- Prosperity REIT is a Hong Kong REIT that owns several office and other commercial buildings located around Hong Kong.
- The trust has no exposure to mainland China.
- Prosperity has recently embarked on upgrading several of its buildings to improve its attractiveness to tenants.
- The trust's newest acquisition should result in forward growth.
- Prosperity REIT trades at less than half its book value.
Prosperity REIT (OTC:PREUF) is a Hong Kong collective investment scheme (essentially a real estate investment trust) that owns a diverse portfolio of commercial properties in Hong Kong. The firm offers investors a unique way to invest in China as it trades for a price that is significantly below its book value and pays a substantial dividend yield. In addition, as a REIT, the firm owns physical properties that a person could conceivably reach out and touch (should that person travel to Hong Kong) and so there is a state of tangibility here. After all, a building will always be worth something as it has a real value. In addition to trading significantly below book value and paying out a strong dividend yield, the firm also offers growth potential due to a stated policy of the government of Hong Kong to foster another Central Business District in Kowloon East. I will discuss this in just a few minutes.
Prosperity REIT owns seven commercial properties throughout Hong Kong. These properties consist of:
- Two Grade A office buildings (The Metropolis Tower and the Prosperity Millennia Plaza)
- Two commercial buildings (A portion of the Harbourfront Landmark and the entirety of Prosperity Place)
- Two industrial/office buildings (Trendy Centre and a portion of Prosperity Center)
- One industrial building (A portion of the New Treasure Center)
These seven properties are located throughout Hong Kong and give the firm a total gross rentable area of 1,215,579 sq. ft of space.
Source: Prosperity REIT
The firm upgraded two of these facilities during the first half of 2013. The first upgrade that the firm performed was to Prosperity Place, a former industrial/office building in the Kwun Tong district in Kowloon East that was converted for commercial use in the fourth quarter of 2012. The firm then spent the first quarter of 2013 performing alterations and additions work to the facility in order to obtain approval from the Hong Kong government to perform this conversion. Then, in the second quarter of 2013, the firm replaced the lift controller system for one cargo lift and also installed an Elevator Management System. This work was done with the intent of making the building more appealing to potential tenants as the new elevator systems allow the trust to reduce the traveling time in the elevator system and increase the lift response. This is important because a commercial building is likely to have more people moving around inside it and between floors than an office building does. Prosperity REIT intends to carry out more improvements to this facility in order to make it even more appealing for tenants, including the renovation of the passenger lift lobbies and common corridors and the replacement of the concrete parapet wall on the building's 3/F flat roof with a tempered glass wall.
In addition, the firm performed some upgrades to Trendy Centre, a building located in Lai Chi Kok, the heart of Kowloon's garment and fashion wholesaling district. The REIT renovated the common washrooms and the cargo lift lobbies in order to improve the current tenants' working environment and improve the building's potential to attract new tenants to it. This work was performed in the first half of the year and has now been completed. The work to Trendy Centre as well as the work performed to Prosperity Place shows that the REIT is dedicated to maintaining the competitiveness of its buildings in order to attract more desirable tenants in the competitive Hong Kong market.
This commitment to continually improve its properties has paid off in terms of the rent that the REIT can charge to its tenants. In the first half of 2013, Prosperity REIT had an Average Effective Unit Rent of HK$18.54 per square foot. This is significantly higher than the HK$16.22 per square foot that the REIT had in the first half of 2012. This increase in rent has driven an increase in Prosperity REIT's revenue, which climbed to HK$167.1 million in the first half compared to HK$149.3 million in the same period of 2012. This also increased the REIT's Net Property Income to HK$130.4 million in the first half of 2013 compared to HK$116.5 million in the first half of 2012. This all enabled the REIT to increase its distribution per unit to HK$0.0744 in the first half of the year compared to HK$0.0660 in the same period last year. This represents a 12.7% increase in the firm's distribution per unit over the past year.
Source: Prosperity REIT
One potential risk could be that Prosperity REIT has a number of expiring leases in 2014 and these leases account for approximately 40.6% of its gross rental income. This is a significantly higher percentage than what the REIT had in 2012 and 2013.
Source: Prosperity REIT
The reason why this is a potential risk for the REIT is that the firm will need to either renegotiate these leases in order to keep its current tenants in the building or find a new tenant for the now unoccupied space should the current tenant opt to move out. However, this is also an opportunity for the firm as it can negotiate a lease with a higher rent payment and thus improve its revenue and cash flow. Fortunately, there may be more opportunity than risk here for Prosperity REIT. First, the Hong Kong property market still appears to be quite strong. As can be seen on the property map above, two of Prosperity REIT's properties are located in the Kowloon East district, a mature area of Hong Kong where many multinational corporations have located their respective offices. The presence of these corporations has been drawing other companies to locate to this area, putting pressure on the supply of commercial real estate space in the district. Thus, the tenants of these buildings may want to stay where they are as there is limited ability to find another rental space in the district. The firm saw evidence of this strong demand for office property over the first half of 2013 as it managed to achieve a stable occupancy rate of 98.1% and a rental reversion rate of 37.8%. The rental reversion rate is a metric that states the percentage of current tenants whose rents the firm is able to increase to bring them in line with the current market. This is a solid metric that clearly shows that the market is strong enough that the firm can increase a high percentage of the rents of its existing tenants to market rates and still have those tenants stay in the REIT's buildings.
Another potential risk is a slowdown of economic growth in Mainland China. However, the stock is so cheap right now and has sustainable revenues that this should not be much of a problem for investors. For starters, the REIT has an annualized distribution of HK$0.1488 which gives the firm a yield of 6.76% at current levels. Thus, investors will enjoy a solid return even if the share price does not move. Additionally, the company trades at a price to book ratio of 0.4848. This provides a significant margin of safety for investors at the current price level as a person who buys the stock today at its current level will essentially be acquiring the company's real estate portfolio for less than half of what it should be able to get by selling off all of its buildings. Additionally, despite all the hype about China's slowdown, the country is still growing its GDP at a rate of 7.6% annually. This is a growth rate that any western country would likely be very envious of. Additionally, the company is likely to have forward growth which I will discuss in just a few minutes.
On 12-15-2013, Prosperity REIT announced that it intends to acquire an office building located immediately adjacent to Prosperity Center in the Kowloon East District of Hong Kong. This property, 9 Chong Yip Street, will cost the REIT HK$1,010 million to purchase. This property consists of a 25 story tall office tower, 64 parking spaces, and 4 loading/unloading spaces. This building contains a gross rentable area of 136,595 sq. ft. which will increase the REIT's total gross rentable area by approximately 11.24% over its previous level.
Source: Prosperity REIT
This building will be purchased primarily via debt financing, increasing the trust's gearing ratio to 29.4% from its current low gearing ratio of 20.9%. Because the property will be purchased with debt and not through the issuance of new equity, unitholders will not be diluted by this acquisition. However, this acquisition should prove to be accretive to unitholders. This is because the company will be able to earn a rental yield from the building that is higher than the interest rate that it will be paying on the debt that it uses to purchase the building. This increased revenue and income will occur as soon as the company purchases this building. However, following the purchase of the building, there will be the potential for even greater upside through rental reversion in 2014. Over 50% of the tenancies in the building are currently slated to expire in 2014 and these 50% are all well below the rental market rate for a property such as this. Therefore, the REIT should be able to further increase its revenue and distributable net income by increasing the rents on these tenants next year as the leases expire.
The REIT provided an analysis of the projected increase on its per unit NAV and per unit distributable net income in a presentation that accompanied its announcement:
Source: Prosperity REIT
As the chart shows, the acquisition of this building will likely allow the REIT to increase its distribution per unit by approximately 3.62% following the acquisition of the property. Unfortunately, the REIT did not state exactly when this building would be acquired, but early next year would be a fair estimate.
The acquisition of this building could be one factor that acts as a catalyst to push the share price higher. As previously mentioned, the company trades at a discount to both its book value and its NAV. This is much lower than where its American peers trade (most American REITs trade at a premium to book value). For comparison, here is the comparable pricing for some American REITs (data sourced from Bloomberg and company filings):
Liberty Property Trust
DCT Industrial Trust
As the chart reveals, Prosperity REIT trades at a tremendous discount to book value whereas the American REITs trade at prices well above book value. If Prosperity REIT's book value were to rise sufficiently to give the stock a P/B of 1 (still well below the multiples being assigned to the American companies, but roughly equivalent to the value of all of its buildings minus the company's outstanding debt), then it would have a stock price of HK$4.54 or an increase of 101.78% over present levels. This prospective gain does not even include the dividends that an investor in the trust units today would receive over the lifetime of the investment.
However, the trust's price to book value is not as out of line with other Hong Kong-based REITs as it is compared to the American REITs, as shown in this chart.
There are two reasons why Prosperity REIT trades below book value. The first is that, given its location in Hong Kong, investors may be concerned about the trust's exposure to emerging markets (which have shown significant weakness in recent months) in general and China in particular. However, Prosperity REIT does not have any exposure to mainland China - every one of its buildings is located in the Hong Kong Special Administrative District. Hong Kong has its own currency and its own economics that differ from those of mainland China. In particular, Hong Kong is a much more developed economy than that of the mainland. Regardless, the trust is a commercial real-estate investment trust that rents out space in its buildings under long-term contracts. These long-term contracts should allow the trust to ride out any short-term economic weakness.
The second reason for the trust's low valuation relative to its book value might be the dividend yield. While the trust is trading for substantially below its book value, its dividend is only 6.61% at the time of writing, which is higher than American REITs but it is not as out of line when measured by dividend yield as it is when measured by book value. As most investors in real estate investment trusts are seeking income first and foremost, the trust is likely to trade at a price that is much more in line with its peers in terms of its dividend rather than on its book value.
Investors that wish to purchase shares in Prosperity REIT have a few options available. The trust's shares trade over-the-counter in the United States under the ticker symbol PREUF. However, investors that wish to purchase the trust's units in an environment with more liquidity may wish to consider purchasing shares on the Hong Kong Exchange, where the shares trade under the ticker symbol 808.