The REITs Investment Forum (RIF), titled “Trends to drive REIT Recovery” — organised by The Edge Singapore and sponsored by ESR-REIT — covered industrial property trends, and factors and metrics used in property valuation.
Adrian Chui, CEO of ESR-REIT’s manager, kicked off the forum with his presentation titled “Challenges and Opportunities for Industrial REITs”, followed by “Pivot to Hi-Tech” by Natalie Ong, an investment analyst at Phillip Securities. Tan Keng Chiam, executive director & head, valuation & advisory, at Colliers International, presented on how industrial propeties are valued.
The industrial sector is highly regulated to keep rents affordable for industry, including new economy sectors such as logistics, e-commerce, data centres and high-end manufacturing, as these are the cornerstones of the Singapore economy.
“The purpose of the regulation is to ensure that there’s the prevention of speculation on industrial land in Singapore and to make sure that land that is set aside for industrial usage is actually put to [industrial] use,” says Chui during the RIF.
As at April 1, 2020, JTC has a revised list of regulations on third-party facility providers which include REITs. The current regulations would still imply that buyers of industrial property are a limited pool, as they have to be approved by JTC.
For instance, only end-users, developers, or REITs and holders of trust business or capital markets services licences, can get permission to buy properties from organisations such as REITs and other owners. In the past few years, ESR-REIT has sold five properties, all to end-users. To discourage speculation and to promote price stability in the industrial property market, JTC implements an Assignment Prohibition Period to ensure companies that purchase industrial land will stay for a minimum period before they are allowed to sell. Hence, industrial property is subject to a non-sale moratorium of five years for land leases of less than 30 years and a moratorium of 10 years for land leases that are more than 30 years.
In addition to who can buy industrial property, JTC has restrictions on who can be tenants. It implements a minimum occupation period on the original leaseback anchor tenant to ensure that industrialists remain committed to their proposed business plans for a sustained and reasonable period of time.
A minimum anchor tenant rule requires the tenant to occupy a large portion of the property for a certain number of years, depending on the land lease of the property. Anchor tenants are required to occupy at least 50% of gross floor area within five years from obtaining the first temporary occupation permit (TOP), and at least 70% thereafter. At least 60% of industrial space has to be used for industrial tenants, and 40% for ancillary services, which can involve cafeterias or a food court.
Impact of Covid-19
In 2020, industrial REITs had to provide rental relief for their SME tenants, including ESR-REIT. Altogether it put aside $10.1 million for rental rebates, and $8 million is likely to be required for these rebates and lease restructuring. The amount includes the mandatory oneand two-month rental relief for industrial and retail tenants, under the Covid-19 Temporary Measures Act for SMEs.
During the “circuit breaker” in April to June and for a few months afterwards, construction activities had come to a stop because of a Covid-19 outbreak in the dormitories. This caused construction delays. “A lot of the supply was pushed into 2021,” notes Ong.
Most of the new supply is likely to be in business and science parks, followed by logistics assets. Although light industrial has the smallest increase in supply, most of the supply in industrial property is light industrial.
“In terms of pre-commitments, high-specs had the highest pre commitments, warehouses are somewhere in the middle, and light industrial [is the lowest] because of the large supply and options that tenants actually have,” Ong observes. Of note, though, is that data centres are not separated from high-tech, which is why high-tech probably has the highest pre-commitments.
Build back better
Covid-19 caused shutdowns in global economic activity. Yet, new e-commerce activities emerged, new supply chains are being formed on the back of US-China trade tensions, demand for data storage in data centres is rising, and demand for cold storage facilities is growing on the back of vaccine economics. And given that vaccine immunity lasts for months rather than years, cold storage demand will persist for years. Interestingly, ESR Cayman, ESR-REIT’s sponsor, has diversified into data centres in Japan and cold storage in China.
“The new economy sectors are the high growth industries that are on the cutting edge of technology, which I believe to be the driving forces of economic growth and productivity. Some examples are high-value technology-based businesses such as data centres, advanced manufacturing in information communications technology, as well as biomedical,” Ong says.
Industrial REITs are increasingly futureproofing their assets with acquisitions of data centres, logistics assets and high-tech business parks, she adds. In addition, industrial REITs are converting light industrial assets into high-spec asets, which allow REITs to modernise their assets, remain competitive, and achieve higher returns on investment (ROI). ROIs on asset enhancement initiatives (AEI) and redevelopments are usually higher than on acquisitions.
Ong cites a few examples of industrial REITs redeveloping properties to achieve higher ROIs. Mapletree Industrial Trust (MINT) announced the redevelopment of its Kolam Ayer 2 Flatted Factory Cluster in July 2019 with estimated completion in 2H2022. The total project cost is likely to be $300 million, up 14% from an initial estimate of $263 million, Ong indicates. This includes its $70.2 million book value. The property has a 43-year land lease tenure from July 1, 2008, with a B2 zoning.
On the advantages of the redevelopment, Ong says: “First of all, of course, there is the increased plot ratio from 1.5 times to 2.5 times, with gross floor area increasing by 71% to 865,600 sq ft. So there’s a very substantial increase in the leasable area as well, and, of course, based on previous redevelopment MINT has managed to double their rents.”
She adds: “The anchor tenant is a global medical device company headquartered in Germany, and MINT decided to actually undergo a repositioning and redevelopment with one of the buildings fully leased to this medical device company.”
In general, flatted factories command lower rents, within the $1.50 to $1.80 psf per month (psf pm) range, compared to high-tech rents, which are above $3 psf pm.
Yield on the cost for MINT is 7% compared to earlier estimates of 7.5%, because of higher construction costs but includes tenant relocation costs, Ong indicates.
Similarly, ESR-REIT has asset enhancement plans for certain properties. “The key part is actually rejuvenating our portfolio, to ensure that it’s future ready. We have identified across our portfolio two to three assets for AEIs over the next 12 to 18 months. We are also developing a standalone multi-tenanted high-specs building, suitable for advanced manufacturing, infocomm and data centre tenants,” Chui says of ESR-REIT’s property at 7000 Ang Mo Kio Ave 5. The yield on cost on a stabilised basis is around 7%, he adds.
ESR-REIT is planning to divest around $50 million of properties, subject to regulatory approval. “Sales from the divestment could be used to support any potential loss of incomerom assets during construction and our different AEIs,” Chui indicates.
Land tenures
In addition to the various restrictions on industrial property use, and ownership, land leases of industrial property are shorter than for other sectors such as residential, office and retail.
“[The authorities] will consider extension provided you have a business plan to be able to support the extension,” Tan says. Extensions are subject to an upfront land rent, though. “When we do the assessments, the tenure, the land lease is taken into consideration,” he adds.
Based on Singapore Land Authority’s table, leasehold values as a percentage of freehold values decline by 0.7% to 0.8% a year when land tenures decline from 40 to 30 years. The rate of decline in value quickens as land tenure falls below 30 years, to around 1.6% to 1.8% a year for leases of 20 to 10 years. With one year of land lease left, the residual value is just 3.8% that of freehold land.
Tan points out that property is not homogeneous, and valuation also depends on the building, its age, design, and of course location.
Interest rates
Yields on US 30-year treasury notes have surged since the start of the year, from just below 1% to more than 1.5%. Although lower than yearago levels, these higher levels indicate inflation in the system.
According to Tan, interest rates such as yields on 10-year bonds affect capitalisation rates and discount rates indirectly, which in turn impact capital values. Income capitalisation and discounted cash flows (DCF) are two methods using rents, rental outlook and interest rates to value property.
The other methods are comparisons and comparables, and the cost approach which incorporates land value and the cost of the building. The DCF method is the most common method for determining the value of investment property.
“For discounted cash flow, we will project 10 years’ cash flow capturing the growth in rental, capturing the inflation rate, and take into account the cost of operations. Then we’ll apply a discount rate,” Tan says. Terminal value is the second major component of a DCF, which estimates the property’s cash flow beyond the forecast period. “DCF is actually the most frequent method that we use as compared to the direct comparison method which is actually a very simplistic methodology,” Tan points out.
REIT managers manage interest rate movements as part of their capital management. “From a practitioner’s point of view, the key is always that we take into consideration interest rate cycles. We have to do that because it affects cap rate evaluation. More immediately for us is that rising interest rates have an impact on our cost of debt, which has an impact on our P&L, and that affects distributions per unit (DPUs). This is where capital management actually comes in,” Chui says.
Interest rates usually rise because of a return to growth, which is mildly inflationary. And, according to Ong, DPUs can outrun the rise in inflation. “If you look at the leases in REIT with tenants with very long weighted average lease expiries, they usually have escalations if you’re in Europe (or Australia), with rents that are CPI-linked. These can be anywhere between 2% and 3%,” Ong says. “In a sense, the hope is that of course the REITs will be able to provide inflation protection.”
“Of course interest rates are key for us practitioners, and there will be obviously property cycles. It’s a long-term game: What is your strategy? What are your plans and actions for these assets? Where will they be in 10 years?” Chui asks. “Generally property rises overtime, when you look at your total return over say 10 years.”
