Building Wealth Through REITS - Bobby Jayaraman

“My first REIT investment was way back in 2002 when I bought Ascendas REIT. How I wish this book was available at that time. I would have made less mistakes and more profits!” —Mohamed Salleh Marican, Founder and CEO of Second Chance Properties Ltd

“Building Wealth Through REITs is a great contribution to the nascent REIT market in Asia. We believe REITs are a perfect investment vehicle for Asian investors, yet to date the popularity and investor enthusiasm in Asia for REITs is still lacking. This comes down to various misperceptions that Bobby sets out to debunk with this ground-breaking book.” — Raymond Wong, Executive Director, SaizenREIT

BUILDING WEALTH THROUGH REITS Bobby Jayaraman

© 2014 Marshall Cavendish International (Asia) Private Limited First published 2012 and reprinted 2013. This expanded edition published by Marshall Cavendish Business An imprint of Marshall Cavendish International 1 New Industrial Road, Singapore 536196 All rights reserved No part of this publication may be reproduced, stored in a retrieval system or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without the prior permission of the copyright owner. Request for permission should be addressed to the Publisher, Marshall Cavendish International (Asia) Private Limited, 1 New Industrial Road, Singapore 536196. Tel: (65) 6213 9300, Fax: (65) 6285 4871. E-mail: [email protected] The publisher makes no representation or warranties with respect to the contents of this book, and specifically disclaims any implied warranties or merchantability or fitness for any particular purpose, and shall in no event be liable for any loss of profit or any other commercial damage, including but not limited to special, incidental, consequential, or other damages. Other Marshall Cavendish Offices: Marshall Cavendish Corporation. 99 White Plains Road, Tarrytown NY 10591-9001, USA • Marshall Cavendish International (Thailand) Co Ltd. 253 Asoke, 12th Flr, Sukhumvit 21 Road, Klongtoey Nua, Wattana, Bangkok 10110, Thailand • Marshall Cavendish (Malaysia) Sdn Bhd, Times Subang, Lot 46, Subang Hi-Tech Industrial Park, Batu Tiga, 40000 Shah Alam, Selangor Darul Ehsan, Malaysia. Marshall Cavendish is a trademark of Times Publishing Limited National Library Board, Singapore Cataloguing-in-Publication Data Jayaraman, Bobby, author. Building wealth through REITS / Bobby Jayaraman. – Expanded edition. – Singapore : Marshall Cavendish Business, [2014] pages cm eISBN : 978 981 4516 98 3 1. Real estate investment trusts. I. Title. HG5095 332.63247 – dc23

OCN866600533

On the cover: Singapore CBD image by Marty Windle/Getty Images Photographs on p15 courtesy of Bernard Goh Kwang Meng Book designed by Adithi Khandadai Shankar Printed in Singapore by Markono Print Media Pte Ltd

For Elena and Mark

CONTENTS Acknowledgements Introduction CHAPTER 1 An overview of Real Estate Investment Trusts (REITs) • What is a REIT? • Singapore REIT regulations • The structure of a REIT • How is a REIT managed? • How do REITs grow? • The Singapore REIT cycle: where are we today? CHAPTER 2 REITs versus other yield investments • Property • High dividend stocks • Bonds • Perpetual securities • Business trusts CHAPTER 3 Perception versus reality • Seven common misperceptions CHAPTER 4 Different types of REITs • Retail REITs • Hospitality REITs • Office REITs • Health care REITs • Industrial REITs • Cross-border REITs CHAPTER 5 The health of a REIT • How to read the financial statements • Balance sheet and financing strategy • Future performance CHAPTER 6

How much is a REIT worth? • Valuing REITs • Value of management CHAPTER 7 Building a strong REIT portfolio • REIT investing: slow and steady • Risks and challenges • The best days are ahead CHAPTER 8 REITs in a volatile interest rate environment • Long-term and short-term interest rates • REIT valuations and bond yields • Choosing “interest rate proof” REITs • Conclusion INTERVIEWS WITH S-REITS CEOS APPENDIX • List of REITs in Singapore • Glossary

ACKNOWLEDGEMENTS

I have always been interested in investing and sharing my thoughts about investments from the perspective of a practising investor. My first articles on REITs were published in Pulses, a finance magazine (now defunct), and Singapore’s The Business Times newspaper in 2010. I wish to thank Ms Teh Hooi Ling for giving me that opportunity. It was the positive feedback from many investors on the articles that inspired me to write this book. I wish to express my appreciation to the management of several REITs who not only took time from their busy schedules to have in-depth discussions with me on REITs for this book but who have always been very co-operative in openly discussing the many aspects of REITs whenever I had questions. They have been instrumental to me in deepening my understanding of how REITs really work. Special thanks to Simon Ho and Jeanette Pang from CapitaMall Trust; Dr Ronnie Tan, Victor Tan, Jacky Chan and Hao Wee Lee from First REIT; Ho Siang Twang and Vincent Yeo from CDL Hospitality Trusts; Lynette Leong and Ho Mei Peng from CapitaCommercial Trust; Dr Chew Tuan Chiong and Chen Fung Leng from Frasers Centrepoint Trust; Raymond Wong, Arnold Ip, Chang Sean Pey and Joey Goh from SaizenREIT; and Viven Sitiabudi and Alvin Cheng from LMIR Trust. I am grateful to Mr Mohammed Salleh, founder and CEO of Second Chance Properties, for his feedback on the book and for sharing with me his philosophy and insights about property investing and business in general. I have learned to appreciate the many details of running a retail business and the impact on retail REITs through these conversations. Many thanks to my fellow investment enthusiasts — too numerous to mention, regrettably — with whom I have frequently exchanged ideas and who have encouraged me to write this book and provided valuable feedback. Thanks to Lee Mei Lin from Marshall Cavendish, the publishers of this book, and Violet Phoon for her patience in editing it. Finally, allow me to express my gratitude to my wife Elena and son Mark who put up with regular late nights as I tackled the volatile markets and wrote the book.

INTRODUCTION

“The fact that other people agree or disagree with you makes you neither right nor wrong. You will be right if your facts and reasoning are correct.” — Benjamin Graham Real estate investment trusts (REITs) allow you to become part owner of some of the best commercial properties in Singapore and other countries, and earn a regular income stream. The first Singapore REIT (S-REIT) was launched by CapitaMall Trust in July 2002. As of December 2011, there are 27 REITs listed on the Singapore Exchange (SGX) with a market capitalisation of close to S$40 billion. They cover malls, offices, hotels, industrial assets and residential homes. Although in Singapore REITs have been around for a decade, many investors still seem unsure as to what to make of this asset class. Yes, it is similar to property in that it owns physical assets and earns rentals from tenants but its stock prices seem to act like that of any other stock, making it very volatile and, in the eyes of many investors, risky. Yet many would know of friends and acquaintances who have achieved capital gains and earn a regular income from strong REITs they have been holding for years. My goal in writing this book is to help readers understand how REITs really work — in plain language. It is not meant to be an academic treatise or to give readers a superficial treatment of the different aspects of REITs. Instead, the approach I have used is a fundamental and intuitive one which a businessman would take before making any investment — be it in property, stocks or any operating business. The book does not recommend any specific REITs for investment but gives you the tools to pick a good REIT. A deep understanding of REITs will increase your conviction in your investments and allow you to sleep peacefully during bouts of periodic market volatility. It will allow you to pounce quickly on undervalued REITs and realise strong returns. Some investors may well find that just by investing solely in a few REITs which they understand well, they will have outperformed the vast majority of stock market investors who jump in and out of stocks they know little about. The biggest attraction about REITs is that it is a very simple business to understand: a few properties managed by a team of people. Unlike many stocks, virtually all the information needed to understand REITs is publicly available. This book will provide guidance to investors on the key areas to look for when evaluating REITs. As a REITs investor I attend annual general meetings (AGMs), speak to REITs managers and other investors and follow on-line forums on this subject. I remain amazed by the many myths and misconceptions about REITs that continue to be held even by experienced investors. It is hoped that this book will help to clarify some of these issues. Also included in

the book are several in-depth interviews with REITs senior management which I hope you will find insightful. This book is meant for anyone considering to invest in REITs and interested in understanding all about this asset class — that could be a young college graduate just stepping into the world of investing, a retiree wishing to increase his dividend income or someone who is already a seasoned investor and keen on deepening his knowledge. You may not agree with everything I have written but if this book deepens your understanding of REITs and helps you to become a more knowledgeable REITs investor, I will consider it a success. I personally have benefitted enormously from investing in REITs and want to share the knowledge I have gained. I don’t claim that this book (or any book for that matter) will make you an instant millionaire. But I firmly believe that a steady approach to investing and learning more about REITs as you progress will help you build your wealth with minimum downside risk and provide you with a sustainable source of passive income. Unlike the message preached in business schools and finance textbooks — that high risk is required for high returns — I believe you can earn good returns over time with low risk if you are prepared to do your homework. Reducing risk in investments is not about reducing beta and volatility and jumping from one asset class to another. It is about increasing your level of knowledge and conviction in your investments. As Warren Buffett has pointed out many times, “risk comes from not knowing what you are doing”. Some of the most successful investors I know are income investors be it from stocks, REITs, property, farmland or their operating business. They have identified a good, safe and sustainable source of cash flow and have put a significant portion of their capital in it, giving them steady returns with peace of mind. This is what successful investing is all about and REITs are a great vehicle for that. I welcome all feedback at [email protected]. Bobby Jayaraman January 2014

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The author owns some REITs discussed in the book. All examples of REITs and other companies used in the book are only for learning purposes and do not constitute an opinion or recommendation to buy or sell. Readers are ultimately responsible for their own investments.

(top) Office buildings along the Singapore River and a shopping mall on Orchard Road

CHAPTER 1

AN OVERVIEW OF REAL ESTATE INVESTMENT TRUSTS (REITS)

WHAT IS A REIT? Investing in real estate has been popular for ages because of the attractive returns. Most Singaporeans (close to 90%) are homeowners. Some among us also own investment properties such as a condominium unit which we may rent out as a source of passive income. Wealthier investors may own shophouse units, small hotels and other commercial real estate. Investors invest in these brick-and-mortar assets to benefit from regular rental payments and potential capital appreciation. A REIT is similar to brick-and-mortar real estate in that it is a company (listed as a Unit Trust) that owns and operates properties and receives rental income from its tenants. As a REIT investor, when you buy a unit, you are actually buying a share in the underlying property of the REIT (for example, offices). The REIT units are traded in the stock market like any other stock, allowing investors to easily buy and sell units. This makes REITs a much more liquid investment as compared to physical property. REIT investors benefit through regular dividend payments (from rentals paid by tenants) and can also enjoy share price appreciation similar to any other stock. Many highly visible properties in Singapore such as shopping malls like Raffles City and Plaza Singapura are owned by REITs, as are many of the office buildings in the Central Business District (CBD) area. These include Marina Bay Financial Centre (MBFC) and One Raffles Quay (ORQ). Hotels such as Grand Copthorne Waterfront and hospitals such as Gleneagles Hospital have also been packaged into REITs. Buying into a REIT offers the small investor an opportunity to own a share in these buildings and collect rent (as dividends) with minimum capital outlay and without the hassle of managing the property and dealing with tenants. When an investor buys, let us say, 1,000 units of a REIT like CapitaMall Trust (CMT), he is buying a share in the more than 15 malls and 2,500 tenant leases that CMT owns. This gives the investor a much higher level of diversification versus owning a single condominium unit where the investor depends on a single tenant for his rental income. Just as an investor buying a house uses some of his own savings (equity) and a loan from a bank (debt) to buy a house, a REIT raises money from investors (equity) and takes a loan from banks (debt) to fund its properties. The ratio of debt to the value of properties is called the “gearing” of the property. If it is high (this is subjective and will vary by REIT), the REIT is said to be highly geared or leveraged. This is no different from an individual investor who puts in, let us say, only 10% of his own money and borrows the remaining 90% from a bank to buy a house.

Another aspect of REIT financing that is worth mentioning at the outset is this: when an individual takes out a loan to buy a property, the loan is usually what is called an “amortising loan”. This means that the individual pays a part of the principal amount and the interest so that over a period of 20–25 years, he would have paid the whole loan. This is different from the loan a REIT takes, in two ways. First, the tenure is much shorter, usually between two and five years; and second, the loans are not amortised, meaning only the interest amount is paid. The implication of this is that the loans are never fully paid but have to be rolled over at maturity date. We will explore this very important area and implications for the REIT investor in detail further in the book. A major attraction of REITs for investors is their high yield. As per MAS (Monetary Authority of Singapore) regulations, REITs enjoy tax transparency only if they pay out at least 90% of their profits as dividends. Most Singapore REITs (at the time of writing) yield from 5% to 9%. This means that if you put S$10,000 in a REIT, you can expect to receive upwards of S$500 every year in dividend income. It must, however, be noted that there is no guarantee that a REIT share price will be higher at the time of sale than when the investor first purchased it. In other words, the investor may face a capital loss. Thus, it is not wise to compare the yield of a REIT or any high dividend-paying stock or corporate bond with a bank fixed deposit as in the case of the latter there is virtually no possibility (at least in Singapore) that you will lose your capital. REITs were conceived in the United States and gained popularity when the US Congress enacted the Real Estate Investment Trust Act in 1960 which exempted REITs from taxation at the corporate level. This was a major incentive for property companies to hold their assets in a REIT. From the 1960s to the 1980s, REITs grew in popularity and went through several boom-and-bust cycles as investors got used to the idea of property trusts. However, it was not until the US commercial real estate bust of the early 1990s that REITs really took off with the general population. Banks during that time were burdened with a large amount of real estate loans in their books, backed by properties which had lost a lot of value. They were thus eager to get these properties off their books. This led to a fire sale of commercial assets and created the perfect environment for US REITs to acquire assets at depressed prices. The market capitalisation of REITs soared from US$10 billion in 1990 to US$160 billion in 1998 as many new REITs were formed and lapped up by an eager public. In Singapore, the first attempt to launch a REIT was made by one of Singapore’s leading property developers, CapitaLand, in November 2001. The REIT, called SingMall Property Trust, was offered at a 5.75% yield at a time when the 10-year government bond yield was 2.89% and fixed deposit rates were less than 2%. The launch was poorly received with low subscription rates which ultimately led to the initial public offering (IPO) being withdrawn. The reasons offered were lack of full tax transparency, poor outlook for the retail and general property market, and a perception that the assets were overpriced. SingMall Property Trust was floated again in July 2002, this time as CapitaMall

Trust, at a higher 7.06% yield. It was a resounding success, with a subscription rate of five times (The Business Times, 12 July, 2002). Since then, it has performed very well, offering investors stable dividends across business cycles. The success of CMT, along with favourable tax regulations, has spawned a strong REIT industry in Singapore. Today there are more than 30 REITs with a market capitalisation of around S$65 billion (as of December 2013, source: shareinvestors.com). Singapore is now the third largest REIT market in the Asia Pacific region after Australia and Japan.

SINGAPORE REIT REGULATIONS Singapore REITs (S-REITs) are regulated by MAS under the Collective Investment Schemes Regime of the Securities and Futures Act (this document is downloadable from the MAS website, www.mas.gov.sg), along with mutual funds, hedge funds and similar asset classes. A large part of the popularity of REITs in Singapore is due to a few critical regulations. Let me elaborate on three key regulations that were set out to make REITs a safe and attractive investment. 1. Tax transparency. The most important incentive is the attractive tax benefits — both for the REIT and the investor (“investor” refers to an individual investor; companies investing in REITs have to pay taxes on a portion of dividend income). Let us say you own an investment property such as a condominium unit and rent it out for income. You will be liable for property tax at 10% of the value of the property, as determined by the Inland Revenue Authority of Singapore (IRAS). The rental income will also be taxable as part of your overall income. These two taxes will reduce your net returns quite a bit. On the other hand, the dividends you receive from REITs are fully tax-exempt, and the REIT does not pay any corporate tax if it distributes at least 90% of its income to unit holders. What this means is that most of the profits a REIT makes ends up in the pockets of its unit holders. 2. Gearing. REITs are meant to be safe investments. To reduce risks of over-leverage, MAS has restricted the gearing that REITs can employ to only 35% and up to 60% if they obtain and disclose a credit rating from one of the three major credit rating agencies. This is done to protect investors from REITs that generate returns from heavy use of debt as that can leave them vulnerable during times of economic distress. Interestingly, the two biggest REIT markets in the Asia Pacific region — Australia and Japan — do not have any gearing limitations. 3. Property development. Unlike many REITs in the United States and Australia which are active in property development, S-REITs are allowed to develop property only up to 10% of the total value of the properties held on their books. This restricts S-REITs from taking unwarranted property development risks and keeps their business model clean. If

investors want exposure to property development activities, they can always buy stocks of developers and property business trusts; REITs are focused on their key role as landlords.

THE STRUCTURE OF A REIT A large number of REITs in Singapore are sponsor-linked; the sponsor is usually a property developer such as CapitaLand or Keppel Land. The sponsor retains a 20% to 30% stake in the REIT and collects asset management and property management fees through its wholly owned subsidiaries. REITs in Singapore are externally managed (unlike in the United States and Australia where most REITs use an internally managed model) which means that the REIT manager is a separate company that is paid a fee for managing the REIT. The REIT manager is usually a 100%-owned subsidiary of the sponsor, so in most cases a REIT manager just has one shareholder: the sponsor. The investors in a REIT are called unit holders. Let us try to understand the motivation to launch a REIT from a sponsor’s perspective. The business of property developers is to develop properties and sell them. The developers are usually fairly leveraged so they need to sell the properties quickly, pay back the bank loans, and recycle the cash into developing new properties. Their profit margins generally range from 15% to 25%, depending on the market cycle. Some property developers (for example, City Developments Ltd) also hold property as investments for a regular source of income (known as investment properties). This buffers them from the highly cyclical property development business. However, the downside is that this makes the balance sheet heavy, and they remain vulnerable to asset write-downs (this happens when the property is valued lower by appraisers thereby reducing its value on the developer’s balance sheet) during down cycles. A lot of cash is also locked up in these properties, giving them only 5% to 8% return in the form of rental income. This lowers their overall return on equity (ROE: the return a business earns on the capital it has invested). Investors who buy into property developers expect fast growth and high ROEs, not a 5% rental income. Hence, developers are keen to fast-track their growth by lightening their balance sheet through unlocking value from their investment properties and recycling the funds back into high-margin property development. One way to monetise value is to dispose of investment properties to a third party buyer. However, the market for large commercial properties is quite illiquid and it is not always easy to find a buyer. A sale would also mean permanently losing a source of steady income. If times get bad, the developer would not be able to rely on rental income from its investment properties. This is where the REIT, which offers the best of both worlds, steps in. The developer can now sell the investment properties to a developer-sponsored REIT. This arrangement will allow the developer to retain a stake in the properties (usually 20%–35%) while receiving recurring rental income as dividends. In addition to dividends, the developer-sponsor is also entitled to fees for managing the REIT. Let us take a deeper look at how a REIT is managed to understand this better.

HOW IS A REIT MANAGED? REITs, unlike most other companies, are structured as unit trusts. The basic foundation of this structure is a Trust Deed which is constituted between the Trustee and the REIT manager. The document specifies the strategy of the REIT and also outlines the rights of unit holders. Listed below are the key players: Trustee.The Trustee is a caretaker who acts on behalf of the unit holders. As per the Trust Deed, the Trustee is required to make sure all the property deeds are accurate and the rentals enforceable. The Trustee also makes sure all unit holder rights are protected. For his services, the Trustee charges a fee that is based on the value of the deposited property, that is, the property as carried on the books of the REIT. (For example, the CMT Trustee charges 0.10%.) REIT manager.As noted before, Singapore practises an externally managed REIT model. The REIT manager is usually a wholly or partly owned subsidiary of the sponsor, set up to run the REIT. (For example, CMT Management Limited, the manager of CapitaMall Trust, is a wholly owned subsidiary of CapitaLand, the sponsor.) The REIT management company has a board of directors who are entrusted with responsibility for the overall management of the REIT. The CEO of the REIT management company is like the CEO of any company and has complete responsibility for setting and executing the strategic direction of the REIT. REIT managers are paid a base fee according to the value of the properties they manage (for example, CMT pays 0.25%) and a performance component based on gross revenue and/or net property income, NPI. (CMT pays 2.85% of gross revenue.) They are also paid an acquisition and divestment fee based on the value of the assets (1% acquisition fee and 0.5% divestment fee in the case of CMT). Property manager.The key functions of the property management team are to make sure the property is rented out with the best mix of tenants, to collect rents on time, and to design marketing and promotional programmes in conjunction with the REIT manager. This would be similar to an individual investor employing a property manager to take care of several of his properties so that he avoids the headache of dealing with tenants directly. The property manager is, in many cases, also a subsidiary of the sponsor. For example, CapitaLand Retail Management Pte Ltd, the property manager for CMT, is a fully owned subsidiary of CapitaLand, the sponsor. Property managers are paid a fee based on the gross revenue and NPI of the property (2% of gross revenue + 2.5% of NPI for CMT). Are these fees fair, and how are they set? Unfortunately, unit holders don’t have much say in this. There are no regulations that require REITs to set their fees in a specific manner. Investors simply need to consider such fees as the cost of the services of a professional property and asset manager. We will look at the impact of these fees in more detail in the

chapter on understanding financial statements.

HOW DO REITS GROW? Most investors invest in REITs for a stable income. They expect quarterly or half yearly (depending on the REIT) dividend cheques regularly in the mail. Apart from delivering stable dividends or distributions per unit (DPU) as they are called, REITs also strive to gradually increase their DPUs over time. Unit holders of course are not averse to this but would like to see this happen without undue risk. A normal profit-making company will always retain its earnings to reinvest in the business. This means that out of the profit a company makes, it may pay out only a certain amount (up to the discretion of the company) as dividends. Many blue-chip companies in Singapore pay out 30%–50% of their profits as dividends and retain the rest within the company for funding new business development activities. REITs, however, do not enjoy this luxury as they are required to pay out at least 90% of their profits as dividends. This means that a REIT will have to raise funding for growth either from unit holders or borrow from a bank or the capital markets. The growth strategy of a REIT will depend on the type of properties it owns and the lease structure. (We will discuss the various types of REITs further in the book.) A retail REIT will have different growth strategies as compared to an office or hospitality REIT. Broadly speaking, REITs can generate growth within their existing properties or through acquiring new properties. The first method is called organic growth and the second, inorganic growth. Let us take a closer look at these methods for increasing growth.

Organic growth 1. Rental increases. This is the most obvious way of increasing income and the retail REITs especially have been very successful at this. Over the past decade, rentals in most malls have more than doubled, far outpacing inflation. For other REITs such as office REITs, this depends on the state of the market and whether the supply/demand situation is in favour of the landlord or the tenant. REITs with long-term master leases such as health care and hospitality REITs usually have built-in rental increases for their base income and some form of profit-sharing for the variable income. 2. Asset enhancement and repositioning. This is an excellent way of increasing income and has been employed successfully especially by retail REITs. They maximise yield per square foot by converting lower-yield space into higher ones, upgrading the tenant mix (for example, converting a low-yield supermarket space into higher-yield luxury goods space), and sometimes by repositioning the entire mall to give it a new life. Regulations permitting, the plot ratio (the ratio of gross floor area to site area) can also be increased for certain properties. CMT and Frasers Centrepoint Trust (FCT), two major retail REITs, have been generally able to realise returns on investment in excess of 8%, and sometimes in double-digit figures via a variety of asset-enhancing strategies on malls such as IMM,

Northpoint, Anchorpoint and Junction 8. Non-retail REITs, however, have limited leeway to pursue asset enhancement to generate value for their unit holders. In the office and hospitality sectors, refurbishments sometimes have to be done just to maintain competitiveness with the newer properties. 3. Capital recycling. This can be considered a form of organic growth as the REIT does not require external capital. It disposes of properties from its portfolio that it considers to have limited potential and uses that cash to acquire more profitable properties. This is not easy and requires a good sense of timing. The closer to market peaks the properties are disposed of, and the closer to market troughs they are bought at, the greater the value created for the unit holders. However, this might not always be possible and there will be periods when cash from a property that has been disposed of simply sits on the balance sheet waiting for a good opportunity for reinvestment. This leads to reduced DPUs for unit holders. In such cases, an option for the REIT is to simply return cash from the sale of its properties to the unit holders (as First REIT did when it sold the Adam Road hospital in February 2011). Overall, while many REITs in the United States have routinely recycled their properties and created value for unit holders, this strategy has not been used much by Singapore REITs. CapitaCommercial Trust (CCT) is one of the few. It disposed of StarHub Centre and Robinson Point in the first half of 2010 and subsequently invested in Twenty Anson in February 2012.

Inorganic growth 1. Acquisitions. There are times when the market presents attractive opportunities for acquiring a good property. In such cases, a REIT manager may feel that the potential benefits from the acquired property, in the form of increased rentals, will more than offset the cost of debt (interest cost on bank loans or bond interest payment) or equity (dilution through issuance of new units), thus leading to higher DPUs for the unit holder. This is called a yield-accretive acquisition. The problem with this method is that genuine yieldaccretive acquisitions are hard to come by. During a strong market, when funding is easy to obtain, the properties are richly valued. In contrast, during weak markets, properties may be available at attractive valuations but bank loans may be difficult to procure and equity financing may be expensive due to a low share price. This is a very important area for REIT investors to consider, and one we shall examine in detail in a later chapter. 2. Greenfield development. What can a REIT manager do if organic means of growth have been mostly exhausted and property valuations are up in the stratosphere such that acquisitions are out of the question? One way out of this could be to develop a property like a property developer. This is known as greenfield development. Local REIT regulations allow REITs to spend a maximum of 10% of their asset value in greenfield developments, which automatically restricts the contenders to the larger REITs such as CMT and CCT. This method, in principle, can add long-term value as the margins would be higher from greenfield development versus overpriced acquisitions from the secondary markets. The downside for investors is the waiting time as it could be two to three years

from the time the REIT raises funding to the time the property starts generating income. During this period, the REIT will have to pay interest costs (assuming debt is used) but will receive no additional revenue contribution. This method is untested as yet; the first greenfield developments (by CCT and CMT) will be ready only by end 2013. In summary, REIT investors should not be looking for the next Google or Apple among REITs! What is important is the stable income-generating potential of the assets along with a well planned and prudent growth strategy that can help increase dividends and share prices over time. Investors need to have a clear understanding of how a REIT drives growth — how much of its growth is organic and how much is acquisition-driven? The former is dependable and carries much lower risk than the latter. Bear in mind too that the quality of growth matters far more than the pace of growth. A REIT that grows its rentals along with inflation, does a couple of asset-enhancing exercises and acquires, say, one high-quality property every year or two will create more long-term value for its unit holders than a REIT that aggressively pursues growth and acquires a string of properties every six months.

THE SINGAPORE REIT CYCLE: WHERE ARE WE TODAY? Now that we have a basic understanding of REITs, it would be beneficial to look at where we are in the REIT cycle. The REIT cycle can be divided broadly into three periods: the bull phase from 2002 to 2007, the panic sell-down from 2008 to 2009 and the stabilisation period from mid-2009 onwards. Let us look at each of these periods and try to understand the driving factors behind the REIT performance during that time and the lessons to be learned. Bull phase (2002 to 2007). The S-REIT market was established with the launch of CMT in July 2002. This was a time when the general real estate market was in the doldrums, the economy was still in the midst of the dot-com crisis and the stock market was lethargic. A REIT like CMT which offered a yield of 7% attracted good interest from investors as it was backed by visible properties located in Singapore and the one-year bank fixed deposit rate at that time was only around 1.3%–1.5%. So there was clearly a need for a stable, high-yield investment which CMT aspired to fill. Other REITs such as Ascendas, Suntec and CCT soon followed and the market started to gradually overcome its initial scepticism about this new investment class. The REITs were bought as a stable yield-based investment and investors were content with their relatively high yields. What came as a surprise to investors and really led to the strong REIT bull market was the powerful growth trajectories that the REITs began to show. For example, CMT at IPO had only three properties worth S$900 million. Within a span of four years, the REIT accumulated 13 properties through acquisitions and quadrupled its

asset base to S$4 billion. All these acquisitions were highly yield-accretive which meant the DPU that investors received kept increasing quarter after quarter (CMT grew DPUs from 8.03 cents in 2003 to 13.3 cents in 2007). The share price increase followed the DPU increase and REITs suddenly morphed from stable yield investments to hot growth stocks! How were the REITs able to grow so fast? There were two main reasons for this. The first was the availability and reasonable pricing of commercial real estate. The Singapore real estate market from 2002 to 2005 was in the process of bottoming out after a prolonged bear market following the Asian crisis in 1998. During this time, market sentiment was still poor and many high-quality assets such as the Junction 8 mall and the IMM building were available for sale at reasonable prices. For example, the IMM building was acquired by CMT in May 2003 for S$270 million at a yield of around 8% (based on 2002 NPI or net property income). The second reason was the low cost of funding. The average three-month SIBOR (Singapore Inter Bank Offered Rate) from 2002 to 2005 was only around 1.26%, and a new source of financing called commercial mortgage-based securities (CMBS) had started to become widely available. All of this meant that high-quality REITs such as CMT, CCT and Ascendas were able to raise funding at below 3%. This combination of a weak property market coupled with low financing cost led to some very profitable opportunities for the REITs and enabled them to make yield-accretive acquisitions. By late 2006, REITs were starting to be valued as growth stocks. In early 2007, CMT was trading at close to two times its net asset value (NAV) and at an average yield of 2.4%, while the 10-year Singapore Government bond was trading around 2.7%. (REITs normally trade at a premium of around 2%–3% — depending on the market cycle — over 10-year bonds to reflect their risk.) Investors were happy to settle for a low 2.4% yield because they were expecting the strong growth of prior years to continue and lead to capital gains, that is, share price increases. The REIT managers too got carried away by all this euphoria and made three key mistakes. The first one was the steady increase in leverage. The leverage for Mapletree Logistics Trust (MLT), for instance, reached 58% by December 2007. Even CMT, which had always been very prudent with debt, allowed its leverage to rise to 45% in early 2008 from the 25%–30% range in prior years (2002 to 2006). The second mistake was the acquisition of properties at relatively low yields (meaning overpriced) in the hope that future rental increases would increase the yield. The third one was the use of short tenure loans to quickly finance acquisitions with a view to extending the tenure of the loan at a later date. For example K-Reit, an office REIT, took out close to a S$1 billion bridging loan from its parent Keppel Land in December 2007 to finance the acquisition of One Raffles Quay because it was unable to immediately raise financing. There were also other mistakes such as not having diversified sources of funding (for example, over-reliance on CMBS) and not spreading out the maturity of their loans. To cut the story short, both investors and REIT managers expected the good times to keep rolling on. The bull market for REITs peaked around mid- to late 2007. What was to come later had a major effect on both REIT investors and managers.

Panic sell-down (2008 to early 2009). By late 2007, the sub-prime crisis in the United States had started and tremors were being felt across the world. The capital markets where companies go to raise financing were frozen as no one wanted to lend; everyone’s focus was on conserving cash. The speed and depth of the financial crisis caught everyone unawares. The crisis had a particularly strong effect on leveraged investments such as REITs. Let us understand why. The lifeblood of a REIT is the ability to procure financing at reasonable cost. Hence, any turbulence in the credit market will have a strong impact on the financing ability of REITs and in a worst case scenario (if the liquidation value of its properties is unable to cover the loan cost) may lead to bankruptcy. Singapore REITs had also made heavy use of CMBS loans during the boom period from 2005 to 2007. This market virtually shut down during the crisis, and the REITs had to approach banks to refinance the maturing CMBS loans. Other than the financing issue, the financial crisis was gradually starting to affect the real economy and lead to a fullblown recession. People were starting to spend less, companies were downsizing and manufacturers were slowing production. All of this directly affected the business of REITs. If customers shop less in a mall, the shops will have difficulty paying their rentals, and retail REITs such as CMT and FCT would face an increase in bad debts. If companies downsize heavily, there will be fewer tenants for office space and office REITs such as CCT will face high vacancy rates. To sum up, REITs were facing the perfect storm. They were confronted with the risk of not being able to refinance their loans on maturity plus the likelihood of slowing revenues from their properties which would put at risk the REITs’ ability to service their debts and pay dividends to unit holders. There were no precedents for such market conditions and panicky investors were starting to question the fundamental business model of REITs and whether they would survive the crisis. By early 2009, the market was pricing in a bankruptcy for many REITs and investors were taking action by hitting the “sell” button hard! The “Great Singapore REIT sale” had begun with many excellent REITs selling at double-digit yields (the lower the share price, the higher the yield). The sale was, however, short-lived. By mid-2009, instead of the bankruptcies, bad debts and fire sales of assets predicted by doomsayers, the REITs actually mounted a fierce rally! S-REITs proved much more resilient than was initially thought. During the crisis, not a single major S-REIT suspended its dividend payments (SaizenREIT, a Japan-focused REIT did temporarily suspend its dividend payments. For more details refer to an interview with SaizenREIT’s management on page 211.) There were no forced liquidations or bankruptcies either. Why? The most important factor was simply the quality of the assets. Many REITs had highquality properties in good locations that had a proven ability to generate cash through good and bad times. Mall, office and industrial tenants had experienced several boom and bust cycles and knew the right measures to take to weather the crisis. The REITs were also highly proactive in supporting their tenants with appropriate marketing efforts. As a result, mass tenant defaults were avoided; neither were there high vacancy rates or premature lease cancellations.

Secondly, the REITs had acted swiftly to shore up their balance sheets and reduce gearing. This was done through raising equity via rights issues and bank loans. Many investors were not happy with the dilutive nature of some of these issues but immediate disaster was averted. The market had also underestimated the ability of the REITs to refinance their loans at reasonable interest rates during the crisis. CCT and CDL Hospitality Trusts, two REITs heavily exposed to the deteriorating economic conditions, refinanced S$580 million and S$350 million on reasonable terms in the first quarter of 2009, during the depths of the financial crisis. The banks appreciated the resilient earnings power of the REITs’ assets and the strong sponsors of these REITs provided additional assurance. All of the above meant that while many REITs lost more than 70% of their market value during the sell-down, their businesses were running pretty much as usual. Occupancies were stable and tenants were paying their rentals on time. Hospitality REITs such as CDL Hospitality Trusts suffered from temporary reduced tourist arrivals but had no issues servicing their debt (they generated enough cash from their businesses to make interest payments to the bank or bond holders). Most importantly for investors, all REITs continued to pay dividends on time. This indeed speaks to the strength of the assets of most S-REITs. Other than having to undertake dilutive rights issues, the REITs came through the severe crisis in fairly good condition. Their share prices had been hit, but not their operating earnings and ability to pay dividends. Investors should do well to remember this. There is no denying that the crisis was a great learning experience for both investors and the REITs. Investors that were banking on the stability of REITs versus other equities were shocked to see REITs fall even harder than the rest of the market. Between June 2007 and December 2008, the S-REIT index fell more than 66%, as opposed to a 50% drop in the Straits Times Index (STI). A major reason for the severe fall was that in 2007, many REITs had simply become too overvalued (as described in the 2002–2007 bull cycle). Investors also learned to differentiate between different REITs and were awakened to the importance of resilient assets, financially strong sponsors and competent REIT managers. It is hoped that they also learned not to panic in the next crisis! Despite the sharp share price drops, investors who held on to good REITs and did not sell during the crisis sailed through just fine as they collected dividends throughout the crisis period. Meanwhile, the REIT managers learned their own lessons about leverage, the excessive use of short-term financing and the need to have diverse sources of funding. Once more they were reminded of the need to exercise restraint in a booming property market and not overpay for acquisitions and extrapolate current rentals into the future. Relative stability (2010 onwards). From 2010, REITs have been performing well and seem to have become less volatile. During the euro crisis that hit investors from August 2011, the REITs lived up to their defensive reputation by falling much less than equities (and disappointing many investors who had hoped for a repeat of 2009 to pick up REITs on the cheap!). As the market matures and investors learn to appreciate the resilience of REITs, the volatility should further reduce and this in turn should attract more long-term investors.

Let us wrap up this chapter by re-capping some of the salient features of REITs and why they make good investments. • High-quality and resilient assets. Many Singapore REITs own some of the best and most visible properties in Singapore. The assets have proven earnings power across business cycles. Investors can thus sleep peacefully knowing the assets have a proven ability to generate cash in good times and bad. • Mix of yield and growth. REITs are required to pay out 90%–100% of their profits as dividends. This gives investors a stable source of income. Their assets also have good capital appreciation potential which may increase the book value of the REIT and lead to increases in its share price. • Easy to understand business. A REIT is a very transparent business with virtually all relevant information available to the lay investor. A REIT investor feels like a true part owner of a business. This is different from investing in specialised industries such as manufacturing and technology where much of the information is only known to industry insiders. • Favourable tax treatment. REITs do not pay taxes at the corporate level and investors do not need to pay taxes on dividends. This means virtually all of the cash a REIT makes ends up in the pockets of its unit holders. • Inflation protection. Over the years, REITs have been successful in increasing rentals in line with inflation, thereby providing a hedge against inflation, unlike bonds. • Liquidity. Unlike physical property, REITs are liquid investments which can be traded on the exchange just like any stock. • Diversification. When an investor buys a REIT, he is buying a share in several properties and leases; this greatly reduces his investment risk. CMT, the largest retail REIT, receives income from more than 2,500 leases across 15 malls.

CHAPTER 2

REITS VERSUS OTHER YIELD INVESTMENTS

We have learned the fundamentals of REITs and that REITs are meant to be stable-yield investments. What might be helpful now is to look at other yield investments and understand how they compare with REITs. Like any investment, REITs come with their own risks too, and this will be covered in the later chapters.

PROPERTY Brick-and-mortar investments are highly popular across Asia, and Singapore is no exception. Let us say someone has S$200,000 to invest. Should he put that into REITs or as a down payment for a S$1 million condo unit? Going by the crowds at the show flats, it seems that most people are going for brick and mortar! The positives of physical real estate investment are well-known. Property is something you can actually touch and feel; it is believed that over time property always appreciates, and that you have full control over the asset. It would be of more value to readers if I point out some of the pitfalls of property investing not commonly mentioned. 1. Low yields do not compensate for the risks. In Singapore, most properties are priced in normal times at a gross yield of around 3%. By “property”, I mean condo units as they are the most popular form of property investment. This figure is further reduced if we take into account property taxes (10%) and income tax on rental income. From a purely yield perspective, net yields (after taxes and maintenance expenses) of below 3% are simply too low to compensate for the investment risk. The margin of safety is absent. High-quality REITs, meanwhile, are available for net yields of more than 5%. 2. Unpredictable and volatile capital gains. The property market in Singapore is highly cyclical and has had a history of sharp booms followed by long bear markets. This combination has resulted in weak, long-term capital appreciation for an investor unless his timing has been perfect. You don’t believe this? Pick out a few condos that you know well and look at their actual transacted prices over the years. This can be accessed through the REALIS database ([email protected]) for a small fee at the National Library Singapore. You will find that had you bought units in suburban condos in the east, such as Sanctuary Green, Eastwood Green, or Changi Court to name a few, as far back as 1995 or 2000, you would have broken even only in 2010 or 2011! The Singapore property market went into a long slumber after the excesses of the early 90s. After peaking in 1996–1997, the market tumbled and only started showing signs of life in 2005, and that

too mostly for prime condos or the ones in the CBD such as The Sail. The suburban market only started crossing its 1996 peak from 2010 onwards — a long 14-year wait! Singapore is now a mature market with more than 90% home ownership and one of the highest condo prices in the world. The major gains have likely happened. In 1994, private residential prices were 23 times the prices in 1970 and thrice the previous peak in 1983. This came on the back of Singapore transforming itself from a Third World to a First World country. Investors need to ask themselves: what is going to drive the next property bull market? Singapore lacks the fundamental drivers of large developing countries such as India, China or Indonesia where millions are migrating every year from villages to cities, driving up property prices year after year. Long-term gains in property will be much more difficult to come by and are by no means guaranteed as is commonly assumed. 3. Hard to get bargains. Unless you buy during a depressed market, it is hard to get good bargains in property. While many stay away from REITs and stocks because they find them difficult to understand, it seems everyone is a property investment expert — which leads to quick escalation of property prices. The smart investor who has done his homework will be much more likely to find bargains in REITs than properties. 4. High capital outlay and illiquid investment. The capital outlay (including mortgage) is high for a property investment. If you buy an investment property and the economic situation suddenly takes a turn for the worse, you will have to endure months and likely years of paying mortgage on a property worth less than what you paid while you wait for the market to turn. If you want to sell it, you will find that there are only opportunistic buyers around offering to buy your property at deep discounts. With REITs, if you feel you have made a mistake, you can quickly liquidate all or part of your holdings so you can sleep better and conserve your cash for other opportunities. Just because you do not see the day-to-day volatility of properties — the way you do for stocks or REITs — does not mean its value will remain stable. 5. Lack of diversification and control. Most small investors are unlikely to have the means to build a diversified property portfolio. This can pose significant risks. Let us say you own one or two condo units for rental income. The unit may be under your control but you do not control the condo management which may maintain the condo poorly and thus destroy the value of your unit. You cannot stop another building or condo from coming up and spoiling your coveted sea view (just ask the owners of The Bayshore how they felt when Costa Del Sol, another condo, blocked their sea view!) thus reducing the value of your unit. You cannot stop a popular school from relocating and impacting your tenant base. And so on. Contrast this with a REIT where if you buy, say, a unit in CMT, you are part owner of more than 15 malls and 2,500 tenant leases. Diversification reduces risk and gives you peace of mind. In summary, no one will deny that high-quality real estate bought at good prices can be an excellent long-term investment. It is however naive to think of property as a good investment

irrespective of the price paid. REITs also have properties as their underlying asset and can usually be bought at much more attractive prices as compared to physical properties.

HIGH DIVIDEND STOCKS Singapore has several blue-chip stocks that pay high dividends such as Singapore Press Holdings (SPH), SMRT, Singapore Post (SingPost), StarHub and M1. There are also several small cap stocks, especially in the manufacturing and technology sector, such as MicroMechanics, Teckwah and Datapulse Technology that regularly pay good dividends. How do such stocks compare with REITs as yield investments? Before we answer this question, let us try to understand the reasons behind the high dividends. Companies in general aim to grow their businesses over time and for this they need cash. Most companies pay out a certain amount, usually around 20%–30% (also known as the payout ratio), of their net income as dividends and plough the rest back into the business to grow it. So a stock which is attracting investors because it pays a high proportion (upwards of 50%) of profits in dividends is signalling two possibilities. The first is that it does not see suitable growth opportunities for deploying its entire free cash flow (the cash generated by a company after deducting for maintenance capital expenditure) and is thus returning the excess cash (the cash above what is required to maintain the business) back to the shareholders. The second is that it thinks its profits are sustainable to continually fund dividends to shareholders. This is no mean feat. There are not a lot of businesses with an assured source of income to fund dividends year after year. Unlike REITs which are incentivised by regulations to pay out at least 90% of their profits as dividends to unit holders, companies are not. It is up to their board of directors to decide the dividends to be paid to shareholders for a particular year. A company which has been paying high dividends regularly for years can suddenly cut it down as happened with ComfortDelGro which reduced its dividend payout ratio from 50% to 30% of net profits. Ultimately, what the investor should look for when investing in high dividend-paying stocks is strong evidence that the dividends are sustainable for the long term. With this in mind, let me list a few key risks that may impact the sustainability of dividends. 1. A highly competitive industry. This risk is particularly pertinent for small cap companies in highly competitive sectors such as IT, manufacturing, and oil and gas services. These small cap companies generally have no pricing power and are hostage to existing industry conditions. Past track record is also no predictor of the future as market conditions can change rapidly. Investors should be convinced of the long-term earnings power of such companies before investing in them for dividends. 2. Decline in core business. Investors should be aware that some companies that pay high dividends may be facing declining profits from their core business. For example, SPH and SingPost engage in ancillary businesses such as developing properties and becoming landlords (in SPH’s case) or expanding overseas as what SingPost is trying to do because

their core businesses are in decline. These moves are not without risk and at some stage may have the potential to reduce their dividend payouts. 3. Reliance on monopoly pricing power to fund dividends. All the three telecommunication companies in Singapore rely on the cash flow from their privileged positions to fund dividends. An investor should ask himself whether this can continue forever in the rapidly changing telecommunications field. 4. Vulnerability to public pressure. SMRT and Comfort-DelGro, the two major land transport operators in Singapore, have been paying good dividends over the years but a large source of their profits come from providing public services. This makes them vulnerable to public pressure, requiring them to constantly justify their profitability and their dividend payouts to shareholders. In summary, high dividend-paying stocks can make good long-term investments and one should look out for such businesses. However, investors need to do their homework to make sure the dividends are sustainable. The company must not only have the ability to continuously generate cash to fund dividends but also the intention to distribute it to unit holders.

BONDS Bonds are securities that pay a fixed interest and promise to return the principal amount within a certain period. For example, if you buy a three-year bond worth S$100,000 (the principal amount) and the coupon is 5%, you will receive S$5,000 per annum in interest for three years and on maturity date you will receive your principal amount of S$100,000. Bonds can be issued by governments (they are also called sovereign bonds), for example Singapore Government bonds or US Treasury bonds, or by corporates such as Singapore Airlines and CapitaLand. Traditionally, bonds have not been popular with retail investors in Singapore as the Singapore Government bonds pay very low interest rates, almost similar to bank fixed deposit (FD) rates, while corporate bonds issued by Singapore blue-chip companies can only be bought and sold in large blocks of S$250,000, putting them beyond the reach of most small investors. This is changing. CapitaMall Asia (CMA) on 11 January, 2011 issued the first retail bonds at a minimum denomination of as low as S$2,000. The interest rate offered was 3.8% for the first five years and 4.5% for the remaining tenure if the bonds were not redeemed by CMA. The issue was well-received by investors. Since then CMT, a major retail REIT, has issued two-year retail bonds at 2% interest rate. These bonds are also listed on SGX and can be traded like any other stock. How do bonds compare with REITs? As a full explanation of bonds is beyond the scope of this book, let me just touch on a few

key issues for an investor looking to invest in bonds. Bonds carry two major risks: credit risk and inflation/interest rate risk. Credit risk means that the issuer fails to make the promised payments because of business difficulties or some other issue. This is considered a default and legal action can be initiated against the issuer. Given their strong financial position and track record, the likelihood of a default happening with blue-chip issuers such as CMA and CMT is very low. It is the inflation and interest rate risk that investors should really be worried about. Let us explore this in a bit more detail. When an investor buys a bond, let us say a CMA 10-year bond, he can either hold it till maturity at which point the issuer will redeem the principal amount, or he can sell it in the secondary market (meaning to another investor) to get his capital back. In both cases, he will suffer a loss if inflation spikes. In the first case, he will continue to receive interest payments every year for 10 years (3.8% for the first five years and 4.5% for the next five years) but if inflation spikes to, for example, above 5%, his real rate of return (interest rate minus inflation rate) will be negative. In the second case, if interest rates shoot up (due to increased inflation) and the investor wants to sell the bonds in the secondary market before maturity, he will find that his bonds will be worth less than what he paid for them. This is because an investor would want to buy bonds with a higher interest rate, which means that the original CMA bond yielding only 4.5% will have to be sold at a lower price. Thus the investor will face capital loss if interest rates go up and he does not hold the bond to maturity. The longer the tenure, the higher the risk of this happening. A caveat here: Textbook theory states that governments should raise interest rates to combat inflation but the real world doesn’t always work that way. For example, as this book is written (April 2012), inflation in Singapore is more than 5% (versus its average inflation rate of around 2% for the past two decades) but interest rates are still at rock bottom levels (3-month SIBOR