In this series, I will be sharing on how REITs grow and expand their business. So first, they have to raise capital which we have gone through in the previous 2 posts, it could either do so through debt-financing or equity-financing. But after they have raised capital, what’s next? What do they do with the money collected from various avenues? That’s right, they invest it to grow their business. There are mainly 2 methods for REIT to generate growth: the first method is called Organic Growth and the second is Inorganic Growth. This post would be focused on Organic Growth.
REITs Organic Growth
Organic growth as the name implies means growing the business “naturally” (Imagine a tree in a garden, you water it more often, remove the weeds, put higher quality fertilizers etc. to make the tree grow taller and stronger). To put it into context, a REIT grow their business naturally through 3 different ways. The 3 methods of organic growth are none other than:
- Rental Reversion
- Asset Enhancements Initiatives (AEIs)
- capital recycling
1. Rental Reversion
Rental increase is the most common way of growing their revenue organically. Rental income from tenants represents the main bulk of a REIT’s business. They own properties, rent out to tenants, collect rentals, and distribute 90% of the income back to unitholders. Minimally, rental reversions (renewing tenant’s rental leases), should inch up at the same pace with inflation (average CPI-all items inflation is around 0.5% and average core inflation is around 1.6%). The former measures the change in price we pay for a basket of goods and services in our daily lives while the latter measures the long-term trend of inflation by excluding short-term volatility items such as accommodation and transport. So which inflation rate should we use? I would say REITs should at least achieve positive rental reversion of anywhere between 0.5% to 1.6% when their tenant’s lease term expires.
Some rental agreement with tenants have already been pre-agreed upon when they signed the lease. For example, Parkway life has set out annual rent review mechanism that requires Parkway Singapore to pay the higher of (base rent + variable rent 3.8% of adjusted hospital revenue) OR the preceding year rent + (CPI + 1%). Even in the event that Singapore is experiencing a deflationary period and CPI is 0% for the year, rental payments are guaranteed to increase by 1% based on the above formula.
But rental leases are far more complicated than that because there are many factors affecting rentals. Firstly, even the calculation of rental reversion can be complicated as it varies across different REITs and there is currently no standardized way of calculating it. Business Times’s article has summarized it into this picture as shown below.
Secondly, different industries have different rental lease terms, for example, retail malls usually have shorter leases as compared to a healthcare operator.
The advantage of longer lease tenants is that they provide a guaranteed stream of income and REIT manager do not have to face the risk of NOT being able to find new tenants to replace vacant slots. BUT, in a booming economy, shorter lease tenants might be preferred because the REIT manager now has the bargaining power to increase rents (positive rental reversion) when their tenant’s lease profile expires.
On the other hand, REITs that has longer lease tenants have no choice but to accept the locked-in rental rate thus missing out on all the opportunity gains. The key metric used to evaluate how short/long the lease term of all the tenants is by looking at WALE (Weighted-Average Lease Expiry). For example you can see that Capitalmall trust (retail REIT) has a WALE of only 1.9 years as compared to Parkway Life (healthcare REIT) has a wale of 7.31 years.
Thirdly, rentals are very much dependent on supply and demand, whether is it in favor of the tenant of landlord. The demand side would look at questions like: are there more businesses starting up? are SMEs expanding? are foreign investments coming in? or MNCs incorporating subsidiaries here? The supply side would look at how much new space or land are being developed at the moment and in the future, does it exceed or fall short of demand?
That’s why news article always mention about supply tapering, rental recovery, price stabilizing etc. Since majority of my holdings is in industrial REITs, I personally like to keep track of the JTC Quarterly Market Report which is published every quarter. It has everything you need, occupancy rate, rental index, supply outlook etc. The link to the latest quarter Q3 2018 report can be found here.
For example, we can see falling occupancy rate over the years bottoming out in 2017-2018 and the latest quarter we saw an increase of 0.4% from previous quarter (a reversal is coming?). To evaluate how good or bad an industrial REIT’s occupancy rate is or how far it deviates away from the mean, you can compare it with the average occupancy rate of 89.1% as stated in JTC’s report. For example, Ascendas has an occupancy rate of 90.1%.
Rental and price index of industrial properties remain stable meanwhile (Remember price of properties can affect gearing ratio from previous post?). But, the upcoming supply of industrial space is decreasing which is good news! Assuming all things being equal, lower supply should theoretically lead to higher demand, higher rental and higher price valuation. That’s why you frequently see analyst reports mentioning “Tailwind for the sector is the tapering supply of industrial properties“.
2. Asset Enhancement Initiatives (AEI)
AEI is nothing more but upgrading the buildings or improving the layout to increase traffic flow. This is more applicable for retail REITs where they do renovations/upgrading works on their shopping malls, create new space, layout designs etc. Most recent examples of REITs that has done an AEI is Mapletree Commercial Trust. It owns Vivocity which has revamped its basement 1 and 2 adding extensions, new tenants such as Popular, Adidas, Fila, etc. and escalators to improve connectivity etc. It is also going to convert a 3,000 sqft space for a public library at level 3 (previously used to be Daiso). Since public library is under the Government, they do not have to pay rental and in exchange for the free leasing they gave Vivo the extra space in B1 and B2.
Other methods could include optimizing tenant mix, ensuring that there is a diversified range of products and services, maximizing space (major events in the main hall, roadshows etc.), upgrading tenants from low-yield space to higher-yield space (e.g. converting super-market to luxury goods space).
3. Capital Recycling
Capital Recycling simply means selling off properties from your portfolio that is not doing so well and buying another property that gives a higher cap rate. This requires a certain degree of judgement call, foresight and market timing. It is not something that is easily done right. When do you know if a property is overvalued at its peak price or undervalued at its discounted price? It’s just like trading, high can go higher and low can go lower, nobody can catch the bottom nor sell at the top 100% of the time (or even 80%). A REIT manager may not use the profits from disposal to acquire a new property all the time, some times it can use proceeds to pay off debts, keep it in its war chest reserves and wait for opportunity, do an AEI or simply return back to unit holders.
To determine if capital recycling is a good deal, think of it this way. When disposing off an asset, compare the selling price with the cost price and calculate the margin from sale of disposal. When acquiring an asset, compare the buying price and the valuation price and calculate if the REIT manager is paying at a premium or discount and by how much %. Let’s try to find some recent REITs that has done capital recycling.
Earlier this year in 2018, Capitalmall Trust sold away Sembawang Shopping Centre to Lian Beng for $248 million. Net proceeds are expected to be $245.6 million and net gain of $119.6 million. Means the cost of acquiring Sembawang Shopping Centre should be somewhere around $126 million. Margin on Profits of sale can be calculated to be around a 94% gain (119.6/124)! That’s almost a 100% return on investment making 2x gains on cost price. Not bad…
Then in Aug this year 2018, Capitalmall Trust use the gains from divesting Sembawang to partly acquire the remaining 70% stake in WestGate from its parent CapitalLand for $789.6 million (CMT previously owns 30% of WestGate). Let’s see what is the valuations of WestGate from CapitalLand’s website.
“According to the Property Funds Appendix, in the case of an IPT, two independent valuations of the property must be obtained, with one of the valuers commissioned independently by the trustee. As at 21 August 2018, Colliers International Consultancy & Valuation (Singapore) Pte Ltd – an independent property valuer appointed by CMTML – has valued Westgate at S$1,130.0 million, while Jones Lang LaSalle Property Consultants Pte Ltd – an independent property valuer appointed by the trustee – has valued Westgate at S$1,125.0 million.”Source: https://www.capitaland.com/international/en/about-capitaland/newsroom/news-releases/international/2018/aug/CMT-to-acquire-remaining-stake-in-Westgate.html
So… is CMT paying $789.6 mil a good deal? I would think yes. It is fairly priced based on 2018’s valuation figures. $789.6 mil is somewhere in between the 2 calculated valuation. (Discount of $0.4 million from Collier’s International valuation and a premium of $2.1 million from Jones Lang’s valuation). 70% stake of Colliers International’s valuation ($1130 million) is $791 million. 70% stake of Jones Lang’s valuation ($1,125 mil) is $787.5 million
So what are the ways of Organic growth? Firstly, a REIT manager must be able to source quality tenants, achieve positive rental reversion by charging higher rentals progressively that is in line with inflation minimally, keep occupancy rates high (compare it against industry average occupancy rate) and generate higher revenue consistently over the years. (as the tree grows taller and stronger, ensure to water it more often and put higher quality fertilizers)
Secondly, Asset enhancement initiatives involves upgrading works, renovations, being creative with tenant mix, floor space etc. (planting flowers around the trees, trimming the weeds, arranging layout of garden to maintain attractiveness)
Lastly, capital recycling involves knowing when to dispose and acquire property at the right market timing to unlock maximum value for shareholders. (if a tree is old, leaves are falling and flowers have stop booming sell it off and plant a more attractive tree). Keep a lookout for the next post on how REITs grow inorganically!
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