We look at the determining factors and valuation measures for a Reit, but bear in mind that valuing a Reit is far more art than science. By Bobby Jayaraman
DONALD Trump started off in real estate developing residences in Manhattan in the 1970s when New York was on the brink of bankruptcy. Li Ka Shing scooped up property dirt cheap during the 1967 riots in Hong Kong. The late Ng Teng Fong of Far East Organization was the king of Orchard Road in the 1980s.
All these tycoons made fortunes when the value of their investments grew multiple times. However, it is unlikely they invested on the basis of a valuation from a property consultancy! So what is it that drives growth in asset values? And is it possible to value assets accurately?
The noted economist John Maynard Keynes was thought to have observed that
it is better to be vaguely right than precisely wrong. Investors would do well to keep this in mind when reading reports by analysts and valuers. Their neat Excel spreadsheets make it appear that valuing a Reit (or real estate investment trust) is a perfect science. In reality, it is far more art than science.
Following are the common measures of valuing a Reit:
Discounted cash flow: A discounted cash flow (DCF) analysis assumes a certain rate of growth in cash flows over a certain period. This is then discounted back to their present value at an appropriate interest rate that reflects the weighted average cost of capital (WACC) of the Reit.
Book value: This method attributes a certain discount or premium to a Reit's book value (book value or revised net asset value is the latest valuation of all the properties owned by the Reit minus its liabilities).
Cap rate or yield: The annual net property income (NPI) is capitalised at a certain yield thought to be appropriate for the Reit.
While all the above methods are intellectually correct, they are not of much use to an investor if the fundamentals behind the assumptions are not clearly understood. I believe it is far more important to understand the factors that drive valuations rather than obsessing about precise values churned out by financial models. The long-term value of a Reit is driven by the following fundamental factors:
- Potential for capital value growth
- Sustainability and growth of rental income from the properties
- Capital structure of the Reit and the calibre of its managers
Let's delve into each of these factors in greater detail.
Capital values
Let's say you bought some units in CapitaMall Trust (CMT) and are wondering whether the asset values will keep appreciating the way they have mostly done since the Reit was listed in 2002.
If the Reit's assets appreciate in value, that would increase CMT's book value and thus its unit price. The question then is what factors would make CMT's portfolio of suburban malls worth more in the next 10 years.
There are several factors that need to be in place for the malls to appreciate in value. A key factor is whether the trend of suburban shopping will continue since this is what has driven strong demand from retailers for mall space. It was the high occupancies and rentals at suburban malls that drove up capital values in the past decade.
Is it likely that this trend would diminish in the years to come? No one can answer this with certainty, so the investor needs to form his own opinion.
On the supply side, the investor would need to form a view on the potential for new supply and the government policy regarding releasing land for malls in the suburbs.
This question can be answered with a good degree of conviction if an investor does his homework, ie, studying the potential land marked for commercial development in the suburbs, and history and pattern of commercial land released in the past. Were there cases of over-supply in the suburbs in the past? If so, what led to it? Was the catchment area not large enough? Can this happen in the future?
Another factor is replacement cost. Can a new mall be built in the future at a cheaper rate? Unlike the high-tech industry where new technology has historically led to lower costs for components and gadgets, real estate is a fairly staid industry where construction costs usually trend upwards, driven by the increasing cost of labour and materials. So the cost element is unlikely to lead to big surprises in the future.
This is not an exhaustive list and there might be several other factors depending on the specific Reit. However, the general principle is the same:
Understand the factors that lead to capital appreciation and you will gain good insight into the valuation of a Reit.
It also makes sense for an investor to keep tabs on transacted values of properties not only in Singapore but globally at different stages of the economic cycle. When comparing valuations keep in mind that the specific nature of the transaction - whether a competitive bid or a forced sale, etc - will have a major impact on the transacted values.
Rental income
Many investors own property for its ability to generate steady income whatever the economic cycle. The ability of the property to attract tenants is directly linked to its valuation.
The capitalisation rate (or cap rate) is the annual net operating income divided by the capital cost. The cap rate denotes the income-generating ability of the property. It depends on: a) the risk-free rate which, for Singapore, is the 10-year SGD bond; b) the risk premium investors assign to real estate, which is heavily influenced by macro conditions and the prevailing market sentiment; and c) the income growth that investors hope to achieve through real estate.
The cap rate can thus be depicted as (a+b)-c. The trouble with this formula, as you might have already guessed, is that both risk premium for real estate and income growth potential are highly subjective and can change by the day.
In the early 1980s, when the US was suffering from high inflation, the cap rate of 8-8.5 per cent was even lower than the 10-year US government bond rate of 10-12 per cent as investors anticipated strong capital gains due to continued inflation.
In contrast, cap rates in 2009 had moved up to about 10 per cent even in a sub-one per cent interest rate environment reflecting the high risk premium that investors were placing on real estate. This illustrates the highly cyclical nature of cap rates.
The average cap rate in the US historically has been around 7.5 per cent and the average spread over the 10-year bond has been around 250 basis points. In Singapore, the 10-year bond yield over the past decade has been about 3 per cent and cap rates have been in the 5-6 per cent range.
These benchmarks are important to keep in mind. If you are buying a high- quality asset at cap rates of 5-6 per cent it is a fair bet that you are not paying too much. What if you are buying at a 3 per cent yield? In this case, you are banking on income growth which is much riskier.
Calculating cap rates using next year's NPI only works if the rentals are sustainable, so an investor needs to understand the factors that drive the sustainability of rentals. This assessment requires a good sense of supply and demand for the type of property that a Reit owns as well as an understanding of global benchmarks and trends in the particular sector.
For example, office rentals of around $6 per sq ft per month (psf pm) in 2009 made Singapore the 24th most expensive office location globally (as per Colliers second-half 2009 survey of 154 cities globally) while Hong Kong was the most expensive.
Given that Singapore is a major Asian financial centre, this certainly made the city very competitive and one could have made a reasonable assumption that office rentals of $6 psf are sustainable (if not close to bottoming out).
In the case of retail Reits, occupancy costs (rental costs divided by sales turnover) are also a good indicator of sustainability. A good level is around 12-15 per cent, and the lower it is the better.
Similarly in the hotel sector, Singapore's current deluxe hotel rates of US$150-US$170 a night compare well with those in other global cities and a healthy increase from current levels looks to be quite sustainable.
One mistake investors should avoid is to blindly extrapolate current rentals into the future. For example, rentals for Orchard Road malls peaked in 1990 at $60 psf pm. Twenty years on, despite strong GDP growth, rentals today are around the $30-$35 psf level!
The main reasons for this were the emergence of suburban malls and slow growth in tourist spending. This underscores my point: Focus on the fundamentals and trends and not on predicting precise numbers.
Reit capital structure and management
Asset values and rental growth can be quantified and directly impact a Reit's valuation. However, that does not mean one should ignore qualitative factors just because they cannot be put in a financial model.
Keep in mind that a Reit is not just a collection of physical assets but is operated by managers. It is precisely the ability of management to add value to the assets that makes the Reit model attractive.
Three qualitative factors in particular are important in valuing a Reit:
Leverage and interest coverage: We discussed this in an earlier article, so all I will say here is that one should tread carefully if a Reit has low interest coverage as it can easily run into trouble if rentals drop. An investor should be convinced that rents are sustainable before committing to such a Reit.
Ability to raise financing: Reits that can raise financing from a variety of sources deserve a premium, as you can sleep peacefully knowing that banks and investors believe in the Reit.
Management calibre: If the management is able to consistently increase values through asset enhancement, prudently acquire assets, and consistently deliver growth in distribution per unit (DPU) without taking undue risks, then it also deserves a premium.
What about acquisition-led growth? Doesn't that also deserve a premium? Yes, a truly yield-accretive acquisition is a big positive, but my advice to investors is not to pay for this beforehand.
Don't buy a Reit which has already priced in acquisition-driven growth. This is one of the most frequent causes of disappointment as growth through acquisitions is the most risky route and only works during depressed times.
A particularly risky time for acquisitions is the current period where interest rates are abnormally low. This tempts many Reit managers to borrow cheaply to acquire. However,
the 'yield accretion' in such cases comes from low interest rates rather than attractively priced assets. As such, the accretion will likely disappear with the next refinancing.
To conclude, there is no single formula or model where you can plug in all the variables and get a precise valuation. One needs to understand a variety of factors to get a sense of a Reit's valuation.
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