There has been a few placements, non-renounceable rights issues and acquisitions by REITs that I cannot get through all (well by my own standards). But I thought I will just do the Cromwell European REIT one. 

After the burnout work in the office in the past 2 weeks, I really do not feel like doing anything. 

So this one will probably be a short one. 

I have not do much homework on Cromwell, so decide to treat this as a relaxing homework of mine. 

Cromwell European REIT will be purchasing 

• 3 Freehold French Office Buildings in Greater Paris
• 2 Freehold Office buildings in Krakow, Poland
• 1 Freehold Office building in Poznan, Poland  

The numbers look good, particularly impress with the kind of net initial yield that they can still garner in the market like this.

I am not particularly familiar with the markets in Europe, so I am not going to pretend that I know that, but if you go out to a lower tier markets, or countries deemed to be more risky, you can get CAP rates that are higher. However, they usually come with some costs, be it more volatile economies, leading to more volatile occupancy or more volatile market rent. 

The WALE for Poland looks on average rather short, and we can see similarities with the portfolio of Poland retail assets that was suppose to go into Cromwell’s initial IPO but was taken out (you can read my write up of that here)

Majority of the property are freehold and this would refine the quality of Cromwell’s portfolio in that aspect.

Cromwell European REIT’s shareholders would need Eur 248 mil to finance these 6 acquisitions.

What does this do to Cromwell REIT’s existing portfolio?

Well not much. It does make it bigger.

And geographically, it diversifies to two more countries.

What we have are:

1. a lot of properties (103)
2. diversified across 7 European countries, and across even more cities
3. a lot of tenants
4. primarily free hold assets

You might like something like this. I do wonder if Cromwell really have that established team in Europe, and in so many countries, that they can manage to keep the properties well rented.

Adding more properties would also reduce the concentration on top tenants, in case one major tenant not renewing will cause a large drop in dividends per unit. 

While based on tenants, properties, geography, Cromwell looks very diversified, when you purchase, you are hoping that this diversification smooths out the rent and occupancy volatility across the 103 properties.

For example, if a region goes into a cyclical downturn, another region that is in a upturn buffers the drop in occupancy and rent. 

It would be good if the management have a “clock” that shows for each country, and each property segment, where they are in the cycle, so that we can appreciate whether this diversification is a strong point of Cromwell.

Capital Financing: Just Dividend and DPU Accretive after Placement

To finance this rather big acquisition, Cromwell’s initial plan was to use Eur 150 mil in debt and Eur 100 mil through placement.

If they went through with this, the deal would have increase the dividend per unit by 6.5%.

One thing I notice is the low existing borrowing cost of 1.4%, which makes a lot of these deals look very good. There is a huge spread between the debt borrowing cost and the CAP rate (or net/gross initial yield, reversionary yield)  of the property, be it 4% to 9%.

Placement price at EUR 0.46

However, the placement was very popular.

During the acquisition announcement, Cromwell announced that the placement price would be between EUR 0.46 to 0.47. 

Eventually, the private placement was oversubscribed and placed out at EUR 0.46. 

Due to the over-subscription, Cromwell European REIT managed to place out an additional Eur 50 mil in equity. (Total Eur 150 mil)

A total of 326 mil new units will be issued at Eur 0.46, which will raise Eur 150 mil.

This placement price represents:

1. a 5.9% discount to the average volume weighted price for the day before trading, adjusted to the Eur 0.0205 advance dividend
2. a 9.6% discount to the average volume weighted price  without adjustment for the Eur 0.0205 advance dividend

The placement discount, if you factor in the 1% sales charge that placement share subscribers paid, is rather tight. (A less than 6% discount is rather tight, and 6-10% discount to last adjusted price is rather fair)

It would have been better if it was more leveraged

With these stuff becoming clearer, let us plug in the data and see how Cromwell European REIT looks like before and after this acquisition.

The DPU forecast in these rights, or placement documents are not accurate going forward. This is because they are usually using historical distribution income for the existing portfolio and comparing it to the new addition during the same period.

A lot of things might have change. Your REIT might have bought or sold some properties during this period.

So for example, they might be assuming the distribution income to be from June to December of last year and comparing that with the new acquisition. That is useful to show you the level of DPU accretion. ( in the case of Cromwell, they listed a full year income, so they do not have this problem)

However, if you wish to find out what is the projected future DPU, dividend yield, if they have purchase or have not purchase this 6 properties, this might not be helpful. 

The Eur 13.5 mil difference in distributable income is helpful for us to find out the projected yield after interest cost for the additional debt taken up. (in reality, it should be higher, since now we know that we are just taking Eur 100 mil in additional debt instead of Eur 150 mil)

Cromwell, in their slides, explained that the DPU accretion would be 2.4% but somehow when I put in the figures, I did not get the same thing. I get a DPU accretion of 0.92%. 

The dividend yield will be 8.49% versus 8.41% now. 

The gearing is slightly higher, going from 36.6% to 37%.

The book value per share went down, probably because they are acquiring this portfolio below their current portfolio book value (do correct me if I am wrong about this)

This deal looks good for the shareholders, only if the properties are of value (when I say this, it also means the tenants in the properties are quality)

Operation Management of Existing Portfolio

From this point, it is less about the placement and acquisition but on what I think of the REIT itself.

I think I mentioned I am not sure how great the manager is able to manage such a portfolio that spans so many locations. 

A portfolio of this diversity in the hands of a great manager is going to be great. There are a lot of things they can do with it. 

However, it might be very challenging for a sub-par management or perhaps it is just not feasible at all to manage such a diverse set of properties.

The best way is to check out some of the metrics that may show these kind of things. 

There are 2 main segments:

1. Office
2. Light industrial and Logistics

And in these 2 segments there are sub-divided into geographical segments. 

In this table above, I have tabulated the occupancy, office and industrial rental reversion, new leases and renewal and retention rate. 

I was rather disappointed that Netherlands offices, which was part of the IPO, was getting weaker and weaker. We do understand that there was some asset enhancement initiative in the first quarter 2018 report, but it might not have to do with the economy. In the same country, the logistics and light industrial occupancy have been doing very well. 

It feels like their light industrial segment will have a lot of tenant changes. This is during better times. We will have to see during poorer economic times, whether there will be less new leases and the lower retention rate will work against Cromwell.

For now it feels that the whole portfolio, despite the better average WALE, look like our Singapore general and light industrial REIT segment. High CAP Rate, but also more cyclical.

Just that at least, the properties are not 30-40 year land lease properties. 

And we will see if the diversification allows the overall portfolio to maintain its DPU or there is no benefit in diversifying in Europe at all.

Concentrated Debt Risk

The slide above shows the debt maturity profile for Cromwell European REIT. It is very concentrated.

And they are in negotiation to get it renewed. They might have an opportunity there to renew at a low interest rate. But they better ensure that they renew. Because if they don’t, then it will get real ugly.

In my opinion, they should spread out the debt maturity. We are in a situation where the debt cost in Europe is favorable. However the more sensible thing is to “ladder” the debt maturity so that to ensure we do not get unlucky, and have a year where there is a credit crisis and majority of your debt is maturing in that one year. 

French Government will not Take Possession of Parc des Docks

In an earlier announcement, Cromwell European REIT also announced that the French government will not take possession of Parc des Docks. This dispute have been going since Cromwell put in their prospectus during their 2017 IPO. The french government had earlier the intention to develop a hospital, university complex and school on the 10 hectare freehold site. 

The government will thus compensate the Reit Eur 907k for the marketing and leasing activities that were placed on hold for the Parc desk Docks site during its deliberations for the proposed expropriation.

The Reit manager expects the property’s occupancy rate, which stands at 83 per cent, to increase substantially over the rest of 2019 together with significant positive rental reversion due to its accessibility and proximity to the Paris central business district.

Parc des Docks is a last-mile logistics property situated on a 10-hectare freehold site in an industrial area close to the River Seine in Paris. Last-mile logistics fulfilment refers to the final leg of delivery to the end user.

It has a NLA of 73,371 sqm of warehouse and ancillary office space. It was independently valued at Eur 114.1 million as at Dec 31, 2018, which is 16.4 per cent higher than the Eur 98 million that Cromwell E-Reit paid for it in 2017.

Parc des Docks is also the Reit’s third-largest asset by value.

With this announcement, Cromwell will be able to try and lease out the space and they have received encouraging inquiries. 

This slides make it sound so good, but I wonder do the REIT holders own the full 10 hectare! I re-read the prospectus and it did not say so. 

However, if they develop the surrounding, it can only be good for the property occupancy and rent. 

Placement as a form of Financing is a Big Plus to Cromwell REIT

Cromwell European REIT should enjoy this financing as a big win. This is their first placement and it is also oversubscribe. 

I have tabulated Cromwell’s history of capital financing history here:

** click to view larger table **

Cromwell tried to IPO in Sep 2017, but have to go back to the drawing board when things did not work out so well. Eventually they IPO at Eur 866 mil market cap. 

From there, they bump up the number of properties from 74 to 103!

There were some small acquisitions, but the biggest was undoubtedly the Oct 2018 38 for 100 rights issue.

Renounceable Rights Issue has to be more heavily discounted but when your REIT is small, it is difficult to gain institutional support to do a placement.

Rights issue is a necessity. Unless your asset value appreciate a lot.

This is what a lot of investors don’t understand. They kept saying rights issue is dilutive, and management should not use it.

But sometimes… they don’t have a choice!

Cromwell’s original IPO size looks big, and with that, and with adequate liquidity,  they should have able to garner institutional support that they do not need to do a rights issue. But I think they have to take out the Polish retail assets.

The rights issue was not DPU accretive if you are a shareholder and you did not subscribe to the rights. However, that is the nature of rights issue. 

This placement is a win for the management because

1. they can bring in more family offices and institutional investors
2. they do not have to rely on rights issue, which places stress on their share price, killing their future cost of capital for future acquistions
3. they are big enough that they can make these regular Eur 100 mil to Eur 200 mil acquisitions (Eur 200 mil is like 10% of total assets and 20% of market cap, we can think of a 50% debt 50% placement acquisition on a frequent basis)

For the management they can grow their AUM and earn greater fees. 

Hunting Third Party deals

One of the worry we often have, when we have an unknown sponsor, creating a REIT and listing in Singapore is that there will be some asset dumping.

In the case of Cromwell, the sponsors should have some properties that they can unload to the REIT. After all, the original IPO portfolio was formed from properties in the funds they managed for third party investors.

We have seen about 4 acquisitions of different size to date, and if I am correct, all of them are from third parties. This can be good and bad. If you purchase from some funds who are looking to exit their properties for their own investors, then this might not be cheap. 

However, it does show the ability of the manager to find yield accretive properties to add to their portfolio without the help of the sponsors.

At least the ability for the REIT to grow is not capped.

Why is IREIT Struggling to Acquire?

Cromwell, in a short span of 1.5 years have made enough acquisitions through debt, rights issue and placement. It is with this that I thought about one of its Singapore competitor IREIT Global.

The cash flow yield on IREIT is near to 8.2% but its dividend yield is likely in the low 7% range. While its debt to asset have been in the 42% range for some time, recent property value appreciation have brought down its gearing. 

It should be able to make acquisitions. 

When I look at the CAP rate of the properties that Cromwell acquire, it makes me wonder whether it is the case that

1. IREIT chose not to acquire because it does not fit the profile of properties that they are looking for
2. These properties that Cromwell acquire are inferior in grade or quality that they steer away
3. They are not good managers
4. They do not have the liquidity to do less deeply discounted non-renounceable rights issue or placement 

Summary

I think the dividend yield of Cromwell REIT is attractive enough. The grade of properties reminds me of the smaller Singapore industrial REITs (even the yield feels similar!)

The good thing going for it is that its portfolio is primarily freehold, versus the local industrial ones which have limited land lease.

The downside is that as an investor, you take on currency risk with Cromwell being in Euro.

However, given the trend, the local industrial REITs are trying to acquire properties overseas, so this will narrow the difference.

I think Cromwell European REIT is rather speculative for me at this point. Let me know your thoughts (or whether I missed out on something important, if you have studied it longer)

I write more about REITs in Learning about REITs below:

Here are My Topical Resources on:

1. Building Your Wealth Foundation – You know this baseline, your long term wealth should be pretty well managed
2. Active Investing – For the active stock investors. My deeper thoughts from my stock investing experience
3. Learning about REITs – My Free “Course” on REIT Investing for Beginners and Seasoned Investors
4. Dividend Stock Tracker – Track all the common 4-10% yielding dividend stocks in SG
5. Free Stock Portfolio Tracking Google Sheets that many love
6. Retirement Planning, Financial Independence and Spending down money – My deep dive into how much you need to achieve these, and the different ways you can be financially free

Ben Carlson and Michael Batnick’s Animal Spirits have become a great podcast to listen to. If you are the sort that wants a short 30 minute entertaining take on what are some of the best financial data points out there, and discussion on some of the latest articles that they have read (they read a lot), this is the one. 

They have introduced a Talk your book segment where they bring on some interesting financial products that they find, could have a role in your portfolio, and ask the people behind it to talk about it.

You will appreciate the way they context the discussion to a strategic level, thinking about whether you need this financial product in your portfolio.

In last week’s episode, they brought on the folks behind Fundamental Income to talk about their new Net Lease ETF and the index behind it.

The NETLease Corporate Real Estate ETF (ticker: NETL) seeks to track the performance, before fees and expenses, of the Fundamental Income Net Lease Real Estate Index (NNNLSCTR). The index’s goal is to track the performance of the U.S. listed Net Lease real estate sector in a diversified manner by screening for real estate companies that focus on investments in net lease real estate and assigning only those companies identified to the Index. The Index places constraints on constituents to protect against concentration in any one company or tenant.

This ETF that they are discussing is not listed in Singapore. It is listed in the USA and thus if you are attracted to the dividends, you have to take into consideration a 30% dividend withholding tax. So if the forecast dividend yield is 5% the after tax return is 3.5%.

Still, I think the value of this discussion is to hear from the management why they think this segment has a unique proposition that more investors should know about. 

You could also benefit from contrasting this to the other type of REITs you invest in. 

You could also benefit form the discussion of portfolio positioning, risk management for the REITs.

The Net Lease segment is interesting. In the past, I wrote an article about the Perfect REIT experienced investors are looking for and the Net Lease like REITs have many of these characteristics. 

In Singapore, perhaps Keppel DC, Parkway Life REIT matches that description the most.

You can listen to the podcast here:

Here are some of the notes and discussion from this podcast:

1. This is considered a Smart Beta ETF
2. It is also considered multi-factor in that they believe a certain segment of the REIT market has the potential to do an absolute return rather than being too cyclical
3. The Total REIT Market is $1.1 Trillion Market Cap

Michael asked why didn’t anyone came up with this kind of REIT in the past and they answered that this net lease segment is rather small and young in the first place.

They wanted to create this because they realize that this segment is under-represented in the index. There is less index funds that directly invest in net lease company because based on market capitalization, they are rather under-represented. They want to define the sector.

Performance of the Sector

They also explained the difference of Single tenant versus multi tenant. Why is single tenant preferred.

Currently, these net lease REITs trade at lower multiples compared to the rest of the office REITs.

The main reasons are that people tend to gravitate toward the more attractive office buildings, while the sale and lease back properties tend to look less appealing. Due to their cash flow they trade at a higher CAP rate.

So the management at Fundamental Income believe is that there is a need to accentuate the profitability and cash flow characteristics of these group of REITs to the investor by looking at them more form the fixed income angle than the equity angle.

The characteristics of Net Lease properties

1. Single Tenant
2. Long term lease (long WALE some 10 to 25 years)
3. Sale and leaseback
4. Long term stream of cash flow with escalations.
5. During past corrections, they crash less than the index

In 2008, Net lease REITs numbered 11 in public. Today, they now total 24.

Technically, there are some companies like casino companies that are not considered as net lease, but they define a few set of characteristics that they look for in their form of net lease companies and these REITs sub-sector exhibit that kind of characteristics.

Some of these are their profitability, above 90% gross margins, above 80% EBITDA margins, which is 30% above other REITs.

The index is modified capitalization weighted in that the top 5 holdings will not be greater than 8% of the index each. 

Motivation of selling these properties to the REIT for the owners. The owners were comfortable with this decision is that they do not see their balance sheet being saddled by so much tangible assets, managing these assets. They would rather subcontract these portion out. Operating business is looking at cost capital comparison. They are also looking to optimize their ROE and not have that reduced to 12% (from an average of 25%) by having these assets on their balance sheet.

Portfolio Positioning of this ETF or this segment of REITs

In terms of whether net lease REITs are more bonds or equity, they say that this segment leans closer to fixed income than equity.

The underlying business is bond like, but the REIT itself is an equity which make it less bond like. And what will freak people out is more of the stock portion of the REIT. It may be why people prefer hard property because they do not see the fluctuation.

By setting up this net lease corporate index and the ETF, they are breaking out a traditional tax strategy, and letting investors see it as an absolute return strategy. The standard S&P 500 index yields 1.9% in dividends while this strategy historically yields 5% in dividends. If both yields 7% in earnings yield, the latter lets you have more of that return total (in current income) versus the S&P 500. 

The team at Fundamental Income look at the data and found there are stronger correlation between the REIT’s total return and the growth of their cash flow. 

Net lease company should be identified more as financing companies than real estate companies.

Ben Carlson asked whether the Net Lease REITs will be lower in volatility. They replied that they hope that to happen by defining this segment in an index such that people can better appreciate their fixed income characteristics and would price it at higher multiples and also that fund flows would not pull money out so readily.

They believe this net lease ETF is an absolute return strategy that generates long term total return but with a current income component. There is an equity risk premium component in that while there is a current income, this “coupon” on this segment does not stay stagnant but will grow over time. 

REIT itself, is a tax classification, not a business model.

Diversified across different tenant segments. There are advantages in this ETF because it is an aggregation of REIT of differing operating environment, different REIT sector (as compared to a pure industrial or office trust) 

A big addressable market. There is still like 3 trillion of corporate real estate on balance sheet. So there is a real market for these corporate real estate to be sold to REITs. 

The Downside of Net Lease REITs

This is a bet on US Economy because the weakest link is the tenants. So they are betting that the tenants will survive and for that to happen they are betting the economy will go from strength to strength.

Bonds Currently may have too my Negative Asymmetric Risks

Investors usually are more comfortable in owning bonds. 

However, the risk versus reward, according to the management, might be better on the net lease REIT front.

There may be a mismatched in the risk you are taking and the returns you are getting in corporate bonds. You may be taking on equity risk for bond like returns. When the loans default the investor gets smoked. 

In a traditional income statement, rental expense is paid before EBITDA. Thus, in terms of cash flow seniority, rental income to the REIT holder is paid before interest income to the bond holder. 

The high yield bond segment have an  average credit rating is a B. The historical average default rate of this segment is 4% (of the total amount of bonds held).

When the bond defaults, the bond holder is able to get back $0.50 on $1.00 of debt. If the high yield bond returns 6%, you will lose 2% of the return to default (4% x 50%) and so you are getting 4% in return. 

For net lease REITs, historically the average default rate is 30 to 40 basis points (0.30% to 0.40%) and they trade at yields of 7-8%, that is a better probability based, risk adjusted return compare to high yield bonds.

I write more about REITs in Learning about REITs below.

Do Like Me on Facebook. I share some tidbits that is not on the blog post there often. You can also choose to subscribe to my content via email below.

Here are My Topical Resources on:

1. Building Your Wealth Foundation – You know this baseline, your long term wealth should be pretty well managed
2. Active Investing – For the active stock investors. My deeper thoughts from my stock investing experience
3. Learning about REITs – My Free “Course” on REIT Investing for Beginners and Seasoned Investors
4. Dividend Stock Tracker – Track all the common 4-10% yielding dividend stocks in SG
5. Free Stock Portfolio Tracking Google Sheets that many love
6. Retirement Planning, Financial Independence and Spending down money – My deep dive into how much you need to achieve these, and the different ways you can be financially free