I had intended to write on this topic for the longest time, but school commitments meant that this was put on hold. With an entire month ahead before my internship begins, time is aplenty for me to do more in depth research into companies and sectors, so watch this space closely for more articles!
Recently, a conversation with someone on Reits led to the
discussion on this topic – whether the underlying land tenure of a Reit matters
when making an investment decision. In short, I believe that it does, even if
this detail is often overlooked by investors, who may prefer to focus on the
yield instead. I believe that while looking at the yield of a Reit is
important, we should also consider the underlying land tenure of the Reits’
assets as an important decision making metric.
In this article, I would discuss the implications of the
different land tenures for different classes of properties, focusing on the
comparison of industrial assets against retail and commercial assets. In
addition, I would also discuss the importance of looking at the average age of
the properties – another metric that I believe investors tend to overlook. The
average age of the properties is related to the underlying land tenure, and I
believe that investors should consider both factors simultaneously when
evaluating a Reit. I hope this article challenges the status quo of simply
looking the dividend yield, NAV and price to book ratios, which I believe is
myopic and would lead to issues in the longer term.
Firstly, I’d like to start off with the leasehold vs
freehold debate. For the longest time, rightly or wrongly, many Singaporeans
have held the belief that their HDB flats/Condos/Landed properties would be
ever appreciating assets. A common belief was that even as a leasehold
HDB/Condo ages, there would somehow be an opportunity to exit via an en bloc,
or that HDB would want to redevelop the estate and compensate the owners. In
2017, many who held this belief received a wake up call when Minister Lawrence
Wong cautioned that Singaporeans should not assume all HDB flats will be
eligible for SERS – in fact, as of 2017, only 4% of HDB flats were identified
for SERS since it was launched in 1995. I have included the article here:
Mr Wong’s comments were in response to the trend of buyers increasingly
forking out high prices for HDB flats that had relatively short land tenures
left, in anticipation of SERS. His comments sparked quite a debate at that
point of time, as it corrected the notion that leasehold assets would continue
to appreciate indefinitely. Hence, buyers of HDB flats became more aware of the
implications of having a short lease tenure left. The first batch of leasehold
properties in Singapore have already been returned to the Singapore Land Authority
– in short, when the lease runs out, the land reverts to the state, with zero
compensation to the owners. You may read more about this here:
Therefore, if buyers of HDBs and Condos consider the
remaining land lease tenure and the properties’ age when making investment
decisions, then logically, the same decision making framework should be applied
when we are evaluating a Reit as a potential investment.
Land lease tenures of different types of properties
In Singapore, Retail and Commercial properties are usually
on 99 year leases, with a minority of them on 999 year or freehold tenures. For
industrial properties, before 2012, industrial properties were sold with 60
year land leases, which was cut to 30 years in 2012. Since 2019, certain newer industrial
sites for ‘heavier industrial use’ were sold with only 20 year leases.
Looking at things from an IRR perspective
In real estate, we usually evaluate the merits of an
investment using the internal rate of return (IRR). The IRR of an investment
takes into account the initial capital invested, and the cash flows that we
receive during the period that we hold on to an asset. The higher the IRR, the
better.
To simplify things a little, consider this hypothetical
situation where we have two HDB flats, one with 30 years left on the lease,
while the other has 99 years left on the lease. Assume both are now selling
for $500k each, and yielding 5% a year, which is 25k.
From an IRR perspective,
For the first property, we are investing 500k today at a 5%
yield, and will receive 25k a year over the next 99 years. The IRR would be 4.96%.
I used a financial calculator to calculate this, but you can also use the
calculations using the ‘=IRR’ function on excel, or find an IRR calculator
function online.
For the second property, we are investing 500k today at a 5%
yield, and will receive 25k a year over the next 30 years. The IRR would be 2.85%,
which is much lower than the first scenario.
Therefore, from an IRR perspective, the first property is
definitely the better investment, because we are collecting the rental payments
over 99 years instead of 30
Now, you would be thinking: Why would anyone buy the second property,
when we can get a much higher IRR by buying the first property? Surely the second
property would have to provide a higher yield (and hence, sell at a lower
price), in order to compensate for the shorter land tenure left?
If you think this doesn’t make sense, this is exactly what’s
happening in the markets now, where the yields of industrial /logistics reits are
comparable, or sometimes even lower, than the yields on retail and commercial
properties.
Of course, due to the current Covid-19 situation, prices of retail and
commercial reits have been pressed down, and it would not be a fair comparison.
I agree that it would not be fair to make a comparison now, but even if we were
to look at prices in late 2019 and early 2020, before the Covid-19 outbreak, industrial reits have
been trading at yields which are comparable to office/retail reits. Some
industrial reits were trading at yields of high 4%, while some office and
retail reits were trading at yields of low 4%.
So how do we explain this unique situation? Mitigating factors
1 and 2 provide some possible reasons.
Mitigating Factor 1: Industrial rental growth to outpace
office/retail rental growth?
Investors who are bullish on industrial reits may argue –
industrial rents are going to outpace office and retail rents due to the
e-commerce trend, which results in an increased demand for logistics and
industrial space. In fact, some may even hold the view that office rents will
fall due to WFH being a long term trend, while the lockdown would accelerate
the downfall of retail. These perspectives make sense, but considering the much
shorter land tenures of industrial land (30 – 60 years), how much more can the
rents increase to compensate for the shorter land tenure, in order to make the
IRR from the investment in industrial assets comparable to the IRR from
office/retail assets? And if you’re expecting industrial assets to somehow be
worth more than office/retail sometime in the future, wouldn’t landlords of
malls simply convert their empty malls into storage spaces?
Additionally, industrial/logistics reits may also be perceived
to be more resilient in times of uncertainty. This is due to their long WALEs
which ensure that landlords lock in their rental rates for a longer period of
time. To me, the ‘safety’ of industrial/logistics reits are not entirely
convincing. The long WALEs are only applicable if the tenants are still in
business. While it may be correct to claim that industrial and logistics
tenants are benefiting from the e-commerce trend and the current lockdown,
there are certain groups of tenants who may also be affected in the current downturn.
Firstly, consumer discretionary businesses who face bankruptcy may default on
their warehouse rental payments – for example, if a clothing store goes
bankrupt, it is unlikely that they would pay for rental owed to the landlord of
their warehouse. Secondly, SMEs in the manufacturing sector who are in more cyclical
sectors (oil and gas, aviation etc) are also at risk. These SMEs rent manufacturing
space from industrial reits too, and may run into cash flow problems.
Overall, yes, while ecommerce companies like Amazon or third-party
logistics providers like DHL may benefit, there are certain tenants of industrial
and logistics reits that are at risk as well. Hence, the stability of
industrial reits may be overestimated.
Mitigating Factor 2: Will industrial/logistics reits be able
to renew their land leases upon expiry?
I have found the answer here:
To summarise, generally, the Govt’s position is to allow the
leases to expire without extension. This is because Singapore is land scarce,
and the Govt would want to be able to reallocate land to meet changing socio-economic
needs. However, there would be exceptions granted, such as if significant
investment has been made on the property, but these would be evaluated on a
case by case basis.
If the Govt does indeed grant an extension, the landowner
would still have to pay a land premium to obtain the extension of the lease. If
the reit is able to win approval to extend its land lease tenure, that would
affect the IRR calculations, hence we would not discuss this in depth here,
given that there is no certainty of this happening in the first place.
Further metric to consider: Age of the properties
This brings me to the second point that I would be
discussing – the age of the buildings themselves. While we have earlier discussed
the lease tenure of the assets, practically, it would be unrealistic to expect the
buildings to last the entire duration of the lease tenure. For example, an
office building built on a 99-year leasehold land would not be expected to continue
to be in use at the end of the 99 years. At some point in time, wear and tear takes
a toll on the building, and newer buildings built with better technology become
more attractive to tenants. This trend has already played out in Singapore’s CBD,
as the newer buildings (MBFC, Marina One, Asia Square, ORQ etc) have attracted
tenants to move away from the ‘traditional’ CBD area of Raffles Place. In part,
this is due to the larger floor plates in the newer buildings which allows
tenants to optimise their office layouts, and the newer amenities.
Hence, what would be a reasonable age of a building before
we can expect a property to be redeveloped? Going by the precedent cases, URA
had launched the CBD Incentive Scheme in 2019, which aims to rejuvenate the
city centre. Some of the properties identified to benefit from this scheme
would be Shenton House and International Plaza, which were built in the late
1960s and early 1970s. As these buildings are still standing today, it would be
reasonable to conclude that commercial properties can be expected to last at
least 50 years before they are slated for redevelopment.
However, there are also properties which undergo redevelopment
or major asset enhancement initiatives much earlier, for example, Chevron House
was sold by Oxley to real estate fund AEW for $1.025 billion. Chevron House is currently
undergoing major asset enhancement works which is expected to cost around $100
million. Chevron House was completed in 1993, which means that the building is
approximately 27 years old at the point of commencing the major uplift.
Thus, if you’re buying a Commercial/office reit that owns
properties with average ages of 20+ years, in practice, you’re probably only
getting the rental payments for another 30-40 years, before it would be
scheduled to undergo major redevelopment works, even if the land lease tenure
is 99 years or longer. That means if the reit does not sell off the property to
a third party, past the 30 year mark, there could potentially be more redevelopment or asset enhancement
costs for unitholders.
What’s the ideal outcome for investors?
Having discussed the implications of both the leasehold land
tenure and the age of the assets themselves, what would be the best outcome for
reit investors? The two issues discussed above may have painted a rather bleak
picture for reits, but I still believe that reits have a place in our
portfolios, as they provide exposure to real estate, and in ordinary
situations, provide a steady stream of income to investors.
The ideal scenario for reit investors, which would mitigate
the effects of a short remaining land tenure and an older portfolio age, would
be if the reit is able to continually make yield accretive acquisitions over
time. These new acquisitions, assuming that they are assets with long land
tenures and newer properties, would continue to allow the reit to increase its
portfolio average land tenure, while lowering the average age of its
properties.
Here’s the catch – acquisitions funded by rights issues
would mean that the investor has to come up with the cash to subscribe to the
rights. However, if the acquisition is yield accretive, then the investor who
does not want to come up with the cash may choose to sell his rights, as the yield
accretive acquisition means that his dividends would not be diluted.
Alternatively, reits may raise cash through a private placement, usually to institutional
investors or high net worth individuals. Generally, if the private placement is
intended to fund a yield accretive acquisition, then it is beneficial to existing
unitholders, as private placements are usually done at a lower discount than rights
issues, so there is less dilution for all unitholders. In short, existing unitholders
would be benefiting from the capital of new unitholders.
Furthermore, reits may also take a proactive asset
management approach, selling off their older properties to recycle capital into
newer assets.
Conclusion
While investors are right to look at popular metrics such as
dividend yield, DPU growth, NAV and price to book values, I believe that it
would be appropriate to consider the land tenure of the properties and the portfolio
average age as well. The leasehold nature of properties is more common in
Singapore, whereas for reits that hold overseas assets, those properties tend
to be freehold assets. Hence, only the issue of average portfolio age would be
applicable to these reits. Some examples include Manulife Reit’s US Office portfolio,
which are 100% freehold, while Frasers L&C Trust’s Australian logistics
portfolio are freehold as well.
I have complied the land lease tenure of a few popular reits
in the table below. While researching on the data, I realised that most reits
do not specifically state the age of their properties. However, we can simply
calculate it by referring to the date of completion of the properties, which
are provided in the annual reports.
 |
| Source: Various Annual Reports, Quarterly Presentations |
As discussed, the land lease tenures of industrial properties are usually shorter than retail and commercial properties. Hence, it would be logical for industrial reits to provide investors with a higher yield, in order to compensate for the shorter land tenures.
Taking this into account, it would be good if investors consider
the land tenures and building age when making investment decisions. While there
are macro factors (as discussed in Mitigating Factor 1) that are positive for
industrial reits, in situations when industrial reits are trading at similar
yields to commercial and retail reits, it would be wise for investors to ponder
whether the market has priced in and accurately accounted for the shorter land
tenures of industrial assets.
Note: As of writing, I do not have any positions in any of the securities mentioned in this article. From time to time, I may take up positions in the aforementioned securities, without updating this blog.
Disclaimer: This article is intended for informational and discussion purposes only, and do not constitute financial advice. When in doubt, please contact a licensed financial adviser.
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Note: As of writing, I do not have any positions in any of the securities mentioned in this article. From time to time, I may take up positions in the aforementioned securities, without updating this blog.
Disclaimer: This article is intended for informational and discussion purposes only, and do not constitute financial advice. When in doubt, please contact a licensed financial adviser.
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Valuation of REITS taking into account land tenure has always been paramount to my investment decision making. Love it when i read your article.
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