A decade on, REITs remain a mystery

 

  November 25, 2011

It has been a decade since real estate investment trusts (REITs) made their appearance on the Singapore bourse, but it appears many investors are still grappling to understand this asset class.

 

The REIT sector hit the headlines recently when K-REIT Asia’s plans to buy 87.5 per cent of Ocean Financial Centre (OFC) and raise S$976 million through a rights issue to fund part of the cost was approved despite howls of protest by minority shareholders.

 

K-REIT Asia had earlier announced it would pay some S$1.57 billion to buy parent company Keppel Land’s entire stake in the OFC office building. Keppel Land will book a net gain of about S$492.7 million from the sale.

 

It would be fair to say that the controversy would not have erupted if the once optimistic market sentiment in the office sector had not suddenly turned cold. Dissenting shareholders had questioned the historic high price paid for the purchase – especially at a time when the economy is slowing down.

 

The prime Grade A office building in Raffles Place has a tenure of 999 years and 850 years remaining on the lease. However, Keppel Land is selling its stake with only a 99-year lease. Excluding rental support from Keppel Land, the estimated sale price of OFC works out to S$2,380 per sq ft.

 

Leaving aside the equally contentious issue of independence for the time being, it must be said that REIT managers have mostly had to acquire their properties on the higher side of valuations if only because it is the only way they can get the owners to sell it to them.

 

A REIT can get a property on the cheap only when the owner is ignorant of its true market value or if it is a forced sale – many investors still do not realise this. At the same time, the REIT manager can only justify the acquisition to shareholders if it is yield-accretive. Otherwise, the REIT is better off not doing anything.

 

So, a spot of financial engineering is required to get it to be so. This will buy the REIT manager some time to get the asset to perform to expectations or for the market to turn around and justify the values. In a rising market, this is not a problem.

 

Otherwise, for the acquisition to be yield-accretive, the REIT will have to buy a property of lower quality or one with higher risk because such properties have higher yields.

 

As more properties in Singapore are acquired by the REITs, there will be fewer available on the market. As such, the asking price by the remaining landlords can only get higher. Given more time, it will become clear, if it is not so now, that the current model is not sustainable in the long run.

 

REITs are often presented as defensive plays as it relies on revenues generated from income-producing properties held in its portfolio. While it may be so in more mature economies, the situation is different in Singapore.

 

In mature economies, a typical portfolio of properties in a REIT is a lot more stable. The leases are longer, which means the payout is much more consistent. In Singapore, most REITs are on the acquisition trail and their portfolios are always expanding.

 

This may have to do with the existing reward structure – the payoff is better with acquisitions than getting the existing assets to perform better. Is this what the Monetary Authority of Singapore (MAS) intended when it drew up the regulatory framework for REITs?

 

There may be better justification for a hands-off approach in the early days when the industry was in its fledging stages and when the MAS needed to build up the industry.

 

However, as the recent K-REIT Asia controversy has highlighted, it may be time for further regulation, especially in the areas of independence and avoidance of conflict of interests.

 

Many times in the past, I had prodded journalists to look further into certain REIT issues but all have declined, citing a lack of understanding of the subject matter.

 

Also, as pointed out by one reader, most REIT unitholders are not sophisticated enough to look after their own interests because of their lack of understanding. Even a representative of an institutional fund I spoke to immediately after the K-REIT controversy erupted showed a lack of understanding of the issues. They simply trust the management to do the right thing.

 

By Colin Tan – head of research and consultancy at Chesterton Suntec International.