Financial Crisis in 2008/09. It is apparent that the mall is fairly resilient across both the crisis as its retail sales and gross revenue held up fairly well in both incidences. In fact, it was mentioned in the IPO prospectus that only about 18% of the total sales for Festival Walk is likely attributable to tourists. This thus leads me to think that Festival Walk is more like a mass market suburban retail mall in the context of Singapore where it is predominantly visited by the locals for necessity shopping.

Aside from Festival Walk, it was also noted earlier that MNACT’s Chinese assets collectively makes up about 30% of its NPI. In particular, its Beijing asset, Gateway Plaza accounts for 21% of its NPI. Given the substantial contribution of its Beijing asset to its overall portfolio, I do think that it makes sense to analyse this asset a little further as it collectively makes up almost 70% of MNACT’s NPI when combined with Festival Walk. 

Source: IPO Prospectus

Gateway Plaza is a grade-A office building located in the prime Lufthansa Area, approximately 8km away from the Beijing CBD. In terms of its quality, it is one of the highest quality premier grade-A office buildings in the Lufthansa Area. It counts BMW as its key tenant, which is MNACT’s largest tenant by monthly GRI. 

In the table below which I had taken from Cushman & Wakefield’s Beijing Office Marketbeat Q42020 report, Lufthansa area is still classified as part of the CBD and is certainly not considered a suburban office. While I have not been down to Gateway Plaza, my guess is that Gateway Plaza, while not being located in a prime CBD location, is considered to be located in the fringe-CBD kind of location. To put it into context, it could be compared to fringe-CBD locations like the One-North and Alexandra area in Singapore (vs the prime CBD area like Raffles Place).

Source: Cushman & Wakefield’s Beijing Office Marketbeat Q42020 Report

Based on the above table, Grade-A offices in the Lufthansa Area are performing slightly better than the overall Grade-A CBD market in terms of vacancy rates, with an average vacancy rate of 9.9% vs Beijing Grade A CBD average of 10.8%. One interesting thing in the above table is that the Grade-A office rent in the Financial Street submarket, which at ~USD9 psf, is almost twice the rents for equivalent spaces in the Lufthansa area. I am not sure what is with the location that commands such a high rent, but a brief googling seems to suggest that the Financial Street is known as China’s new “Wall Street”. 

Now that we have a better understanding of the portfolio constitution of Mapletree North Asia Commercial Trust, I will dive straight into my detailed analysis of the REIT. Unlike my usual modus operandi where I analyse the REIT holistically from the portfolio operational perspective all the way right up to capital management and the strength of sponsor, I will be adopting a slightly different approach for today’s analysis. Instead, I will be focusing the bulk of my analysis on the outlook for MNACT’s core assets and their operational strength. The reason being Mapletree Investments has already established itself as a solid sponsor through its astounding track record and it has also proven itself to be astute on the capital management front as well. As these in a way can be taken as a given, the performance of the REIT is thus largely dependent on the quality and the performance of its asset. Nonetheless, I will still share some of my high-level thoughts with regards to the management fee structure, valuation and land tenure of its assets and the capital management aspects nearer to the end of my analysis so as to provide a more holistic view.

Challenging Outlook For Its Core Assets

In my introduction, I had mentioned that its two core assets, Festival Walk and Gateway Plaza, collectively accounts for close to 70% of its NPI. I will thus be paying close attention to these 2 assets to assess their outlook. As Festival Walk accounts for half of the REIT’s NPI, I will begin with it first. Among all of the assets, I would think that Festival Walk is the most challenged and it is not difficult to see why. Firstly, it was hit by the civil unrest in 2019 which resulted in the mall having to shut down for 1.5 months at the end of 2019 as protestors stomped into the asset and damaged the building. Before the management had the time to catch its breath, it was slapped once again in the face. This time, it was the COVID-19 pandemic that had paralysed the economy of virtually every single continent of the world apart from maybe Antarctica. While Hong Kong SAR did not go into a full-lockdown unlike countries like Singapore and Italy, it has had to endure multiple waves of outbreak as the government struggled to cope with the highly contagious disease. 

Source: Bloomberg

The double whammy of the Hong Kong SAR protest and the COVID-19 pandemic had caused Hong Kong to fall into its first ever back-to-back recession on record. According to the above Bloomberg chart, Hong Kong’s economy had contracted 6.1% in 2020 after contracting 1.2% the year before.

On the COVID-19 front, Hong Kong has to date had four waves of outbreak with the most recent outbreak that started in November 2020 leading to the cancellation of the travel bubble with Singapore that was scheduled to occur in December 2020. The waves after waves of outbreak have been brutal for the entire retail sector in Hong Kong. In the introduction, I had mentioned that Festival Walk had come through the SARS epidemic and the Global Financial Crisis relatively unscath but it is not so fortunate this time round. The difference is that COVID-19, unlike SARS, is more contagious despite being less fatal. This has led to multiple waves of outbreak which the government is left with no choice but to be in a perpetual state of moving into and out of lockdown mode when a new wave strikes.

Source: MNACT 3QFY20/21 Business Update

As such, the performance of Festival Walk had not been spared. To get a feel of the extent of damage done to Festival Walk, I had extracted a slide from MNACT’s latest 3QFY20/21 business update. In the above screen grab, retail sales at Festival Walk had tumbled 32.5% y-o-y YTD FY20/21. This period (1 Apr 2020 – 31 Dec 2020) corresponds roughly to the period since COVID-19 started. The poor sales performance of its tenants, combined with the gloomy economic outlook in Hong Kong SAR had led to average rental reversion of -17%. Had short term leases been included in the computation, the average rental reversion would have been -23%! This is a pretty dire situation for Festival Walk and it certainly gets me worried since Festival Walk accounts for half of the REIT’s NPI.

Source: MNACT 3QFY20/21 Business Update

I have extracted another slide showing the timeline of the various restrictive measures implemented by the government and the corresponding impact on footfall and retail sales at Festival Walk. The important thing to note here is that prior to the latest round of restrictive measures that came into force on 18 November 2020, retail sales at Festival Walk had actually recovered up to 85% of Pre-Covid levels. This is an affirmation of my initial conjecture made in the introduction that Festival Walk is more akin to a suburban mall that tends to be frequented by locals rather than tourists. The latest wave of restrictive measures could not have come at a worst time for the REIT as it had just started to see green shoots in its tenant sales after months of hovering around 60% to 70% of Pre-COVID level. In this regard, I can totally understand why rental reversion has fallen to a staggering -17% as tenant sales have taken a huge hit in FY20/21.

In view of the above, I believe that rental reversion will continue to face headwind as Hong Kong SAR emerges gradually from its latest round of restrictive measures. In recent weeks, the government had adopted a slightly different approach in the form of an “ambush-style” lockdown. This involves locking down selected areas that tend to be very densely populated and have poor hygiene issues to carry out compulsory testing in a bid to sieve out cases that have fallen through the cracks. This strategy seems to be working with the seven-day moving average of unlinked cases in Hong Kong SAR kept under 5. This has rekindled talks of the much talked about travel bubble between Singapore and Hong Kong as reported by Straits Times. The government had also announced on Thursday, 18 February 2021, that it will be relaxing certain restrictions such as extending the operating hours of dine-in service restaurants by 4 hours to 10pm with a maximum of 4 people per table, up from the current 2. In other welcome news for Festival Walk, sports premises and amusement venues such as skating rinks will be allowed, albeit with limited capacity. This will come as a relief to investors of MNACT, at least in the near term. 

Source: MNACT 3QFY20/21 Business Update

That being said, the main overhang now is whether Hong Kong SAR can avoid any future wave of outbreaks that will warrant a re-imposition of restrictive measures that will hit footfall and hence tenant sales. If life can regain some kind of normality like in the case of Singapore since we have entered Phase 3, I believe that there is a good chance that Festival Walk can reverse its fortune. In the above extract on the Weighted Average Lease Expiry (WALE) of MNACT by GRI as at 3QFY20/21, we can see that the lease expiry at Festival Walk is quite well spread out with on average about 12% to 13% of leases by GRI expiring over the next 4 FYs. My guess is that FY21/22 is likely going to be another wasted year and we are likely to see rental reversion at Festival Walk in the range of -10% to -20%. The reason being most of the leases that are expiring during this period are likely to have been signed in FY18/19 and the earlier half of FY19/20 when rents were at its peak.

Taking COVID-19 out of the equation, I think the longer term issue is with regards to the political situation in Hong Kong SAR. Since the 2019 civil unrest, the city-state had been in a constant state of flux. While some form of stability seems to have been restored (at least for now), one key risk that investors looking to invest into Hong Kong have to be mindful of is the potential shrinkage in Hong Kong’s population as citizens look to relocate away from Hong Kong following China’s crackdown on the city’s protest movement. In the context of Festival Walk, a smaller population likely means less footfall and hence less tenant sales which over the longer term would lead to falling rents. This is of course just a simplified way of looking at things as there are obviously larger repercussions such as the withdrawal of foreign direct investments into the economy which will have more trickle down effect.

Source: Bloomberg

In the above screenshot that I took from Bloomberg’s article “Hong Kongers move to Taiwan in record numbers” published on 3 February 2021, it is apparent that relocation of Hong Kongers had already started. The above chart shows that in 2020 alone, 10,800 Hong Kongers had received local resident permits in 2020, nearly double the amount who relocated in 2019. This was published swiftly after the recent announcement by the British government that a new visa scheme offering millions of Hong Kongers a pathway to British Citizenship goes live on January 31. The above suggests that we might just be at the start of a mass exodus of Hong Kongers following the implementation of the national security law mid of last year.

I don’t think anyone has a definite answer on how this will pan out. Even if there is going to be a massive relocation of Hong Kongers, it is likely to take many years or even decades. This argument then begs the question. If a mass exodus does materialise, would Beijing then gradually take full control of the city-state and move some of its citizens out of China into Hong Kong? 

To sum up, I think there is still a lot of uncertainty revolving around the future of Hong Kong SAR. As investors, we all hate uncertainty and this means that we should place a higher risk premium on our investments into anything Hong Kong SAR related. In the context of MNACT, it is offering a dividend yield of about 7.4% based on its FY19/20’s DPU of 7.124 cents per share and its closing price of S$0.96 as at 26 February 2021. The dividend yield will likely fall to the low to mid-6% for FY20/21 and possibly for FY21/22 as well due to the rental rebates and negative rental reversion that is likely to persist in the coming 1 to 2 years. Is this 6 – 7% dividend yield something that you are comfortable with after accounting for all of these uncertainties that you have to stomach? Before you make a judgement call on this, let us take a look at the performance of its other core asset, Gateway Plaza.

In the introduction, I had given you a brief overview of the asset Gateway Plaza located in the Lufthansa area in Beijing. Located in a somewhat fringe-CBD-ish kind of location, the asset has also been underperforming lately. 

Source: MNACT 3QFY20/21 Business Update

Based on the above extract, it is obvious that Gateway Plaza is a struggling asset amongst MNACT’s other assets outside of Hong Kong SAR. It has the lowest occupancy rate at 92.9% and has registered an average rental reversion of -11% as of 31 December 2020. I had separately created a chart below to see how this asset had fared over the last 5 years and the result is pretty grim as well.

We can see that after reaching an all-time high of 99% occupancy in FY18/19 and registering strong y-o-y positive rental reversion up until then, Gateway Plaza had been struggling in the last 2 years. It’s occupancy has fallen to 92.9% as of 31 December 2020 and rental reversion has been negative for the last 2 years as well. To make sense of these numbers, I had extracted 2 charts from Cushman & Wakefield on the trend of Grade-A office rents, vacancy rate and annual new supply. 

The above chart is very telling. If you were to look at the year 2019 and 2020 for the office annual new supply chart on the right, you would have noticed that there has been an uptick in supply compared to the previous 2 years. This influx in supply is what has been causing a downward trend in rents since the beginning of 2019 as seen from the chart on the left. This means that the influx in supply is not supported by an increasing demand for Grade-A office spaces in Beijing, causing rents to fall and vacancy to inch up. This is in contrast to the influx of supply in 2015 and 2016 that was met by a strong uptake in demand as well, leading to stable rents and vacancy rate back then. A key thing to note when looking at the above chart is that supply is just one side of the equation. While a high influx of supply when seen in isolation is a bad omen, if it is met by a corresponding growth in demand, rentals and vacancy would still hold strong. 

If we were to look at the supply picture beyond 2020, the situation is even bleaker. About 3.17 million sqm of office spaces are due to come online in the next 3 years, approximately half of which is scheduled for 2020. The supply coming online in 2021 alone is almost equivalent to the supply that came onboard in 2019 and 2020 combined. Quoting what Cushman & Wakefield stated in the report, “In the near term, it is expected for the overall vacancy rate to edge up and for rental levels to face downward pressure. However, in the longer term, as the new wave of supply abates and benefits from the expansion and opening-up of services industry and development of the Beijing Free Trade Zone are gradually realised, Cushman & Wakefield expects to see renewed leasing demand in related financial and high-tech industries.”

In a nutshell, what I am getting out of this report is that rental reversions are likely to remain negative for the next 3 years while occupancy might drop further at Gateway Plaza. Any recovery (if any) will only likely be seen after 2024. Based on the chart that I had created above, I noted that occupancy has inched up by about 1.4% while rental reversion had worsened from -4% to -11% when we compare to the year earlier. As such, I think that the management’s strategy in the near term is to defend occupancy by accepting lower rents from its tenants. 

Judging from insights picked up above, I believe we are likely to see another year of negative rental reversions that could be even worse than in the current levels, possibly in the range of -15% to -20%. This is due to the doubling in supply coming onboard in 2021 as compared to 2020. Moreover, based on the above chart from Cushman & Wakefield, a fair amount of this new supply will be seen in the Lufthansa area. The only saving grace is that only about 2.4% of GRI attributable to Gateway Plaza is expiring in FY21/22 as the bulk of the expiry (~12.7% of GRI) will come only in FY22/23. That being said, I expect the bulk of the renewals in FY22/23 to experience negative rental reversions since 2022 will also see a substantial amount of office supply coming online.

By now, I guess you might already feel very exhausted reading my analysis as it’s been pretty content heavy. In case you have the impression that it is all doom and gloom for MNACT, I encourage you to read on as I do think that there are still aspects of this REIT that are positive and could help slightly cushion the negative impact from the underwhelming performance of its 2 core assets.

To quickly wrap up this portion, it is without a doubt that this REIT is very challenged as both its core assets are underwhelming in terms of its performance in the last 1 to 2 years. Moreover, the outlook looks pretty bleak for both the assets, at least in the near term based on the various reasons that I have highlighted above. 

Despite this, I do think that there are some reasons to be positive about this REIT. In the following section, I would highlight how the REIT’s manager’s recent diversification strategy via its acquisition into the Japan and South Korea office market might help to cushion some of the headwinds faced by its 2 core assets.

Shrewd Acquisitions To Reduce Concentration Risk

At the point of its IPO in 2013, Mapletree North Asia Commercial Trust only held its 2 core assets, Festival Walk and Gateway Plaza. I have extracted a slide taken to show its growth trajectory since its listing

Source: Mapletree North Asia Commercial Trust

From the above, we could see that MNACT first made an acquisition in 2015 when it acquired Sandhill Plaza, a premium business park development located in Shanghai. Shareholders then had to wait for about 3 years before the REIT manager made its next move with its acquisition of a portfolio of 6 freehold offices in Tokyo, Japan. The last 2 transactions involve a further acquisition of 2 freehold office assets in Greater Tokyo, Japan and a 50% interest in an office asset in Seoul, South Korea, both executed in 2020. The time frame between each major transaction is about 2 to 3 years.

In my opinion, these acquisitions were very well executed and had it not been for them, I am very certain that it’s share price would be below it’s IPO price of S$0.93. It is important to note that prior to these acquisitions, Festival Walk alone had made up a stagerring 75% of the REIT’s NPI. The acquisitions have thus reduced the concentration risk of Festival Walk considerably as we saw in our earlier analysis that Festival Walk now makes up about half of the REIT’s NPI. In the following paragraphs, I will be providing some high level thoughts on why I believe these acquisitions were well executed and are likely to continue to do well.

First up, there is Sandhill Plaza, a premium Grade-A business park that lies within the Zhangjiang Science City in Shanghai.  I have extracted the below screenshot that was obtained from the presentation deck on the proposed acquisition of Sandhill Plaza back in 2015. 

Source: MNACT’s Maiden Acquisition of Sandhill Plaza, Shanghai, 15 June 2015

What I can make out of this is that the property is located outside of the CBD and within the Zhangjiang Hi-tech park where we see a concentration of companies from high growth industries i.e. Information Technology and Research and Development. In the context of Singapore, it is similar to the Science Park and One North area where the likes of Shoppe and Grab have their headquarters. Back in 2015, the management cited opportunity for positive rental reversions as one of the reasons for its acquisitions and true enough, the asset has delivered strong year-on-year growth in rental income. I have created a chart below showing the occupancy performance and rental reversion performance of Sandhill Plaza.

From the chart above, we could see that rental reversion has been positive over the last 5 years but there is a sign that rental growth has slowed somewhat over the years. However, occupancy has consistently inched downwards from 100% in 2016/17 to 97.4% today. That being said, 97.4% is still a pretty high level considering that rents have been climbing strongly over the years. Aside from the operating metrics of the property, I have also created a chart below showing the changes in the valuation of Sandhill Plaza over time.

Since it was acquired in mid-2015, the valuation of Sandhill Plaza has increased by about 25% or at a CAGR of 5.5%. The strong growth in the valuation was partly driven by the 75 bps cap rate compression that occurred between 2017 and 2019. Despite the COVID-19 pandemic, the valuation of the property is still holding strong at RMB2.4 billion in its most recent valuation exercise. 

From a historical perspective, the points above seem to suggest that Sandhill Plaza has been a pretty decent investment. Despite this, the past is certainly not a predictor of the future and it is still important for us to take a closer look at the outlook of the Shanghai Business Park market to determine if the growth observed at Sandhill Plaza is likely to continue. I have extracted a chart taken from Colliers Q4 2020 report on the Shanghai Business Park market showing the vacancy and rental growth outlook up until 2025.

If you look at the above chart, you could see that the rentals have been relatively flat in the last few years with rentals even coming down slightly in 2020 for business parks in Shanghai. Earlier in our analysis of the rental reversions at Sandhill Plaza, we had noted that rental reversions had come down in the last 2 to 3 years but are still positive. It thus seems to make sense now as the falling rental reversion is likely due to the softening market as indicated by a falling net absorption level from 2018 to 2020. The fact that Sandhill Plaza is still able to achieve positive rental reversion despite this is a testimony of the quality of the asset. Looking beyond 2020, Colliers is projecting for the rentals to grow strongly and for the vacancy rate to come down from 22.8% today to 18% in 2025. This likely means that we will see an uptick in rental reversion at Sandhill Plaza going forward. 

All in all, there are compelling reasons to believe that Sandhill Plaza is a good quality business park that should continue to deliver in the near term and help to partially mitigate the negative impact from its 2 core assets in the near term. That being said, Sandhill Plaza only makes up about 8% of the REIT’s NPI. Even if it continues to give 10% to 15% of rental reversion, it will not be able to fully make up for the negative impact of its core assets. This brings me to the next point on MNACT’s portfolio of 8 Japanese office properties that collectively makes up about 23% of its NPI.

The 8 Japanese properties, when combined together, is almost equivalent to the contribution made by Gateway Plaza in terms of NPI. While it certainly cannot cushion the negative impact from Festival Walk, it can at the very least help to mitigate the negative impact from Gateway Plaza.

The acquisition of the 8 Japanese properties were done in 2 separate tranches. The first 6 properties were acquired for a consideration of ~S$783 million in 2018 while the last 2 properties were acquired beginning of 2020 for a consideration of ~S$477 million. I thought that for the sake of our analysis, it might be more relevant to focus on the second tranche of acquisition since it was only recently completed at the end of FY19/20. This means that its full impact would only be felt in the current reporting period of FY20/21.

Source: MNACT’s Proposed Acquisition Of Two Office Assets In Greater Tokyo, 3 Jan 2020

Based on the above illustration, it seems like the acquisition is pretty well structured as it leads to a DPU accretion of 1.80% assuming an illustrative price of $1.15 per transaction unit to the Sponsor’s Nominee. In actual fact, the transaction units were issued at an average unit price of $1.1703 which according to the table on the right in the above screen grab, corresponds to a DPU accretion of 1.87%. As such, I do think that the acquisition of the 2 Japanese properties completed in early 2020 should help to somewhat stabilise MNACT’s DPU moving forward. On one hand, it gives an immediate boost to the DPU while at the same time reducing the concentration risk of both Festival Walk and Gateway Plaza.

Source: MNACT Proposed Acquisition of Two Office Properties in Greater Tokyo, 3 Jan 2020

Another interesting point that I picked up in the above screen grab was the fact that the occupancy of the subject properties at the point of acquisition was only 85.9%. This suggests that the potential of the properties have not been fully realised as yet and there is a possibility of further immediate upside from a boost in the occupancy levels.

Source: MNACT Proposed Acquisition of Two Office Properties in Greater Tokyo, 3 Jan 2020

Referencing the screen grab above, I realised that the low occupancy was largely due to the fact that one of the assets, mBay Point Makuhari Building (“MBP”)  had an occupancy of only 84.8%. In the latest 3QFY20/21 business update, the management had reported that the occupancy of MBP currently stands at 94.3%, an almost 10% uplift relative to its occupancy at the point of acquisition. In addition, the management had also reported an overall positive rental reversion of 3% for its Japanese office assets in the latest business update. The combined effect of the DPU accretion from the acquisition, uplift in occupancy at MBP and the slight positive rental reversion for its Japanese assets should help to boost MNACT’s DPU slightly to partially offset the negative impact from its core assets.

Last but not least, I would just like to touch a little bit on MNACT’s recent expansion into the South Korean office market. On 25 September 2020, the management had announced that it would acquire a 50% stake in The Pinnacle Gangnam, a 20-storey freehold office building located within the Gangnam Business District (“GBD”) for a consideration of ~S$268 million (inclusive of fees). The acquisition is structured as a co-investment with its sponsor Mapletree Investments holding a 49.95% stake and an unrelated third-party investor holding the remaining 0.05%. Due to its depressed share price at the point of the acquisition, the management had decided to fund the acquisition fully with debt. I believe that the intention was for the REIT to acquire the entire asset but its depressed share price and relatively high gearing had limited its ability to do so. Nonetheless, it should be a matter of time before the REIT acquires the remaining stake from its sponsor.

Source: MNACT To Acquire S$528 million Freehold Office In South Korea, 25 Sep 2020

Based on the above diagram, the acquisition is mildly accretive to its FY19/20’s DPU. I believe that the main reason for such a marginal increase in DPU is the tight yield that the property was acquired at. 

Source: MNACT To Acquire S$528 million Freehold Office In South Korea, 25 Sep 2020 

I have extracted another slide above showing the NPI yield spread of The Pinnacle Gangnam against MNACT’s other properties. The NPI yield of 3.2% seems very tight to me as it is even lower than the NPI yield at Festival Walk. The property certainly seems very overpriced to me so I decided to have a quick sanity check by looking up the average cap rates for office assets in Seoul. I managed to dig out a table below from Cushman & Wakefield’s Q4 2020 Seoul Office investment report that shows some high level parameters for office transactions in 2020 in the various submarkets in Seoul.

From the above table, we could see that the cap rates for Grade-A offices is the tightest in GBD, at 3.6%. The management cited that part of the reason why the NPI yield was so low for The Pinnacle Gangnam is because its occupancy is only 89.6%. The management also mentioned that there is potential for the vacant spaces to be filled up due to the low vacancy rate of 4.2% in the GBD area. 

In its latest 3QFY20/21 business update, about 3 months after its announcement of the acquisition of the Seoul asset, the management had reported that the occupancy at The Pinnacle Gangnam had risen to 97.5%. At an occupancy of 97.5% and assuming an NPI margin of around 75%, the NPI yield of the asset should work out to be around 3.5%. This brings it much more in line with the cap rate of 3.6% that we had seen in the Cushman & Wakefield’s report. Considering the above, I do think that the price paid for The Pinnacle Gangnam might be just in line with the GBD submarket. 

However, even at an NPI yield of 3.5%, the asset only offers about a 180bps spread over the 10-year government bond yield. Based on this, I do not think that there is significant upside in terms of its valuation from the perspective of compression in the cap rates. Any uplift in valuation is likely to come from increasing rental income. For readers who would like a refresher on the key drivers of real estate valuation, you might want to check out my Valuation 101 article here. Mapletree has generally been very shrewd in the way it conducts its acquisition across its 4 listed-REITs and for it to acquire an asset at such a tight yield would seem to suggest that they are pretty confident that the aforementioned asset can generate strong rental growth in the years ahead. As such, I thought I should go one step further to establish if this is likely to be the case. 

Source: MNACT To Acquire S$528 million Freehold Office In South Korea, 25 Sep 2020

I have extracted above to try to add some colour to the outlook of the Seoul office market in the coming years, particularly the GBD submarket. From the above, it is obvious that the year 2020 had seen a strong influx of supply in office spaces in Korea. Yet, the rents have continued to climb in all the submarkets, suggesting an even stronger demand for office spaces. If we were to look further beyond 2020, the supply is expected to fall sharply in the years ahead, likely providing further impetus for growth in rentals. 

Assuming the above is true, I believe that The Pinnacle Gangnam is likely to deliver strong rental reversions and occupancy in the years ahead, helping to further cushion the negative impact from its core assets. Despite this, it is important to note that the NPI contribution from MNACT’s 50% stake in The Pinnacle Gangnam is only about 3%, limiting its ability to offset the negative impact from Festival Walk and Gateway Plaza.

To conclude what we have discussed in this section so far, the assets acquired by MNACT over the last few years from Sandhill Plaza to The Pinnacle Gangnam are good quality assets. All these assets have shown strong positive growth momentum so far and there are compelling reasons to suggest that this is likely to persist going forward. Since these assets collectively make up around 30% of the REIT’s NPI, they should help to partially mitigate the negative impact from Festival Walk and Gateway Plaza moving forward. As such, I do see some light at the end of the tunnel amidst all the negativity that shrouds both Festival Walk and Gateway Plaza. The faster both Festival Walk and Gateway Plaza bounce back, the lesser the need to depend on the REIT’s other assets to try to make up for the shortfall in distributable income. 

With this, I will now like to switch gears once again and talk about other aspects of the REIT. I will start off by running a quick analysis of the REIT’s management fee structure before diving into the valuation and land tenure of its properties. I will subsequently move on to discuss its balance sheet and capital management aspect. With these, it should hopefully allow us to have a more holistic view of the REIT and to ultimately determine if this is a counter worth investing in.

Management Fee Structure

In my analysis of Lendlease Global Commercial REIT that I published last week, I had spoken about why the management fee structure of Mapletree North Asia Commercial Trust is strongly aligned with the interest of unitholders. You can check out the article here. To give you a quick snapshot of MNACT’s management fee structure, I have extracted a slide from its 1HFY20/21 Results Presentation Slides that gives us a quick overview of its management fee structure. 

Source: MNACT 1HFY20/21 Business Update

In the above, we could see that the management base fee is 10% of Distributable Income and the Performance Fee is 25% of the difference in DPU in a financial year with the DPU in the preceding year multiplied by the weighted average number of units in issue for such financial year. To illustrate why such a management fee structure is so important for unitholders, I have extracted some parts of its latest financial statements for 1HFY20/21.

Source: MNACT 1HFY20/21 Financial Statements

Based on the above, it is obvious that the bulk of the management fee for MNACT comes from the base fee rather than the performance fee. Because the base fee is paid based on 10% of its Distributable Income, the REIT has paid almost S$3 million lesser management fees as compared to 1HFY19/20 including the performance fee. This is due to the fact that Distributable Income to unitholders had fallen by close to S$30 million largely due to the S$34.9 million in rental rebate that had been given out to tenants at Festival Walk. To put it into perspective, S$3 million is approximately 3% of the REIT’s distributable income, which is fairly substantial. In comparison, the typical base fees for S-REITs are paid based on 0.3% of the value of the deposited properties of the REIT. As valuation of properties are typically more sticky than the distributable income, such a management fee structure does not usually generate much cost savings from the perspective of unitholders during downturns. However, because MNACT’s base fee is tied to distributable income which tends to be more sensitive to changes in the economic climate, it will come in handy in times of downturns like now. 

Secondly, as performance fees are paid based on the difference in DPU in a financial year relative to the previous for MNACT, unitholders are not subjected to performance fees for 1HFY20/21 as DPU has fallen as compared to 1HFY19/20. In a typical REIT structure, performance fees are paid based on 5% of NPI which means REIT managers get paid performance fees regardless of good or bad times.

From the above, we have observed that because the management fee structure of the REIT exhibits strong alignment of interest with unitholders, a substantial amount of savings can be realised in times of a downturn for unitholders. In the above illustration, I have shown that the savings has amounted to about 3% of distribution to unitholders for 1HFY20/21, which certainly does move the needle.

With this, I will now move on to touch on the valuation and land tenure of MNACT’s investment properties in the next section.

Valuation and Land Tenure

In my recent article on my analysis of Sasseur REIT, a pure-play Chinese outlet retail REIT, I had mentioned that one of the key risks is the relatively short land tenure of its assets. Given MNACT’s high exposure to Hong Kong SAR and China, this risk is also something that investors or potential investors in the REIT should be mindful of. 

Source: MNACT 3QFY20/21 Business Update

I have extracted a slide from MNACT’s latest business update that gives a quick snapshot of its assets under management. I would like to bring your attention to the land use right expiry of its Hong Kong SAR and Chinese assets as I have boxed up in red. It’s anchor asset, Festival Walk has a land use right that expires in 2047, which is effectively 26 years from now. This is actually one of the shortest if not the shortest land use right expiry that I have seen for commercial assets (excluding industrial and logistics assets) across all Singapore-listed REITs. It’s Chinese assets in Beijing and Shanghai have a land use right that expires in 2053 and 2060 respectively. Since all of these assets have a land tenure that expires in less than 40 years, this is something that investors have to be wary about as valuation of the properties tend to come down exponentially as we approach the land use right expiry date. 

Source: MNACT 1HFY20/21 Presentation Slides

In terms of the properties’ valuation, I have extracted a slide that shows the updated valuation of its investment properties based on the latest revaluation exercise conducted at the end of 1HFY20/21. From the above, it is apparent that its 2 core assets, Festival Walk and Gateway Plaza had each suffered ~5% fall in valuation. Since both assets have in 3QFY20/21 suffered YTD rental reversion of <-10%, I would not be surprised if the valuation of both the properties take a further hit in its next revaluation exercise. If this does happen, it will lead to NAV falling further and its gearing inching higher. I will cover more on these metrics in my next section.

Since valuation is a function of rents and cap rates under the income capitalisation method, it is also important to check to see if valuation may be artificially overstated by applying a lower cap rate. I will focus my analysis on Festival Walk and Gateway Plaza since I have established in the earlier section that the operating climate in these 2 markets are very challenging.

Source: CBRE Hong Kong Investment Marketview Q42020

For the case of Festival Walk, the cap rate applied is 4.15% and this hasn’t changed despite the COVID-19 pandemic. To get a feel of whether this is a reasonable cap rate, I have extracted a chart from CBRE Hong Kong Investment Marketview Q42020 showing the historical trends of the rental yield across the various asset classes (except residential and hospitality) since 2005. Since Festival Walk only has a very small component of office space, we should compare the cap rate to the retail yields in the chart above. If you look at the chart above, retail yields were trading at sub-2% prior to the pandemic but have since increased to ~3%. At 4.15%, Festival Walk’s cap rate does not seem overly aggressive at all and it is in fact overly conservative in my opinion. As such, I do not expect the cap rate of Festival Walk to expand in the near term.

Source: Cushman & Wakefield Beijing Capital Markets Marketbeat Q42020

Moving on to Gateway Plaza, a cap rate of 5.5% was applied for its latest valuation exercise, unchanged from its last round of valuation exercise done at the end of FY19/20. Drawing reference to the above chart taken from Cushman & Wakefield’s Beijing Capital Markets Marketbeat Q42020 report, we could see that there is a slight expansion in the cap rate for Grade-A Office (Non-CBD) to ~5%. At 5.5%, Gateway Plaza’s cap rates seem fairly reasonable as well and I do not expect it to expand in the near term

Based on the above, I seek comfort in the fact that its properties’ valuation assumptions are relatively conservative when compared against the wider market in Hong Kong and Beijing. Despite that, there might still be some risk of revaluation loss in the periods ahead as I believe that negative rental reversions are likely to persist for both Festival Walk and Gateway Plaza, putting downward pressure on its valuation. With this, I would now move on to the next section where I will discuss the capital management side of things.

Balance Sheet & Capital Management

On the capital management front, there are some potential red flags that unitholders or potential investors should be aware of. First and foremost, MNACT’s gearing had risen quite substantially over the last 1 year, mainly due to its recent acquisitions in Japan and South Korea that were predominantly debt funded. The recent revaluation loss that was recognised at Festival Walk to account for the lower market rents did not help the situation. At 41.3%, it is one of the more leveraged S-REITs in the market and this is something that investors have to be wary of. 

The only bright spot is the fact that the management has successfully refinanced its borrowings at a lower interest rate, bringing down its annualised effective interest rate from 2.46% a year ago to 2.04% for YTD FY20/21. While it might seem that it is just a ~40bps reduction in borrowing costs, the impact is actually pretty material. Based on the assumed total gross debt of ~S$3.5 billion as seen from the above screen shot, a 40bps reduction in interest cost effectively translates into an interest savings of ~S$15 million per annum. This is approximately 10% of MNACT’s distributable income, which is very substantial. As such, the lower borrowing costs will help provide a further buffer for the REIT to cushion some of the fall in rental revenue from Festival Walk and Gateway Plaza. 

Source: MNACT 1HFY19/20 Results Presentation Slides

I have extracted the 1HFY19/20 Gross Revenue breakdown of MNACT to kind of estimate how far this fall in interest cost could go towards cushioning the impact of falling rentals. I have decided to use 1HFY19/20’s figure as it corresponds to the period right before the Hong Kong protest blew up and rental rebates had to be given out to tenants. It should thus give us a good gauge of what rental revenues should look like in normal times. Since ~S$130 million of rental income is generated from Festival Walk in half a year, annualising it would give us approximately S$260 million of gross revenue per annum. In the worst case scenario where we assume all forward leases at Festival Walk are renewed at -20% rental reversion, gross revenue would effectively fall by ~S$52 million. However, this is unlikely to be the case as leases are often not renewed all at once and are staggered as per the Lease Expiry profile below. That being said, if the situation in Hong Kong does not improve and sentiment continues to be negative, I certainly would not rule out the worst case scenario being the base case.

Source: MNACT FY19/20 Results Presentation Slides

With about one-third of leases by GRI at Festival Walk due in FY20/21 based on the above screen grab, the loss in gross rental revenue from Festival Walk that is likely to be realised for the whole FY20/21 would amount to ~S$15.6 million. This means that the interest savings (~S$15 million) alone should be sufficient to offset the fall in gross rental from Festival Walk in FY20/21, effectively buying the REIT manager another year to turn the fortune of Festival Walk around. However, do note that my assumption does not account for the timing differences in rental renewals and the refinancing in loans.

The above illustrations effectively shows how powerful movement in interest rates can impact the bottomline of a REIT’s income. In addition, If we were to assume that the performance of Sandhill Plaza, its Japanese properties and The Pinnacle Gangnam is able to offset the negative impact from Gateway Plaza, then the DPU for FY20/21 (had the rental rebates to tenants at Festival Walk not been given out) should only be marginally impacted.

Based on the 3QFY20/21 business update, a total of S$43.5 million of rental rebate had been given out to tenants at Festival Walk YTD. Combined with the fact that S$34.9 million of rental rebate had been given out to tenants in 1HFY20/21, this means that about S$8.6 million of rental rebates have been given out in 3QFY20/21 alone. If we were to extrapolate this amount for 4QFY20/21 as well, this means that ~S$17.2 million worth of rental rebates will be distributed in 2HFY20/21. With this, I do expect the DPU for 2HFY20/21 to come in somewhere between 3.3 to 3.4 cents per share, bringing the total DPU for the FY20/21 to ~6.2 to 6.3 cents per share. Do note that the above are just my very rough back of the envelope calculations and are based on the simplified assumptions that all other cost items such as management fees, trustee fees, etc are kept constant. At the current price of S$0.96, this translates to a projected yield in the mid-6% range after accounting for all the rental rebates that have been and should be given out for the rest of the FY. In my opinion, if Hong Kong SAR avoids another wave of restrictive measures and more for the rest of the year and the trend of negative rental reversion at Festival Walk can be reversed, I think that a mid-6% yield is still a worthy bet considering that the REIT is backed by a proven sponsor with a solid track record.

Concluding Thoughts

To wrap things up, it is without a doubt that there are many inherent risks and unknowns for Mapletree North Asia Commercial Trust at the moment. It’s fate is tied closely to the development of the COVID-19 situation in Hong Kong in the near term and the political situation in the longer term. Will there be a mass exodus of Hong Kongers to other countries like the UK and Taiwan? If so, how will the future of Hong Kong pan out? These are questions that I doubt anyone will have an answer to.

To add oil to the fire, Gateway Plaza which makes up approximately 21% of its NPI has been struggling in recent years and is likely to remain so amidst an avalanche of upcoming supply. It’s saving grace for now is the reduction in interest costs achieved through its latest refinancing exercise and the resilience of its other assets in Shanghai, Japan and South Korea.

For now, everything does seem very gloomy and this has been reflected in its sluggish share price performance. At the current share price of S$0.96, I am unlikely to add to my position given my already substantial exposure to this counter. Nonetheless, I would be happy to hold onto it and enjoy its mid-6% dividend while I keep close tabs on the COVID-19 situation in the coming months to ascertain if there is any further deterioration in the outlook of the retail market in Hong Kong and the office market in Beijing. Do let me know your thoughts by commenting below!

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