If you have been closely observing the S-REIT market recent years, you will notice there is an obsession by REITs to grow. This can be seen from the flurry of mergers that have happened / are going to happen like the Ascendas Hospitality – Ascott merger, OUE Commercial – Hospitality merger and ESR – Viva Industrial Trust merger. If they’re not doing mergers, they are looking to acquire properties, with too many examples to mention here.
Given all these activity, it feels like a right time to explain this phenomenon and what it means for the S-REIT sector.
Why does size matter?
The most simple way to explain this is that once a REIT crosses a certain size threshold, REIT managers have a easier time at their job. Reaching that threshold sparks a virtuous self-sustaining path to further growth. Let’s go through this path step by step.
1) Institutional Interest
Institutional investors like funds tend to have minimum size and liquidity requirements before they would even consider your REIT for their fund. To illustrate, let’s take a look at the entry requirements for the FTSE EPRA/NAREIT Index, considered the gold standard for Real Estate / REIT indices, as a indicator of what institutional investors look for in a REIT.
As you can see, there are minimum size (or market capitalisation) and minimum liquidity requirements that REITs have to satisfy. This is for good reasons too, as if the REIT is too small, a big fund buying/selling the REIT can cause seismic shifts in the unit price.
As such, a REIT needs to attain a considerable size with a market cap of about 1.5 to 2 billion before institutional investors will even start to consider them as a viable investment. I’ll explain why this is important next.
2) Premium REIT Valuations
Once you get institutional investors on board, you will start to see these REITs be given premium valuations.
A prime example is the meteoric rise of Frasers Logistics and Industrial Trust after it joined the FTSE EPRA NAREIT Development index in March this year,
The mere increase in institutional interest led to a revaluation of a REIT upwards. Here is a list of Price to Book ratios from some of the largest S-REITs in Singapore.
As you can see, most of these large cap REITs trade at massive premiums to book, which helps reduce the cost of capital for REIT managers.
3) Lower cost of capital
As you may know, REITs grow inorganically by borrowing money or issuing equity in order to raise funds to purchase new properties. As you grow bigger, the cost of borrowing money (in the form of interest) and issuing equity (in the form of distributions) is usually reduced. Let’s study each aspect individually.
a) Cost of Debt
As a small REIT, you are seen as less diversified and more risky. 1 tenant shifting out naturally has a more significant impact on a small REIT than on a large REIT. As a result, you are quoted a higher interest rate generally. Growing bigger tends to reduce cost of debt which in turn will lead to higher DPUs.
b) Cost of Equity
As you saw earlier in the previous section, large REITs tend to be valued at a premium to book. This in turn leads to low distribution yields. Low distribution yields encourages REIT managers to use equity to raise funds as the cost is very low.
To elaborate, if you issue equity that yields 4%, it is like a commitment to pay the investor 4% annually in the future. Compared to issuing equity at 8%, this is much cheaper.
4) Easier to find accretive acquisitions
With low cost of capital, it is much easily to find yield and NAV accretive acquisitions. This is because the bar you need to clear is much lower as indicated in the diagram. This ease helps to sustain growth in the REIT.
5) Ease of Raising funds
This point plays into a combination of the fact that institutional investors are able invest in the REIT while also having a lower cost of capital. Tapping into institutional funds is much easier and faster than tapping on public market funds.
If you were to raise equity from the public markets, you would need to serve notice to investors on a EGM, convene a EGM to seek approvals, launch the rights issue, give unitholders time to sell their rights if they wish, give rights holders time to exercise the rights before finally closing the deal. The whole process can take months, by which time the opportunity may be gone.
Contrast that with private placements with institutional investors, where you can launch the private placement and close it within the same day.
The other point to note is that rights issues tend to have deep discounts of 15-30% off current share price due to underwriter demands. As such, rights issues have a high cost of equity. All this can be avoided by private placements which typically have a smaller discount of between 5-10%.
6) Ability to perform development work
If you are familiar with MAS Regulations on REITs, you will know that REITs are only allowed to perform development work for up to 10% of the value of its deposited property.
If you are a small REIT, the amount of development work you are allowed to perform is usually tiny. You are probably allowed to perform small asset enhancements and that’s about it. Greenfield developments or major redevelopments of existing properties are probably out of your league.
Only when you’re big like Capitaland Mall Trust will you be able to undertake a major redevelopment project like Funan (pictured above). Having this option can be a useful tool for REIT managers to unlock value from properties that have under utilised plot ratios.
7) Minimise impact of redevelopment / asset enhancements
Related to point 6 is that size mitigates the impact of asset enhancements / redevelopment on DPUs.
Picture a REIT with 10 identical properties that contribute equal amounts of rental income. If 1 of those properties were brought offline for redevelopment, the REIT’s DPU will drop by 10%. A much larger REIT with 20 identical properties will only see a 5% drop in DPU by comparison.
This gives larger REIT managers more wriggle room to perform redevelopment works without severely impacting DPUs while a property is under redevelopment.
All these knock-on effects can be achieved simply by growing to a considerable size, thus its attractiveness to REIT managers.
Implications for the S-REIT sector
We are already seeing the effects on the S-REIT sector through 2 phenomena.
Widening gulf of valuations between large and small cap REITs
The neverending rally on large cap REITs like Capitaland Mall Trust and Mapletree Industrial Trust is placed in stark contrast to limited gains of small cap REITs like IREIT Global and EC World REIT.
Increases in REIT Mergers and Acquisitions activity
As mentioned earlier, rarely a week goes by nowadays where there are no news on REIT M&A.
Implications for Investors
I have obviously benefited hugely from the S-REIT rally this year as I happened to invest in some of the larger cap REITs and have thought of selling them off.
Large Cap REITs
After much thought, I feel that as long as these large cap REITs are trading at a premium and continue to be good custodians of my money, I will not sell. This is because they already have the critical mass and fundamentals necessary to grow the REIT on their own. They will eventually grow into their valuations as a result.
That said, I will not add to them at current prices.
Mid Cap REITs
It is the mid-cap REITs that are trading at a slight premium that are the most interesting investments. If these REITs play their cards right, they have the potential to grow themselves onto the radar of institutional investors and join the large cap hype train. They are also not trading at very over-stretched valuations at the moment thus offering some opportunity for investors to belated join the hype train.
This thesis has been playing out for 2 of my holdings – AIMS APAC REIT and Manulife US REIT recently as I see them edging up on little news..
Small Cap REITs
It is the small cap REITs that are trading below book value that I feel investors should be concerned with,. They will likely continue to languish in obscurity and will need something drastic happening like being acquired by a larger REIT to ever shake them out of their slumber.
My concern is that the potential for a drastic event has increased over the past year. it is also uncertain if it will be beneficial for investors. We have seen a merger of OUE Commercial REIT and Hospitality Trust that, in my opinion, was driven purely out of a desire to grow big at all costs. This is seen by the value destruction OUE Commercial REIT investors faced as part of the merger.
I certainly hope this sort of merger is one off and not something other REITs will look to emulate.
What are your thoughts on this trend of increasing REIT size?