Asian REITs Discovery Weekly: Lifting The Gearing Limit Of Singapore REITs, High Gearing REITs, And REIT Consolidation Wave Continues

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Includes: ACDSF, CPAMF, FHOSY, MAPGF, MPCMF
by: The Value Pendulum
Summary

Regulators in Singapore are proposing to raise the statutory gearing limit, which is a net positive for REITs.

Screening for Singapore REITs with high gearing finds investment candidates that are the biggest beneficiaries of a potential increase in the gearing cap for REITs.

REIT consolidation continues in Singapore, with the proposed combination of two hospitality REITs to form a larger entity announced this week.

Introduction

This week's Asian REITs Discovery Weekly continues to hunt for potential investment candidates in the following categories: 1) REITs in specific property segments, geographies or possessing some unique characteristics; 2) screening REITs on quantitative factors; and 3) REIT investment ideas derived from financial results, mergers & acquisitions and other capital raising activities.

Property Sub-Segment/Category: Singapore-listed REITs And Gearing Limit

On July 2, 2019, The Monetary Authority of Singapore published a consultation paper proposing a review of the current one-tier 45% gearing (defined as aggregate borrowings as a percentage of total gross asset value of a REIT) limit on Singapore-listed REITs to "provide Singapore's REITs with more flexibility to manage their capital structure and to streamline the fundraising process for REITs."

Let's review the history of changes to the gearing limit for Singapore REITs and the gearing cap for REITs listed in other markets.

Prior to 2016, Singapore REITs' gearing limit was governed under a two-tier structure. Singapore REITs without a credit rating had their gearing capped at 35%, while those REITs with a credit rating could go up to as high as 60%. This was similar to Thailand REITs whose gearing limit is 35% for those without an investment grade credit rating, but the gearing cap is 60% for Thailand REITs with an investment grade credit rating. Since 2016, Singapore REITs had to abide by a one-tier 45% gearing limit.

In other parts of Asia, REITs listed in Malaysia and Hong Kong have statutory gearing 45% and 50%, respectively. Japan, similar to other developed REIT markets in the U.S., Australia and France, does not impose any gearing cap on REITs.

The potential raising of the gearing cap for Singapore REITs is positive for a couple of reasons.

Firstly, Singapore REITs could employ a higher degree of leverage as part of their financing mix in property acquisitions to lower their cost of capital, since debt is cheaper than equity.

Secondly, Singapore REITs will become more competitive with foreign REITs and non-REITs (e.g. private equity firms, sovereign wealth funds etc.) with either higher statutory gearing limits or no gearing limits at all.

Thirdly, Singapore REITs could grow their assets under management more easily with greater debt headroom. A higher level of assets under management potentially leads to higher net property income due to economies of scale, and also potential inclusion into certain REIT benchmark indices which have criteria for minimum market capitalization.

While an increase in gearing limit is positive for Singapore REITs in general, there are a few categories of REITs which could benefit to a larger extent.

One category of REITs is those with high gearing close to the current 45% cap, as they were previously constrained by low debt headroom, referring to the amount of additional borrowings REITs can take on further without breaching statutory limits.

Another category of REITs that are beneficiaries includes office REITs listed in Singapore. As capitalization rates or cap rates for office properties remain low, office REITs find it difficult to make yield-accretive acquisition of office properties in Singapore. This implies that acquisition of office properties in Singapore requires a higher mix of debt (versus equity) in the financing structure to be accretive. This is validated by a UBS research report published in March 2019, which highlights the decline in deal activity in the Singapore office sector due to tight cap rates (my emphasis):

Real estate investment volumes in Singapore slipped roughly 16% YoY in 2018 amid a fall in office transactions. This is likely to be reflective of pricing levels and tight cap rates rather than a lack of interest, as Singapore still ranks high on investor surveys due to the ongoing cyclical recovery in the office market.

Using actual office transactions as examples, the sale of Twenty Anson in 2018 was done at a cap rate of 2.7%, versus cap rates of 3.2% for similar transactions of Asia Square Tower 1 and One George Street in 2016 and 2017, respectively.

Singapore-listed Singapore-centric office REITs include CapitaLand Commercial Trust [CCT:SP], Keppel REIT, [KREIT:SP], OUE Commercial Trust [OUECT:SP], Frasers Commercial Trust [FCOT:SP], and Mapletree Commercial Trust (OTCPK:MPCMF) [MCT:SP].

The flip side of potentially lifting the gearing limit for REITs is that it increases credit risk, and certain REIT managers could become reckless in their pursuit of acquisitions. In the consultation paper, one of the suggestions the regulators have proposed is that the increased gearing limit comes attached with a minimum interest coverage requirement, defined as "earnings before interest, tax, depreciation and amortization EBITDA (excluding effects of any fair value changes) divided by interest expense". Specifically, it is proposed that a Singapore-listed REIT could have a higher gearing of 50% if it achieves a minimum interest coverage ratio of 2.5 times.

In the next section, I screen for Singapore-listed REITs with the highest gearing approaching the current 45% statutory gearing limit, as they could be potentially the biggest beneficiaries of any increase in the current gearing limit for REITs.

Bottom-Up Metrics: Singapore REITs With The Highest Gearing

Singapore-listed REITs with high gearing are not the preferred choices of conservative investors and could have suffered a valuation discount due to two key reasons.

Firstly, a higher gearing implies a higher level of credit risk. From the perspective of a dividend discount model valuation, REITs with higher gearing have a lower valuation because of both lower dividend payments (net of higher interest costs paid) and higher discount rates applied (to factor in the higher degree of financial risks highly-geared REITs have).

Secondly, a higher gearing close to the statutory gearing cap of 45% implies less debt headroom, which limits the aggregate value of acquisitions they could execute to grow their assets under management before they hit the regulatory limit.

The 10 Singapore-listed REITs with the highest gearing ratios approaching the current statutory gearing limit of 45% are presented below, all data are accurate as of the latest interim financial period:

Top 10 Singapore REITs With The Highest Gearing

  1. ESR REIT [EREIT:SP] has a gearing of 42.0%.
  2. Far East Hospitality Trust (OTC:FHOSY) [FEHT:SP] has a gearing of 39.9%.
  3. OUE Commercial Trust has a gearing of 39.4%
  4. Soilbuild Business Space REIT [SBREIT:SP] has a gearing of 39.3%
  5. Suntec Real Estate Investment Trust [SUN:SP] has a gearing of 38.6%
  6. OUE Hospitality Trust (OTC:OSPQF) [OUEHT:SP] has a gearing of 38.4%
  7. Keppel-KBS US REIT [KORE:SP] has a gearing of 38.1%
  8. Eagle Hospitality Trust [EAGLEHT:SP] has a gearing of 38.0%
  9. IREIT Global [IREIT:SP] has a gearing of 38.0%
  10. Mapletree Logistics Trust [OTC:MAPGF] [MLT:SP] has a gearing of 37.7%

The 10 REITs listed above will benefit the most from an increase in the allowable gearing for Singapore REIT, as any valuation discount applied to them due to their high gearing should narrow with a higher statutory gearing limit.

Events: Singapore REIT Sector Consolidation Continues

Three weeks ago, I mentioned in an earlier issue of the Asian REITs Discovery Weekly that I see the Singapore REIT sector, particularly the industrial REITs segment, undergoing consolidation over time. This consolidation wave is primarily due to smaller REITs being accorded lower valuations (higher discount to book value, higher dividend yield) and a couple of REITs sharing common unit-holders.

On July 3, 2019, Ascott Residence Trust [ART:SP] and Ascendas Hospitality Trust [AHT:SP] announced they will combine to form Asia Pacific's largest hospitality REIT and the eight largest globally with expanded assets under management of S$7.6 billion, by way of a trust scheme of arrangement. Ascott Residence Trust proposes to acquire all of Ascendas Hospitality Trust's units for a consideration of S$1.0868 per unit, comprising S$0.0543 in cash and 0.7942 Ascott Residence Trust units issued at a price of S$1.30. This combination offers a case study of why REIT consolidation is happening and how to spot the next REIT consolidation candidates.

REITs merge for two key reasons.

Firstly, larger REITs benefit from economies of scale and scope, which results in higher distributable income and dividends distributed to unitholders. This is because of operating leverage i.e. there is a certain proportion of fixed costs which don't change with the amount of assets under management. One example is that a REIT likely does not need two CEOs or two CFOs; the removal of duplicate costs is part of cost synergies in a combination of two REITs.

Ascott Residence Trust and Ascendas Hospitality Trust have guided for dividend per unit or DPU accretion of 2.5% and 1.8%, respectively, a reflection of the synergies from the combination. Synergies in this combination include revenue synergies in the form of a more diverse portfolio of hospitality brands (more than 15 global brands combined including Courtyard by Marriott (MAR), ibis, Novotel, DoubleTree by Hilton (HLT) and Sheraton among others) available and financial synergies in the form of a larger debt headroom, S$1.0 billion (or S$1.8 billion if statutory gearing limit is raised to 50% in future) for the combined entity versus S$0.8 billion for Ascott Residence Trust and S$0.4 billion for Ascendas Hospitality Trust individually.

Secondly, larger REITs typically enjoy higher P/B multiples and lower dividend yield. The value of assets under management is positively correlated with market capitalization and trading liquidity of REITs. This is illustrated by the benefits of index inclusion for REITs. Morgan Stanley research finds that REITs that are part of the FTSE EPRA/NAREIT Developed Index enjoy a valuation premium (i.e. a yield spread of 130 basis points) over those REITs that are not in the index.

In the case of Ascott Residence Trust and Ascendas Hospitality Trust, the combined entity post-combination is estimated to have a free float of S$2.4 billion, which exceeds the minimum $1.3 billion or SS$1.7 billion free float requirement to be included in the FTSE EPRA Nareit Developed Index. In contrast, Ascott Residence Trust and Ascendas Hospitality Trust on a stand-alone basis have smaller free float of S$1.6 billion and S$0.7 billion, respectively.

The combination of Ascott Residence Trust and Ascendas Hospitality Trust comes about half a year after their respective sponsors and major unitholders CapitaLand (OTCPK:CLLDF) (OTCPK:CLLDY) [CAPL:SP] and Ascendas-Singbridge came to a deal themselves. In January 2019, CapitaLand announced that it will acquire Ascendas-Singbridge to "create the largest diversified real estate group in Asia."

CapitaLand is the sponsor and major unitholder for five REITs, Ascott Residence Trust, CapitaLand Mall Trust (OTCPK:CPAMF) [CT:SP], CapitaLand Retail China Trust [CRCT:SP], CapitaLand Commercial Trust and CapitaLand Malaysia Mall Trust [CMMT:MK] (the only one listed in Malaysia of the five). Ascendas-Singbridge is the sponsor and major unitholder for three REITs, Ascendas Hospitality Trust [ASCHT:SP], Ascendas India Trust [OTC:ACNDY] [AIT:SP] and Ascendas Real Estate Investment Trust (OTC:ACDSF) [AREIT:SP].

Another major REIT sponsor in Singapore is Mapletree, which is the parent and sponsor of four REITs listed in Singapore, namely Mapletree Logistics Trust, Mapletree Industrial Trust (OTCPK:MAPIF) [MINT:SP], Mapletree North Asia Commercial Trust [MAGIC:SP], and Mapletree Commercial Trust.

Going by the logic of the combination of Ascott Residence Trust and Ascendas Hospitality Trust which belong to the same sector (hospitality), it is possible to speculate that CapitaLand Mall Trust (owns malls in Singapore) could possible combine with CapitaLand Retail China Trust (owns malls in China) to form a bigger pan-Asian retail REIT in future. It is notable that the current CapitaLand Mall Trust's CEO Mr Tony Tan Tee Hieong was formerly the CEO of CapitaLand Retail China Trust Management Limited between July 2010 and March 2017. Note that this is pure speculation, and both REITs have not mentioned plans to do anything similar. According to a Singapore Business Review article published in August 2017, "Industry rumours that there could be a consolidation amongst CapitaLand's retail real estate investment trusts have been played down by the management itself."

Closing Thoughts

There is a common thread that runs through what I have written about today; it speaks of a well-defined growth path for REITs.

REITs have to grow to a sufficient size to enjoy economies of scale, trading liquidity and index inclusion, which in turn lead to higher valuations. With higher valuations and lower trading yields, REITs can raise equity financing in an accretive manner to fund more acquisitions of either properties or other REITs to become even bigger, building a virtuous cycle. REITs with the potential to grow are either REITs with significant debt headroom or REITs with opportunities to grow via M&A due to the presence of sub-scale peers that can be consolidated or affiliated REITs with a common unitholder and sponsor.

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.