InvestingNote Interview Series: 8 Questions With Dehong May 22, 2017 1507

So, here are the 8 questions that were selected to be interviewed with Dehong, PhillipCapital’s analyst who specialises in REITs and property counters.

1. Is a REIT with a larger portfolio of freehold properties better than another REIT with a portfolio of shorter leasehold properties?

Land tenure is only one consideration but just by looking at the land tenure of the REIT portfolio alone is insufficient to conclude if the portfolio is better or worse. Usually if we compare like-for-like two properties in the same vicinity, one with a freehold tenure vs another with a shorter leasehold, the freehold building usually trades at a lower cap rate (i.e higher valuation, valuation is inversely related to cap rate) than the shorter leasehold property. So the NAV of the REIT would have already priced in the freehold factor. Another example of REIT pricing already reflecting the shorter land tenures is this: one of the reasons industrial REITs trade at higher yields is due to the fact that industrial properties in Singapore tend to have shorter 30-year leases vs retail or office properties. The higher yield compensates investors for the shorter tenure and lower potential for capital gains over the long run.

2. We know REITs are leverage plays, how would you calculate and compare their metrics and duration vs fixed income in falling, flat, rising interest rate environments?

Unlike fixed income, REITs do not have fixed “maturities”, so calculating a duration that measures the sensitivity of the REIT’s price to fluctuations in interest rates in not as straightforward. Unfortunately this bond metric is not a concept I’ve explored before in using to price REITs. An easier metric for investors to watch out for instead is the sensitivity of the REIT’s earnings (not price) to fluctuations in interest rates or forex movements in the annual report under “sensitivity analysis”.

3. What metrics do you use to evaluate if a particular REIT manager is a good or bad one in relation to shareholders’ interest?

At the end of the day, a consistent track record of DPU growth and proven ability to carry out AEIs with heathy ROIs to return decent yields on costs in the long run is important. Fees as a percentage of revenue can be one of the metrics to look out for as well but typically this number fluctuate between 5-10% unless boosted by one-off acquisitions or divestments. Eventually these fees impact DPU so an important consideration is how much of an impact outsized fees (if any) have on DPU. Consistent healthy DPU growth is key. Of course, a manager with average industry compensation who grows DPU at above sector average rates is best, but I would not mind paying higher management fees to a team who is able to grow earnings better than sector pace. REIT managers who acquire non-accretive properties or “churn” properties for acquisition/divestment fees would likely struggle to maintain DPU growth over time.

4. Is book value a good way to judge if a REIT is under or over valued? If not, what are the good ways to judge it? Could you then bring us through some blind spots that REITs investors need to make aware of in property valuation reports, so they can make informed choices?

Price/NAV is one metric to determine valuation of a REIT but on top of comparing across the industry vs peers, it is useful to compare over a REIT’s own historical P/NAV too. Big cap REITs typically trade at higher valuations than smaller REITs. Mapletree Industrial for example trades at an average Price/NAV of 1.22 post GFC. Reasons being these big cap REITs typically are able to obtain lower costs of funding, which makes it easier for accretive acquisitions. They also enjoy economies of scale in the management of a larger portfolio. So, a cross sector comparison would be more meaningful, if you compare with a basket of similar size market cap peers instead of widely across the sector. Even similar size companies can have portfolios with different geographic exposures too so it is important to take that into account when comparing. When comparing over its own historical P/NAV investors should note if the macro environment is similar to the historical period and whether changes in the environment can justify it trading at a premium/disc to the average over the historical period.

5. When REITs acquire properties with income support, I understand that there are 2 kinds of income support; 1. to help support the NPI for new properties, or 2. to make it seem like the properties are cash flowing well for matured properties. A very recent example of a REITs potentially acquiring properties with income support for the 2nd reason is Sabana Industrial REITs. While the regulations were tightened in 2014 by MAS which require disclosures in annual reports for income support arrangements, do you think there should be more regulations in place to further protect the average investor’s interest from such arrangements?

Regulatory policies to improve transparency and align Managers’ interests with shareholders should be a continuous process, especially now with our neighboring countries also upping their game in opening up their own REIT markets. Ultimately investors should do their own due diligence and seek advice from their brokers if unsure before buying. After the Sabana REIT saga I would think most managements would up their game and improve disclosures and transparency to shareholders.

6. With Singapore’s stance on attractive tax incentives for REITs, why aren’t more REITs listing here? Are there other countries with even more attractive incentives for reits to list there?

We have a young but very fast growing REIT market. In the past few years we have seen various listings such as Frasers Logistics, EC World REIT, BHG Retail, Manulife REIT so the listing momentum is there. Since the first listing in 2002 by CMT, we have grown to become the 2nd largest REIT market (>S$70b market cap) in Asia after Japan. Our neighboring countries are trying to open up their REIT market but we remain one of the more attractive listing venues for REITs with our favorable tax structures and easy access to capital. Our reputation is also down to our very diverse mix of REITs with international geographic exposure vs eg Japan Reits which have predominantly domestic exposure or Hong Kong listed REITs which are concentrated in China/Hong Kong properties.

7. If you were to ALL IN one reit counter and hold forever, which one will you choose and why?

Land scarce Singapore sounds like the perfect place to own a property but I would choose a sector with favorable structural dynamics. Our region’s aging population means that demand for healthcare services will continue to be strong. For the long term, I would opt for Parkway Life REIT. I think this is also one sector where demand for space is less susceptible to advancements in technology. E-commerce will pose as a strong headwind for retail malls for years to come. Office landlords will also need to continually re-invent with technology re-inventing jobs, tasks getting automated or computerized which could lead to reduced reliance on human workforce or less need for office storage space for files/annual reports etc, as well as conferencing technology enabling work from home. Healthcare is also impacted. Singapore rolled out a national video consultation system earlier this year in its major hospitals where patients can e-consult doctors through a webcam or carry out physiotherapy sessions at home. However, I think these will always be constrained within the less important medical functions such as follow up consultations or physiotherapy sessions. One definitely can’t do a virtual medical surgery or blood test over Facebook Live.

8. Read this on Investopedia: “In estimating the value of an REIT, professional analysts therefore use a measure called “adjusted funds from operations” (AFFO)”. However, in local REIT reporting, there is no reference to this. Why is that so? How can we extract this value from the financial statement?

AFFO is a term more commonly used in western markets US and Canada. FFO is basically earnings readjusted to exclude non-cash and one-off items such as depreciation and divestment/revaluation gains. The closest to this in local context is income available for distribution which is net income adjusted for non-cash items such as management fees payable in units. AFFO will be FFO – Capex and routine maintenance amounts.

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