Ng Hui Min, portfolio manager at Manulife Investment Management, who looks after its Asia Pacific REIT Fund, has a few pointers for investors looking to invest in REITs. This includes lessons learnt during and after the Global Financial Crisis (GFC).
“We don’t buy REITs based on attractive headline yields for the next six to 12 months. We look at the quality and sustainability of the yield rather than the quantum of the yield,” she says in a recent interview with The Edge Singapore.
Ng prefers total returns over the medium-term. For this, she studies the REITs individually for a bottoms-up approach. Since REITs are all about the property they hold, the quality of the property and its ability to generate cash flow is key. “We look at a basket of qualitative and quantitative factors,” Ng says.
Among the most important qualitative factors — in addition to the property — is a strong sponsor and a good manager. She adds: “We like REITs with strong sponsors. History has taught us that a strong sponsor matters in terms of capital strength and relationship with bankers which brings about a more efficient and cheaper cost of borrowing.”
The stronger the sponsor, the more robust the REIT’s capital management. During REITs’ half yearly presentation slides, investors should study in particular slides which display the REIT’s debt maturity profile. Most REITs usually take on bullet loans rather than amortising loans to fund acquisitions.
“We are all aware that REITs leverage or take advantage of borrowing to help them grow assets under management (AUM) and to finance acquisitions,” Ng continues.
She prefers REITs with comfortable gearing levels, strong capital management, diversified funding sources, having a meaningful percentage of borrowings in fixed rate debt, and having a debt maturity profile that is well staggered such that the REIT is not affected by a sudden rise in rates — of if there is a liquidity issue — they would not be able to finance a big part of their debt.
“We’ve gone through this during the [global financial crisis] where REITs in Australia and Singapore were forced to do dilutive rights issues because they were not able to refinance and some REITs had big towers of debt maturing in a single year. Since the GFC, REITs in Asia are more disciplined in capital management given lessons learnt and well staggered and lengthened debt maturity profiles so that in a single year they don’t have a lot of borrowing maturing,” Ng adds.
Sometimes, the debt maturity profile does not reveal the true picture. More recently, First REIT had to be recapitalised with a $158.2 million rights issue even though its debt maturity was spread out over three (non-consecutive) years.
At first glance, First REIT had loans of just $195.9 million maturing in March last year. But this was part of its 2018 secured loan facilities of $400 million. A change in the lease structure of its properties because of a weak sponsor-cum-master lessee, immediately shaved around $382 million off First REIT’s AUM of $1.34 billion. Its banks were willing to lend First REIT $260 million of the $400 million secured loan facility. Hence, First REIT had to come up with $140 million, which was eventually raised through a dilutive rights issue.
Strong sponsors
The First REIT case study demonstrates the importance of a strong sponsor, and hidden risks in loan agreements and master leases. “Strong sponsors with very strong development pipelines are able to bring good deals to the table, which are quality assets, accretive to unitholders of the REIT,” Ng says. In addition, sponsors must be able to support the REIT during its equity fund raising exercise.
The local market has experienced financial engineering in the form of master lease rents which were higher than market rents, in order for these assets to be sold into a REIT at an inflated valuation. This was the case in some independent REITs before and after the GFC, in particular for REITs with industrial assets.
The most well-known case of inflated valuations based on master lease rents is Eagle Hospitality Trust, which is now suspended. Investors need to be wary of master lease rents that are markedly different from market rents.
“We look at individual REITs where we study the lease structure, and organic growth and inorganic growth opportunities,” Ng says.
For REITs with master lease structures where the master tenant is a big part of the guarantor for the lease, Ng suggests checking the financial strength of the master lessee. “We are very mindful to check the credit strength of the master lessee. If the master lessee’s business is not doing well, they may not be able to honour the long-term master lease. So we do check on the credit strength of the master tenant,” Ng says.
One way to gauge the financial state of the master tenant is to check on the occupancy cost of the master leased property. Occupancy cost comprises all the expenses a tenant pays for space, including gross rents, and this is usually displayed as a ratio to sales. Hence, the lower the ratio the better. For healthcare REITs — which usually has a master lessee — occupancy cost is the ratio of gross rents to Ebitda of the property.
As a guide, Ng says: “For occupancy cost, does it make sense for the master tenants if it is too high? During downtime, committed rental rates will be higher than the cash flow the master tenant can earn. At the end of day, the credit strength of the master tenant is very important and we tend not to favour REITs with dependency on one or two key tenants for their income contribution.”
Supply and demand
On the other hand, long leases lend stability to a REIT’s net property income (NPI). “Where rental rates are flat, there is preference for longer weighted average lease expires given that you know the income is there for the longer-term, which helps provide visibility and certainty of income stream,” she adds. Some shorter-term leases are desirable to take advantage of market cycles, in particular when rental rates start to rise.
Organic growth for REITs depends on occupancy rates and rental rates. These in turn usually depend on supply and demand outlook. Supply in developed Asia, such as Singapore, Australia and Japan, are pretty transparent.
Demand is often affected by economic cycles. For instance, office space is usually a proxy for the economy. An economic recovery usually leads to more demand for office space with companies setting up. Office space is usually used by white collar workers, hence during periods of economic growth, employment trends will be more robust, leading to better office occupancy.
With Ng’s focus on strong sponsors, Manulife’s Asia-Pacific REIT Fund has as its top 10 holdings REITs with very strong sponsors such as CapitaLand, Mapletree Investments and Frasers Property (FPL).
Meanwhile, Link REIT ranks highly in the fund — it is different from the S-REITs in that it comprises an internal management structure, with fees based on a recovery basis.
Liquidity and economic cycles
Ng does not have a preference for an internally or externally managed REIT. “It is more a factor of qualitative and quantitative factors, and the total return potential of the REIT,” she says.
Typical valuation metrics for Ng are likely to be the yield spread across sectors and markets relative to history, and at the REIT level, where the yield spreads have been trading compared to its peers, and its trend over time. Ng also checks out price to NAV ratios to gauge whether its valuations are too bullish, or bearish.
Another metric that needs to be checked out is the spread between the REIT’s property income yield and cost of debt. The fund’s top 10 REITs are the largest in their respective markets, and liquidity is an important consideration for the fund.
“We have liquidity screens in our investment process and we want the liquidity requirement to enable the fund to accumulate or to liquidate positions [easily],” Ng says.
Ng says the fund’s top 10 holdings are unlikely to change much, despite the negativity around office property. “We’ve seen office capital values for Grade A buildings holding up very well in Singapore and Australia because of the property yield spread over the cost of borrowing. This spread remains very attractive for property funds and private capital looking to invest in quality assets in Asia. These healthy spreads continue to underpin real estate investment and office assets continue to hold up very well despite bearish views of work-from-home trends in the past six to 12 months.”
In addition, the office is the best proxy for an economic recovery should interest rates start to rise, she adds.
With vaccinations underway across developed Asia, Ng reckons that we are unlikely to see the broad lockdowns this year. Most parts of the economy are likely to remain functional, and the vaccine rollout is positive for REITs’ cash flows.
“We are looking at an economic recovery and growth in Asian REIT distributions in the next six to 12 months, and this should offset volatility in higher bond yields,” Ng adds.
