Interesting Times for REITS
Issue 45 - September 08

Investors and creators of Real Estate Investment Trusts (REITs) in Asia have had mixed fortunes over the past two years. RFP asked the experts, how have the markets been performing, and how has sub-prime affected the performance of REITs.

The The Quest for Values in an Uncertain Time, A market view from Sing Tien Foo, Associate Professor, Department of Real Estate, National University of Singapore
The crises associated with sub-prime mortgage defaults in the US started in August 2007 and was followed by a steep hike in oil price that sent the US stock market into a downward spiral. The turbulence has rippled quickly and intensely across the world causing melt-downs of prices in other stock markets. Asian REIT markets were not spared. The aggregate market capitalisation of Asian REITs declined by 11.3 percent in just a quarter from the peak in 2Q2007 to 3Q20007 (Figure 1).

Singapore's REIT market was robust enough to suffer a smaller decline of 4.4 percent in its market capitalisation over the same period. However, in contrast the commercial real estate markets have been much more resilient. Both office pricing and rental values have been held up strongly against the gravitation. The office rental market in Singapore has in particularly shown an impressive growth of 27.4 percent from the start of the crisis in Q3 2007 to Q2 2008 (Figure 2). What implications do the volatilities in stock and rising prices in real estate markets have for REIT investors, and how will these influence the growth of REITs?

Healthy rental income from commercial real estate space is an indication of strong expected earnings from REITs' portfolios. REIT investors should therefore expect strong dividend payouts from REITs. Coupled with declining REIT stock prices, REIT stocks are expected to offer attractive yields. In a recent report by Credit Suisse (on 7 August 2008), the average yields for Singapore REIT is estimated at 7.3,percent and industrial REITs outperformed the industry average with the highest yield of 8.97 percent. These expansive yields, however, reflect increasing risks in the REIT markets.

The high REIT yields and escalating real estate prices are not good news for the growth for REIT portfolios. It means a difficult market environment ahead for REITs to raise new equity, even if they have attractive new acquisitions in the pipeline. On the other hand, the higher dividend yield in the equity market, which implies more expensive equity capital, will limit the upside of prices they could pay for in new acquisitions. The rapid growth through yield accretive acquisitions, as observed in the periods running up to the sub-prime crisis 2007, is not likely to be repeated unless and until the dust of the US sub-prime crisis has settled. Acquisitions of quality properties could still though be funded through debt financing, but the scope of debt-financing is limited by the high gearing of some REITs.

The debt issurances are unlikely to be cheap, given the liquidity crunch resulted from massive write-down of banks' exposure to sub-prime related mortgage-backed securities (MBSs) and collateral debt obligations (CDOs). The supply of debt liquidity was further aggravated when rating agencies down-grade the credit ratings of some REITs in early 2008. The legal injunction sought by Allco REIT to prevent Moody's from downward revision of its credit rating reflects rising concerns of credit risks and costs of debt in a difficult environment. More creative financing structure or capital raising methods such as the use of convertible bonds by CapitaMall Trust in funding the Atrium@Orchard acquisition are needed.

The growth through new listings in the year ahead is not likely to be positive following the subdued performance of the first Indian REIT, Indiabulls REIT IPO, in June 2008 in Singapore. Many prospective REIT IPOs especially those from India have been shelved, probably till the next reversion in the bearish climate.

Figure 1: Sub-prime mortgage crisis has reversed the strong growth in Asia REIT markets


Figure 2: Strong Growth in Office Rent in Singapore Central Areaet

While the scope of external growth through accretive expansion of REIT portfolios is restrictive in the tough market ahead, extra growth internally through increasing same-store revenues and better cost controls could provide a more stable growth in earnings. For commercial REITs, there is still upside in office rents given the tight supply of prime office buildings in some markets. Retail REITs, on the other hand, could generate further earnings growth in their revamped mall space by adopting better risk and revenue-sharing arrangement through percentage leases.

As REITs have limited access to free-cash flows from retained earnings, the growth of REITs is dependent on the supply of capital. While there are no shorts of yield accretive investments in the forms, either acquisitions of income-generating properties or development projects, the challenge is to find creative ways to raise capital in a volatile market to fund such investments. Strong asset managers with proven track records in boosting bottom line, and with creative skills in fundraising, will be the critical factor that differentiates blue-chip REITs from others in the crunch time.

RFP spoke to Simon Reid-Kay, Partner, Allen & Overy about how the issues affecting REIT markets in Asia.
How have the REIT markets performed over the past 12 months?
There has been a general slowdown in the REIT markets in Asia. Things have certainly quietened down over the in terms as the listing of new REITs, the excitement that we have seen over the past few years has abated somewhat. There are a number of reasons for this, firstly is the general uncertainty in the market and secondly the yields that REITs have been offering simply haven't been attractive enough compared to recent years to encourage people to create REITs.

There have been announcements of REITs being developed for China, are we seeing this happening?
It hasn't really happened yet. I guess one has to go back to the history of REITs. In fact, they were really devised as a way of helping a property market that was in trouble, and obviously with China that's not the case. In that sense the timing is not right for REITs in China at the moment- one of the reasons people create REITs is to divest property and raise cash. Even in the current climate people are having a difficult time doing that, there is still quite a lot of liquidity in Asia and particularly in the real estate markets.

What is the role of legislation in helping to drive the REIT markets?
Again I think the growth of REITs depend on the macromarket rather than the local regulation. Malaysia is a good example. They have had REIT legislation for decades, and so people were able to create REITs, but actually no-one did because the macro-market drivers were not right. I think that in terms of the world being more sophisticated, any market such as Vietnam can say: "we want to be modern, we want to attract people, so let's set up the legislation."

Hong Kong and Singapore are interesting in the different way they approach these things. Singapore has set out its stall to be the REIT capital in Asia, and the regulators were very accommodating in providing an environment for people to set up REITs. Whereas Hong Kong has adopted a more laissez faire approach, where they set up the regulation but did not bend over backwards to help. Taxation is a big part of this, historically in the beginnings of REITs in the US, the income was not double taxed for the REIT and the dividend, whereas in HK we don't have dividend tax. In order to make it attractive for the Hong Kong market you might say that regulators have to go further and not tax the REITs profits at all. RFP

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