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REITs: Leasehold properties.

Friday, December 16, 2011

I have had quite a few exchanges with readers regarding REITs and their properties' land leases, if any. Readers who follow the comments section of my blog would be aware of this.

After a while, I realise we could just be running through the same points again and again. So, I am putting up my thoughts in a proper blog post written as a reply to a comment by a reader, Marti:

Hi Marti,

Yes, land leases should not be looked at in isolation. Like you said, if shorter leases are coupled with very high yields, they could still make great investments.


So, properties with shorter land leases if for any reason should be in great demand could command higher rents while freehold properties if for any reason should be lacking in demand could have lower returns. So, investing in the former might make sense as there is also time value of money to consider especially if the difference in yields is stark. We get back more money in a shorter period of time instead of a dragging out of much smaller payouts (although we could receive them forever).

So, if a property has say 15 years left to its lease but is able to generate a 20% return per annum, it would still make a fairly good investment. In situations where people feel that it makes more sense to rent than to own properties, this could come to pass.


I don't think an argument that REITs with properties with shorter land leases should offer higher yields to make investment sense is a persuasive one unless we assume that the managers do nothing to their portfolio of properties under management from IPO to the time their properties' land leases run out. How likely is that?

REIT managers will very likely divest older, less productive properties and acquire newer, more productive properties. They will very likely, conditions permitting, undertake development of properties and have AEI. Asset renewal keeps overall age of leasehold properties younger while development properties and AEI improve distributable income, all else remaining constant.

The issue of whether REITs have leasehold or freehold properties and their implications is not unimportant but I feel that it could have been given too much prominence in some quarters and by some people at the expense of a more holistic approach in the analysis of REITs.

We want to keep things simple but not simplistic.

38 comments:

SnOOpy168 said...

makes sense. I too liked to have my return of investment higher in $.

In that 20-30 years, not sure if I am still holding to the same REIT anymore.

Marti said...

Thanks for this reply. I do agree that we have to look at the whole picture, and also have invested myself in industrial REIT with "short" leases. In the end it's the total return that matters. However, all things being equal, freehold-invested trusts should offer better capital appreciation since freehold properties should grow better in value than leasehold.

Also yes the manager can reinvest to acquire new properties or extend leases, however since most of the income has to be distributed, that means the trust will be making cash-calls. So in the end there's no free lunch: you extend average lease by putting more money into the trust and sharing the distribution with more unitholders.

My point is not that one should not invest in trust with short leasehold assets, but that when we do so, we must keep in mind that such trusts are also returning back some equity. It is important when comparing trusts yields because I would prefer having a 9% yield from freehold properties than a 10% from 40 years leasehold.

This is the same decision real-estate investors have to make when buying a condo in Singapore: you get the same rental from a leasehold or freehold, but eventually the leasehold value will start decreasing.

AK71 said...

Hi SnOOpy168,

Yes, the only constant is change. Conditions might not always be so benign for REITs.

I am almost sure that there would be a time to divest or to be a lot lighter in REITs anyway. :)

Ray said...

AIMS AMP, LMIR, First REIT falling...
Those with extra cash can snap up. I'm all out of ammo unfortunately
:(

AK71 said...

Hi Marti,

In the example you have given, it is a no brainer to choose a 9% yield from a freehold property over a 10% yield from a 40 years leasehold property, everything else remaining equal. ;)

As for cash calls by REITs to undertake asset renewal and to grow through acquisitions, I don't really have a problem with this as long as it is yield accretive and is value adding. This depends on how good the management is.

I have seen some well run REITs which did private placements to do acquisitions and were able to maintain the DPU. Although I would prefer rights issues so that I could take part in the enlarged capital base, not everyone likes rights issues for various reasons.

Ultimately, if the distribution yield on my investment is unaffected, it doesn't matter if the REIT has more unitholders and if we have to share the higher distributable income with more people.

In theory, yes, a leasehold property is "depreciating" over time. In practice, however, it could be something else. I was surprised to find that a 1,200sq ft walk up HDB flat in Tiong Bahru has a valuation of $960k now. It has less than 60 years left to its 99 years lease. ;)

Property valuation is based on current day circumstances. What is supposed to depreciate in time might surprise us and move in the other direction. However, when the lease becomes really short, I too wonder: What then?

I seem to have drifted into the realms of residential property investments. Apologies. ;p

AK71 said...

Hi Ray,

I am not moving to accumulate more at current levels. Won't make a meaningful difference. :)

Drizzt said...

The industrial reits make themselves look much better than the shipping trust because they haven't had their black swan events yet unlike the shipping trust. They pay out 90-100% of cash flow similar to shipping trust before the crisis but their returns are half that. The lifespan is 40 years versus 30 years. Not too big of a difference.

Yet the investors feels that the 3 shipping trust should do proper or better financial management to pay off the loans. The industrial reits do not.

A leasehold have limited lifespan. You need to be compensated well for it. If you look at the return on asset of most trusts and infrastructure stocks the yield is 6%. They only look good because leverage and trading severely below nav.

Asset enhancement need capital injection or debts. Sell and buy due to inflation means you need more money as well. Lease may be renew for 30 more years but investors will need to pay for it.

The industrial reits are liquidating. Had lease hold not be an issue the xirr for aims amp would have been closer to 10% then current 7%.like Marti say the other % is your own money return to you.

Its not good or bad. You just need to be aware that its not a free lunch

Anonymous said...

Industrial land with shorter lease term is normally cheaper than long lease term for similar location. However, whether it is long lease or short lease, it commands similar rental, hence, the yield is normally higher for those with shorter lease term as the initial investment cost is lower. However, for shorter lease term, you should expect lower capital appreciation or even depreciation unless it's is in the prime location like kallang, ang mo kio, or even clementi area which normally owned by those like Areit, MIT, MLT, etc. Industrial land at more remote area normally worth nuts when it come to final years of lease term. For area Tuas, one need to pray harder. Many vacant factories remain vacant, as most new comers prefer to get the land through gov agencies via direct land allocation. To get the lease extended? Singapore land is scarce, one has to justify with the reinvestment that provide higher value added than others. At this time, it is totally different story from few years ago.

Casey.

AK71 said...

Hi Drizzt,

Yes, I am aware that there is no free lunch in this world. ;)

Every investment has its risks and every investment has a possibility of being hit by a black swan event. I know because my investment in Saizen REIT was hit earlier this year and they only have freehold properties. ;)

All businesses should be well managed in all aspects, not just shipping trusts. REITs too. It would be good if all loans taken by REITs are amortizing in nature like Saizen REIT's. Of course, it would mean a lower DPU.

For sure, all leasehold properties, be it 30 yrs, 45 yrs, 60 years or 99 years are limited in lifespan. No arguments there.

This is a reason why I rather be vested in Sabana REIT and AIMS AMP Capital Industrial REIT than A-REIT which has a much lower yield. The last I looked, A-REIT's distribution yield is about 6% and its properties have similarly shorter leases. However, A-REIT is always being waved around as a BUY. ;)

As long as investors know what they are getting themselves into and are satisfied with the yields they are getting, as long as they are comfortable with all the risks and benefits, there are no issues. This is the same with all investments.

If people should talk about all REITs with only leasehold properties as self-liquidating vehicles given certain assumptions which I made, I don't have any issues either.

It is people who target industrial properties S-REITs whom I take issue with as it lacks objectivity. More often than not, they unduly emphasize the shorter land leases at the expense of a more holistic analysis.

Our discussion here in my blog has definitely gone up several notches in terms of quality by now.

I must thank you and Marti for taking the time and effort in contributing to this lively and constructive exchange. :)

AK71 said...

Hi Casey,

Thank you for your insights. Very enlightening. :)

Anonymous said...

Forgive me if I am projecting something that might be negative. Although I think that certain high yield but unpopular industrial reits' yield is good, I am consistently disturbed by some doubts:
1. How things will turn out when a significant tenancy come to expiry 2 years later?
2. How sensitive is the share price react on any negative news?
3. Unlike hotel or office or even flatted factories, the landed factory normally build to suit certain specific purpose. It will be difficult to convert a food factory to warehouse due to it's much lesser floor loading design compare to warehouse. Similarly, it will be very costly to convert a electronic factory to an edible oil factory due to lack of effluent water treatment capability. Converting a warehouse to a food factory is never ideal too, due to difficult zoning plan, and lack of cold storage facility. So, such reits has definitely much higher potential risk if not manage carefully.

Risk level is not the same as those in other segment. Hence, higher returns.

Casey.

AK71 said...

Hi Casey,

There will always be some doubts plaguing the minds of investors. I am a worrier by nature and I think a lot about what might go wrong too. However, I try to be more zen about certain issues these days.

1. The managers will have to do their best to retain tenants. Failing this, the managers will have to find new tenants. Nothing much I can do about it. So, I don't let it bother me.

2. How will Mr. Market react to negative news? In the usual way, I guess. Again, nothing much I can do about it. So, I don't let it bother me.

3. Tenants of industrial properties are generally less footloose. It is also less easy for tenants requiring buildings built for specific purposes to move unless they can find similar buildings elsewhere. In fact, they typically take on relatively long leases.

So, I do not see this as a risk. I see purpose built buildings which cater to specific tenant requirements as a strength when it comes to tenant retention.

I have seen tenants moving because they got a better deal elsewhere or because they need to move to bigger or smaller premises. Usually, however, they would prefer to stay where they are instead of moving. Moving incurs a lot of cost.

Higher yields for certain industrial property S-REITs, I believe, is really due to a lack of pedigree. ;)

Anonymous said...

Hi Ak,
Thanks for sharing your views. I explained mine.
Casey.

AK71 said...

Hi Casey,

Indeed, sharing well considered views is always much appreciated. I look forward to you sharing your insights with us again soon. Thank you. :)

Anonymous said...

Hi AK,

Let me throw in my ideas into this interesting discussion !

Personally, I would attribute the difference in yield between industrial reits mainly to managerial strength and asset quality. A-REIT has been in the game for the longest and they are creating a lot of value in their development projects - just compare the difference in fair valuation of their properties and the cost price - approx $0.8 bil if I am not mistaken. Imagine this - $0.8 bil of value created from managerial actions which translates into more room for borrowings and hence more acquisitions leading to higher DPU growth and if those assets appreciates a virtuous cycle is formed. This is how a well managed REIT should function in a bullish property market (which we have been in for the past decade). I believe that's why they trade at a premium - the value add is something which small cap reits have yet to exhibit. Asset quality plays another role - Cache REIT owns ramp up warehouses on long term leases. This is certainly safer than a general warehouse leased to some unknown company. I thinkk AIMS is recognizing this judging by the investments/divestments made since recapitalization exercise.

I think one reason why industrial reits trade at higher yields than commerical reits is due to shorter land lease. I don't think its risk profile - the only true measure of risk is operating risk (counter-party risk and natural disaster) and gearing. Don't think they differ much here. Land lease is the key difference. A 40 year land lease implies 2.5% annual depreciation while 99 year lease implies 1% annual depreciation. So the difference of 1.5% can be seen when we compare blue chip reits where commercial reits trade at 5-6% while industrial reits trade at 6.5 - 7.5%. This is taken into account in the dividend yield since the DPU is both a return of capital and distribution of profits. Shipping trust trade at higher yields since their assets life-span is 20-30 years. But since 2009, this is no longer true as the shipping trust retain a lot of cash (but we are also ignoring their higher operating risk for this discussion). Same concept applies for utilities etc. In short, I don't think land lease is an element of risk but rather it just impact the yield since capital must be returned faster for shorter lease if there is no plans to retain cash to replenish assets independently. This is how I see it haha.

Feel free to disagree and correct my mistakes/misconceptions.

Cheers
Nick

AK71 said...

Hi Nick,

This discussion would not be complete without your contribution. Now, it is. :)

Thank you so much for the points raised in favour of A-REIT. I have always thought that a well managed larger REIT would have advantages beyond economies of scale and you have put it across so well as to how value could be added. It would have been nice to catch A-REIT in its earlier years.

When MI-REIT was going to be recapitalised, I supported the offer by George Wang et. al. as that was the only option that would work, I felt. I also hope that AIMS AMP Capital Industrial REIT, under George Wang's leadership, would continue its transformation. An A-REIT in the making? Dare I hope?

I like the way you put across your points comparing the returns within industrial property S-REITs and between industrial property S-REITs and commercial property S-REITs. It is clear to me that you have spent some time thinking about this.

I like this:
"I don't think land lease is an element of risk but rather it just impact the yield since capital must be returned faster for shorter lease if there is no plans to retain cash to replenish assets independently."

A question just popped into my head. Is it better to get a higher yield from a shorter lease or is it better to get a lower yield from a longer lease if it all works out to be the same absolute returns when the leases end? Yes, it is a simplistic question. If you are smiling, you have caught on. OK, I will have my bit of fun. ;)

Drizzt said...

i think we can all agree here that land lease theoratically tells us the diff in expected returns between different classes of reits due to their depreciation.

longer lease just means a larger valuation compare to one with a shorter lease (all else being equal)

Nick put up a blue print of explaining it. Compare the yield at historical asset cost. This takes out the gearing and the trade below NAV. Which one have the highest yield?

Next, evaluate each's quality of industrial assets. which one is of greater future value and their quality versus each other. whether they acquire the assets at a good price

Next, look at the operation risk, their gearing, their loan repayment, their tenant lease expiry and renewable profile, their average interest rate and whether its floating or fixed


that would be a fair comparison.

note i am vested in MLT, Aims and Areit.

AK71 said...

Hi Drizzt,

Yes, I like the "blue print" Nick came up with. Can always trust Nick for quality stuff. ;)

Anonymous said...

Hi,

Appreciate if anyone could comment on the below that is related to the discussions.

Could it be the reason that its price has been declining steadily?

LMIR

A BOT Scheme is not registrable with any Indonesian authority. Rights under a BOT Scheme do not amount to a legal title and represent only contractual interests.

LMIR Trust holds some of the Existing Properties (as defined herein) which it cquired at the time of its initial public offering via BOT Schemes. These Existing Properties are

(i) Cibubur Junction,
(ii) The Plaza Semanggi,
(iii) Ekalokasari Plaza,
(iv) Bandung Indah Plaza and
(v) Istana Plaza.

Pluit Village :
* BOT tenure expiring in 2025

Plaza Medan Fair :
* Operational since 2004 with Build Operate and Transfer (“BOT”) tenure expiring in 2027/28

The above shows very short "lease" (BOT period).

AK71 said...

Hi Anonymous,

Land leases in Indonesia can be very short but, apparently, they could be renewed quite cheaply.

As for the BOTs, there is definitely no guarantee that the contracts would be renewed. However, from what I could gather from my contacts in Indonesia, contracts are typically renewed.

I think this could also explain why LMIR trades at a larger discount compared to retail REITs in Singapore. The way things are done in Indonesia is definitely very different.

It is not easy for me to understand Indonesia too but I have over the years worked out some of the distrust in my system, if I could be allowed to put it that way, because of my work with counterparts in the country. :)

Anyway, if it still disturbs you, the best thing to do is to send the management an email with your concerns. Do share with us here if they should reply. Thanks. :)

Anonymous said...

Hi AK,

I read somewhere that Indon does not not have leasing arrangements, only BOT.

Is that true?

Yep, one reason why I am not into LMIR is bcos of different way things are done in Indon, as well as political risks.

By the way, the price action is very bearish.

Could reach rights price soon?

Drizzt said...

indonesia have a few kind of lease. first reits is HGC which is land lease provided by govt. 30 years lease you can extend for 20 years after which you need to renew. first reit have renewed a few plots of land for thousands of dollar.

for BOT it is more of a lease from the owner to another party. in this case lippo to lmir. its more like an agreement between 2 private party. there are more moving parts to this. much would depend on the relationship between lippo and lmir

AK71 said...

Hi Anonymous,

Could you include your name or initials in future comments? ;)

Indonesian government does lease out land. They are usually renewable leases at nominal rent.

In BOT, the developer uses the property for an agreed length of time before handing over the property to the land owner.

The reason why such contracts are typically renegotiated and renewed is because the land owners are not developers or managers. They would rather the status quo continue but for a fee, of course. However, this is not guaranteed.

It would be interesting to see the fate of a BOT property in LMIR's portfolio when its contractual period comes to an end.

You are not alone in avoiding LMIR and First REIT. The "Indonesian discount" is quite real.

As for how low LMIR's unit price could go, although I find it hard to envisage it going under 31c, your guess is as good as mine. :)

Anonymous said...

Hi AK,

It is no coincidence that after the rights issue to acquire Pluit Village and Plaza Medan Fair (both having short BOT period) the price has been on a steady decline.

Though some look at the acquisitions as yield accretive and therefore a positive, the price action (which is always right) is saying otherwise.

A lower price is perhaps required to justify its risks and uncertainties.

Aaron

AK71 said...

Hi Drizzt,

Lippo had the BOT contract for Pluit Village but I believe Medan Fair is from a non-Lippo entity.

I do not think Lippo is the holder of the land leases from the government in either case. If they are, then, I won't have any concerns because Lippo has a vested interest in LMIR to do well. :)

I could be mistaken. So, please feel free to correct me.

AK71 said...

Hi Aaron,

I will agree that Mr. Market is always right but we might also want to recall that Mr. Market is also known to be perverse. ;p

It is also in times when Mr. Market is overly exuberant or excessively depressed that savvy investors are able to capitalise on opportunities. :)

Anonymous said...

Hi AK,

Agree that Mr M may be maniac at times, sometimes its just being temperamental; but other times there are reasons behind its behaviour.

There could be several reasons for LMIR's steady decline; but it just seems a bit too coincidental that the decline started after its rights issue to acquire Pluit Village and Plaza Medan Fair.

Coupled with the Europe crisis which still have quite a bit way to go, its quite possible for LMIR to fall to 0.31 and even below.

AK71 said...

Hi Anonymous,

Anything is possible, of course. Coincidences do happen although there is no way of knowing if that is what they are. :)

Translated from Chinese: Strange things every year has, this year especially so. ;p

Although I still do not think it likely that price would fall below 31c, it could. Similarly, as you think price should perhaps fall to reflect a higher level of risk, there could just be a rebound. Hahaha.. :)

OK, this is my last reply to comments for now. Got a very early flight to catch tomorrow.

Will catch up with all of you when I am back in Singapore end of the month. Happy holidays! :)

Anonymous said...

Have a great holiday!

Aaron

AK71 said...

Hi Aaron,

I had a great holiday. Just came back in the wee hours this morning. Thanks. :)

JCK said...

"A real estate investment trust or REIT is a tax designation for a corporate entity investing in real estate. The purpose of this designation is to reduce or eliminate corporate tax. In return, REITs are required to distribute 90% of their taxable income into the hands of investors. The REIT structure was designed to provide a real estate investment structure similar to the structure mutual funds provide for investment in stocks."

http://en.wikipedia.org/wiki/Real_estate_investment_trust

Does the above still hold true?

i am very new to REITs, more so S-Reits.

i have been heavily invested in gold for the last 10 years. It has given me extremely good returns over those years.

i see you have a blog on precious metals. :)

Since those returns are so good, it has in a good way caused my portfolio to be rather lopsided, so much so 68% of my portfoliois in precious metals or related instruments!

Its probably time to divest out a bit these profits into other instruments and S-Reits maybe one of them.
This has been a rather difficult decision as the returns over those years have been extraordinary where i have yet to find any asset class which has given better returns, for me anyway.

But REITS maybe a good way of having a nice passive income stream! Provided that the tax incentive is maintained.

Thanks

AK71 said...

Hi JCK,

Congratulations on the astronomical returns your investment in gold must have secured for you in the last 10 years. :)

I also think 68% asset allocation in gold is somewhat heavy. Gold does not create cashflow and if we are thinking of investing for passive income, gold is definitely not in the running.

To confirm, yes, all income distributions from S-REITs are non-taxable. There could be a taxable component but that does not apply to Singaporeans.

Finally, investing in precious metals in the current day, for me, is an insurance against the possible failure of fiat currencies and the world financial system. In such an instance, precious metals could see their prices going even higher.

JCK said...

"Gold does not create cashflow"

BUT it does give GREAT returns! :)

Just wondering if anyone knows anything on taxes for foreign shareholder.

Will i be subjected to a withholding tax on dividends from Reits as a foreigner? If Yes, how much? i am a Malaysian.

Thanks in advance

AK71 said...

Hi JCK,

Gold has been very good for me as well. So, I will say that it did give me very good returns but will it continue to do so? At this point in time and with current market wisdom, it seems like it could do so. ;)

I know I have readers from Hong Kong, Malaysia and Europe who are vested in S-REITs. I hope they read your comment and share with you their experience. :)

JCK said...

AK

When i invested in Gold, it was for
fundamentals reasons.
If anything, those reasons are being reinforced further 1st in the U.S and now Euroland.
Thats the reason i am still invested in gold and reaping the benefits since 2001/02.

Nevertheless, its given me a good headache in making my portfolio rather lopsided at the moment.

Your blog is very informative and
as would be a good start for me to equip myself mentally before making a decision.

For your info, i started reading about gold in 1998/99 during our Asian crsis and only starting investing heavily in 2002. :)

AK71 said...

Hi JCK,

You got a great headstart on gold, no doubt. :)

For me, being in Singapore and making S$, the sense of urgency is lesser since with a strong currency, appreciation in gold's price in US$ terms could be more muted for me. Even so, it has appreciated more than 50% since the last crisis in S$ terms. So, I'm happy. :)

Currently, I am not adding to my long positions in gold and silver, being more interested in generating passive income from my investments. However, I am staying invested in the precious metals as an insurance.

kh said...

Hi AK71,

will like to ask on the following qn to help me to understand more about the underlying risks of investing in REITs.

I can understand that industrial REITs trades at a higher divi yield than commerical reit to compensate for the shorter land lease that industrial reit. But, i don't understand on how the difference on 1.5% came about and how part of DPU is a return of capital. Does it means that the REIT is paying dividend out of "depreciation" but yet doesn't make sense when calculation of distributable incomes doesn't include depreciation?? Could you elaborate more about it?

"A 40 year land lease implies 2.5% annual depreciation while 99 year lease implies 1% annual depreciation. So the difference of 1.5% can be seen when we compare blue chip reits where commercial reits trade at 5-6% while industrial reits trade at 6.5 - 7.5%. This is taken into account in the dividend yield since the DPU is both a return of capital and distribution of profits."

Appreciated if you could enlighten me on this.
Thanks.
kh

AK71 said...

Hi kh,

I will blog a response to your comment. :)

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