Business Trusts, Reits And Shares Of Trust

Foreword from ShareInvestor

This article “Business Trusts, Reits And Shares Of Trust” by Mindy Tan and Ong Chor Hao was first published in The Business Times on 27 Nov 2013 and is reproduced in this blog in its entirety.

IT trades like a real estate investment trust (Reit), and often emulates its characteristics, but business trusts (BTs), sometimes loosely labelled the “poorer cousin” of Reits, operate very differently from Reits.

Broadly speaking, the key differentiating factors between Reits and BTs lie in their development restriction, gearing limit, and minimum distribution payout.

Taking development restriction as an example, Reits have a development cap of up to 10 per cent of its asset value. In addition, they have to maintain a minimum distribution of at least 90 per cent of distributable profits, which in turn grants the vehicle tax transparency. Finally, Reits have a gearing limit of 35 per cent of assets, and 60 per cent of assets if they have a credit rating.

On the other hand, BTs have no development restriction, gearing limit, or minimum distribution payout. Instead, these are bound by the trust deed, which many BTs have fashioned after Reits.

Croesus Retail Trust, for instance, has a development limit of 20 per cent. The trust, which is the first Asia-Pacific retail business trust with an initial portfolio located in Japan, listed in May this year. It intends to distribute at least 90 per cent of its distributable income, and its asset leverage limit is set at 60 per cent.

Perennial China Retail Trust on the other hand has undertaken to distribute at least 50 per cent of its distributable profit. Asset leverage limit has been set at 60 per cent of trust property; it does not have a development cap.

In these cases, the respective managers believe that having a higher development limit and higher gearing ratio would enable them to offer higher growth and upside through development.

The problem is that investors compare the yield of BTs with Reits, said Pua Seck Guan, executive director and chief executive of Perennial China Retail Trust Management.

“The problem we face today is that investors use yield to measure share price. So when you have development projects and you have growth, the market discounts it,” said Mr Pua.

Despite its apparent similarities – both distribute dividends on a regular basis – BTs were originally created to target infrastructure companies.

“The philosophy the regulator had when the BT regime was started, is to target infrastructure companies which have very high depreciation,” said Tan Kok Huan, managing director, asset-backed structured products, capital markets group, at DBS Bank.

“If you stay as a company, you can pay very little dividends because the depreciation would eat into your profits. Companies won’t pay more than accounting profits, as depreciation is an accounting expense. However, a trust allows you to pay more than accounting profits and that’s one of the key advantages of BT,” he said.

“At the end of the day, people looking at BT must understand and appreciate the underlying asset and business,” he added.

Interestingly, having a BT framework in tandem with a Reit framework is what enabled stapled hospitality trusts to list.

“(A) landmark project was in 2005, when we worked on the CDL Hospitality Trust. Reits are not supposed to have very operational assets. We studied how hotel Reits are structured in the US and had extensive discussions with regulators. In the end we chose a stapled structure, as we needed to consider the options available in the event there is no master lease,” said Jerry Koh, partner at Allen & Gledhill LLP.

Having a BT stapled to the Reit allows the BT to hold and operate the assets, or have a master lease between the Reit and the BT and have the BT operate the assets.

“Being able to use the stapled structure enabled us to undertake hotel Reits . . . We created something that was unique in Singapore to allow the hotel structure. That was significant,” he said.

For investors, knowing BTs from Reits, and discerning one type of Reit from another, is important.

When investing in hospitality Reits, investors should look at the rental formula under which the Reit is getting its cash flows, said Galen Lee, managing director, head of South-east Asian real estate, at UBS Bank.

“The less variability in a hotel Reit’s cash flows, for example by structuring a high fixed rent with a low variable rent component, the lower the risk in a hotel Reit. Conversely, a hotel Reit with a large proportion of cash flows tied to the operating performance of the underlying asset will be viewed by investors as being more risky,” he said.

“Investors should also look at what the managers of stapled securities are looking to do in terms of undertaking more development activities or leverage via the business trust side of the business, as this may increase the risk profile of the vehicle.”

For other Reits, investors should focus on the fundamental real estate portfolio, and take the mentality that they are buying a piece of real estate via the equity markets, said Mr Lee.

“For example, when property investors buy commercial properties they look at capitalisation rates (cap rates) as a key valuation metric,” said Mr Lee.

Cap rate is the net property income divided by the purchase price of the assets.

But given that the markets value a Reit through the capital markets, it is possible to compute its implied cap rates by dividing the Reit’s net property income over the sum of its equity market capitalisation plus its debt.

“This is because an investor who theoretically buys up all the Reit’s units and all its debt will own all the financial claims on the underlying properties. Investors can then assess whether this implied cap rate is attractive relative to other Reits and whether it’s in line with the cap rate prevalent for that asset class and geography,” said Mr Lee.

Taking this approach cuts through the differences between Reits, given that different Reits have different gearing levels, varying cost of debt, different fee regimes, income support and other structural differences. All of these factors impact a Reit’s distribution yield and risk profile.

“Investors will therefore look at other factors than just a Reit’s distribution yield when evaluating it.

Likewise they will need to look beyond whether an acquisition is yield accretive, especially if it results in excessive leverage or if the target property is a higher risk market,” added Mr Lee.

Investors should also be aware that by virtue of its makeup, Reits have a lower risk profile compared with other investment classes.

“Reits have no construction risk. They should be largely or fully leased out whereas a developer may end up building empty condos or offices and valuations can move quite sharply. So these two are very different animals. The fact that they are trading so closely means that investors are still seeing Reits as no different from a developer stock, which is not meant to be,” said Wen Khai Meng, chief executive officer, CapitaLand Singapore.

“This is a problem to the extent that managers react to investor demand. I’m supposed to be an income-producing stock, but my shareholders insist I must grow, so you are forcing a camel to run like a horse.

“But people forget the risk (of Reits) is also lower as the leases are locked in at least for a period of time. People look at returns and they forget about the risk.”