Still safe

The first signs of more cash calls to come have surfaced. Whilesome REITs look vulnerable,the sector as a whole is in a much stronger capital positionthan in2008. Portfolio rationalisation is turningout to be a much less painful alternative.

We highlight KREIT, FCOT, ART and Suntec as having weaker financial metrics and as possible candidates for near-term cash calls. We maintain our Overweight position on the sector. CDLHT returns our top pick.

Short-term debt less pressing than before

We assess the capital structures of the sector in 2011 vs. the last crisis in 2008 and conclude that the key difference is significantly lower short-term debt, at 8% of total debt now vs. 38% in 2008. Even though sector asset leverage is not very different (36% in 2011, 34% in 2008), less-pressing short-term liabilities would reduce the likelihood of cash calls, in our view.

Portfolio rationalisation the new alternative

More REITs are recycling and raising funds through asset divestments rather than tapping debt and equity markets. This alternative is made possible by less-pressing impending debt expiries than before.

Top picks: CDLHT, AREIT and PLife

We believe REITs’ attractive yield spreads will remain supported by depressed risk-free rates over the next 12 months. We continue to advocate REITs with strong balance sheets and resilient earnings. Our top picks are CDLHT, AREIT and PLife REIT.

3Q11 results roundup

Quarterly growth within expectations. Industrial REITs ended the financial quarter ended 30 Sep on a positive note, with all companies registering healthy YoY growth in their financial performances. On the aggregate level, we note that REITs under this sub-sector reported a 28.6% YoY and 5.2% QoQ growth in distributable income, reflecting the still buoyant market. Unsurprisingly, contribution from new investments and positive rental reversions were among the key growth drivers, as a number of companies have been actively involved in acquisitions/asset enhancement works over the past year, and have passing rents lower than the market rates. These results were generally in line with market expectations, except for Ascendas REIT (BUY, FV: S$2.23) and Sabana REIT (NOT RATED) which outperformed our and consensus projections, respectively.

Positive operating performance. On the operational level, industrial REITs also put up a strong showing. Overall portfolio occupancy came in at a high range of 94.5-100%, displaying the resilient nature of the industrial rental market (relatively unchanged from 94.3-100% range in the prior quarter). As at 30 Sep, we note that the weighted average lease expiry for the REITs stood at 2.5-6 years, which is still healthy in our view. The only noteworthy concern we felt was AA-REIT’s (NOT RATED) hefty 41.9% leases by NLA that were expected to expire in FY13. However, we understand from its management that it will focus on renewing the leases for underlying subtenancies of the master leases expiring in the period. In fact, progress has already been made, as the percentage lease expiry was reduced to 35.7%, based on a ‘look through’ basis (which includes subleases).

Leverage still at healthy level. Aggregate leverages of industrial REITs as at 30 Sep were between 23.8% and 41.3%. Sabana REIT, we note, had the lowest debt-to-asset level, but is expected to increase to 33.5% upon the completion of the proposed acquisitions in 3Q11. This is also the case for Ascendas REIT, which should see its leverage rise from 31.5% to 34.5% after funding all its committed investments. Only AA-REIT leverage is expected to fall below the 30% mark after the sale of 31 Admiralty Road. Mapletree Logistics Trust (MLT), on the other side of the spectrum, had the highest leverage. However, interest cover of 6.3x (with all loans being unsecured) is still comfortable, in our view. We maintain our OVERWEIGHT view on the industrial-REITs subsector, with Cache Logistics Trust and MLT as our preferred picks due to their high yields and resilient portfolio.

Don’t let Reits be the next wave of governance lapses

SINGAPORE boasts of a thriving real estate investment trust or Reit sector, but recent events have served another reminder that beneath the glowing surface, there are some key fundamental concerns.

K-Reit Asia, last week, pushed through its plan to buy 87.5 per cent of Ocean Financial Centre (OFC), and raise some $976 million through a rights issue to fund part of the cost. It had earlier announced that it would pay some $1.57 billion to buy parent company Keppel Land’s entire stake in the OFC office building. Keppel Land will see a net gain of about $492.7 million from the sale.

Put before shareholders for their approval at an extraordinary general meeting (EGM), the proposal ran into howls of protest. Shareholders questioned the stiff price and timing of the deal, at a time when the economy is facing a slowdown. Shareholders noted that while the prime Grade A office building in Raffles Place has a tenure of 999 years with 850 years remaining on the lease, KepLand is selling its stake with only a 99-year lease. Others questioned why K-Reit is paying its manager (which is owned by KepLand) an acquisition fee – even though it is buying the asset from its parent company. There were also rumblings about the independence of the manager.

In a nutshell, the EGM brought to the fore two key issues relating to Reits here that corporate governance advocates have been highlighting for some time: sponsor groups offloading assets to their Reits on terms that seem disadvantageous to the Reits, as well as the apparent lack of independence of the Reits. K-Reit chairman Tsui Kai Chong’s comment that ‘Our father organisation, Keppel Land, is only willing to sell it (OFC) to us for 99 years’, says it all. And the fact that both resolutions – to buy the OFC stake and for the rights issue – were passed with a show of hands, after a bid by institutional investor to vote by poll was denied, simply drives home the point.

This isn’t the first time – and probably it won’t be the last – that issues like these arise at a Reit. For some time now, there has been growing disquiet among corporate watchers about weaknesses in the corporate governance structures in Singapore Reits.

Earlier this year, a review of Asia-Pacific Reit markets by the CFA Institute produced less-than-assuring results. Looking at the governance of Reits in Singapore, Australia, Hong Kong and Japan, the institute in its report called strongly for Reit managers to be independent. In the current most common scenario, the Reit sponsor wholly owns the Reit manager, and also holds a large stake in the Reit.

And even before the latest K-Reit development, cases of sponsors selling properties to Reits have triggered concerns about conflict of interest, and unitholders have often questioned the purchase of these assets and how they were priced. The CFA Institute said that to better protect ordinary unitholders, most directors on the boards of Reit managers should be independent of management, sponsors and substantial unitholders. This should be made law, rather than just a best-practice guide. There is also the need to have more transparent structures to pay Reit managers and to tie these more closely to performance, and indeed to require all Reits to hold annual meetings for unitholders.

Reits are often presented as defensive plays, and given their yield structures, there is some truth in this. But it would be unfortunate if investors buy into Reits for their relative safety just to have their interests as minorities undermined by weak corporate governance structures. If nothing is done, the Reit sector could be where the next wave of governance lapses emerge, and that would be a pity for a sector that has done quite well so far.