2019 could be characterised as the year of the S-REIT. A combination of low interest rates and record high S-REIT valuations drove a flurry of REIT mergers and acquisitions. It also led to 4 REITs deciding to list themselves in the past year on the SGX.
As such, it is no surprise we begin 2020 where 2019 left off with yet another REIT IPO. The latest challenger is Elite Commercial REIT (ECR) with an offering of mostly freehold offices in the UK.
Suffering from REIT IPO fatigue yet? If not, let’s take a look at this offering together.
Here is a brief overview of the offering details based on the term sheet seen by the Business Times:
- The IPO Price will likely be £0.68
- There will be 175.7m – 192.9m units on offer in total. 92.9m – 109.3m units is reserved for the placement tranche and 77.8m units going to cornerstone investors. This leaves only 5 – 5.8m units for the public tranche, which is very small.
- This implies a market capitalisation of £214.5m to £226.2m, which makes ECR a small cap REIT.
- Applications are expected to open on 28 January and close on 4 February.
The preliminary IPO prospectus can be found here.
The IPO portfolio consists of 97 office properties spread across the whole of the UK. 96 of them are freehold properties, with only 1 of them with a remaining lease of 235 years.
The properties are mostly small office buildings with 2-4 floors which mainly serve as benefits service centres for the UK Government. Eyeballing the valuation reports provided, most were first constructed between the 1960s – 1990s.
The properties are generally well located within city centres and close to public transportation and highways.
The Only Tenant
The IPO Portfolio is 100% occupied, of which 99% is leased to the UK Government, specifically the Department for Work and Pensions (DWP).
80 of the 97 properties serve as Jobcentre Plus centres. These centres administer a range of social services like pensions, unemployment and disability services to the public. The remaining 12 properties serve as back office and call centre functions for the DWP.
While single tenant risk is present, this should not be a problem due to the following factors:
- The tenant is effectively the UK Government and backed by sovereign debt.
- The offices form part of important public infrastructure
- DWP is a uniquely counter cyclical tenant whereby footfall to its Jobcentre Plus locations increases during economic downturns.
The only issue I can foresee is policy changes that may affect the need for pension and other public services, something which I think is quite remote for now.
Lease Expiry and Characteristics
The IPO Portfolio has a long weighted average lease expiry (WALE) of 8.6 years by gross rental income (GRI). However, do note that most of the properties have a break option in 3.6 years time. If the options were assumed to be exercised, the WALE would drop to 4.89 years.
The REIT manager feels that 80-90% of these leases should not experience early termination though, as the UK Government need these offices to provide crucial social services to the public.
The leases include contractual annual step-ups based on Consumer Price Index (CPI) increases, with a collar of 1 to 5% annually. This means that rents should increase at a minimum 1% annually with a maximum of 5%.
Another thing to note is that the leases are let on a triple net basis, with the tenant responsible for repairs and insurance costs.
Overall, quite favourable lease terms that will provide income visibility for investors at least over the next 4 years. The key issue is the potential early termination clause, which for now is assessed to be a remote possibility.
Brief Portfolio History
The IPO portfolio was acquired from British property developer Telereal Trillium by the Sponsor in November 2018 for £282.15m. The property portfolio was parked under the Elite UK Commercial Fund I.
Now, with the upcoming IPO, the Sponsor is bringing these properties public as Elite Commercial REIT only 1 year later. The adopted valuation of £319.1m represents a return of 13%.
The properties have an adopted valuation of £319.1m, which is the valuation prepared by Colliers as at 31 August 2019.
Inspecting the valuation report, the following assumptions used by Colliers.
- Valuation Method – Market and Investment Approach
- Exercise of termination option – Assume 50% of leases will exercise early termination
- Portfolio premium – 9.6% over value of individual assets
For reference, Knight Frank provided a valuation of £300.1m with using the Market and Investment Approach as well. They were not as specific in specifying their other assumptions.
Comparing current rent and market rent provided by both valuers, you can tell that the portfolio’s current rent is greater than market rent.
|Valuer||Current Rent (£)||Market Rent (£)|
As such, the portfolios may be more richly valued compared to their actual fundamental value.
The Sponsors of the REIT are a trio of Elite Partners Holdings, Ho Lee Group and Sunway Re Capital. This is an interesting combination as Elite Partners provides the REIT management skills while Ho Lee and Sunway bring capital to the table.
Elite Partners Holdings is an alternative investment firm based in Singapore founded in 2017 by Victor Song (ex-CEO of Viva Industrial Trust), Chiew Chuan Jin and Charles Hoon. It has over S$1b of assets under management and managed the IPO Portfolio under the Elite UK Commercial Fund I.
Ho Lee Group is a Singaporean private construction firm. It had previously served as the major sponsor of Viva Industrial Trust.
Sunway Re Capital is the investment arm of Sunway Berhad, a Malaysian property conglomerate involved in property development and investment.
The Viva Connection
As you can see above, there is a strong Viva Industrial Trust (Viva) connection between its key sponsors, Elite Partners and Ho Lee Group.
Elite Partners counts former Viva CEO Victor Song as one of its founders. Ho Lee Group was one of Viva’s major sponsors. Also, Ho Lee Group’s executive director Michael Tan is executive Chairman of Elite Partners.
As a relatively young fund management firm founded in 2017, it has no public track record for reference. Due to the Viva Connection, perhaps it is useful to examine Viva’s performance from listing till merger with ESR REIT as a proxy for management / management competence.
Viva’s track record
Viva IPO-ed in 2013 at issue price of $0.78. Its final price prior to merger with ESR REIT in 2018 was $0.905. This represents a CAGR of about 3% over 5 years. If you add its high distribution yield over the period (no reinvestment), you get a return of 13.7% per annum.
That is some pretty decent returns. Some caveats to this:
- Viva’s property portfolio had very short land leases which drove the high yield.
- Viva merged with ESR REIT in 2018, which may have artificially driven up the unit price of Viva prior to the merger.
I couldn’t find much blogger coverage of Viva, probably because most of them shunned this high yielder. AK from A Singaporean Stocks Investor (ASSI) did highlight the short land leases and management’s curious acquisitions with even shorter land leases.
Given these facts, let’s say for now that Elite Partners and Ho Lee Group are average REIT managers and sponsors.
Potential Right of First Refusal (ROFR) Assets
One key benefit of having a Sponsor is the ability to tap on their expertise and pipeline of properties to grow the REIT. The 3 sponsors have each given a ROFR to ECR on any disposal of UK commercial properties.
The only explicit portfolio that is the ROFR given by Elite UK Commercial Fund II to ECR. It is described to be a portfolio of 62 commercial buildings that is leased the UK Government. These buildings were not included in the IPO portfolio as the acquisition of these buildings were only closed by Elite Partners Capital on 30 December 2019.
A quick Google search only yielded an article in MorningStar confirming the sale of 19 regional offices to Elite Partners Capital for GBP65m on 31 Dec 2019. Not much further detail is available on the properties in the pipeline.
I guess investors can expect more regional offices rented to the UK Government in the future.
The REIT employs a fee structure similar to most of 2019’s REIT IPOs:
- Base management fee: 10% of annual distributable income
- Performance management fee: 25% of annual DPU increase
- Acquisition fee – 1% of acquisition value
- Divestment fee – 0.5% of divestment value
- Lease Management Fee – 1% of Property Revenue
- Lease commissions
- 1 month of rent for lease terms exceeding 3 years
- 0.5 month of rent for lease terms less than 3 years
- 0.25 month of rent for leases secured through 3rd party agents
The fee structure has some alignment of interest by having a performance fee tagged to 25% of annual DPU increase.
The REIT Manager has undertaken some minor financial engineering to support IPO forecast yields. It has opted to take all its base and lease management fees in units for 2020 – 2021.
Additionally, the REIT Manager has undertaken that performance management fees will not be payable till 2022. These measures help to support DPU in the initial IPO period.
The other thing to note is the lease management fees and commissions payable to the REIT Manager. These fees are not unheard of for S-REITs but not all REITs have them.
As the prospectus is still preliminary, I had to manually estimate the unit holdings of the various investors post IPO.
The percentages presented is calculated based on a total unit base of 315.4m – 332.6m, derived by taking the post IPO market cap divided by IPO unit price of £0.68. It also assumes that Private Trust investors choose not to subscribe to the private placement tranche and there’s no overallotment option exercised.
|Sponsor & Related parties|
|Ho Lee Group||11.52%||12.18%|
|Other Private Trust Investors|
|Kim Seng Holdings||8.62%||9.09%|
|Sing Lun Industrial||2.21%||2.33%|
|Private Trust Total||21.55%||22.72%|
|Cornerstone Investors (Private Banking clients)||23.40%||24.68%|
As you can see, there is weak institutional support for this IPO, with mainly private banking clients and private trust investors supporting the IPO.
2 of the Sponsors will own about 20% of the REIT post IPO. Interestingly, Elite Partners Capital owns no stake in the REIT. As such, the REIT Manager has no skin in the game, serving purely as a manager.
Financial Highlights and Valuation
Having examined a lot of the qualitative factors, let’s dive into the financials.
Historical Property Performance
Due to reasons disclosed in the prospectus, the REIT is only able to disclose figures from the portfolio’s acquisition in Nov 2018.
For FY2018 and FY2019, the REIT earned a consistent NPI of £22.2m (annualised) for both years. This works out to a portfolio property yield of about 6.97%. This is lower than forecasted DPU yield of 7.1 – 7.4%.
This is probably the result of the manager opting to take 100% of its management fees in units.
The REIT has taken out £97.5m in unsecured loans from a facility of £135m provided by Deutsche Bank. The loan facility appears to be a floating rate loan bearing an interest of Libor + X%.
The gearing of the REIT at listing will be 32% with a debt tenor of almost 5 years according to the prospectus.
The balance sheet provided as at 31 August 2019 indicates an NAV per unit of £0.60 – £0.63. If we adjust the property value upwards to £319.1m (the adopted purchase consideration) instead of £296m (accounting valuation) in the balance sheet, the adjusted NAV per unit is approximately £0.67 – £0.70.
Using the indicative IPO price of £0.68, the REIT is priced at close to book with an indicative yield of 7.1 – 7.4%% in FY2020 and FY2021.
These valuation metrics, when taken together with other indicators like market rent and property yield, indicate that ECR’s IPO price is at best fair. It is more likely to be overvalued.
What I liked about the REIT
- Freehold IPO portfolio that is well located and occupied.
- Low tenancy risk as the portfolio is leased to the UK Government
- Triple-net leases with CPI-linked step-up structures which give some visibility on future income growth
- Ready pipeline of ROFR assets to tap on for growth
- On balance, strong alignment of interests between sponsors and investors due to significant stake in the REIT and DPU growth based performance fees.
What I’m concerned about the REIT
- Small and unknown sponsor with ECR accounting for approximately half of its AUM
- Unattractive valuation with signs of premium valuation
- Potential for early termination of leases after 4 years from now
- Sponsor flipping the portfolio to the public after only 1 year of ownership
- Weak institutional support for the REIT
The Key Unknown
- Unknown impact from Brexit outcomes
My Personal Take
What the past year has demonstrated to REIT investors is that Sponsor strength and REIT size matters. This is evident in the bifurcation of REIT valuations between large and small REITs, with large REITs being rewarded with rich valuations.
Given that ECR falls under the small REIT category with small sponsors and weak institutional support, I do not expect fast growth for this REIT. That said, due to its low initial gearing of 32%, it should have some debt headroom to acquire some properties from its Sponsor to boost DPU in the foreseeable 2 years.
Where I see ECR fitting into a portfolio is as a high yield bond due to its portfolio characteristics. If you are happy with 7% yield per annum that is relatively safe with not much growth potential, ECR might be for you.
As an investor who looks out for value and / or growth in my investments, ECR with its premium valuation and limited scope for growth doesn’t fit my investment criteria. Throw in the uncertainty of how Brexit will affect the British pound and economy, I’ll rather adopt a wait and see approach.
Only if it falls to more reasonable valuations post IPO will I be tempted to invest.
Editor’s Take: Interest Rates Rising Will Endanger Unprepared REIT Holders
We’ve had a decade of low interest rates. If it hasn’t been clear to you, low interest rates are how we managed to achieve lift off and rocket into a bull market after the 2007-2008 sub prime crisis.
That can that we kicked down the road from 2007-2008 will now come to bear should we face yet another slump in the markets.
Because this time, we can’t simply cut interest rates anymore to stimulate economic growth.
Yes, Trump will almost certainly do everything in his power to win the re-election – and that includes pressuring the Feds to lower interest rates since he has the power to fire the Chair of the Federal Reserve – but what happens after he wins is anybody’s guess.
Interest rates are at all time lows and the fiscal stimulus “NOT QE!!” engine has had its pedal close to the floor for awhile now. Just look at the damn chart. We had 3-4% in 07/08. If this margin continues to be chipped away, what happens is we lose ammunition to fight the coming slump, which forces massive fiscal spending to boost the economy which only leads to inflation and higher interest rates. We are looking at a net negative no matter where we turn.
So what happens when interest rates rise? Bond values drop. So do REIT values. The expected yield spread (between risk free interest rate and what the reits/bonds gives you) tightens and real expected return goes lower, which typically results in a sell off. If interest rates continue to rise and the REIT is unable to hike rental rates higher vs rising interest rates, it suffers – badly.
Part of the reason REITs have done so well in the first place for the past decade is that we have seen a decade of ultra low interest rates and hence, strategies with high yield spreads have outperformed (especially for Singapore). Can this be maintained in an environment where interest rates are rising?
Even if there remains substantial debt overhead to use, I doubt that it will be able to use it to easily add properties and rental income in a period of time where interest rates are rising (and hence financing is more expensive) too.
I think a bigger drop is coming whether we like it or not through inflation -> rising interest rates -> equities/bonds suffering. The cycle might take some time to play out, but come it will. How we position ourselves will matter.
- Remember that buying low in and of itself offers tremendous protection. We don’t have to buy when we don’t want to. We only need to swing our bat at opportunities so good, we’d be stupid not to swing.
- Not all REITs will suffer equally. There are REITs with the ability to raise rental rates above interest rates. If yield / dividend is your thing, find these REITs and hang on to them. Christopher Ng Wai Chung has mentioned Keppel DC REIT as one of them due to the high cost and incredible difficulty in moving data centers. That means Keppel DC REITS has decent if not good pricing power. Find more Keppel DC REITs.
- Remember that dividends are always paid out (preferably) from free cash flow. If a company has great amounts of free cash flow, in a rising interest rate environment where it can’t grow, and where insiders hold large amounts of stock, they are far more likely to return capital to shareholders through increased yields since they benefit too. This means finding companies with high, recurring businesses generating real profits and significant free cash flow in proportion to their share prices and buying them when the yields are still comparatively low. Even if interest rates don’t rise, these guys tend to either spend capital growing, buying back stock, or increasing yield, all of which is great for investors. This is doubly so when companies with significant free cash flow previously had to contend with money-burning losers like WeWork who will almost certainly be dead if interest rates tick up leaving the industry wide open and for the taking.
TL; DR: You can buy Elite REIT when it’s way cheaper. At this prices, it’s just too much risk for too little reward. Also, the stock doesn’t have strong pricing/bargaining power against rising interest rates with a government as your client – that’s a bad place to be when rates rise. Hard pass for now.