valuebuddies.com is probably the place you want to be if you are into fundamental analysis. And the most interesting discussion that I was informed taking place is a discussion on REITs valuation.
One respected forumer d.o.g. made some great comments and I just find that I need to highlight them to investors that never had to experience what happen in the credit crunch in the 2007-2008 bear market.
Back then, a lot of REITs did rights issue because the cost of getting debts refinancing is so high that it doesn’t make sense for REITs.
It soft of highlights a lot of negatives of REITs. But the general idea d.o.g. is driving across is that REITs can be good or bad, depending on how an investor evaluates fundamentals and valuation. The general consensus is that REITs exist to benefit the sponsers to cash out on it to get money and lessen risks rather than benefit the owners.
Generally, no business trust will pay down its debts, because it is not in the interest of the trust manager to do so. The trust manager is paid as a percentage of assets, not equity. Therefore, the incentive is to borrow as much money as possible to raise the assets under management, thus raising fees, and never pay down the debt except under duress from banks.
An investor in a business trust has to understand that the trust structure is basically a packaging gimmick. It is given tax incentives by the authorities to encourage a more “sophisticated” capital market. Essentially, the original owner of the assets can enjoy tax savings if he owns the assets through a trust instead of within a normal corporate structure. With an IPO his ownership decreases, but he then enjoys the management fees. As a result he gains several advantages:
1. The management fees are economically an inflation-indexed annuity;
2. Partial asset divestment through the IPO raises cash for other higher-return projects;
3. Reduced ownership reduces the amount needed to fund a future rights issue; and
4. Trust distributions are taxed at a reduced rate (normally 10%)
Net-net, the overall income decreases slightly as the reduced share of trust income is partly offset by the management fees, but the potential liability decreases greatly. It is a huge risk-reward improvement.
Investors should not harbour any delusions that REITs are created primarily for their benefit. REITs are created first and foremost to help owners dispose of unwanted assets.
As a general rule, the best assets do not get sold into a REIT, they are held forever by the original owner. From a purely rational perspective, REITs are simply a convenient dumping ground to offload undesirable assets to a gullible public. An outright sale would be difficult since the buyer would likely do due diligence and negotiate a discount for lousy assets. But the public can be convinced to buy anything in a bull market. In fact very little convincing is needed – the public is happy to convince itself, especially in today’s low-interest rate environment.
Sponsored trusts are created to help owners divest unwanted assets. The management fees are just a bonus.
Non-sponsored trusts are created primarily for the management fees.
Since a trust seeks to grow by buying the type of assets it already owns, its own assets and unit price are likely to be marked down at the same time that bargains are available in the market. Therefore it can’t buy these assets since its currency (its units) is also marked down. In a bull market its units are priced higher, but so are the targets, so we are back to square one.
This is true regardless of whether or not there is a sponsor. Where the sponsor can help is to market/hype the trust to get its units overvalued against the physical market e.g. if the cap rate in the market is 5% and the trust yields 4% then yield-accretive acquisitions can be done.
A sponsored trust can rely on the bigger marketing budget of its parent to help hype the units. A non-sponsored trust has only the limited resources of its trust manager. So all things being equal, the sponsored trust has a better chance of becoming overvalued and thus able to grow.
Ideally one would buy a sponsored trust at a low valuation. Then, while waiting for the hype/revaluation, one can still enjoy the higher dividend yield. The sponsor wants to unload their assets to the trust, so they have an interest in getting the trust units overvalued.
Of course, the sponsor’s hype machine doesn’t always work – see Hyflux Water Trust. The trust never traded at a sufficiently low yield to be able to overpay for projects from Hyflux. Eventually Hyflux decided to kill it and find a Japanese buyer for its projects instead. But due credit to Hyflux management for their intelligent attempt to (ab)use the capital markets.
This is precisely why non-sponsored trusts exist – because people want to own a REIT manager. It is no accident that while there are plenty of listed REITs, there are very few listed REIT managers.
The fact that REITs and business trusts are created to benefit either asset owners who wish to divest, or managers who wish to create an income stream, is neither good nor bad. It just is.
Investors simply have to understand this when doing their due diligence and not invest based on the yield alone. Management behaviour (rights issues, debt refinancing, acquisitions etc) can and will drastically change the future yields.
Just because the structure of REITs encourages value-destroying behaviour (debt-funded acquisitions in bull markets) doesn’t mean that all managers behave this way. The sensible ones keep gearing low. At the right price, such REITs can be fantastic investments.
In the 2008/2009 stock market crash/recovery, some of the biggest capital gains were recorded by REITs. IIRC one of the big winners was CDL H-REIT. In the bear market, one could have safely bought all the REITs with strong balance sheets, and obtained both high income and good potential for capital gains. As a group, they were low-risk, high return investments. Note the past tense!
Conversely, some of the worst losses were also recorded by REITs. Essentially, everyone who did a rights issue destroyed shareholder value e.g. CMT, CCT, MLT, K-REIT (twice), Starhill, Fortune etc. With the exceptions of Starhill and Fortune, all of them had horrible balance sheets that were train wrecks waiting to happen.
Starhill was unusual in that the management actively chose to destroy value – despite low gearing and their debt not being due for over a year, they raised cash at the bottom of the market, then let it sit around until they bought the Malaysian properties much later. Ditto with Fortune – the purchase of the Cheung Kong properties was a massively DPU-negative transaction.
As for normal companies, the division between ownership and management also encourages value-destroying behaviour, since managers are paid salaries and bonuses before shareholders get dividends. Therefore the temptation is to take maximum risk, since if it works there is a big bonus waiting, and if it doesn’t work the shareholders cough up for the rights issue.
Does this also mean that one should not invest in stocks at all? Of course not. But it behooves the investor to inform himself of the risk/reward equations faced by the key managers so that he can understand how the managers are likely to behave.
Again, not all managers behave badly. Normally the owner-managers are better behaved, since they are the biggest shareholders and must cough up money in a rights issue if they screw up. Notice that the family-run UOB and CDL did not have any rights issues during the crisis, in contrast to the professionally-managed DBS, Capitaland and NOL.
There are of course bad owner-managers and good professional managers. But my experience has led me to favour owner-managed companies.
As usual, YMMV.
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