According to Vijay Natarajan, property and REITs analyst, RHB Bank Singapore, several factors can fortify a REIT and make it Covid-19 resilient. Among the well known factors are asset quality, tenant quality and lease structures. In addition, businesses in general, and REITs in particular, need to adapt to changing trends. Post-Covid, the focus is on new economy sectors such as logistics assets — which are necessary with growing ecommerce trends — and data centres.
Most of all, the REIT’s manager and sponsor are perhaps the most important cog in the wheel. “The REIT needs a good manager and sponsor who are committed to growing the REIT. I think that’s the most important thing for me,” Natarajan says.
CEO of Elite Commercial REIT’s manager Shaldine Wang adds that investors always look at distributions. “Other things that investors will be keen to look at would probably be distributions, and DPU yields, because ultimately that’s the returns they are getting.” Elite Commercial REIT which listed in February this year, has outperformed its forecast distributions and DPU. It announced a DPU of GBP 0.0195 in 1HFY2020 ended June, 1% above its prospectus forecast, largely on lower funding costs than initially anticipated.
“Gearing and market capitalisation are some of the key metrics that investors will be keen to know when they’re coming to invest and deciding which REIT to invest in,” Wang adds.
Elite Commercial REIT owns 97 office assets in the UK, which are mainly freehold. The portfolio’s weighted average lease to expiry (WALE) is 7.6 years, and the portfolio is 100% unencumbered. This means that none of the properties are secured for bank loans.
Often tenant risk is a focus for REIT managers. Hence most managers opt for a mixture of Fortune 500 names or MNCs along with the inevitable SMEs that comprise 30% to 40% of industrial and retail portfolios. Tenant diversification helps to lessen tenant concentration risk.
Elite Commercial REIT is unusual in that it has one main tenant. “I guess we are quite unique. We have always been criticized for having one tenant. However, the credit worthiness of the tenant speaks for itself. Our tenant — the Department of Work and Pensions (DWP) — is the equivalent of an AA-credit rated sovereign tenant,” Wang explains.
Of course no S-REIT has this amount of concentration. But DWP, which is part of the UK government, is unlikely to default on its rents. Moreover, DWP has been extremely busy since the onset of Covid because unemployment has risen. DWP is the UK’s largest government department with the largest budget and employees, and is responsible for welfare and pension policy.
Elite Commercial REIT’s UK portfolio comprises JobCentre Plus properties which are used for job seekers, and pension, child maintenance and disability services. “The DWP is a very counter cyclical tenant. DWP plays a crucial role in the social infrastructure serving the UK’s local communities. The utilisation of the REIT’s assets, JobCentre Plus’ footfall and DWP benefit spending are all inversely correlated to the UK economy and employment rates,” Wang points out. So DWP actually needs more space during these troubled times than normal office tenants.
To diversify or not
S-REITs have been gradually diversifying their portfolios — both in terms of asset types, and geography. For instance, commercial REITs have merged with hospitality REITs. An example of this is the merger in 2018 of OUE Commercial REIT and OUE Hospitality Trust to form a larger OUE Commercial REIT. At the start of 2020, Frasers Logistics and Commercial Trust was formed from the merger of Frasers Logistics and Industrial Trust and Frasers Commercial Trust. And, in the largest REIT transaction in 18 years, CapitaLand Mall Trust merged with CapitaLand Commercial Trust to form CapitaLand Integrated Commercial Trust (CICT), arguably one of Asia’s largest REITs by AUM.
Some investors prefer concentration. For instance, Frasers Centrepoint Trust (FCT) trades at a tight DPU yield of under 5% because it owns mainly suburban malls and its assets are all in Singapore. Elsewhere, Keppel DC REIT has outperformed the S-REIT indices because it only owns data centres.
Savills director Mat Oakley says, “I’m very bipolar on this, to be honest. Part of me says I want a specialist, I want an expert.” That is, if it is a data centre REIT, the manager would need to be completely focused on data centres. “The manager needs to know everything about data centres. Or if it’s a UK office focused REIT, the manager would know everything about UK offices,” he explains.
On the other hand, fund managers seek diversification. “You want a variety of asset classes, you want to spread your risk, different asset classes move in different cycles. That’s the general thinking,” Oakley acknowledges.
In his presentation, Natarajan points out that Covid has resulted in positive effects on data centres and logistics assets and posed challenges to hospitality and retail. Indeed, specialised retail and hospitality REITs have suffered in terms of their revenue, net property income and DPU. However, there are other aspects to a REIT, such as the quality of the property, its location and of course manager and sponsor - all these factors also have a bearing on how well the REIT is perceived or how well it can navigate its headwinds.
“I wouldn’t necessarily rush towards what is new and fashionable in many cases,” Oakley adds. Natarajan says investors need to examine REITs in the adversely impacted sectors to understand how they are adapting to changes.
For instance, CICT has introduced an ecommerce marketplace for its retail tenants, and cross sells other services and products from different parts of the CapitaLand group to its customers. FCT has also started introducing an ecommerce marketplace for its tenants. Even REITs which are positioned in the beneficial sectors need to adapt to changing trends. For instance, the US-China trade war has caused a change in supply chains which would inevitably impact the usage of warehouses.
Valuations are important
Some S-REITs have had issues with valuations, the latest being Eagle Hospitality Trust. It listed with 18 hospitality assets in the US valued at US$1.2 billion ($1.6 billion) in May 2019. Yet its valuation on an “as is” basis as at end of August was just US$726.9 million, and US$899.6 million on a stabilised basis. Valuations can be inflated through length of master leases, and by selling the properties into the REIT at higher passing rents than market rents.
Oakley says in the UK the Royal Institute of Chartered Surveyors lays down valuation methodology and acts as an arbitrator if two parties cannot agree on valuation. “The UK is a very transparent market in that sense,” Oakley says. It is also a very liquid market. “You can look at the market and see all the deals that have happened to check the value. I think that is a huge factor for non-domestic investors, because you need transparency as well as liquidity and I think the UK is probably the most transparent market in the world.”
Valuation is also dependent on location, rental outlook, tenant quality and cash flow in general. “At the moment in the UK market relatively few transactions are happening, primarily because of the difficulties of transacting in a lockdown period. Many of the clients who want to buy assets can’t visit the UK. In a period of low activity, valuers are only allowed to value based on evidence,” Oakley says, referring to historical transacted values. “At the moment, it’s very difficult to put a value on anything in the UK, because there is no comparative sale,” he adds.
In Singapore, valuers usually look at three main methods, discounted cash flow (DCF), income capitalisation, and comparable valuations. DCF generally takes into account the operating cash flow during the lease periods. A DCF spreadsheet for a property can get quite complicated for a property with many tenants who have different lease profiles. Properties with long WALEs are often valued at a premium, which is why the hospitality assets for Eagle Hospitality Trust were so high at IPO — they were valued based on unattainable master lease rents for 20 years. Since the onset of Covid, portfolio valuations have declined by around 5% or so for some REITs.
“Despite this crisis, I think valuations so far have not been adversely impacted like in past crises. The key reason here is low interest rates. In a low interest rate environment, capitalisation rates don’t change that much. And there is also ample liquidity in the market,” Natarajan indicates. Valuations are important to analysts because investors often look at P/NAV to determine whether a REIT is overvalued or undervalued.
Although Elite Commercial REIT has a single tenant, its properties are not master leased to its tenant. “Our REIT actually doesn’t have a master lease, unlike a lot of other REITs. We’ve got a long term tenant whereby each of the buildings has its own individual lease. The valuations of the buildings have been based on the income capitalisation method which it takes into account the cash flows of each of these properties,” says Wang.
According to her, Elite Commercial REIT’s valuers have put in a couple of assumptions. These assumptions include a break clause at year five of a 10-year lease for 50% of the portfolio. This is despite the low likelihood that DWP breaks these clauses. And a second assumption is the rent based on the length of the leases.
“If you signed a full 10-year lease without a break clause, it is probably going to be at a lower rent rate compared to one with with the five year break clause. So these are the considerations that have been built into the leases,” Wang explains.
Interest rates to remain low
Finally, Oakley agrees with Natarajan that interest rates — a key component for both the property and equity markets — are unlikely to rise in the next couple of years.“ Economists have been predicting a normalisation in interest rates since the global financial crisis. Most governments’ debt to GDP ratios are at record levels. There is no prospect short of a sharp rise in inflation in Western economies, would interest rates go up. And they’re not going to normalise back to the levels that we saw in the 70s, 80s or 90s,” Oakley says. And the good news is that low interest rates act as a tailwind for REITs
