AlpacaInvestments: May 2020

Will Working From Home Change Real Estate Trends?

Will Working From Home Change Real Estate Trends?

With 80% of Singapore’s workforce said to be working from home over the past two months, I would like to share my thoughts on the longer-term implications of the trend towards working from home (WFH). I will be touching on two main issues – firstly, the viability of working from home, with regard to office culture in Singapore, and secondly, the impact of working from home on commercial real estate, especially in the CBD and business parks.

To begin, I’d like to say that I firmly support the trend towards working from home. For me, the main benefits of working from home are the time saved without the daily rush hour commute and the increased flexibility. The lack of social interaction may be a concern, but I believe that these can be mitigated through socialising in the evenings and the weekends. Moreover, in a normal, virus free situation, my ideal arrangement for working from home would probably include one or two days in the office per week, as I believe that building camaraderie and a team culture is important as well.

Are we over-hyping the trend towards WFH?

A few months back, Jes Staley, the CEO of Barclays, said that “the notion of putting 7,000 people in a building may be a thing of the past”. He said that in the longer term, the bank would adjust how they think about their location strategy. This implied that commercial real estate may see an irreversible shift in tenant preferences.

Interestingly, within a month from those comments, Hong Kong office workers are mostly back to work. HK has been very successful in curbing the spread of the virus, and banks based in HK have reported that they have been running their offices at 50-70% capacity recently, with plans to allow more employees back to their offices. Thus, if WFH is here to stay, why the rush to get employees back to the offices?

With regard to this, I think that we as humans tend to extrapolate certain current trends into the future, and draw our conclusions based on what we’re seeing at present. However, my counterargument to that would be that as leases for office space tend to be of longer durations, by the time these office leases are due for renewal in 4 to 5 years’ time, the pandemic may have blown over by then, which results in changing priorities at the point of renewing the leases.

Social and cultural issues standing in the way

Humans are hard wired to seek social interaction. We form communities and rely on family and friends for support. If we were to be working from home permanently in the future, how then do companies form strong cultures which are a key selling point for recruitment? Think of Google’s offices which include bowling alleys and sleeping pods – aren’t these amenities part of what makes Google such an attractive company to work for?

Thus, I believe that the ideal balance would probably involve in-person team bonding activities at least once a week. People would need places to meet and network, and therefore maintaining a physical office space may still be necessary to support these activities. In this situation, it is very likely that commercial tenants would downsize their space requirements, as the number people in the office at any given time is reduced. One trend which is already taking place would be the practice of hot-desking, which is popular among the Big 4 accounting firms.

On the point of cultural issues, perhaps the following observations are more prevalent in Asia as compared to the West. Firstly, Japan has a bizarre culture which glorifies falling asleep on the job – which supposedly serves as a signal to bosses that the employee has been working to exhaustion. Japanese office culture also frowns on the practice of junior staff leaving the office before their superiors. Additionally, Chinese companies are known for the backbreaking 9-9-6 culture - working from 9 to 9 daily, 6 times a week. With companies increasingly implementing WFH arrangements due to Covid-19, the lines separating work and personal life have become blurred.

When faced with such drastic change, how do managers who are used to these styles of management cope? I have heard horror stories of how some micromanagers have constantly called up their staff to check if they are working. Ultimately, it boils down to trust – trusting employees to get their job done regardless of where the are working. And herein lies the issue – trust is not built overnight, or even over a matter of months. My view is that change in management styles may not go away in the near future, perhaps it may take years, or even an entirely new generation of senior managers to impose change.

City fringe office space over CBD?

One possible trend that has been cited would be the increased demand for suburban office space, while the CBD hollows out. The assumption here is that companies would shun pricey CBD locations in favour of city fringe or suburban areas such as business parks, where rents are lower. The relocation of office space towards suburban locations has already happened for some time; think of banks shifting their back office functions to Changi Business Park, or MNCs opting to relocate their HQs to city fringe locations such as the Paya Lebar Quarter.

For this issue, I don’t think we can look at these two segments in isolation. After all, they are closely interdependent. An intuitive conclusion to make would be that demand for suburban office space would rise, pushing rents up, while demand for CBD office space would fall, pushing rents down.

To me, this is a fallacy, because CBD rents are likely to continue to hold a premium over city fringe rents. Think about this – current Grade A CBD rents are around $10-11 psf/month, while business park rents at areas such as MBC costs around $6 psf/month. Hence, if we were to expect CBD rents to fall and city fringe rents to rise, then the premium between both areas would narrow considerably, maybe to $8 psf/month for city fringe offices and $9 psf/month for CBD offices. Would this be logical? In that situation, why would companies still prefer city fringe locations, if they can get a prime CBD location by just paying slightly more?

Hence, I won’t expect suburban office to perform any better. If CBD rents fall, then rents across the entire spectrum of office locations should fall as well.

Would prime CBD offices be repurposed?

One mitigating factor for CBD office buildings would be that their prime locations still command a certain value. Thus, even of some office space becomes redundant, the land itself can still be sold or redeveloped, most probably into residential or mixed-use developments. URA had launched the CBD Rejuvenation Incentive Scheme in 2019, which encourages the conversion of older office buildings in the CBD, to develop more mixed-use projects to create a more friendly live-work-play environment.

Thus, I wouldn’t completely write off commercial properties, because the land themselves still hold considerable value.

Would cities become less attractive?

This applies more for countries with large rural areas, for example, the US. Some people were prediction a mass exodus from cities, with people moving to rural areas to work remotely. Staying in a ranch or farm while keeping their city jobs. To me, that sounds completely ridiculous. Sure, some people may prefer the slower pace of life there, but think about it – the allure of cities is the ease of access to everything: having your family and friends around you, entertainment options, and basically just having that connectivity. Yes, the novelty of the slower pace of life may appeal to some, but think about our current situation – we can’t even get people to stay home for a couple of months. Apparently, boredom kills. How different would that be if people who spent their entire lives in cities get to work remotely from a farm in Arizona or Texas?

Macro factors driving real estate investments

Macro factors driving real estate prices are equally important when considering the long-term direction of the real estate market.

While rents may drop due to the demand and supply imbalances with regard to tenants, if there is still significant demand for investment properties from investors, we may simply see a compression of rental yields, which means that real estate values hold steady even as rents fall.

Institutional investors or high net worth individuals may continue to view real estate as a hedge against inflation, and simply accept that lower rental yields are the new normal. With interest rates back at record lows after a brief ascent over the past few years, real estate continues to offer attractive spreads to investors.

Think about the trend of Mainland Chinese buyers bidding up the residential real estate prices in Sydney or Vancouver. The main factor driving property prices up in these areas was more because of the influx of deep pocketed buyers rather than the underlying demand from end users (residential tenants). Thus, do consider the larger macro factors at play, instead of being overly fixated on the possibility of falling rents.

Conclusion

While I am highly supportive of the entire WFH exercise, I think the idea that a large majority of us would be working from home permanently would probably remain distant a dream. And the idea that being able to work from home results in a mass exodus from cities into rural areas is even more ridiculous. There are social, cultural, and practical issues which limits an overhaul of how we view cities.

On the impact on real estate prices, post Covid-19, there would definitely be a change in how we utilise office space. But to simply conclude that commercial properties would become redundant would be too premature.

My view is that sprawling cities are here to stay. After all, as the saying goes, when it comes to real estate, it is always about three things: Location, location and location.

Do let me know your thoughts in the comments!

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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Why I Averaged Down on SATS (SGX:S58)

In early February, I bought SATS at $4.49. Back then, the Covid-19 situation seemed to be largely confined within China, with just a few cases in Singapore. I think at that point of time, most of us would have expected Covid to blow over fairly quickly, and be able to get on with our lives.

How wrong were we. And how wrong was I to initiate a position in SATS in early Feb. Over the next few months, with most countries imposing travel bans, air travel and tourism were completely decimated. By March, SATS’ share price had collapsed to around $2.50, more than a 50% decline from its 52-week highs.

When I bought SATS at $4.49 in Feb, in theory, it seemed a pretty straightforward strategy – Covid would surely affect SATS, but if we don’t know exactly how serious the impact would be, thus it’d make sense to dollar cost average. My purchase at $4.49 was my first tranche, and I had the ability to average down one or two more times if necessary. After all, Warren Buffett said that if one is a net buyer of stocks, then one should be happy that stock prices are falling, right? But in practice, when the entire market sells off, when you look at the US market swinging with 5% to 10% moves in a single day, and you look at your entire portfolio declining across the board, it’s not as easy to simply stick to your plan.

Now that things have cleared up a little, I’ve spent the past week looking at SATS again. Make no mistake, fundamentals have changed drastically. Passenger flights are almost non-existent – in April 2020, at grand total of 25,200 passengers passed through Changi Airport – a 99% decrease from a year ago.

Today, it is no longer about projecting revenue growth, or expecting SATS to even turn a profit in the near term. Instead, it is about survival – analysing whether SATS would be able to survive the Covid crisis and emerge stronger.

Here are the reasons why I believe that SATS would be able to survive the Covid crisis:

1. SATS’ profit guidance released in April estimated that they would suffer a 50 to 70m loss for Q1 FY20/21.

https://links.sgx.com/1.0.0/corporate-announcements/L5NKKF5YPBP061IE/b2c8c2b43d28e4026ca6b30064127d320bf1c8ee7b7b6a2eb7597f2c1c33ff20

The estimated 50-70m loss is “after taking into consideration grants received from governments”.

Given that this is for the 3-month period from April to June 2020, where we are already in full-blown lockdown with a complete ban on all tourists and transit passengers, I believe that this is as bad as it gets. The only passengers at Changi Airport are returning Singaporeans, or foreigners leaving the country. Which make up a grand total of 25,200 passengers.

Source: Changi Airport Traffic Statistics

https://www.changiairport.com/corporate/our-expertise/air-hub/traffic-statistics.html

2. SATS started off on a strong cash position, and has the ability to raise more debt

SATS last reported their financial results on 31 Dec 2019. As at 31 Dec 2019, SATS had 212m in cash and 103.6m in short term and long term debt, with a debt to equity ratio of 18%.

Note that the increase in debt to equity ratio from a year earlier was due to recognising changes from IFRS 16. For those with some accounting background, IFRS 16 is basically a silly rule that requires companies to recognise their long-term lease liabilities as a liability, instead of recognising them in their P&L each year. For example, if SATS leases an office for 10 years, then they would have to record these 10 years worth of future lease payments as a liability, which distorts the ‘true’ financial position, because it is not exactly a ‘debt’. Excluding the impact of IFRS 16, SATS noted that their ‘actual’ debt to equity ratio still remains at 6% as at 31 Dec 2019.

Subsequently, SATS announced that they completed the acquisition of Monty’s Bakehouse, for a total consideration of S$48.4m, which includes a deferred earn out consideration of up to S$18.3m. To simplify things, I’ll just assume that a total of 48.4m was paid.

SATS also announced their intention to raise S$500m thorough their MTN programme. To date, 300m has been raised, with 200m @ 2.88% p.a. and 100m @ 2.60% p.a., which I believe are reasonable borrowing rates and reflects the financial stability of SATS. The remaining 200m of notes have not been sold yet. Even if SATS were to raise up to 500m of debt, based on their total equity of c.1.8b as at 31 Dec 2019, their debt to equity ratio would rise to 30-40%, which is still reasonable to me. Hence, I believe that SATS can still tap the debt markets if necessary. Personally, I would be comfortable with a debt to equity ratio of up to 50-60%.

Therefore, if we were to estimate SATS’ cash level as of 31 March 2020, the ballpark figure would be 212m – 48.4m + 300m, which gives us a total of $463.6m. Of course, this is assuming that the quarter from Jan to Mar had delivered at least a net cash inflow, which is likely possible, because the effects of the travel bans only started in March. Hence, if SATS’ burns cash at a rate of 60-70m per quarter, they should still be able to last for at least more than a year. If 200m more is raised, their cash runway then increases to beyond 2 years.

3. Government wage subsidies and relief for rental & license fees

SATS currently benefits from some of the measures undertaken by the govt to alleviate the impact on the aviation sector:

75% wage subsidy for local workers, capped at a maximum salary of $4,600
Subsidies for retraining of workers for redeployment
License fees relief for ground handlers
Rental relief for ground handlers

Given that the average salary of SATS’ employees was $52,304 in 2019, it would be reasonable to assume that a sizable proportion of their workforce would be included in the JSS. The key assumption underpinning my analysis of SATS would be the continued subsidies from the govt. This is because SATS’ operating costs in an ordinary year is c.800m, hence without the various subsidies, it is likely that SATS’ losses would be far greater than the 50-70m they projected for Q1 FY2021.

In their profit guidance dated 30th April, SATS’ projection of a 50 to 70m loss for the quarter included the effects of govt subsidies, hence a major assumption of my valuation would depend on the continuation of these subsidies.

4. Food solutions and cargo flights are still operating

While c.65% of SATS’ revenue is derived from Singapore, mostly from Changi Airport, (some from Marina Bay Cruise Centre), the few bright spots for SATS would be that their food solutions segment and the handling of cargo flights are still in operation. Air freight volume has fallen by a lesser degree as compared to passenger volume, because cargo flights are still necessary for the import and export of goods.

Source: Changi Airport Traffic Statistics

Recently, there was also news that SATS has started catering meals for some of the quarantined foreign workers. This is positive for the company, although the returns from this would probably be rather insignificant, given that margins for food solutions tend to be lower.

5. Aviation remains a strategically important sector to Singapore

https://www.straitstimes.com/singapore/government-determined-to-see-sia-through-covid-19-crisis-pm-lee-hsien-loong

During PM Lee’s latest speech, he mentioned that aviation remains a strategically important sector to Singapore. “Air transport is fundamental to Singapore's role as a global and regional hub.” SIA is strategically important as our national flag carrier, and the govt has indicated their intention to ensure that SIA survives this crisis. SATS plays a crucial role in our aviation ecosystem too. Think about them as being similar to Boeing for the US or Airbus for Europe – strategically important companies that should be backed by the state during a crisis.

With Temasek being a major shareholder in SATS (39%), if things get really dire, would we see them take corporate action, similar to that for SIA? I don’t know, and I don’t wish to speculate.

Valuation

I used a simple DCF model to estimate SATS’ valuation. The assumptions are rather straightforward, and I didn’t want to dive too deep into the P&L projections because these are just ballpark figures.

The main assumptions are:

1. Covid lasts for 2 whole years – from FY2021 to FY2022

As SATS’ financial year starts from 1 Apr, that means 2 full years of losses (cash burn) from 1 Apr 2020 to 31 Mar 2022. Think of that – no overseas holidays until April 2022!

Beyond Apr 2022, hopefully, a vaccine is developed or we achieve herd immunity. Air travel returns to pre-covid levels for FY2023.

2. Cash burn of S$250m for FY21 and S$250m for FY22

I derived the cash burn based on SATS’ projected 70m loss per quarter – that implies a full year loss of 280m. However, this 280m loss would reflect the accounting losses, hence we have to add back depreciation, which is a non cash expense. For FY19, depreciation amounted to c.80m, which we will add back. Additionally, capital expenditures are assumed to be 50m for FY21 and FY22, on the assumption that capex would be scaled back due to the crisis. Hence, that gives us a cash burn of 250m per year.

Again, I want to reiterate that these assumptions are based on the expectation that SATS continues to receive govt subsidies.

3. Return to pre-Covid levels in FY23 (from April 2022 onwards)

Pre-Covid FCF was c.200m per year based on SATS’ annual report. The discrepancy between the FCF, OCF and Capex is mainly due to SATS only including ‘cash capex’ in their FCF calculations. Capex of 100m per year is assumed.

SATS Cash Flows from FY15 to FY19
Source: SATS FY19 Annual Report

4. Discount rate of 7.5% and terminal growth rate of 1.5%

To explain why I have chosen these inputs, the finance-y answer would be: Due to SATS’ historically low beta, their more efficient capital structure as a result of raising more debt, and in light of the lower interest rate environment going forward, a WACC of 7.5% is derived.

But the short answer would be: Just use any discount rate you’re comfortable with. For a comparison, DBS used a WACC of 5.7% and TGR of 3% in their SATS research dated 5 May 2020.

Conclusion

I have averaged down on SATS at $2.84, and it has become my second largest position, at an average cost of $3.41. I believe that the long term bet on aviation remains intact.

Additionally, it was reported that Changi Airport would start to allow transit passengers from June 2, after the circuit breaker ends, subject to strict measures. Hopefully, this would be the first small step towards resuming airport operations. I await SATS’ results by 31 July 2020 for greater clarity.

Additional details not covered in my analysis:

1. Upside potential: Projection of revenue growth was based on the assumption that passenger capacity at Changi Airport remains at 85m across 4 Terminals; the impact of T5 is not included, as I don’t believe that it can be meaningfully estimated. Hence, the DCF derived value for SATS may potentially be higher, if the increase in passenger capacity upon the completion of T5 is included.

2. Downside risk: Bankruptcy of airlines resulting in default of payments. SATS had $373.9m of receivables as at 31 Dec 2019. If certain airlines go bankrupt, SATS may have to write off some of the receivables owed by these airlines. Additionally, the solvency of SATS’ individual associates were not considered. If some of their foreign associates/ subsidiaries do not receive adequate government aid, they may be at risk of bankruptcies too.

If you are keen to learn more about SATS, do check out my other articles on the company:

1. How SATS earns its Revenue

2. Estimating SATS' cash burn

Note: As of writing, I hold a long position on SATS at an average price of $3.41.

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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Understanding Sheng Siong Group's (SGX:OV8) Financial Statements

I have mainly been writing about reits as real estate is an asset class which I understand well. For a change, I would be analysing the financial statements of Sheng Siong Group, a supermarket operator based in Singapore. Sheng Siong has evidently been one of the few companies to benefit from the Covid-19 outbreak, as supermarkets are classified as essential services and remain open during this period of lockdown.

From a financial standpoint, Sheng Siong has posted strong results for their first quarter of FY20, with revenue and net profit rising 30.7% and 49.9% respectively from a year earlier. These strong operating results meant that Sheng Siong was able to provide employees with an additional month of bonus – very appropriate, in my opinion, given the risk that frontline workers put themselves in.

I looked at Sheng Siong’s past 5 years of financial statements, from FY2015 to FY2019 to get a better understanding of the company’s business model, and how it earns its profits. Although we are probably familiar with Sheng Siong from a consumer’s perspective, looking at the individual line items in the income statements provides us with a better understanding of the factors that affects its profitability, and an idea of how Sheng Siong can continue to grow its business going forward.

Gross Profit Margins

Firstly, Sheng Siong’s gross profit margins have increased from 24.7% in 2015 to 26.9% during the past 5 years. This means that in FY2019, for every dollar of sales Sheng Siong makes, the items cost them around 73 cents. This steady improvement in gross profit margins may indicate that Sheng Siong is has increasing bargaining power when purchasing from its suppliers. This could be due to increase economies of scale, as Sheng Siong may be able to negotiate for better prices if they are purchasing larger volumes.

While gross profit margin of 27% is on the low side, given Sheng Siong operates in the consumer staples sector with little product differentiation, it is understandable that Sheng Siong would not have much pricing power when selling to customers.

Increasing its gross profit margins would be one way for Sheng Siong to increase its profitability. This could come in the form of higher mark-ups on their products, or lowering the purchase price from suppliers. The first option may be tough for Sheng Siong, as it operates in a highly competitive industry where consumers are price sensitive. If Sheng Siong were to increase the price of its goods by too much, consumers would simply purchase their groceries from other supermarkets for a cheaper price. Hence, the second option would be more practical, and further increases in gross profit margins may instead have to come from its purchasing strategies, to be able to negotiate for more favourable prices from its suppliers.

Operating expenses

As selling and distribution expenses and other expenses only constitute 0.8% and 0.3% of revenue respectively, there isn’t much to elaborate on these as their impact on profitability is minimal.

Sheng Siong’s Administrative expenses form the bulk of the operating expenses, at around 17.4% of revenue for FY2019. Looking at the 5 year trend for administrative expenses, it has been creeping up gradually from 16.4% in FY2015 to 17.4% in FY2019. This can be attributed to an increases in depreciation and manpower costs which make up the bulk of administrative expenses.

Drivers of Revenue Growth

Basically, Sheng Siong can grow its revenue in three main ways.

1. Same store sales growth

2. New store sales growth

3. Overseas Expansion

In the table above, I have compiled the growth rates for each of the revenue drivers from Sheng Siong’s annual reports from 2015 to 2019. In 2019, Sheng Siong did not provide a breakdown, except for noting that growth was mainly from the new stores opened in 2018 and 2019.

Sheng Siong’s growth has mainly been driven by new store sales growth. This may be more unpredictable, as it depends on Sheng Siong being able to consistently identify locations to open new stores. There is also the competition from other supermarket operators when bidding for new retail space from the HDB. Conversely, same store sales growth would be a more stable source of growth. Regarding overseas expansions, Sheng Siong has two stores in Kunming, China. These stores contribute to less than 2% of Sheng Siong’s revenue.

Free cash flows

The table above shows Sheng Siong’s free cash flows for the past 5 years. Free cash flows are calculated by deducting capital expenditures from operating cash flows. This indicates that Sheng Siong is able to consistently generate strong free cash flows for shareholders.

Capital Expenditures

I have complied Sheng Siong’s capital expenditures incurred from 2015 to 2019, and included the breakdown of each of the categories. In 2017, Sheng Siong did not provide a breakdown of their capex.

Capex had fluctuated from year to year, but if we were to focus on the capex on old and new stores, we get a clearer picture of the capex incurred to maintain and grow the business. Going forward, we can also estimate the capex required per new store opened, to get better visibility of Sheng Siong’s future capex, hence estimating Sheng Siong’s future FCF.

The main uses of cash are to purchase retail space for its stores, however, these are harder to forecast, as Sheng Siong can choose to either lease or purchase the retail space. Hence, the cash outlay of 30 to 50 million incurred for the purchase of three locations over the past 5 years should not be viewed as a recurring capex.

In summary, here are the positives and negatives of Sheng Siong:

Positives

Resilient to economic cycles: Operating in the consumer staples industry, Sheng Siong sells necessities which would be in demand regardless of the economic cycles. A good example would be the current recession; while most companies have seen their share prices hammered, Sheng Siong recovered after a brief sell off and has continued to hit all time highs.

Strong free cash flow generating business: As discussed above, Sheng Siong’s business has generated strong free cash flows for shareholders.

Risks

Low margin business: Susceptible to rising manpower costs. Given that Sheng Siong’s business model has low operating margins, Sheng Siong would have to manage its operating costs well.

Threat of e-commerce: A few years back when Amazon first entered the Singapore market, investors were concerned that Sheng Siong may face disruption from online grocery sales. However, a few years later, there seems to be little change in consumer spending habits, as Sheng Siong continued to post strong growth. Hence, the question that investors should ask would be whether consumer preferences for in-person grocery shopping would be likely to change anytime soon – will the Covid-19 lockdowns accelerate the switch towards home deliveries of groceries?

Increasingly saturated home market: Sheng Siong’s store count in Singapore has increased from 39 in end-2015 to 59 today, there are fewer neighbourhoods where Sheng Siong isn’t present. Hence, with the market becoming increasingly saturated, Sheng Siong would have to expand overseas for new growth areas. Currently, its China operations only contribute 2% of revenue, and could be a potential area of growth. However, overseas expansion brings about execution risks as well.

Conclusion

Sheng Siong’s business has definitely been doing well over the past 5 years, and the current situation has showed the resilience of its business. I hope this write up has provided investors with a clearer understanding of Sheng Siong’s financial performance.

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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Singapore REITs: Do Leasehold Land Tenures Matter for Valuations?

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:

https://www.straitstimes.com/singapore/housing/dont-assume-all-old-hdb-flats-will-become-eligible-for-sers-cautions-lawrence-wong

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:

https://www.straitstimes.com/singapore/housing/geylang-private-homes-to-be-returned-to-the-state-when-leases-expire-in-2020-no

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.

https://www.straitstimes.com/business/economy/singapores-industrial-land-supply-reduced-again-for-first-half-of-2020

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:

https://www.sla.gov.sg/state-land-n-property/land-sales-and-lease-management/lease-management/lease-policy

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.