Office REITs: CapitaCommercial Trust & K-REIT Asia

Introduction

This research note is the second part of a series on commercial REITs listed in Singapore (see here for 1st part). It is about the two office-sector REITs, CapitaCommercial Trust and K-REIT Asia. Both have the vast majority their assets housed in Singapore, although K-REIT is actively seeking acquisitions in the Asian region, and CapitaCom has stakes in Malaysian real estate related assets.

The charts below give us an idea of how the respective REITs have performed in the stock market.

Economic Conditions

The main properties under the management of K-REIT are

• Prudential Tower Property;
• Keppel Towers and GE Tower and
• Bugis Junction Towers

Meanwhile the main properties under the management of CapitalCommercial are

• Capital Tower
• 6 Battery Road
• Starhub Centre
• 60% interest in Raffles City

Which together account for 82.3% of the gross revenues of the REIT.

The rental rates and other income of REITs thus depend largely on the performance of Singapore office rental market as a whole.

A recent Colliers report on the Singapore office sector records a “severe supply crunch” in 2Q07, felt most acutely for Grade A office space, which is primarily the market in which the 2 REITs participate in. Buoyed by the broader growth of the Singapore economy, there has been a surge in demand for office space in Singapore and relative lack of supply has seen rental rates rise. The government has taken steps to ease the supply crunch, with LKY expressing concern that over-inflation in office rates would threaten Singapore’s economic competitiveness. Nevertheless, office rates are expected to remain robust in the coming quarters and the longer term.

This analysis by Colliers is corroborated by other property players like CB Richard Ellis, and the optimism expressed in the financial reports by both REITs is not in doubt. Operating conditions are favourable and will be expected to remain so for both CapitaCom and K-REIT

Financial & Profitability Analysis

The table shows some key comparative ratios of the two REITs.

We can see that CapitaCom is much larger that K-REIT, by several times. Both REITs are similarly leveraged at around 27-29% of total assets.

However, in terms of profitability we see that the operating and net margins of CapitaCom are significantly higher than K-REIT by about 6 percentage points for both. This translates into a higher return on shareholders equity, 3.21% to 3.08%.

Cash flow quality is also slightly better for CapitaCom.

An interesting thing to note is that the revenue/assets for these office REITs is significantly lower as a group than the revenue/assets for the retail REITs, which average around 8%.

Valuation & Conclusions

As we can see CapitaCom is trading at a better valuation than K-REIT, it has a lower P/B and higher payout yield based on latest share prices. The profitability analysis reveals that CapitaCom is operating slightly more efficiently than K-REIT.

If I had to choose between the two, I would definitely choose CapitaCom over K-REIT. However both are trading at relatively low yields compared to other trusts like the retail trusts and the shipping trusts. An investor would have to be very optimistic that the expected economic growth is going to result in significant rental increases, in order to justify current valuations in the market.

Note: See also this piece on the healthcare REITs.

Mall REITs - CapitaRetail China, Fortune, and Frasers Centrepoint

Introduction

This research note is on three of the pure-retail commercial REITs listed on the SGX, Frasers Centrepoint Trust, Fortune REIT and CapitaRetail China Trust. They are all in the business of acquiring and managing retail properties within their respective geographical mandates and paying out 90% or more of their distributable income, as per standard REIT rules. This note will be the first of a series analysing the commercial REITs in Singapore

The charts below give us an idea of how the respective REITs have performed in the stock market.

Competitive Comparison

These three trusts operate in different geographical jurisdictions and do not compete directly against each other. They compete with other trusts and retail malls within their respective geographical areas. Because the market for retail space is relatively fragmented on the supply side, lease and occupancy rates depend on the macroeconomic performance of the region.

CapitaRChina – The majority of CapitaRetail China’s retail properties, Wangjing, Jiulong and Anzhen mall, are in Beijing. Together, they account for 77% of CapitaR’s net property income for 2Q 2007. The performance of the REIT will therefore depend largely on the Beijing commercial property market. A recent research piece on the Greater China property market by Jones Lang Lasalle has a positive outlook on Beijing:

“Some pessimists may point to the fact that Beijing’s double-digit vacancy rate of 15.5% in 2Q07 is already a clear indication of an over-supply condition. We hold a different opinion, viewing this as a structural problem, due to the existence of a pool of stock that cannot meet the requirement of tenants, and as such contributing to the high tenancy levels. … The implication from this is that new quality buildings with the right specifications should not have a problem finding tenants to fill the space.” – Lee Wee Liat of Jones Lang Lasalle

Fortune REIT – A recent report by Colliers on Hong Kong’s property market gives the following commentary. The general economic sentiment in Hong Kong, as in Greater China, is positive, and this has had the effect of causing rents to rise:

“Essentially, asking rentals were raised by vendors in view of the positive market sentiment attributed to the record-breaking stock market prices and the positive consumption sentiment. Meanwhile, retailers were impressed by the stronger-than-expected business volume registered in late 2006, thus becoming even more aggressive in securing their outlets. Individual retailers were found to raise their rental offer for a shopping unit in the prime districts by as much as 40% in an attempt to outbid rivals during 1Q 2007.”

Frasers CT – 3 main retail malls in Singapore all connected through MRT and bus routes and in populated housing areas. A recent Colliers’ report on the real estate market in Singapore indicates that the retail rates as a whole grew slightly due to growth in the tourism market and the expansion of the presence of retailers in Singapore. However, Frasers’ retail properties are mainly in residential areas and not in the prime shopping districts so the impact of the expansion of the upscale retail industry and tourism industry is likely to have a muted impact on Frasers’ performance. Nevertheless the general economic condition in Singapore remains positive and Frasers is expected to experience the benefits of the economic expansion as announced by PM Lee Hsien Loong in his latest NDP Rally Speech.

Quality of Accounting

CapitaRetail China – The first thing confronting the analyst is the page long note explaining the lack of historical comparative statements for various reasons such as “ownership period is too short,” “period of operations is too short,” and “relevant information to prepare the historical pro forma financial information is unavailable to the manager.” While these are valid reasons to exclude comparative preceding year statements, the lack of comparatives makes it slightly difficult to gauge the performance of CapitaR relative to its peers.

Another thing to note is that in the cashflow statement CapitaR starts the calculation of CFO using net income after tax, instead of using net income before tax as is usually the case for the other REITs. CapitaR also does not exclude the asset revaluation figure from its starting net income after tax, making it harder for the analyst to make comparisons while excluding non-recurring items. The Fraser CT financial statement is much more investor-friendly in this respect.

The quality of disclosure of CapitaR is quite high, although not as detailed as Frasers CT, which is considered below.

Fortune REIT - Shortest report of the 3, by far. While length of disclosure is not necessarily indicative of quality of disclosure, this is still a point of notice. However, compared to the CapitaR financial statements, the footnotes are more detailed than CapitaR.

Frasers CT – Of all the 3 financial statements, I found Frasers’ to be the most comfortable to navigate. It is the longest of the three, and there are very detailed footnotes to every financial statement.

A couple of things to note regarding Frasers CT is that it has a relatively high proportion of gross revenues coming from “other revenues.” This will be dealt with below in the financial & profitability analysis. Another thing to note is that is has recorded a significant surplus on revaluation of properties of $44.5m. This is not a problem because the surplus is appropriately recorded below the investment income as a non-recurring item and is not included above the bottom line unlike HMI.

Financial & Profitability Analysis

The table above shows key comparative ratios between the three REITs.

Operating Efficiency – Fortune REIT appears to have the greatest operating efficiency amonst the three REITs by a substantial margin, while CapitaR has the lowest operating margin. However, due to taxation, Fortune REIT yields a lower net margin compared to FrasersCT, with CapitaR having the worst performance.

Cash Flow Quality – The numbers show that CapitaR has the worst cash flow quality of the three REITs, by a substantial margin. There has been a marked increase in accounts receivable and this has had the effect of lowering operating cash flows. The CFO numbers for the other REITs are quite normal, with FrasersCT having the best cash flow quality.

Leverage – In terms of leverage, CapitaR has the greatest amount of debt, at 37% of assets. Fortune at 27% has the greatest capacity to take on debt in order to make yield-accretive acquisitions. Frasers is somewhere between the two.

Relative Valuation

The numbers clearly show that CapitaR is the worst performer, from a financial analysis standpoint. It has the highest leverage, the lowest margins, and the poorest cash flow quality. Yet the bizarre thing is that it has the highest valuation, by a mile. The projected payout ratio based on latest share prices is a mere 2.52%. Yet it has the highest leverage. Furthermore, it has a P/B of 2.48. This looks like an insane valuation.

Fortune REIT appears to be the most reasonably priced of the three. With a yield of 6.16% and a P/B of 0.67, it looks like a relative bargain. Furthermore, its balance sheet has much greater room to take on debt for accretive acquisitions

FrasersCT is somewhere in the middle, and looks fairly priced on a comparative basis. It’s yield of 4.18% is somewhat below what you would expect from a REIT, but is not too low as compared to CapitaR

What is keeping CapitaR up high in the sky? Is it the expectation that the REIT will find an opportunity to unload assets at a significant gain? Or is it because rentals are expected to soar overnight? I really don’t understand.

As far as I’m concerned, I’m staying away from CapitaR for the time being, and I’ll keep Fortune on my watchlist.

First REIT (AW9U.SI) - Ignored Value

First REIT was the first healthcare REIT listed on the Singapore Exchange. Most of its assets are housed in Indonesia (mainly the Siloam Hospital group). Meanwhile, the REIT has been acquiring some hospital assets in Singapore, most recently the Adam Road Hospital. First REIT is one of two healthcare REITs listed on SGX, the other being the recently listed Parkway Life REIT.

This research note considers First REIT a reasonable addition to an investor's portfolio at around $0.75 or less.

Reasonable Competitive Position

The Siloam group of hospitals is one of the main hospital groups in Indonesia. Indonesia might not be the most attractive destination for medical tourists seeking for top quality healthcare. Nevertheless, people still fall ill and need to find care. Amongst the second tier healthcare market serving Indonesia, Siloam is the leading hospital group. The Siloam hospital group was first established in 1996, through joint efforts of PT. Lippoland Development Tbk and Singapore based Gleneagles Development Healthcare Ltd. The partnership with a credible healthcare player (Parkway) and one of the biggest property management groups in Indonesia (Lippo) should ensure that there is reasonably strong competitive strength and quality healthcare provided by the Siloam Hospital group. Furthermore, the acquisitions of Singapore-based healthcare properties should maintain the quality of the First REIT healthcare assets.

Financial & Profitability Analysis

	First REIT	Parkway Life REIT
Revenues (FY est.)	$24,896	$45,000
Operating Profit (Persistent)	$22,024	$36,930
Net Profit (Persistent)	$17,080	$33,110
Total Assets	$306,660	$786,735
Total Liabilities	$67,582	$36,420
Equity	$239,078	$750,315
Liab/Assets	22.04%	4.63%
ROE	7.14%	4.41%
ROA	5.57%	4.21%
Operating Margin	88.46%	82.07%
Net Margin(Persistent)	68.61%	73.58%
CFO/PBT	NA	NA
Earnings Growth y-o-y
Shares Outstanding ('000)		601669
EPS/Payout Estimate	$0.065	$0.061
NAV	$0.88	$1.25
Stock Price	$0.75	$1.20
P/E	11.54	19.80
P/B	0.85	0.96
Yield	8.67%	5.05%

The table above shows key comparative ratios for the two healthcare REITs listed on the Singapore Exchange. As can be seen, First REIT is yielding a very respectable 8.57% based on a stock price of $0.75. Taking into consideration that the REIT is still quite conservatively leveraged (Liab/Assets = 22.04%), this means that there is still room for the REIT to squeeze out higher returns on shareholders’ funds by taking up leverage to acquire hospital properties.

Furthermore, the REIT seems to be returning a respectable return on assets of 5.57%. Compared to Parkway which is projected to return 4.21%, this is surprising because one would expect a premium collection of hospitals like Mount Elizabeth and Gleneagles to squeeze out a higher return than a supposedly 2^nd tier group of hospitals like the Siloam group. The operating margin of Siloam 88% is also higher than the projected Parkway numbers 82% (operating margins are calculated while excluding finance costs). If anything, this demonstrates that Siloam is able to manage their hospitals effectively and efficiently.

Valuation & Evaluation

At 8.67% yield, First REIT is quite attractive compared to its REIT peers. Other REITs seem to be yielding somewhere in the region of 5%. Furthermore, this yield is created using reasonable leverage. It appears that First REIT is unfairly punished due to the recent subprime sell-down and the perceptions that Indonesia might be a poor healthcare destination.

First REIT looks like a good buy at around $0.75.

For a research note on Parkway Life REIT, click here.

In Defense of REITs

While surfing on WallStraits Forum, I came across a post criticising REITs:

Originally posted by ocean21
During an economy downturn, i believe REITs will have the hardest impact, because:

1) Its fundamental business is very narrow and specific. When times are bad, pple spend less $$. Shops will not have business and cannot afford the high rental and they will go bust. Once REITs cannot continue to have their regular flow of high rental, they will not meet their expected yield. Its gonna have downward spiral effect.

2) Most REITs acquired their properties at pretty high prices (and at premium) from their "owners". When times are bad, valuation of these properties will fall and their NTA will be greatly affected since properties account for almost their entire balance sheet.

While these may sound like valid points to stay away from REITs, I feel they stem from a misunderstanding of how to invest.

These 2 reasons are insufficient by themselves to stay away from REITs. Every investment has its own pros and cons and advantages and risks.

What is important is to have a good understanding of the business and never to pay too much for it. Purchasing a REIT at a suitable margin of safety will mitigate against the risk of loss during an economic downturn.

with regards to point (1), this criticism can be made of the entire consumer brands sector as a whole. Every retail outlet and consumer brand has a particular niche and focus in their respective markets. Quality commercial REITs acquire shopping centers in good locations and fill them with quality tenants.

While this does not gaurantee that every tenant will stay in business during a downturn, a quality selection of tenants will still attract a reasonable clientele during a recession. Furthermore, REITs are at liberty to negotiate lower rents during times of economic difficulty - this prevents unnecessarily high rates during recessions and keeps their tenants in business.

With regards to criticism (2), again, this could be made of the entire property sector as a whole. Every investor who buys real estate will see market valuations of their property fall during a time of economic downturn. The trick is not to stay away from property, but to purchase assets only at reasonable valuations. If you look at the market now, you can find REITs that are priced very reasonably after the stock market pullback.

Like any investment, REITs should be evaluated while taking into consideration the business risks involved while remembering never to pay too much. If an investor keeps these factors in mind, he can profit by purchasing REITs when the market underprices them and selling when the market overvalues them. The solution is not to make a blanket condemnation of any asset class.

REITs in Singapore

REITs (Real Estate Investment Trusts) can be a valuable addition to your investment portfolio if utilised properly. They provide steady, dependable capital gains and dividend payouts and generally have a much lower volatility than the average stock. They also tend to be resilient during economic downturns with smaller dips, and sometimes are able to resist the business cycle because investors know that property retains its value through economic recessions.

REITs also provide the liquidity of the stock market that owning property itself does not provide. In the event that you find yourself needing the money on short notice, or if you a great alternative investment vehicle, REIT stock can be liquidated quickly and safely without having to go through the hassle of an property agent. REITs also remove the need for constant monitoring that owning real estate requires, such as tending to difficult tenants and having to make repairs to the wear and tear of the property.

The only major drawback of REITs is that it does not provide the same upside that investing in other rapidly growing companies provides. Commercial and industrial property (which are mainly what REITs manage) tends to appreciate at a more moderate pace than technology stocks, for example. REITs also not typically the vehicle that speculators and 'flippers' of property what to invest in. But as mentioned, REITs do provide a protection from downside that risky startups do not, and they provide liquidity that real estate by itself lacks.

Singapore is striving to become a center for REITs; there are several REIT stocks listed on the Singapore Exchange. Here is a list of them:

• AllcoReit
• AscendasReit
• AscottREIT
• Cambridge Industrial Trust
  
• Capital Commercial
  
• Capitamall
• First Reit
• Fortune Reit
• Fraser Commercial Reit
• K-REIT
• Macarthurcook Industrial REIT
• Macquarie International Infrastructure Fund (not strictly a REIT but has similar characteristics)
• MMP REIT
  
• Suntec REIT

As of writing there are also more REITs coming to the market. If you are thinking of a reliable investment that needs less tending to than other investments, do consider adding a few REITs to your portfolio. The list above provides a good place to start your search.