Asian REITs Discovery Weekly: Coworking A Boon For Office REITs, Screening For Superior Shareholder Returns, REIT-Consolidation Investment Opportunities

by: The Value Pendulum

Coworking space operators are driving office space demand for office REITs. The key question is whether this is sustainable.

Screening for REITs that have delivered superior total shareholder returns historically could identify potential investment candidates.

Fragmented industries in the process of consolidation tend to throw up investment opportunities. The Singapore Industrial REIT sector could be one industry with M&A deals possibly in the pipeline.


Last week, I started the first issue of the Asian REITs Discovery Weekly, which focuses on profiling and analyzing Asian REITs listed in Hong Kong, Singapore and Malaysia. The Asian REITs Discovery Weekly takes the format of "discovering" new Asian REIT ideas in the following three categories: 1) zooming into a specific property sub-segment 2) screening for bottom-up REIT-specific metrics such as price-to-book, gearing and rent reversions among others; and 3) taking into account events like financial results and capital recycling activities like acquisitions/divestments.

Top-Down Property Sub-Segment: Office REITs And The Impact Of Coworking

Last week, I wrote about the impact of e-commerce on Asian-listed retail REITs, using Singapore-listed CapitaLand Mall Trust (OTCPK:CPAMF) (SP:CT) as a case study. This week, I focus on another disruptive threat: coworking and the effect it has on Asian-listed office REITs.

I start this section with a quote from Danny Ismail, an analyst at Green Street Advisors, who describes the relationship between coworking space operators and office REITs very well (my emphasis): "Coworking companies are an interesting mix of competitor, customer and partner for office REITs." When coworking started becoming popular, conventional wisdom was that it would depress overall office demand in the mid- to long term as tenants shift from conventional office space to flexible workspace. The reality is somewhat different.

Singapore-listed CapitaLand Commercial Trust (SP:CCT) is Singapore's largest office REIT with a portfolio of eight office and commercial buildings located in the country's Central Area and a single commercial property located in Frankurt, Germany. At its fiscal 2018 earnings call in January 2019, the company acknowledged (my emphasis),

...a significant share of demand [new leases signed in 2018] was coming from the coworking sector, business consultancy, technology and financial services... They [coworking space operators] are a big source of new demand. ...In the current market right now, we are continuing to see interest from coworking space operators to take up new space, both coworking space operators that are already in Singapore and also new entrants to the market.

Matthew Chisholm, director of Flexible Workspace at Ascendas-Singbridge, also commented in a 2018 interview with Colliers that he thinks Singapore and Hong Kong will see growth from coworking space operators (my emphasis): "As operators and landlords start to tap into corporate demand we will see more growth from this new source of demand in the more regulated economies of Singapore and Hong Kong."

Similarly, Hong Kong-listed Sunlight REIT (HK:345), owning a portfolio of 11 office and five retail properties in Hong Kong, undertook a major renovation of its Bonham Trade Centre (within walking distance of the Central District) in Sheung Wan, Hong Kong this year to reconfigure part of the building to cater to demand from coworking space operators. Following the renovation, coworking space operator theDesk is taking up seven floors totaling 29,000 square feet at Sunlight REIT's Bonham Trade Centre to set up its fifth coworking space in the city at the end of 2019.

Some office REITs are going even further; they are not simply relying on coworking space operators to drive demand for office space, but also playing the role of coworking space operators directly. For example, CapitaLand Commercial Trust spent S$3 million to refurbish Level 9 of its Capital Tower in the first quarter of 2019, as part of what it terms as "Office of the Future" initiatives. Following the refurbishment, the "new" Level 9 of Capital Tower offers an integrated mix of both conventional office space and flexible space (including coworking, business club and collaboration spaces complete with shared amenities like open spaces, auditorium, and multi-purpose rooms). In other words, CapitaLand Commercial Trust's existing conventional office tenants can lease its flexible space to meet any expansion needs, while its existing small and medium enterprise or startup tenants currently leasing flexible space have the option to eventually lease its conventional office space if and when they scale up in future.

This is probably just the start of a multi-year growth trend led by coworking. Colliers' research suggests that only 2.8% and 2.4% of office space in Hong Kong and Singapore respectively are occupied by flexible workspace in 2017. This implies that there is still a significant growth runway for coworking space operators and the office demand they drive.

But not all is rosy. There are two key risks associated with having coworking space operators contributing a significant share of office REITs' rental income.

Firstly, certain coworking space operators, which are expanding too fast, could potentially face cash flow issues and eventually have trouble paying their rents. This is because, like all capital-intensive businesses, coworking space operators need a period of time before they can achieve cash flow breakeven on their new coworking spaces. Coworking space operators have higher credit risks when they lack strong financial backing and still recklessly forge ahead with aggressive expansion plans. A January 2019 South China Morning Post article, titled "China’s coworking operators squeezed by a lack of funding are shutting down", quoted a report by the China Real Estate Chamber of Commerce stating that 40 Chinese coworking operators shut down in the 10 months between January and October 2018, and that 40% of the Chinese coworking projects have occupancy rates below 50%.

In the case of CapitaLand Commercial Trust, the company does credit checks before accepting any coworking operators as tenants. Take for example Mapletree Commercial Trust (OTCPK:MPCMF) (SP:MCT), a Singapore-listed REIT that owns a mix of office and retail properties, including Mapletree Business City I; a large-scale integrated office and business park complex and PSA Building; an established integrated development with a 40-story office block; and a three-story retail center. This firm also disclosed at its recent fiscal 2019 earnings call in April that it is selective in accepting any single coworking space operator as tenants, and it is unlikely to have more than one coworking space operator as a tenant at each of its properties in order to minimize concentration risks.

Second, the coworking space industry is expected to eventually consolidate with a few major players dominating the market. Also during the fiscal 2019 earnings call, Mapletree Commercial Trust shared that it thinks that there will be eventually be some shake-up in the Singapore coworking industry and the stronger ones with the staying power and longevity will grab a larger share of the market and see improved profitability. There are definitely advantages that larger coworking space operators enjoy by virtue of their size. Economies of scale allows larger coworking space operators to spread their fixed costs over a much bigger revenue base to enhance profit margins, and network effects suggest that coworking space operators with more locations across a single geographical market should be more attractive to companies looking for flexible workspace. Colliers estimates that the seven largest coworking space operators in Singapore as a whole have approximately 63% market share.

The eventual consolidation of the coworking space industry in Singapore could pose some challenges for office REITs. The existing tenancy with coworking space operators could potentially be impacted if they are acquired by other coworking space operators; the newly merged entity could require less office space. Also, the few dominant coworking space operators remaining will likely have more bargaining power with office REITs with respect to rents. More important, it is possible that coworking demand for office space might drop as the industry consolidates, with the remaining coworking space operators only generating "genuine demand" versus the past reckless expansion by sub-scale coworking space operators to grab market share at all costs.

In closing, the mid- to long-term growth prospects of coworking sounds promising. CapitaLand Commercial Trust has a good summary of what lies ahead for coworking and office REITs, as it shared at its fiscal 2018 earnings call (my emphasis):

And as we've shared many times before, we don't see coworking or flexible space as a flash in the pan kind of a phenomenon. It has been around for years in the form of a service office, and then there's a bit of morphing in terms of how they look at their space and how they design their space and how they... operate their spaces. So we see that as a complementary set in terms of how... office occupants will want to utilize their space. So as a working concept, we don't see that as a flash in the pan. It is here to stay and definitely set to grow... As far as we can see in our portfolio,... coworking space operators, the space itself, is... cash flow positive. Whatever rents they pay and then vis-à-vis what they lease out to their tenants, it generates a positive cash flow that sustains them."

Bottom-Up Metrics: Historical Shareholder Returns As A Measure Of Quality

I covered the key points from Link REIT's full-year fiscal 2019 results briefing in the prior week's edition of the Asian REITs Discovery Weekly. I also highlighted that Link REIT is the best-performing Asian REIT in terms of total return (capital gains and dividends) for shareholders over the past decade, having delivered a 10-year annualized total return CAGR of 21.65%. This gave me an inspiration for the screening criterion that I will use this week to identify potential REIT investment candidates.

Although past performance is not indicative of future performance, REITs that have delivered superior total shareholder returns in the past must have done something right. It is possible that their assets could be of top quality and that they benefited from secular growth tailwinds in specific property sub-segments, or the management team could have been been very astute and excelled in value-accretive capital recycling activities.

I screened for Asian REITs listed in Hong Kong, Singapore and Malaysia with five-year annualized total shareholder returns in excess of 10% and listed the top 10 REITs below. (I decided not to use a 10-year time frame, as that longer period would exclude more REITs with a shorter listing history.)

Top 10 REITs With The Highest Five-Year Annualized Total Shareholder Returns

  1. Link Real Estate Investment Trust (HK:823) delivered a five-year annualized total shareholder return of 21%.
  2. Sunlight Real Estate Investment Trust REIT delivered a five-year annualized total shareholder return of 17%.
  3. Champion Real Estate Investment Trust (HK:2778) delivered a five-year annualized total shareholder return of 16%.
  4. Mapletree North Asia Commercial Trust (SP:MAGIC) delivered a five-year annualized total shareholder return of 15%.
  5. Mapletree Commercial Trust delivered a five-year annualized total shareholder return of 14%.
  6. Fortune Real Estate Investment Trust (HK:778) delivered a five-year annualized total shareholder return of 14%.
  7. Mapletree Industrial Trust (OTCPK:MAPIF) (SP:MINT) delivered a five-year annualized total shareholder return of 13%.
  8. Yuexiu Real Estate Investment Trust (HK:405) delivered a five-year annualized total shareholder return of 13%.
  9. Fortune Real Estate Investment Trust (HK:778) delivered a five-year annualized total shareholder return of 13%.
  10. YTL Hospitality REIT (OTC:SLLXF) (MK:YTLREIT) delivered a five-year annualized total shareholder return of 12%.

Interestingly, I have already written about some of the REITs listed above. Champion Real Estate Investment Trust and Yuexiu Real Estate Investment Trust were placed on the Aggressive Investors' Watchlist comprising Asian REITs with the lowest proportion of fixed-rate debt in the Asian REITs Discovery Weekly last week. It is possible that aggressive (and more astute) capital management have played a part in their superior historical shareholder returns. This week, Sunlight Real Estate Investment Trust and Mapletree Commercial Trust were named as REITs in the earlier section which have tried or are trying to capitalize on the coworking space-driven office demand. I also wrote about Link REIT's defensive tenant mix and balanced capital return strategy involving both buybacks and dividends last week.

Events: Industrial REIT Consolidation

In the earlier section, I suggested that large, surviving coworking space operators could benefit from improved profitability as the industry consolidates over time. Perhaps unsurprising, this line of reasoning is applicable to most if not all industries undergoing consolidation, which tends to throw up interesting investment opportunities in both the consolidator/acquirer and the consolidated/acquired. More consolidation could be underway for the Singapore industrial REIT space.

In October 2018, ESR-REIT completed the merger with Viva Industrial REIT, which was the first merger among Singapore-listed REITs; both are industrial REITs. There are a couple of reasons a further consolidation of the Singapore industrial REIT sector is more likely than not.

Firstly, there are five Singapore-listed industrial REITs among the 12 Singapore-listed REITs with a market capitalization below S$1 billion, namely AIMS APAC REIT, Cache Logistics Trust, Soilbuild Business Space REIT, EC World Real Estate Investment Trust, and Sabana Shari'ah Compliant Industrial Real Estate Investment Trust. (EC World REIT is the odd one out here, as its assets are located in China, while the other REITs have assets primarily located in Singapore.) The smaller market capitalization of these industrial REITs make acquisitions or mergers more feasible, since the price tag (and financing required) would be lower.

Secondly, four of the five Singapore-listed industrial REITs with a market capitalization below S$1 billion are trading below book value, and all five of them offer trailing dividend yields in excess of 7%. (Price-to-book ratio is a commonly used valuation metric for most Asian-listed REITs, as the value of the property assets on their books are revalued by independent property valuation companies at least once a year in line with International Financial Reporting Standards.) The valuation discount that the market applies to these industrial REITs is partly attributable to their size - lack of economies of scale leads to lower profitability - and also the fact their size precludes them from being included in the relevant benchmark indices, which means that a lot of benchmark-hugging funds can't invest in them. Morgan Stanley research, as quoted by Bloomberg, indicates that REITs in the FTSE EPRA/NAREIT Developed Index trade at a dividend yield 130 basis points lower than REITs that are not included.

Third, a few of the five Singapore-listed industrial REITs have common unitholders (includes both direct and indirect stakes). Warburg Pincus has stakes in both ESR-REIT and Cache Logistics Trust, while ESR-REIT and Soilbuild Business Space REIT share common unitholders in billionaire Mr Tong Jinquan.

The next potential merger or acquisition could happen with ESR-REIT and Sabana REIT. On May 22 Sabana REIT announced that InfinitySub, a wholly owned subsidiary of E-Shang Infinity Cayman Limited (parent company for entities involved in the management of ESR-REIT) - which is indirectly owned by logistics real estate developer ESR Cayman - acquired a 51% stake in Sabana Investment Partners from former sponsor logistics company Vibrant Group. Sabana Investment Partners is an investment vehicle that owns the manager of Sabana REIT. The manager of Sabana REIT also owns 3.9% of the units in Sabana REIT, which are now indirectly owned by InfinitySub/ESR Cayman. InfinitySub/ESR Cayman also acquired another 7.99% of Sabana REIT's units from Vibrant Group and the companies it controls.

Following the series of transactions outlined above, ESR Cayman, which was already a unitholder with a 9.1% stake in Sabana REIT, following an aborted takeover attempt in 2018, has become Sabana REIT's largest unitholder with a 21.4% stake. Furthermore, ESR Cayman also indirectly owns a 93.8% stake in the manager of Sabana REIT.

See the following, an August 2018 Business Times piece on an interview with a director at Warburg Pincus, which has a 38.35% stake in ESR (my emphasis):

In a recent interview, Jeffrey Perlman, ESR director and managing director and head of South-east Asia at private equity firm Warburg Pincus, said it is very important to build up ESR-REIT's scale, given that larger Reits enjoy better cost of capital and trading prices. ...Mr Perlman noted that there are still many "subscale" REITs "caught in what we call a 'no man's land'", because they are not large enough to enjoy economies of scale. ...Mr Perlman does not rule out purchases of other Singapore REITs, even as it looks to the region for other potential targets.

Sabana REIT currently trades at 0.76 times P/B based on its share price of S$0.435 as of June 10, 2019, while ESR-REIT is valued by the market at 1.20 times P/B based on its share price of S$0.56 as of June 10, 2019. The disparity in valuations between the two is reflective of size; ESR-REIT's net assets is about 2.5 times that of Sabana REIT. Investors have the choice of either taking the short-term event trade associated with Sabana REIT potentially getting acquired, or buy and hold ESR-REIT for a few years to benefit from the positive re-rating of valuation as ESR-REIT consolidates the industrial REITs space and grows in size.

The key risk of investing in either ESR-REIT or Sabana REIT is that consolidation takes a longer than expected time to happen.

Closing Thoughts

It is easy to be distracted or misled by headline-grabbing news when it comes to investing. With coworking and coworking-space operators in the news, it is natural to assume the death of office REITs. Reality is quite different, as Asian office REITs highlighted above have benefited tremendously from new office space demand driven by coworking space operators. I also identified 10 REITs listed in Hong Kong, Singapore and Malaysia that achieved an impressive minimum 12% five-year annualized total shareholder returns. In terms of event-driven investment opportunities, the Singapore industrial REITs sector was the first to see a merger of REITs, and signs are indicating that further consolidation is underway.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.