Sunday, July 21, 2013

Real estate investment trusts: Opportunity abounds in battered sector

Real estate investment trusts: Opportunity abounds in battered sector
Written by Goola Warden  
Monday, 15 July 2013 20:28
John Doyle, chief investment officer of UOB Asset Management (UOBAM), figures he launched the United Asia Pacific Real Estate Income Fund at the right moment.

The new fund, which is benchmarked against the S&P Asia Pacific REIT Index, was launched on June 17, just as financial markets across the globe were reacting to growing concerns that the US Federal Reserve would soon begin to “taper” its massive bond buying programme. That sent long-term bond yields significantly higher. In Singapore, yields on the 10-year Singapore Government Securities (SGS) had doubled in six weeks to 2.6%.

That sparked a steep sell-off in high-dividend stocks as well as yield instruments such as real estate investment trusts (REITs). The S&P Asia Pacific REIT Index had fallen some 21% from its peak in May by the third week of June. In Singapore, the average yield on REITs rose about 90 basis points. Ascendas REIT and Sabana Shari’ah Compliant Industrial REIT saw their yields jump by some 124bps.

“The timing worked out for us,” says Doyle. The way he saw it, the sell-off in REITs would prove temporary, and it would be a matter of time before investors begin craving the steady yield they offer. “We felt there was a demand in the market for stable income-generating assets in the portfolio. The reality is that government bond yields have compressed to levels that real rates are negative and investors have started moving up the risk curve,” he says. “We fit in between… offering that pick-up in terms of yield but with a higher risk profile than typical bonds.”

Doyle believes that interest rates are not about to begin an uptrend any time soon. “Globally, we think growth will be tracking below historical trend. Inflation is certainly tracking below trend for the most part. That means interest rates should stay lower for longer and REITs will hold some attraction.”

Indeed, the sell-off REITs experienced in the recent weeks has only served to make them more attractive. Meanwhile, bond yields are still low by historical standards and bank deposit rates are miniscule. “You are not getting enough returns on fixed deposits or SGS,” says Ng Hui Min, director at UOBAM and manager of the real estate income fund. “REITs are still giving a decent yield after the recent selldown.”

Apart from the yield they offer, the exposure that REITs offer to the real estate market is likely to be positive for investors in the long term. “We are positive on this asset class. In Asia-Pacific, especially Singapore and Hong Kong, we see the sector as a proxy to Asia’s rising wealth and its increasing property valuation,” Ng says.

Meanwhile, the best-managed REITs will likely grow in scale as property securitisation grows in Asia. The trend is also likely to support the listing of new REITs, giving the new UOBAM fund a growing pool of prospective investments. Both Singapore Press Holdings and Overseas Union Enterprise lodged prospectuses for SPH REIT and OUE Hospitality Trust. “We see more markets in Asia adopting the REIT structure and more companies being open to securitising their assets. We expect more REIT listings, which would grow the capitalisation of this market,” Ng says.

Doyle and Ng say the new UOBAM fund will initially track its benchmark index closely. The largest components of the index are Westfield Group with a market cap of US$23.3 billion ($29.73 billion), Link REIT (US$11.3 billion), Westfield Retail Trust (US$8.6 billion), Nippon Building Fund (US$7.8 billion) and Goodman Group (US$7.5 billion). The Westfield and Goodman groups are listed on the Australian Securities Exchange (ASX), and Link REIT is Hong Kong based. The largest S-REIT is CapitaMall Trust, with a market cap of $6.7 billion.

By country, the index has weightings of about 40% in Australia and 30% in Japan, which are relatively big and deep markets for REITs. On the other hand, Singapore and Hong Kong together have a 20% weight. “We are starting the fund slightly underweight Japan and Australia, and overweight Singapore and Hong Kong,” Ng says. The management of the Australia, New Zealand and Japan assets will be done by Sumitomo Mitsui Asset Management, which is partnering UOBAM for this particular fund.

As markets turn volatile, Ng stresses the importance of understanding the assets in the REIT and recognising the risks of their financial structures. The REITs that offer the highest distribution per unit (DPU) yields often are not the ones with the best assets and operating strategies. “You must really study the underlying fundamentals of the property, and how sustainable the cash flow is instead of looking at headline yields, which is a bit risky,” Ng says. Notably, investors should beware of “financial engineering” that boosts near-term DPUs in an unsustainable way, she adds.

For the most part, REITs in Singapore are of reasonably high quality. That is partly because of a relatively discerning and savvy investor base, which rewards the best-managed REITs with higher-market valuations. For instance, REITs that rely on excessive financial engineering are shunned, Ng notes.

“During the initial stages there was rental support, rental guarantees and deferred units payment to boost yield,” Ng explains. “Over time, managers realised that these structures were not favoured by investors, and they tend to penalise [those that pursue such strategies.] They can differentiate between those REITs with income support or financial engineering and those with real cash flows. Those with genuine real cash flows always trade at a premium to those that have some financial engineering in the DPU.”

That’s not to say that UOBAM’s new fund would avoid REITs that indulge in financial engineering. In some instances, the risks might not be acceptable. “When it’s a new property and it’s not seasoned yet, and they’re trying to price it as if it were seasoned, and fully occupied, if they provide some rental enhancement in the first few years but you know it’s in line with the seasoned spot rent, then it’s deemed less of a concern than one which is being pushed up for headline purposes,” says Doyle.

Singapore REITs also tend to hold assets on their balance sheets at conservative valuations. Hence, rising interest rates are unlikely to hurt those book valuations too much. “Cap rates used to value industrial and retail property have been very stable. They have not compressed despite the ridiculous prices done for individual retail and industrial units,” Ng says. Capitalisation rates are the rate of return on an investment property based on the expected income that the property will generate.

Ng says the new UOBAM fund will hunt for REITs with yields that offer a decent “positive carry” over long-term interest rates and that are likely to grow. While declining to reveal precisely which REITs the fund is buying now, she notes that office property REITs are one segment of the market where rents could rise.

“If you take the view that there is a better outlook for the economic environment, if the rental rate growth expectations were to improve, that would offset the rise in cap rates for valuation of office property,” Ng says. The ability to deliver growth through yield-accretive acquisitions could be an additional catalyst for the performance of such REITs, she adds.

In Singapore, office property REITs such as CapitaCommercial Trust (CCT) are trading at relatively low yields because of an expectation that office rents might have bottomed. CCT also has a pipeline of potential acquisitions to expand its portfolio because of its affiliation to the CapitaLand group. Notably, it owns a 40% stake in CapitaGreen, the former Market Street Car Park that is being redeveloped into a 40- storey tower with net lettable area of around 700,000 sq ft. CCT has an option to acquire the other 60% stake in CapitaGreen. Other REITs where Ng sees good growth potential is Mapletree Commercial Trust, which owns VivoCity and the recently acquired Mapletree Anson. “VivoCity will see very strong rent reversions,” Ng says.

Elsewhere, Hong Kong’s retail REITs such as Link REIT and Fortune REIT are likely to experience high single-digit growth in DPUs as they have been undertaking asset enhancement initiatives (AEIs) to boost their earnings potential. “We have a preference for REITs which have identified an AEI programme, or are under-rented with a portfolio that can grow in rental reversions,” Ng says.

With the recent sell-off in REITs, Ng is more confident about the valuations that the new UOBAM fund will be paying for its initial investments in the sector. “Before the sell-down, some of the industrial [property REITs] were trading at 1.4 times book. That was a bit excessive, but now a lot of froth is gone and they are back to 1.1 times book,” Ng says.

Moreover, if the runup in long-term interest rates proves unsustainable, the yields that REITs currently offer could be very attractive. “Yields-wise, I still see a positive carry over the negative real interest rate, especially in Singapore where inflation is still running at a 2% to 3% clip,” Ng says. The yield gap between REITs and the 10-year SGS is around 380bps, which is a long-term average. Australia is a high-yielding market and the spread between its REITs and the 10-year bond is tighter than Singapore, at about 200bps.

The United Asia Pacific Real Estate Income Fund will be principally distributed to retail investors in Singapore. Distributions will likely be 5% per year, paid quarterly and the minimum investment is $1,000. “We plan to open it around the region once the track record has been established,” Doyle says.

Publish date: 17/07/13


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