What’s that REIT really worth?

While the minorities did not succeed in removing the manager, they managed to thwart the acquisition back in 2017. Three years on, the manager and sponsor are no longer around.

More recently, valuations have warranted closer scrutiny following the fiasco involving the IPO of Eagle Hospitality Trust. Here, the sponsors boosted valuations with long master leases which they did not intend to honour.

Indeed, valuations are important for REITs because they impact net asset values and gearing. In turn, valuations are affected by rental outlook and growth, discount rates and capitalisation rates. Interest rates can indirectly affect valuations too. While capital values are usually stable or rising when interest rates are low, they can sometimes adversely be affected by rising interest rates.

In addition, valuers usually assign higher valuations to properties with master leases due to the perceived stability of longer weighted average lease expiries (WALE) compared to buildings with lots of tenants and a variety of leases. Some market players have taken advantage of this characteristic to overvalue properties by assigning them with a long master lease at above market rents.

On July 16, when ESR-REIT and Sabana REIT announced a merger, Sabana REIT revalued its portfolio by around 5% lower while ESR-REIT revalued its portfolio by 1% lower.

Donald Han, CEO of Sabana REIT’s manager, explains, “When some properties were converted from master leases to multi-tenanted properties — for example at 10 Changi South Street 2 — we had expected a drop in valuation because valuers used a higher vacancy rate and lower rental outlook in their discounted cash flow (DCF) model due to the Covid-19 situation.”

The other properties in Sabana REIT whose master leases were being changed to multi-tenanted ones were 51 Penjuru Road, 33 & 35 Penjuru Lane and 30 & 32 Tuas Avenue 8. They too recorded valuation declines because of a change of assumptions by the valuers.

“The ‘circuit breaker’ didn’t help because we could not pursue the tenants,” adds Han. “However, the tenants are now more open to renewals, and we are confidently working towards renewing our tenants.”

Another factor that affects valuation is the land tenure. This is particularly relevant for industrial properties whose land leases are typically shorter than that of commercial properties.

Take ESR-REIT, the owner of 11 Lorong 3 Toa Payoh and Viva Business City in Chai Chee that were acquired through its merger with Viva Industrial Trust. The two properties have short land tenures.

Adrian Chui, CEO of ESR-REIT’s manager, says, “Our own valuation fell by 1.3% because of short land leases in some of our assets. The cap rates did not change even though risk premia have risen due to Covid-19 as this was balanced out by the low-interest rate environment.”

In the income capitalisation method of valuation, the income from a property is capitalised by a certain percentage. In contrast, the DCF method of valuation uses rents, rental outlook and rental growth to calculate the cash flow from a property and estimate its net present value (NPV) using a discount rate. In a low-interest rate environment, both the discount rates and cap rates are generally softer.

“The rental outlook for ESR-REIT will still be soft because assets in the general industrial segment are smaller, more dated and demand for those spaces for customers is lower,” Chui says, despite pockets of demand from government stockpiling and MNCs that see Singapore as an attractive node in its global supply chainwhich has been disrupted by the pandemic and US-China trade war. However, rentals from logistics and hi-tech properties are expected to hold, adds Chui.

In a report dated July 22, Desmond Sim, head of research, Southeast Asia, CBRE, confirms Chui’s sombre outlook. Sim says rental declines that occurred in 2Q2020 show downward pressures continue to be act on the industrial sector

Although government stockpiling and demand for storage space by e-commerce, food logistics and third-party logistics players caused occupancy rates of logistics properties to edge up by 0.8 percentage points to 88.3%, the JTC Warehouse Rental Index shrank by 0.7% q-o-q in 2Q2020.

“While CBRE Research expects factory rents to be less resilient amid the unfavourable economic conditions, heightened demand for prime logistics spaces as well as the limited upcoming supply compounded by delays in project constructions could help to lend some support to overall warehouse rents,” Sim notes.

Retail REITs badly hit

Nevertheless, the industrial property sector is expected to fare better than the retail property sector. “Demand for retail space will likely stay depressed, keeping rents on the downtrend in 2H2020,” says Tan Huey Ying, head of research and consultancy at JLL Singapore, in a 2H2020 update. “Singapore’s retail property market was hit hard by Covid-19 in 2Q2020 and we expect overall market sentiment to stay soft in the rest of 2020.”

URA’s 2Q2020 real estate statistics released on July 24 showed that the retail rental index for Central Region fell 3.5% q-o-q to its lowest since 2011. The quarterly rent fall in 2Q2020 was also steeper than the 2.3% q-o-q correction recorded for 1Q2020.

“In the coming quarters, more retail closures could emerge as government and/or landlord support for retailers ease and the Temporary Deferment Bill no longer protects businesses of their deferred liabilities,” Tay of JLL cautions.

No surprise then that in its half year portfolio revaluation, CapitaLand Mall Trust (CMT) recorded a 2.5% decline in value for its wholly-owned malls while its share of Raffles City’s valuation fell by 3.5%, causing a 2.7% decline in portfolio value as at June 30.

Tony Tan, CEO of CMT’s manager, explains, “Rent growth assumptions going forward and taking into consideration some leases we signed, caused the 2.7% decline in valuation. The situation is unprecedented and the valuer has assumed no cap rate changes. Post-June 30, there was a transaction and but in 1H2020 there were no transactions, so cap rate was maintained.”

The decline in valuation caused CMT’s gearing to rise to 34.4% as at June 30, compared with 33.3% as at March 31. NAV fell to $1.99 as at end June, compared with $2.07 as at end December after its last valuation exercise.

Changing lease structures

Looking ahead, valuations of retail properties may become more volatile because of changing lease structures. In 1H2020, CMT’s gross turnover (GTO) rent was just 5% of total rental revenue. If the retail sector remains weak, CMT may bear a larger part of the risk alongside its tenants.

“Tenants are a bit more cautious and leasing has to be more flexible going forward. This could include taking some risk on the landlord’s side and participate a little bit more on the turnover rent. We need to be flexible with existing tenants and new-to-market concepts,” says CMT’s Tan during a recent results briefing. This would include a lower portion of fixed rents and a higher percentage of GTO rents for new-to-market concepts.

“For tenants who embark on an omnichannel strategy, we’re able to capture their turnover sales,” Tan says. On June 1, CapitaLand, CMT’s sponsor, introduced its e-commerce platform, eCapitaMall and Capita3Eats. Since then, 280 online merchants have signed up. By the end of the year, the programme hopes to sign up at least 500 merchants.

However, retail REITs are unlikely to move towards a wholly GTO leasing strategy. Instead, the distributable income of retail REITs may eventually comprise a fixed portion and a variable portion in order to maintain income and distribution stability.

Take Sasseur REIT for example, the owner of four outlet malls in China that capture discretionary spending. Nearly all (97%) of Sasseur REIT’s rental revenue come from percentage of sales, with no fixed rents. So, in order to stabilise distributions, the sponsor has committed to a fixed rent portion and a percentage of sales portion. In FY2019, the fixed portion contributed around 54% to total income. In 1QFY2020, the fixed portion contributed 80% to total income.

According to its FY2019 annual report, the valuations of Sasseur REIT’s properties are based on DCF analysis using both the fixed and variable component of its income model. Interestingly, Sasseur REIT’s IPO prospectus — it was listed in March 2018 — had two valuations, one with the fixed component, and the other without. Undoubtedly, the valuation without the fixed component was lower as assumptions for occupancy and rental outlook tend to be more conservative.

This year, Sasseur REIT’s portfolio sales in RMB terms was more than 50% lower in 1QFY2020. If the trend persists, its portfolio valuation is likely to fall. Despite this, its DCF valuation would be mitigated by the larger fixed component, which is a form of income support from its sponsor.

Industrial REITs and data centres

When it comes to data centres, the reason why they are so beloved by local investors is because they are usually leased on a “shell and core” basis with relatively long WALEs because the tenants have a capital expenditure component to install plant and machinery. Data centre owners rent their properties to operators such as Equinix, HP or Singapore Telecommunications, who install its infrastructure and pay for utilities. For instance, many of Keppel DC REIT’s properties are on double and triple net leases, with long WALE.

In terms of valuation, triple net leases with a single tenant on a long lease is the easiest to value. The cash flow is relatively transparent as there are no deductions to be made, with no volatility during the lease period. The capitalisation rate and rent growth assumptions are only changed when there are rent reviews, or break clauses. However, when the master lessee of a REIT sub-leases the space to third parties, which is typical for industrial REITs, these valuations can muddy the waters, especially if the master lease is higher than market rents or the sub-tenant’s rent.

With Keppel DC REIT’s yields at sub-4%, and valuation of around twice its NAV, investors are turning to Mapletree Industrial Trust (MINT). When it announced its results on July 22, MINT’s manager said that from April 1, its manager has reclassified data centres as a standalone property segment. The manager added that portfolio occupancy fell to 91.1% from 91.5% a quarter ago because all property segments except data centres recorded lower average occupancy rates compared to the previous quarter.

Like Keppel DC REIT, MINT’s data centres are rented on a shell and core basis, and on triple net leases where the tenant bears utility costs and the like, builds its own infrastructure, and the leases are long. In fact, its US portfolio has a weighted average lease expiry of more than seven years.

The situation with office REITs

During a results briefing on July 23, Kevin Chee, CEO of CapitaLand Commercial Trust’s (CCT) manager says that 21 Collyer Quay, the former HSBC Building, is being leased to WeWork for seven years. Its valuation as at June 30 has fallen around 0.1% to $465.5 million from $466.1 million. This prices the property at $2,322 psf, which sounds reasonable for a building with a 999-year land lease, given the nearby Straits Trading Building was sold for $560 million in 2016, or $3,520 psf.

“21 Collyer Quay was valued on a fully committed basis to WeWork on the WeWork rent for seven years. After expiry of the lease, the valuers assume market rent. The capitalisation rate is similar to what was used in December 2019, which was 3.45%,” Chee explains.

When asked about the certainty of the WeWork lease, Chee says, “The WeWork lease is status quo, that is, the lease is committed and we’ve been engaged in discussions on the timing of handover of the premises. We believe WeWork will continue to be our tenant.”

For now, Chee says that asset enhancement initiative (AEI) works have not started on 21 Collyer Quay as the manager is still in the process of getting approvals on the labour needed to start work. “We are expecting the completion in 1Q2021 which means handover to WeWork will be slightly delayed,” Chee says.

Should investors be concerned about WeWork’s ability to sustain those rents for seven years? Clearly they are but WeWork chairman Marcelo Claure reiterated to the US media in July the company’s commitment to turn in an operating profit and positive operating cash flow, following a cut in its workforce and renegotiated leases.

Meanwhile, CCT’s all other office buildings in the CBD such as Capital Tower, One George Street, Six Battery Road and Asia Square Tower 2, are multi-tenanted. Since the outlook for rents and rental growth is negative, CCT’s portfolio valuation fell by 1.7%. Among the top losers are Six Battery Road, down 1.7%. The property is likely to undergo AEI following the exit of anchor tenant Standard Chartered Bank and the occupancy is 78.7% as at June 30 compared with 98.7% as at Dec 31, 2019.

“All the valuation reports come with a health warning and a note of caution saying due to Covid-19 there is a large amount of uncertainty,” Chee warns. Cap rates and discount rates did not move, and valuers took into account lower market rents and rental growth rates, Chee explains. “Valuers have announced they are expecting rental growth to soften and we are constantly engaging valuers to see how it goes,” he adds.

As for CCT’s two properties in Germany — Gallileo and Main Airport Center, they recorded a 1% increase in valuation each from 4QFY2019, although they account for less than 10% of the portfolio.

CCT’s NAV fell to $1.76 from $1.83 in 1QFY2020, and $1.82 in 4QFY2019. Gearing rose to 36.4% as at June 30, compared with 35.5% in 1QFY2020 and 35.1% in 4QFY2019.

Office property leasing activity grounded to a near halt in 2Q2020, hindered by the inability to conduct physical viewings in most part of the quarter due to the “circuit breaker” measures and phased re-opening of the economy, says Tan of JLL. “Given a downcast outlook, most occupiers also chose to hold back relocation and expansion plans to avoid incurring capital expenditure. To entice tenants to renew or commit to new leases, landlords have become more accommodating to tenants’ request and generous on incentive offers,” she elaborates.

“As the economic fallout from Covd-19 sinks deeper and widened in its spread, we expect rent correction to intensify in 2H2020, bringing full-year CBD Grade A rent correction to around 12%. Rent could potentially bottom in 2H2021 and recover by 2022 assuming economic recovery alongside the successful management of the spread of Covid-19 globally and domestically.” JLL’s Tan reckons.

Office cum retail REITs and gearing

While CCT’s gearing is relatively benign and was only modestly affected by the fall in valuation, REITs with office and retail assets with higher gearing levels — such as OUE Commercial REIT (OUE C-REIT) at 40.1% — could experience a rise in gearing levels in 2HFY2020 if or when its properties are revalued downwards. While the regulatory ceiling has been lifted to 50%, gearing levels above 45% could cause a selldown.

Some 55% of OUE C-REIT’s revenue comes from the office sector while 26% comes from hospitality and 8.6% comes from retail. OUE Downtown continues to enjoy income support from the sponsor, but in an outlook statement, the manager acknowledged that office occupancy and rents are expected to remain under pressure and the operating environment for its retail sector is expected to remain challenging.

Going long

On a brighter note, retailers with a deeper balance sheet and a medium-to-long-term perspective are likely to continue to anchor in Singapore as a gateway to Asia, says Tan of JLL. The eventual successful containment of the Covid-19 outbreak would see the government lift safe-distancing measures and travel restrictions while reinvigorating economic activities. Retailer and consumer confidence as well as business expansion should resume. Occupier demand should also recover as foot traffic and retail sales pick up alongside economic growth. Coupled with the supply tightness, vacancy rates could fall to support rent recovery by 2022, JLL’s Tan suggests.

Already, CMT is experiencing a recovery of sorts. In July, shopper traffic in the better malls have recovered to 80% of pre-Covid-19 levels, says CMT’s Tan. “We’re monitoring tenants’ performance closely and actively managing tenancy issues. Barring no [further] issues on safe management measures, 2H2020 will be better than 2Q2020. That is our wish. We try our best to make sure our tenants are able to trade well. And we’ve announced the omnichannel platform that should help some retailers. Hopefully, this will take on a life of its own and we can truly operate an omnichannel shopping centre,” says CMT’s Tan.