REITS: Differentiating between the Good, the Bad, and the Ugly

Stephen Chung

Managing Director

Zeppelin Real Estate Analysis Limited

June 2006

At the time of writing this article, the fourth Hong Kong REIT (Real Estate Investment Trust), Champion REIT, has just been launched. However, its share price lost ground on the day of debut amid poor sentiment for stocks worldwide. Without specific REITS or real estate funds in mind, and looking from a longer term perspective, REITS are not born equal and will not perform the same, just as there are publicly listed stocks with good overall performance and ones with less than desirable overall performance. 

Hence, as in the assessment of publicly traded stocks, how to assess and analyze REITS remains a valid concern. Your humble author can offer no rocket science fool-proofed methods, though the following may help investors in picking the more likely winners

A)     Pricing = everyone would agree that a luxury real estate location e.g. the Peak has more investment appeal than a comparatively run-down location e.g. Sham Shui Po, an old urban district in Kowloon. However, before one jumps to a conclusion that a luxury Peak property REIT is thus worth investing while a run-down Sham Shui Po property REIT is not, think again and look at the pricing! Your humble author admits that given all things being equal and that the pricings are market-based, he would quite likely go for the Peak REIT in part for the pride of owning something on the Peak. However, using extreme figures for better illustration, if the Peak REIT is priced at say HK$100,000 per ft2 floor area, and the Sham Shui Po REIT is priced at say HK$1,000 per ft2 floor area, your humble would definitely go for the latter. The reason is simple; the Peak REIT is way overpriced and the Sham Shui Po REIT is a steal. 


B)     Comparison to replacement cost = this hypothesizes the existing properties are to be built to their current status and seeks to estimate the costs, including both land and construction, which would be incurred. In fact, your humble author had used this approach to arrive at an overall positive advice on the LINK REIT when it was first conceived in late 2004 [read the related article:]. Simply put, if the pricing of the REIT is not way above or is even close to (or in the rare case even lower than) the replacement cost, it merits consideration or at least further study.


C)     Look at not just the rental yield% but also the risk aspect = say there are 2 REITS offering the same annual rental yield of 6%. Would you say they are technically the same rental income-wise? Your humble author would not so say unless the rent roll (listing the tenants, rentals, terms etc) has been considered. A REIT with stronger / steadier rent-paying tenants is likely to have its shares priced higher (at a premium) than a REIT with comparatively weaker tenants, despite both REITS offering the same rental yield. In turn this has to do with the perception of risk, and generally stronger tenants, e.g. reputable publicly listed companies or multinationals, are perceived to contribute to a steadier and surer rental income stream for the REIT. With a rent roll, one can also abstract other useful information such as the tenant types and mix proportions, rental expiry and continuation issues, cash flow projections, volatility of rental incomes based on different tenant mixes, and the like. One may even differentiate between the different rental sources by order of different risk tranches. Also, while having stronger or anchor tenants is a plus, having too many of them may not be desirable either because first, such anchor tenants tend to pay comparatively lower rents, and second, they might have occupied space that could otherwise be rented to non-anchors who generally may be willing to pay a higher rental rate albeit for a smaller space.


D)     Beware of overly creative financing = it is not uncommon for REITS to go for mortgages that help to reduce the repayment amounts in the early years, thus boosting up the rental income initially, with heavier interest payments later banking on significant rental growths to cover for them. Such arrangement by itself is not a sufficient condition to forego investing in the REIT, yet the rental growth expectation needs to be explored in detail. For instance, if the rental growths derive from the fact that current leases-rents are below market ranges thus harboring significant upsides on renewals, then the financing arrangement may work to the advantage of investors. On the other hand, if such rental growths are based mostly on having the market going from strength to strength, then the financing may be a riskier bet when such market expectations do not materialize.


E)     Competent asset managers = the REIT manager is similar to a stock fund investment manager, in that he or she is seeking to bring the best possible value and return in the broadest sense for the share holders (REIT investors). At times, he or she will also face challenges related to property acquisition, disposition, renovation, maintenance, tenant liaison, potential tenant targeting, promotions, leasing / renewal / termination etc. He or she will also need to understand the links between the various REIT teams, whether such are in-house or outsourced e.g. the asset management team, the property management team, the maintenance team, the shareholder liaison team, the financing / taxation / legal teams and so on. These teams where practicable should also be at arms length to one another. Having a clear and coherent investment and asset management strategy will certainly help too.


F)     Beware of dumping ground = just as some business owners take advantage of IPO (Initial Public Offerings) to retrieve their invested capital (instead of using the capital raised to expand operations or for researches etc), given time it is likely that some property owners may wish to utilize the REIT vehicle to get rid of their properties in the hope of seeking better overall pricings which otherwise might not happen if the properties are to be sold individually.


At this point, it seems that not too many people in Hong Kong, including sponsors, bankers, investors etc, realize the full potentials that the Hong Kong REIT vehicle may bring in terms of real estate market reaches, market segmentations, REIT commingling, product differentiations, capital sourcing, investors targeting, and the like. In short, the Hong Kong REIT is NOT limited to securitizing Hong Kong or Mainland China real estate or to Hong Kong and regional investors only, retail or institutional.

Notes: The article and/or content contained herein are for general reference only and are not meant to substitute for proper professional advice and/or due diligence. The author(s) and Zeppelin, including its staff, associates, consultants, executives and the like do not accept any responsibility or liability for losses, damages, claims and the like arising out of the use or reference to the content contained herein.

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