In the previous post, we have covered how REITs can grow organically, but they can also do so Inorganically. The 2 MAIN ways of inorganic growth are Property Acquisitions and Greenfield development. Inorganic growth can be thought of growing externally (outside its own garden) rather than from a REIT’s underlying core business activity (inside its own garden).
When does a REIT grow inorganically? Usually, but not always the case, a REIT start its wave of acquisitions, expansions into new markets when it finds itself in a position where there is limited growth opportunity available in its own land. For example, Ascendas started with light industrial, business parks, high-specs industrial in Singapore but subsequently expanded its portfolio to Australia and this year into UK. Other reasons could also be to diversify its business across multiple countries rather than centralizing its revenue risk all in one country. Singtel is an example of overseas diversification as it has investments in associates from India, Indonesia, Philippines, Thailand, Africa, subsidiaries in Australia as compared to pure local players like M1 or Starhub.
1. Property Acquisitions
Property acquisition simply means buying new properties using capital raised either through debt-financing or equity-financing. It can do so to diversify its portfolio or realign management’s strategy. For example, Ascendas’s exposure to logistic properties used to be only 22% (11% from Singapore and another 11% from Australia) but after the 2 rounds of acquisitions in UK, it added 38 logistic properties into its portfolio thus expanding its exposure of logistic properties to 30%! The acquisitions are completed to add on more logistic properties so as to take advantage of the rising demand of warehouses and freight from growing e-commerce.
OR, it could also acquire property simply because the benefits of increased rentals, increased asset size outweigh the cost of debt or cost of equity. This term is otherwise known as yield-accretive.
Yield-accretive acquisition is a rather tricky subject. If the current dividend yield of a REIT is 7%, the property cap rate is 5% and cost of debt is 2.5%, is it a yield-accretive acquisition? On first glance, yes it might be. Since yield of property is higher than cost of debt, it is bringing in additional stream of income and thus the deal should be taken up.
BUT, if you add the new property cap rate of 5% on top of the current yield of 7%, the dividend yield of that REIT now becomes (7%+5%) / 2 = 6%, a 1% drop from its previous yield. Suddenly, it’s not yield-accretive anymore?
In fact, this is a common problem in strategic management accounting of evaluating a manager’s performance based on Return on Investment (ROI) or Residual Income (RI). Many times, an investment if evaluated individually is beneficial for the company as a whole but the manager rejects such opportunity because it’s evaluated based on ROI and that particular investment caused a drop in ROI. Hence, how management’s performance is evaluated can actually lead to dysfunctional decisions that is not goal-congruent with the business’s strategy.
If a REIT already has high dividend yield for example at 9%, do you think its still possible for an acquisition to be “yield-accretive”? The cap rate of the acquired property must be minimally 11% for the REIT manager to take on such a deal, since (9+11) / 2 = 10%. Average cap rate across all industries is around 3% – 7%, so you can imagine how challenging it is for the REIT manager to find one property that generates a yield of 11%. This is all the more so in a booming economy where property valuations are all sky-high thus pushing down the cap rate. (Calculation for cap rate = Annual Net Property Income / Purchase Consideration of Property).
That’s just the macro high-level view and analysis of acquiring yield-accretive properties. More importantly, unit holder does not care the information above as much as REIT manager, they only look at the distribution level and only one metric which is “DPU Yield accretive”. Does it increase the distributions per unit? Does it increase my dividends?
There are 2 parts to DPU Yield. The first is calculating Distribution per unit = Distribution Income / Total number of units and the second is calculating DPU Yield which is = DPU/share price. Looking at this 2 equations, would you want the REIT manager to fund acquisitions using higher proportion of debt or higher proportion of equity? Hmmm….It depends, but..
I would want more debt ideally. If it raises capital mainly through debt-financing, total units issued remains unchanged, Distribution Income increases, DPU increases, share price increases. That’s a win-win scenario for unitholders, you get increased dividends + capital appreciation. The condition is that increase in marginal distributional income MUST at least cover the cost of borrowing so that unitholders can benefit from the acquisition.
On the other hand, if it raises capital mainly through equity financing, that would increase the number of units (Refer to previous post on why) thus lowering DPU, when DPU is lowered, share price inevitably would drop at a much lower rate than the drop in DPU. For example if DPU drops 3%, share price drops 7%. (The bull climbs the stairs and the bear jump out of the window). The increase in marginal distributional income from the newly acquired income MUST at least offset the reduction in DPU from share dilution so that unitholders can benefit from the acquisition. Therefore, i would prefer debt. Remember cost of equity is generally more expensive than debt?
But if the REIT’s gearing is 39-40%, would you want debt or equity? Answer is of course more equity. If it raises capital through debt-financing and gearing increases to 43%, that is a very dangerous level to play around with! In the event that property valuations falls, the REIT is going to face serious trouble liquidating its assets to reduce its gearing.
If market is good, do you want more debt or equity? And if market is bad, do you want more debt or equity? Generally speaking, if market is good, interest rates would be rising to cool down the market, cost of borrowing would be higher and property valuation would be higher. If cost of borrowing is high, then ideally we would want proportion of debt to be lowered, but then again, is it a good time to be acquiring properties when property valuations all around are sky-high? (from my previous post e.g. OUE purchased downtown office for $908 million, CMT purchase 70% of westgate for $789.6 million) I will leave that question to the REIT manager’s judgement.
BUT if market is bad, interest rates would be decreasing to spur economic activity, cost of borrowing is cheap and property valuation is low, is it a good time to buy? Definitely! And using a higher proportion of debt would be wiser since its cheaper, but during market downturns, banks would also want collateral as risk is higher, and a REIT must be able to be willing to encumber a portion of its assets without affecting its operations or portfolio strategy. But is it easy? Probably not because of our human nature (FEAR). While everyone else is conserving cash, keeping debt low, maintaining safety of margin, would you stand against the herd and make aggressive expansions, take on risks, increase borrowings, acquire properties? But actually the lowest point represents the maximum financial opportunity! (Would you dare to buy BTC now?)
Being contrarian pays dividends! When the SARS crisis hit Singapore in 2002-2003, Travelers avoid travelling in SEA region and all airlines cut back their budget on marketing campaigns. Air Asia took the opposite route, they tripled down on its marketing because Tony knows deep down, price conscious Asians doesn’t care about SARS. If there are CHEAP flights, they are bound to be snatching up any available deals and offers! During this period they expanded their business faster than other airlines.
2. Greenfield Development
Greenfield development simply means developing a property ground up from a large green patch of grass just like what a property developer does in its ordinary course of business. There are certain local REIT regulations, e.g. REITs are only allowed to spend a maximum of 10% on their asset value in greenfield developments (not sure if it has been revised). Meaning if a REIT has $10 billion of asset under its portfolio, it is only allowed to use $1 billion to develop a new property.
Greenfield Development is seldom seen among REITs as the business of developing property are often left to their parent or sponsor companies who are usually the property developers themselves. The parent company (a property developer) has all the necessary resources and expertise to develop properties as that is their core business. After which, the property would subsequently be disposed off to the REIT company (just like how westgate is sold from capital land to capitalmall trust).
Furthermore, developing a property ground up could mean a waiting time of at least 2-3 years before its benefits (sourcing tenants and generating rental income) can be realized for investors. It still has to source for a plot of land, purchase the land, apply for occupation permit, search for construction companies, pay for construction materials, source for tenants etc. During this period of time, either debt or equity is taken up and the REIT would incur cost of borrowings/equity to service interest without any additional stream of income coming in as the building are still under construction. Sounds pretty risky?
When is greenfield development a good strategy? It is when Cash reserves are high, gearing is low, debt is low, all organic means of growth has been exhausted and property valuations are sky-high for property acquisitions. But more often than not, REITs usually avoid all the hassle and just acquire properties upfront to increase distribution income and DPU immediately.
1 example of greenfield development in recent years is Ascott Residence trust. It spent $62.4 million just to acquire a prime greenfield site and they are planning to build a co-living property which has 324 units near One-North. The entire project cost is estimated to be about $117 million and is fully funded by debt. Post-transaction gearing will be increased to 37.2% which is still relatively acceptable within the safety zone. The earnings from the proposed project will only be realized in 2021, 3 years from now! More information on the deal can be found here.
We have come to an end of how REITs grow and expand their business. They do it through 2 ways, organic growth and inorganic growth.
Ways of organic growth include increasing rental income, optimizing tenant mix, enhancing or upgrading its assets to maintain attractiveness or efficient use of capital recycling. Inorganic growth includes acquiring properties locally or overseas or developing a property ground up from scratch.
It is good to be aware and understand the drivers of growth, does expansion comes mainly from organic growth or inorganic growth? The best is to see a mix of both! Growing organically generally carries on lesser risk and is healthier as its internal growth. Growing inorganically takes on higher risk as it requires a higher cost of debt/equity. But if acquisitions are yield-accretive, then its asset portfolio size and DPU can increase significantly as compared to organic growth.
Credits to Tam Ging Wien for sharing his insightful knowledge in REITs. You can learn more about REITs from www.ProButterfly.com, www.REITScreener.com and his best seller book REITs to Riches: Everything You Need To Know About Investing Profitably In REITs