In March this year, I wrote about
the possibility of REITs having to raise capital through rights issues if Covid-19 were to cause severe declines in asset valuations (What Happened to REITs during the GFC?). Eight months on, this has
not occurred, and although I believe that the likelihood of this has diminished, we cannot completely ignore it. In October, I initiated a position in
Capitaland Mall Trust (CMT) at a price of $1.91, which has now merged with
Capitaland Commercial Trust (CCT) to form Capitaland Integrated Commercial
Trust (CICT). As a shareholder, I was curious to assess the likelihood of CICT
having to raise capital through a rights issue, by analysing its gearing ratio
and asset valuations.
I have not ran the numbers to
determine the gearing ratio of the merged entity, although Kah Kiat at Dr
Wealth has calculated that the pro-forma gearing for CICT would be 38.3% post-merger.
However, these figures were calculated based on the valuation of CMT’s and
CCT’s assets as of 31 Dec 2019. Thus, it would be appropriate to note that as
of 30 June 2020, CMT’s portfolio valuation has declined by around 2.7%, while
CCT’s portfolio valuation has declined by 1.7% (refer to screenshots below). Thus, the gearing ratio of the
merged entity would be slightly higher than the 38.3% calculated as of Jan
2020.
Given that we’re in the midst of a global pandemic that has resulted in an economic fallout rivalling the Global Financial Crisis in 2009, I decided to take a look into history to understand how CMT’s and CCT’s asset valuations were impacted during the GFC. As I had written in my previous article, CMT and CCT both had to undertake rights issues at heavily discounted prices, which resulted in existing shareholders being severely diluted if they did not participate in the rights issue. CMT undertook a 9-for-10 rights issue in Feb 2009, raising $1.23 billion through rights priced at $0.82 per unit, a discount of 43% to the closing price of $1.45 per unit. CCT undertook a 1-for-1 rights issue in May 2009, raising $828 million through rights priced at $0.59 per unit, a 44.3% discount to the closing price of $1.06. The rationale provided for the rights issues were to reduce leverage and strengthen the REITs’ balance sheets.
I went through both CMT’s and
CCT’s quarterly financial statements from 2004 till 2011, to get a deeper
understanding of the economic climate leading up to the GFC, the turmoil during
the GFC itself, and the recovery post-GFC. In particular, I was curious to
analyse how the valuations of the REITs’ properties had changed during the
entire period, and how excessive leverage was a double edged sword that worked
well in good times, but detrimental to the REITs during the crisis. What I have
found was pretty interesting, and I have summarised my takeaways below. On a
side note, I just want to add that the Powerpoint slides back in those days
were indeed hideous.
Irrational exuberance leading up
to the real estate bubble: My first observation was that the run up to the GFC
was indeed a crazy period. Asset valuations had increased by double digits over
6-month periods – just look at that increase in valuation of 35.1% for CCT’s
Capital Tower (Currently occupied by GIC, JP Morgan and Capitaland) from Dec
’06 to Jun ’07. To compare that against our current situation, I don’t think
there has been a run up in valuations of a similar scale relative to pre-GFC,
thus a spectacular fall in real estate prices may be less likely. Nonetheless,
even without the irrational exuberance causing a real estate bubble, we have to
be cognizant of the demand side shock affecting certain classes of real estate,
which may drive valuations down.
Acquiring properties during the
initial stages of a crisis is generally a bad idea: As seen from the valuation
figures, real estate prices are generally a lagging indicator of a crisis.
Stock prices adjust downward much faster to negative future expectations as
compared to illiquid assets like real estate. Thus, there is the likelihood of
overpaying for real estate when making acquisitions during the initial stages
of a crisis. For example, CCT’s share price peaked in May ’07, and by Jun ’08
had fallen significantly from its peak. Yet, the valuations of CCT’s assets
continued to climb, as seen from the broad increase in valuations across all
properties from Dec ’07 to Jun ’08, which was when the asset valuations peaked.
Acquisitions made during the GFC proved
to be poor deals, as evident from the valuations of One George Street and
Wilkie Edge by CCT, and the acquisition of Atrium@Orchard by CMT. The
valuations of these properties declined significantly after they were acquired,
thus on hindsight, if the REITs had waited a year or two, they might have been
able to acquire these properties at much more attractive valuations. Thus, for
REITs which have been going on a shopping spree recently (think of private
placement/preferential offerings from Ascendas REIT, MLT and FCT), I am
skeptical as to whether this is the right strategy.
Gearing and access to credit has
to be viewed together: CCT’s gearing increased from c.30% in Dec ’04 to 42.3%
in May ’09, just before it raised equity to deleverage down to 31%. On this
point, I am not exactly sure on the urgent need to deleverage at that point of
time in May ‘09. From my understanding, before 2015, MAS’ rules for REITs was
that gearing was capped at 35%, but allowed up to 60% for REITs with credit ratings
from Fitch, Moody’s or S&P. CMT and CCT had ratings from Moody’s, thus
would have been able to leverage up to 60% of their asset value. Thus, with
their gearing ratios at 42-43% in early 2009, I am unsure of the urgent need to
deleverage through rights issues.
My guess is that it was a
combination of two main factors – 1. It was extremely difficult to refinance existing
debt during the GFC, as banks were wary of extending credit to REITs when the
global real estate market was crashing. Thus, CMT and CCT had to raise equity
to pay off the debt. 2. Perhaps REIT managers expected the sharp decline in
asset valuations to continue (as seen from the double digit declines in asset
values in ’09), thus they wanted to pre-empt this (even though their gearing
was some distance away from 60%) in order to stay within MAS’ gearing limits.
During the GFC, I was still an
oblivious primary school kid, so perhaps if you’ve invested through the GFC and have better insights on the need
for REITs to deleverage during that time, please let me know in the comments
below, or feel free to drop me a direct message on my Instagram page and we can
have a chat. Would greatly appreciate any additional insights on this matter!
Retail properties more resilient
than office properties: As seen from the changes in valuations for both CMT’s
and CCT’s portfolios, CMT’s assets only recorded one period of decline in
valuations, from Dec ’08 to Jun ’09. Whereas CCT’s portfolio was hit much
harder, with asset values falling >20% from ’08 to ’09. To compare that
against CICT’s current gearing and asset valuations, assuming CICT has a
gearing of 40% currently, asset valuations would have to decline by 20% for it to
breach MAS’ gearing limit of 50%. Going by history, the risk may be greater for
office properties instead of retail properties. Of course, we are in an
unprecedented pandemic, and the impact on retail and office properties may
still surpass that of the GFC.
Closing Thoughts
I think a key distinction to make
between the GFC and our current situation would be that the GFC was primarily a
real estate bubble that led to a financial crisis, whereas what we are
currently facing is a demand side problem cause by movement restrictions due to
Covid-19. Of course, there is the possibility of the domino effect causing a
real estate crisis, especially for sectors such as hospitality, retail and
office, whereas sectors such as logistics and data centres have been doing
well.
A mitigating factor for CICT
would be that the enlarged asset base provides some form of diversification, as
retail properties have shown to hold their assets values better than office
properties during the GFC. With regard to the impact of WFH policies on commercial
property valuations, my view is that the downside would be limited. As we have
seen, tech firms have still been taking up prime office space in the CBD, and
ultimately, I believe that there would be some form of equilibrium between WFO
and WFH. Offices would not be redundant so soon. Additionally, as I have written
in my previous article – Will
WFH change real estate trends? – I believe that the land that commercial properties occupy still
hold significant value. As we have seen from the redevelopment of Funan Mall, integrated
developments seem to be the way forward, and office properties may potentially
be converted to integrated developments (subject to zoning restrictions) if remote
working does indeed threaten the existence of office buildings.
To conclude, with CICT’s gearing level at approximately 39%, I am slightly concerned as it is a relatively high level compared to its historical average. Recently, we have seen FCT using part of its $575m raised from its private placement to pay of a $325m revolving credit facility and an $80m bank loan. Personally, I would prefer that the REIT manager acts to reduce CICT’s gearing ratio, perhaps via a private placement to reduce its debt position slightly, even though the MAS gearing limit for REITs was recently increased from 45% to 50%.
If you've read to this point, and are still keen to learn more about REITs, I have written two other posts about Singapore REITs here:
2. Do leasehold land tenures matter for valuations?
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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