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Friday 27 August 2010

REITs. Simply explained! (3)

Read older posting? REITs. Simply explained! (2)

"If you are near the Temple of Cows and keep hearing a bunch of cowboys chanting the Sutra of Milk, soon you will become religious." - Createwealth8888

Before you become so enchanted by day and night of non-stop chanting of Sutra of Milk by the bunch of cowboys and then run out and put a load of money into these Cows, be sure you understand the risks that are involved. Milk can become sour. Cows may be infected by Mad Cow disease.
Rising Interest Rate Risk
There is only one way for interest rate to go now - UP!. It may not happen so soon but it will definitely happen - RISING interest rate is the way to go!
Most REITs will use leverage to maximize returns on their Cows. So it is degrees of leverages that make them different from each other. Like any other leveraged investment, rising interest means higher cost of borrowing for growth and higher refinancing cost for maturing debts. Rising interest rate will soon cause the milk to turn sour.

Rental Market Cycle Risk

Real estate property typically goes through a boom to bust cycle so there is a risk in using current rental income to value a REIT for its high yield.

What current tenants are paying may be more or less than current market rents. When the current leases expire, the company will have to negotiate current market rents.

When current rents are below market rents, that's known as embedded rent growth or loss to lease, because when the lease is renewed, rents will have to go up.

When current rents are above market rents, that's known as rental roll-down, because when the lease is renewed, rental income will have to go down.

So the current high yield for new buyers is never guaranteed but still depends on the rental market cycle. So there will be a period known as renters' market, and that is generally bad for REITs. Milk will turn sour or can even bad and cause their stock price to decline or plunge.

Potential Management Risks - Mad Cow Disease

What Ho Ching said at her speech on S-REITs?

First, I would like to reiterate the vital role that the boards play in protecting the collective interest of unit holders.

The importance of a strong and experienced board with a high level of integrity becomes even more critical, as more S-REITs venture abroad for more assets, or as more regional assets from different emerging economies and judicial regimes are listed here as S-REITs.

Normally, the role of a board is to guide and direct management, acting as an experienced guide, friend and mentor. To properly fulfill their fiduciary duty, it is wise for a board to keep a healthy distance from their management and not be held to ransom by their CEOs. It is crucial that boards have the courage to hire and fire CEOs. Their hardest test comes when they have to make hard choices between high CEO performance and core institutional values.

As the Chinese say, 居安思危 戒奢以俭 [ju an si wei, jie she yi jian]: “Watch for danger in times of peace, Be thrifty in times of plenty”. Without a culture of strong values and self restraint, success can lead to corporate hubris and CEO imperialism. Such hubris is often the seed of eventual disaster.

Next come the REIT managers. Apart from being real estate specialists with deep knowledge and experience in the market, trust managers must also be familiar with credit, financial, operational and regulatory as well as real estate and market risks. Financial transparency is especially important for REIT managers.

Fundamentally, the strength of any REIT lies not only in the physical and financial quality of its assets and tenants, but also the integrity and business acumen of its managers in extracting and enhancing embedded value from the properties. The greatest risks are the subsequent poor assets acquisitions. Individual managers may also change over time, and asset acquisition norms may deteriorate.

Without a sense of fiduciary duty and moral obligation to the unit holders, a trust manager may ramp up the portfolio size indiscriminately without due care or regard for quality and sustainable value of its portfolio. This agency problem is even more acute if the trust manager is paid based on a percentage of the value of the portfolio it manages, and the size of acquisitions it makes. An incompetent or negligent manager can also similarly store up future time bombs if they don’t understand the risks involved.

Let me illustrate with a few simple examples.

For instance, an irresponsible or incompetent trust manager could collude knowingly or unknowingly with financially troubled or desperate vendors. The latter needs cash and the trust manager needs more assets in order to earn more fees. The trust manager agrees to buy assets at highly inflated prices, and the vendor agrees to lease back the asset, also at inflated rents which are well above market rates. Prerequisite hurdle yields are technically met. And both the vendor and the manager walk away, happy to be “winners” in an apparently win-win transaction.

In such a situation, the losers are the unit holders. In substance, they would be sitting on a capital loss right from the start, as the purchase price consideration far exceeds the fair market or replacement value of the asset. They would also be unwittingly saddled with a much larger credit risk than appropriate.

Imagine what happens if the economy takes a nose dive, and the troubled vendor goes belly up. The trust manager would have to scramble to find replacement tenants. Rentals would realistically be much lower than the previously inflated level. The unit holders would be hit with a drop in distribution yield. The value of the asset in the trust will similarly take a serious beating.

Thus, in reality and substance, the trust manager would have destroyed value, through deliberate fraud or through incompetence, by poor asset acquisitions. In the worst case, poorly supervised REITs may even evolve into a nasty pyramid game for crooked managers.

Another potential way to circumvent short term investment hurdle rates is to defer issue of trust units to the future in an asset purchase. This may make the investment case look better initially. In reality, the pain will come later.

Such charades shore up short term performance indicators at the expense of longer term pain. Worse still, they leave little buffer for the REITs to weather future storms. If, for whatever reason, rental rates cannot improve or asset enhancements fail to raise operating income, such deferred financial burdens could become very painful for the unit holders.

It is therefore vital that unit holders are made aware of the possibility of subsequent dilution of distribution yield. They need to understand the true all-in economic cost of any acquisition, and not be taken in by the initial understated costs.

In substance, such deferred capital payments may be nothing more than a form of shareholder’s loan. If so, they should be captured in the trust’s gearing ratio at the point of purchase commitment. Not doing so allows a trust to circumvent the prevailing 35% gearing cap imposed by the regulators.

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