Sailing through choppy waters

Strong REIT managers will shine in difficult times. The completion of 651,000 sqm of retail space between 3Q08 and 2011 would inevitably put downward pressure on rental rates. But during the slump in retail rental rates in 2001-2003, CMT had been able to raise its rental rates through asset enhancement initiatives (AEIs) and space reconfiguration despite challenging operating condition. As such, we think strong retail mall managers can still ride out the tough period through well-executed asset management and enhancement.

Expecting a smooth transition in stewardship. Last week, Mr Pua Seck Guan, the CEO of CMT, announced his resignation with effect from 1st November 2008 and Mr Lim Beng Chee will take over Mr Pua’s role as the new CEO. Transition in stewardship should be smooth as Mr Pua had already made known to CapitaLand of his intention to pursue personal interest since last year and this would have given CapitaLand ample time to prepare for the transition.

Growth unlikely to be derailed with management change. Mr Pua had been instrumental in the growth of CMT since its IPO. With his departure, concerns have been raised on the outlook of CMT, which was evidenced in the sharp decline in CMT’s share price after the announcement. We think such concerns have been overdone. With plans for future AEIs in place, we do not think the change in management will derail the progress of AEIs going forward.

Yield discount attributable to size difference. While CMT is still trading at FY08 yield discounts of 1.3% to 2.0% to other retail REITs, we note that this yield discount correlates to the size of the REIT and this is also prevalent in office and industrial REIT sectors. For CMT, this yield discount is expected to narrow in FY09 with the increase in DPU.

Fair value lowered to S$3.05. We do not see significant change in the fundamentals of CMT’s retail malls, but we are lowering our fair value to S$3.05 (previously S$3.21) after raising our office cap rate from 4.5% to 5% and lowering our office rental forecasts, in line with our cautious stance for the sector. Share price could stay depressed for a while as the market awaits further clarity on the direction of CMT under the new CEO and yield spread over 10-year bond could stay wide under the tight credit market condition. We are keeping our BUY rating.

Retail unit management changes

Story: In a round of management changes at both CMT and CRCT, Mr Pua Seck Guan has resigned as CEO of CapitaMall Trust Management Ltd (CMTML), citing pursuit of personal interests as the reason. The leadership of CMTML will be transferred to Mr Lim Beng Chee, who will in turn relinquish his position as CEO of CapitaRetail China Trust Management Ltd (CRCTML) to Mr Wee Hui Kan, currently the Deputy CEO of CRCTML. Mr Lim who is currently the Deputy CEO of Capitaland Retail (CRTL), will also assume the role of CEO of CRTL from 1 Nov 2008.

Point: We expect the change in management to be effected smoothly given that Mr Lim has been with Capitaland since 1999 and was instrumental, together with Mr Pua, as key drivers of Capitaland’s growth as a leading retail mall manager and owner in Asia. In addition, Mr Lim was also involved in the formation and growth of the two retail reits, CMT and CRCT. We believe CMT would continue to enjoy its pole position as the largest retail S-reit with an ability to execute its asset enhancement activities.

Relevance: Share price of CMT had held up well in the recent market rout. Current valuation of 5.4-5.5% FY08 and FY09 yield appears relatively expensive in view of the hefty 200-300bps premium over its comparable peers’ yields of 7.4-8.4%. We downgrade the stock to Hold largely on valuation grounds, given the small 6% upside to our target price of $2.85. The significant trading yield spread premium over other retail S-reits and current volatile market conditions may likely cap the short-term performance of the stock. Catalyst for share price performance of the stock could likely depend on newsflow on potential acquisition of new properties in the pipeline.

A leader in asset enhancement

Key strength lies in asset management and enhancement. The tight credit market has raised concerns that REITs could face a tougher time making yield-accretive acquisitions and thus resulting in slower DPU growth ahead. For CMT, investors should focus on its growth via asset management and enhancement instead, which can potentially generate between 8% to 25% return on investment. CMT had proven its astuteness in the area of asset enhancement initiatives (AEIs) and with its ongoing AEIs, CMT should still be able to grow its DPU even if there are no new future acquisitions and a freeze in rental rates.

Big is beautiful. Bigger REITs have comparative advantage over smaller REITs in the area of AEIs, as the latter may face a lower limit on borrowings, which is partly determined by asset value, and can not afford similar largescale AEIs. Bigger REITs such as CMT can leverage on their size to undertake larger scale AEIs that can generate higher incremental value without significantly affecting short term distribution.

Debt expiry profile. CMT will have S$936.2m of borrowings that need to be refinanced in 2008 and 2009, with the majority due in August 2009. Part of these can be refinanced using the untapped portion of its multicurrency medium term note programme. For the remainder, we do not think that there will be any serious issue in terms of refinancing with the backing of a strong sponsor – CapitaLand. CMT has also locked in the swap rate for five years for its S$320m term loan that is due for refinancing in August 2009, which protects it from any future increase in interest rate.

Resume coverage with BUY. Based on our RNAV valuation and factoring in The Atrium, we peg the fair value estimate for CMT at S$3.21, at par to its RNAV, which provides a potential upside of 16.8% from its last price of S$2.75 and offers FY08 and FY09 distribution yields of 5.3% and 6.3%, respectively. Share price has corrected 16.9% over the last 3 months, and CMT had underperformed the rest of the retail REITs and this brought its distribution yield closer to the rest of the retail REITs. We believe CMT deserves to trade at a premium to its peers, given its size advantage and visible growth from AEIs. We resume coverage on CMT with a BUY rating.

Is CMT morphing from pure retail play into a mixed Reit?

CAPITAMALL TRUST (CMT), Singapore’s first real estate investment trust when it listed in 2002, has enduring appeal.

Six years since its flotation and with another 20 contenders in the Singapore Reit (S-Reit) market today, CMT remains Singapore’s biggest Reit with an asset size of $7.2 billion.

The market has rewarded the trust’s consistent ability to deliver total returns by according it one of the lowest costs of capital for any Singapore Reit. That is, CMT trades at one of the lowest distribution yields among S-Reits. The market demands a lower risk premium from CMT than it does for just about any other S-Reit. CMT is also trading above its net asset value. This has to do with CMT’s track record in managing retail properties.

However, lately some institutional investors have been concerned that the shopping centre trust could be morphing into a mixed development trust. In 2006, CMT bought a 40 per cent stake in Raffles City, which comprises a mall, office tower, convention space and two hotels.

In May this year, CMT announced it was buying Atrium @ Orchard – a predominantly office asset – for $839.8 million.

Is CMT being forced to buy mixed developments because of the challenge of sourcing for pure-retail assets in Singapore as more shopping centres are already owned by Reits and private property funds?

Some investors would prefer CMT to be a pure retail play. If CMT dilutes its portfolio by acquiring mixed developments with office and other components, investors may demand a higher risk premium, that is, CMT may have to trade at a higher distribution yield, putting pressure on its unit price.

Not only that, there may be potential conflict of interest within the CapitaLand stable of Reits, since CMT’s sister Reit CapitaCommercial Trust (CCT) owns mostly offices.

It may be timely to revisit some of the reasons behind CMT’s acquisitions of Atrium and Raffles City.

Offices make up nearly 96 per cent of Atrium’s existing net lettable area (NLA) of 373,446 sq ft. CMT’s attraction to the property, however, is due to its strategic location next to the trust’s existing mall, Plaza Singapura. By drawing synergies between the two properties, CMT can extract more value out of Plaza Singapura. Atrium is directly linked to Dhoby Ghaut MRT Station, which will be the interchange station for three lines. By integrating Atrium with Plaza Singapura, the latter will have improved MRT connectivity. CMT plans to boost Atrium’s retail NLA from about 16,100 sq ft now to 172,100 sq ft by converting the first three levels into full-retail use. It also plans to create retail space on state land that it hopes to buy in front of Plaza Singapura.

CMT could also potentially move some big tenants from Plaza Singapura’s upper floors to Atrium’s upper levels and subdivide the vacated space at Plaza Singapura into smaller units that will hopefully fetch higher rents. Another possibility is to attract fitness centres and signature restaurants to Atrium’s upper levels as office leases expire.

Given CMT’s impressive track record at asset enhancement plans and its ability to create new retail space in its properties, it’s possible to imagine Atrium transformed into a predominantly retail asset in future.

So too at Raffles City, asset enhancements have boosted the retail net lettable area by 12.5 per cent. These initiatives required the close cooperation of CCT, which owns the remaining 60 per cent in Raffles City. Had CMT bought only the mall in Raffles City, leaving the office tower to CCT, the two Reits might have had sibling arguments during the mall’s refurbishment as many common areas were involved. Instead, by taking stakes in the entire development, the two Reits worked in unison.

When Raffles City’s asset enhancement potential has been substantially realised, CMT and CCT could neaten their ownership – with CCT holding the office tower and CMT the mall. This will sharpen the two Reits’ respective foci and give investors clearer choice to invest in their preferred asset class. Likewise, when CMT is done transforming Atrium and creating more retail space, it could sell the remaining office space to CCT. After all, CMT should not be competing with CCT – a big office landlord – for office tenants at Atrium.

There will also be office space when CMT builds four more floors on top of Funan DigitaLife Mall to tap the site’s unutilised development potential. CMT has all approvals in place but will begin work only after the new office space has been substantially leased; this should make it easier for CMT to dispose of the office space and once more stick to its core strength in retail.

Moving ahead, CMT is unlikely to shy away from mixed assets as long as there are strategic reasons and where such assets have a retail component that it can add value to.

CMT will have to hope that investors will still find this defining strength endearing.