Thursday, January 31, 2019


Germany's office real estate has been on a roll over the last few years. Judging from its share price, IREIT Global (IREIT) was deep in slumber amidst the real estate frenzy. I will examine this much unloved and non-covered REIT, as it offers an interesting, albeit long-term value proposition. This is a reversal of my usual investment thesis, where I tend to prioritise macroeconomic factors over company specific ones. 

Summary of Investment Thesis

  1. Rental rates and book value are below market rates
  2. Robust office market in Germany
  3. Brexit may lead to companies relocating to Germany
  1. EUR is vulnerable to Europe's political turmoil
  2. Tenant risk concentration
What does IREIT do?

IREIT is a pure-play office REIT consisting of five office buildings located in various cities across Germany, with the largest contributor being its Berlin Campus. The REIT was listed in 2014, and the Berlin campus was subsequently injected in 2015, with no further additions since then.

The REIT's management has changed hands in 2016, when Tikehau Capital acquired 80% of the REIT manager from the previous sponsor. The previous Sponsor who carried out the IPO is an Israeli investor into European office assets. Tikehau is a pan-European Asset manager and investor and is listed on the Euronext Paris (Bloomberg Code - TKO:FP).

Change in mandate. Subsequent to the acquisition, Tikehau announced that IREIT's mandate will be broadened to include European retail and industrial assets. However, there has been no addition to IREIT since the Berlin Campus in 2015, leaving it a pure play German office REIT at present.

Shareholders. IREIT's largest shareholder is Tong Jinquan, a Chinese tycoon, with a 55% stake at present. The stake was acquired as part of the IPO, from the previous sponsor. Tong Jinquan's stake has remained largely unchanged since the IPO. On the other hand, Tikehau has gradually increased its stake in the REIT since becoming the REIT's manager in 2017. At present, Tikehau owns 8.3% of the REIT. I view this gradual increase as an encouraging sign, as it increases the alignment of the REIT manager with that of unitholders.

Macroeconomic Outlook

Germany's inflation has been stable. IREIT's leases are generally inflation-indexed, that is periodically adjusted when cumulative inflation reaches a threshold between 5-7% for the leases. The ECB’s Governing Council adopted a quantitative definition of price stability in 1998:

"Price stability is defined as a year-on-year increase in the Harmonised Index of Consumer Prices (HICP) for the euro area of below 2%."

The Governing Council clarified in 2003 that in the pursuit of price stability it aims to maintain inflation rates below, but close to, 2% over the medium term.  Inflation pressure in Germany has averaged 1.5% per annum over the last 20 years, indicating that the ECB has been able to meet its goal in the long run, at least for the German economy.

German office rental market has been running red hot over the last few years, with a robust economy generating new jobs and unemployment rate hitting record lows consistently. The steady growth of jobs and workers in the economy has resulted in office vacancy rates falling rapidly in major cities.

Interestingly, though vacancy rates have been declining steadily since 2012, rental rates started to surge from 2015 onwards. This indicates that the market tightness only set in once excess supply has been absorbed. The brightly coloured lines in the charts are the cities that are relevant to the REIT, while the grey lines are for the other major cities in Germany. Reuters has highlighted the shortage of office space in Berlin.

Brexit Catalyst. Naturally, investors will be wondering, can this spike in rental rates continue? I believe that it is possible, given that German office rental rates are much lower than that of the UK and France. A key catalyst that investors have not factored in is that a hard or messy Brexit could lead to a flood of companies seeking to relocate to mainland Europe. While France is likely to be the main beneficiary of any exodus, German cities will also be a recipient of some corporates seeking to relocate. Should this materialize, this outcome will be impetus for further increases in office rental rates.

Economic Outlook for Europe and the Euro (EUR). The economic outlook for Europe is rather bleak, given the aging population, deteriorating social cohesion and political turmoil. Events such as Brexit, while may be beneficial for IREIT, bodes poorly for the grand European project and it's single currency in the long run. In my opinion, politics beyond Germany's borders is likely the biggest threat to the long term performance of this REIT, as the EUR's existence may be called into question. As shown below, the trajectory of the EUR appears to be that of a weakening trend against the SGD since the Global Financial Crisis.

Company Analysis

Given the overwhelmingly positive backdrop of the German office market, why hasn't IREIT's unit price moved positively? My answer to this question is, investors in Singapore and Asia are still oblivious, as they remain focused on IREIT's DPU, which will remain largely flat (at least in EUR terms) until 2022 at earliest, with a periodic bump up due to inflation-adjustments.The chart below captures how monotonous the REIT's revenue and NPI have been since the Berlin Campus acquisition in 2015, with any fluctuations largely due to changes in the EUR/SGD rate.

DPU rose after 2015 following the acquisition of the Berlin Campus, but declined in 2017 as the new REIT manager, Tikehau, revised the distribution rate to 90% from 100% previously. The DPU has remained stable since then, with any changes due to fluctuations in the exchange rate. Looking forward, the DPU can be expected to decline in 2019, as the EUR weakened in 2018 against the SGD. The currency hedge is expected to roll over at a lower rate, with my estimated 2019 hedged exchange rate of 1.57, as compared to 1.63 for 2018. This is a 3.7% reduction in DPU in SGD terms.

IREIT's long lease profile. At the point of IPO in 2014, IREIT's properties have always had a long lease profile. The leases for the original properties were structured with no rental escalation, save a periodic inflation adjustment. This lease structure has left the DPU relatively stable, albeit unexciting.

The bulk of the leases will start to expire commencing 2022.

Based on the table below, we can see that the Berlin Campus, with a 40% weight in the REIT, has the widest gap between market rental rates and the present lease rate for the asset.  IREIT's leases are generally far below the average market rental rate. This presents an opportunity for a bump up in DPU in 2022-2024 as the leases are renewed at prevailing market rates.

Source: Colliers

In terms of book value, the assets are likely to be undervalued. This is because the book value of real estate are commonly valued on the basis of NPI divided by the capitalisation rate. As IREIT's NPI will be adjusted upwards when the leases are renewed, the book value of the assets should be higher. Thus, the NAV of IREIT is likely to be understated.

Although there have been concerns that the REIT is highly leveraged (Sep-18: 39.1%), given my view that the assets are undervalued, the true debt-to-asset ratio is likely lower than that of the book value. In any case, the ratio has been gradually drifting downwards from the high of 43.4% reached post-acquisition of the Berlin campus in 2015.  This gradual improvement is due to the 10% retention of distributable income, paring down of debt and gradual upward revaluation of properties as Germany's capitalisation rate has been declining amid falling interest rates.

REIT Management Fee Structure
  1. Management Fee-
    • Base Fee: 10% p.a. of Annual Distributable Income
    • Performance Fee: 25% p.a. of the difference in DPU between a financial year and the prior year
  2. Acquisition Fee - 1.0% of the value of real estate investment purchased or acquisition price 
  3. Divestment Fee - 0.5% of the value of real estate or sale price 
  4. Trustee Fee - 0.01% p.a. of trust property value 
The performance fee ensures that the REIT manager's and unitholders' interest are aligned since the REIT manager is incentivised to pursue DPU-accretive deals. Nevetheless, despite the change in REIT manager and broadening of the mandate in April 2017, the REIT has shown little appetite for new acquisitions.


IREIT is a deep-value REIT, with a potentially significant upward revision of DPU in 2022 and beyond as the leases are renewed. The primary short term risk for IREIT unitholders appears to be a weakening EUR, as DPU for 2019 will be lower than 2018. IREIT remains an excellent stock to hold if you are only looking for dividends, as any DPU growth can be expected in 2022 and beyond. The stock has been trading with a dividend yield of 7-8% over the last few years.

Monday, January 28, 2019

REITs Part I: Decomposing Dividend Yields

This is the first part of my series in how to analyse REITs.

In this article, I will be dissecting a REIT’s dividend yield so that an investor will have a better grasp when combing through the sector. This is not a recommendation to buy or sell any REIT in particular, but is intended to broaden your perspective when looking at REITs in general.

As the factors that shape a REIT’s dividend yield appear to be poorly understood by the average investor, I will be sharing my framework of decomposing a REIT’s dividend yields into simpler blocks for investors to understand. REITs, to a large extent, trade like junk (high yield) bonds, as institutional investors approach them as such. Under this paradigm, REITs are usually valued in terms of dividend yields, unlike common stocks. While REITs are also evaluated by their Price to NAV (P/NAV), it is usually a secondary factor that comes after the dividend yield.

My framework for decomposing the dividend yield is a derivative of the model typically used to analyse a corporate bond. Corporate bonds are tradeable loans of companies, and are valued according to their yields. Broadly speaking, a bond issued by a company with stronger financials will have a lower yield as compared to a bond of a weaker company. This is also reflected in the REIT market, with ‘riskier’ REITs generally offering higher dividend yields. The dividend yield can be broken down into the following factors:

Dividend Yield = Risk-Free Rate + Sector Risk + REIT-specific Risk + Other Risks

Risk-Free Rate
This is the rate of return that an investor can get by investing into a risk-free asset. This is typically represented by the yield on a government bond, though if this is not easily accessible for the average investor, using the best-in-town interest rate for a fixed or term deposit is a reasonable substitute. For the purpose of this discussion, this is theoretically the highest annual interest rate that an investor can get without subjecting his savings to any risk of capital losses.

The risk-free rate is the baseline for all bonds and in our case, REITs. To illustrate this point with an extreme example, if one could put his money in the bank at an interest rate of 10%, it is highly unlikely that he would choose to be holding REITs that yield less than 10%. This assumes that the REIT has an operating currency that is the same as the bank deposit and assets are domestic.

What if there is a REIT that yields exactly the same as the bank's interest rate, that is 10%? Would you invest in a 10% yielding REIT or a 10% bank deposit? A rational investor would prefer the bank deposit, as holding the REIT runs the risk of capital losses. The risk-free component is actually a major driver of the REIT sector as a whole, but I will address this in the next analysis of the REIT sector as it deserves a whole piece of its own. For now, we will return back to decomposing a REIT's dividend yield.

How much higher does the REIT need to yield above the risk-free rate, in order to tempt an investor to hold it, over putting it in the bank or perhaps buying a government bond? That is a question that I will be addressing in the next part. Investors need to be compensated for bearing the risk of capital losses, and that reward is known as the risk premium, which basically explains all the other components of the REIT's dividend yield.

Sector Risk
An astute REIT investor would have over time grasped the concept that certain sectors are more 'risky', that is experience greater volatility in terms of rental income and DPU. These sectors are typically more exposed to the business cycle, and include sectors such as industrials and hospitality. In contrast, sectors such as healthcare and retail are less vulnerable to fluctuations in earnings and DPU. By this point, you can probably deduce that sectors which are more resilient and have stronger growth prospects will generally have a lower sector risk premium, and trade at lower dividend yield than 'riskier' sectors. The chart below shows the distinction between the retail REITs and the industrials.

REIT-specific Risk
This component captures the factors that distinguish one REIT from another within the same sector. Although REITs within the same sector tend to have similar dividend yields, specific factors usually drive differentiation. Factors such as sponsor, growth prospects and the quality of assets can lower or raise the yield relative to the sector. Another important factor that leads to differentiation despite two REITs having identical risk profiles is leverage. REITs that leverage up should naturally have a higher dividend yield, though this relationship is clearer in sectors that are perceived to be more risky, such as industrials, hospitality and logistics. On the other hand, Investors do not seem to demand a higher risk premium (and there higher yields) for retail and office REITs.

Other Risks
This factor encapsulates the various risks that are not covered above, and broadly includes a premium for REITs with foreign assets, foreign exchange risk, poor liquidity, among others. Some factors can constitute a fairly large risk premium, and should be allocated a risk factor on its own. One of these is the country factor, which exist due to the equity home bias factor, where investors prefer to hold stocks with assets in their home country over foreign countries, on the basis of familiarity. Also, foreign exchange risk should be priced in accordingly, given MAS' monetary policy stance of gradually appreciating the SGD in the long run.

Case Study - Capitaland Retail China Trust (CRCT)
CRCT, as a retail REIT with operations purely in China, trades at a higher yield than its counterparts with Singaporean assets, particularly those under the CapitaLand umbrella such as CapitaLand Malls Trust (CT) and CapitaLand Commercial Trust (CCT). This is likely due to its operations being in China (Foreign Market-China risk). However, when compared to the other Chinese retail REITs, it trades at a lower yield. This is due to CRCT being part of the Capitaland group, which investors have assigned a risk-reduction premium. We can therefore dice CRCT’s dividend yield up in several different ways.

The first, is to view CRCT’s dividend yield as CT’s dividend yield (CapitaLand’s Singaporean mall assets) plus a Chinese risk factor, which captures the foreign exchange risk (SGD/CNY) and foreign market risk. We then add a CRCT specific risk factor to capture other subtle differences such as different leverage levels.

CRCT = CT Dividend Yield + China Country Risk + Foreign Exchange Risk + CRCT Specific Risk

Or to fully describe it in terms of my model above, we can break down CT's dividend yield as well.

CRCT = (Risk Free Rate + SG Retail REIT Risk + CT Specific Risk) + China Country Risk + Foreign Exchange Risk + CRCT Specific Risk

Alternatively, we can also express CRCT as a Chinese retail REIT, but with a risk reduction due to its backing by CapitaLand, Asia’s largest real estate company and is majority owned by Temasek.

CRCT = Chinese Retail REIT Sector Dividend Yield - CRCT-Specific Risk (CapitaLand-backed)

By understanding how REITs are priced according to their sectors, and to one another within the same peer group, we will be better prepared to take advantage of opportunities as they come by. A high yielding REIT may look attractive on a standalone basis, but what if you could invest into a peer with a slightly lower yield, but for a much lower risk profile or higher growth prospects? The key to investing into a REIT is to know what is being priced in, and more importantly, what is not being priced in, at times. Understanding this is an important source of alpha, not just for REITs, but for all assets in general.

Friday, January 25, 2019

Ascendas India Trust (SGX:CY6U) 4Q18 Review

This is a quarterly update to my previous write-up on Ascendas India Trust (AIT). AIT reported stellar results, even in SGD terms, considering the steep decline of the INR versus the SGD. The INR slid by 9.8% over the comparable quarter a year ago. NPI rose by 14% in INR terms, and 4% in SGD terms.

Economic Outlook

The outlook for the INR is more positive for 2019, following a turbulent year for Emerging Markets in general. India's Current Account Deficit should narrow this year, as crude oil prices have plunged. As India is a net importer of crude oil, lower oil prices strongly benefits the Indian economy and reduces its import bills. Also, other external factors such as the end of the US Federal Reserve interest rate hike cycle, will ease pressure on Emerging Market currencies. However as we will see below, AIT still managed to generate decent returns in SGD terms despite the rough year for the INR.

The Indian economy is quite insular, unlike the other major economies of Asia that are heavily dependent on exports and broader global economic growth. The country is a net importer, resulting in a persistent current account deficit. While this insularity has hampered growth in the past, this cushions the economy from the worst of a global economic slowdown. The ongoing trade war between US and China is expected to have little impact on India regardless of the outcome. In addition to that, India is Asia's fastest growing major economy, growing above 7% annually, and is expected to keep that position as China continues to slow down.

Company Analysis

In NPI terms, AIT continues to demonstrate solid growth, with the growth trajectory set to be sustained in coming years. Strong rental reversion driven by a robust Indian economy and a healthy pipeline of assets under development remain the primary growth drivers for AIT.

Quarterly dividends continue to rise, following the private placement of shares in 2018, acquisition of new assets and strong rental reversions. This is an example of a management undertaking accretive acquisitions that seem to be frankly, quite lacking in the S-REIT space as of recent years. Note that over the last few years since 2014, AIT has been able to increase its floor space and DPU consistently by raising equity and debt in the right proportions so as to not stretch the balance sheet. 

Total debt-to-asset ratio remains comfortable at 33% (statutory limit: 45%), giving the REIT headroom to grow further.

Long-term prospects secured by steady pipeline. The asset pipeline as of 31st December 2018 points to AIT's floor area rising to 20.1 million square feet from the present 12.6 million square feet. On 3rd January 2019, Ascendas-Singbridge announced the acquisition of a parcel of land in Chennai to develop a new IT park, with a potential floor space of 2.3 million square feet. This represents potential assets that could eventually be injected into AIT, boosting the pipeline to a potential 22.4 million square feet.

Acquisition of Ascendas-Singbridge by CapitaLand. AIT will come under the CapitaLand stable of REITs following the merger. As CapitaLand has no meaningful presence in India or overlap in terms of business operations with Ascendas-Singbridge in that market, I do not expect this merger to materially change AIT's business model or fundamentals.

AIT remains fundamentally solid, with the latest quarter results affirming its growth story. With the INR expected to be on a stronger footing this year, the drag on DPU growth should be lower this year. In an environment of weak or zero DPU growth for the overall SREIT sector, I expect AIT to be one of the better performers.

Sunday, January 20, 2019

China Aircraft Leasing Company (HKEX:1848)

Please refer to my guide to dividend stocks to understand my approach to this class of stocks. 

China Aircraft Leasing Company (CALC) is an interesting play on the world's largest growing airline market. In the era of the 19th century gold rushes that took place all over the New World, the masses hopped onto the bandwagon and travelled the globe in the hopes of striking gold literally. Few gold miners actually ended up rich, but many more became rich not off gold, but through the selling of shovels, pickaxes, tents and other equipment to miners. 

In a similar vein, the China airline industry has been exploding on the back of rising affluence of the average Chinese; intra and inter country flights have been rising at a very rapid pace. However, airlines operate on volatile margins, subject to the unpredictability of fuel prices. Investment maestros Benjamin Graham and Warren Buffet are prominently known for their aversion towards investing in the aviation sector for these reasons. Likewise, with reference to the business history lesson that we can draw from the 19th century gold rush, we can capitalise on the boom in airline travel by investing into companies that lease planes to airlines, instead investing into airlines stocks itself.

Summary of Investment Thesis

  1. Large orderbook provides clear profit trajectory
  2. Stable and wide profit margins
  1. Highly geared business model- debt-to-equity of 9x
  2. Customers are operating in an industry notorious for volatility in profitability
What does CALC do?

CALC is in the businesses of long-term direct aircraft purchase and lease transactions and long-term aircraft sale and leaseback transactions, primarily with leading airline operators in China. Basically, CALC offers aircraft leases to airlines that prefer to lease planes instead of incurring large borrowings on their balance sheet to purchase their own planes. In turn, CALC obtains long term bank borrowings to finance the purchase of these planes. The recurring cash inflows of lease income from its airlines customers are utilised to service CALC's bank borrowings. CALC earns the spread between its bank borrowing costs and that of the lease income. As we will see further on, this is a very lucrative business model. Besides, it also provides airlines with value-adding services, such as trading and re-marketing of used aircraft.

As at June 2018, the company has an aircraft fleet of 115 planes and the bulk of its customers are Chinese airlines. The company has a large backlog of orders for more than 200 planes from Airbus and Boeing that will be delivered in various stages until 2023. This translates into a fleet of over 300 planes by 2023, providing very strong visibility for the company's outlook. It should be pointed out that the company also engages in the sale of its aircraft leases periodically. This essentially means that instead of collecting the lease income stream patiently until the end of the lease tenure, the company opts to sell the lease to institutional investors. The nature of this transaction is complex, but it usually results in the company realizing an upfront profit and return of capital in exchange for the stream of future lease income.

Macroeconomic Analysis

Rise of the world's largest middle class. Air traffic in China has been growing relentlessly as strong GDP growth has translated into robust demand growth for air travel. Even if economic growth slows down in China as the traditional growth drivers of manufacturing and construction sputters, air travel growth is unlikely to slow down. This is because as China transitions from a middle to a high income economy, this will naturally lead to the development of an increasingly complex tertiary (service) sector as well as rising disposable income. An the estimate by McKinsey points to a sizeable upper middle class in China 2022, which has been the driving trend behind this explosive demand for air travel. A combination of rising income levels as well as increasing complexity of the tertiary (service) sector of the economy results in a surge of air travel.

The Civil Aviation Administration of China (CAAC) aims to construct 216 new airports by 2035 to meet the growing demands for air travel. China has a total of 234 civil airports at the end of October 2018, and this number is likely to hit 450 by 2035. China recorded 549 million air passengers and 7.12 million tonnes of air cargo in 2017, a 12.6 and 6.6 percent year-on-year increase respectively. The following chart with data from the CAAC illustrates the strong growth of air traffic in China.

Company Analysis

Major Shareholders

As at June 2018, the largest shareholder was China Everbright Limited (CEL), with a 33.58% stake in the company, followed by the CEO, Mr Poon Ho Man with a 29.69% stake. CEL is part of the Everbright Group, a State-Owned Enterprise (SOE), and is wholly owned by Central Huijin Investment. CEL initially took up a 40% stake in the company in July 2011. Despite having CEL as the largest shareholder, CALC is still regarded as an independent player in the market, unlike the other major players that are explicitly SOE-backed.

Being regarded as an independent has led to higher borrowing costs, as banks have traditionally preferred the relative safety of lending to SOEs. Also, this has led to lower stock valuations compared to its SOE peers. Yet recent measures taken by the central government is expected to be beneficial for CALC, including the directive for banks to ramp up lending to the private sector. This, coupled with various measures to boost banking system liquidity, is expected to lower borrowing costs for CALC.

Business Analysis

CALC's fleet size has been expanding steadily on the back of the rapid explosion of air travel in China. In 2017 and 2018, CALC has accumulated a sizeable backlog of orders, ensuring the strong growth will accelerate in the coming years. Based on the order backlog, CALC is expected to triple its fleet size by 2023, from 2018 levels.

Understanding a leasing company's business model is crucial in analysing the CALC's financial statements. As this company functions in certain ways like a bank, it is important to keep this in mind. Just as a bank would take a deposit while promising a certain deposit interest rate, and then proceed to lend it out at a marked-up interest rate, CALC (as with all leasing companies) operates under a similar model. CALC borrows funds from a bank or the bond market, uses that funds to purchase an aircraft for its customer under a lease agreement, and then receives a stream of lease payments for the tenure of the lease agreement. For 2017, CALC was borrowing at a rate of 4.4% while collecting lease payments with a gross lease yield of 7.9%. The difference of 3.5% is the net lease yield which represents CALC's gross profits.

Essentially, the company's business model relies on incurring large amounts of debt to fund the asset purchases. As a result, CALC is heavily geared, typical of leasing companies and banks. The company's gearing ratio (debt-to-equity ratio) stands above 9.0x, though this has remained stable since its IPO. This indicates that the rapid expansion of CALC's fleet has not increased the financial stress on the company.

The company typically borrows at fixed interest rates, or hedges its floating interest rates loans, thus locking in the margins on its existing leases. However, the company is subject to market interest rates when signing on new loans as the business expands which is a function of market rates and the company's credit profile. This is usually a major determinant in a leasing company's operating margins, as lease yields are controlled and capped by market forces (not unlike housing mortgage rates which typically does not vary much from bank to bank in a particular market due to competition). The company still has leeway in managing the interest rates of its debt, as the company can refinance its bank borrowings when interest rates decline.

The major risk that leasing companies such as CALC faces however, is default by its customers who are typically in financial distress. However, these planes are easily re-sold in the aircraft market given the commoditization of commercial planes, limiting the losses for the lessor should a customer default.

CALC's operating currency is USD as the aircraft purchases, leases terms and debt are denominated in USD terms. As such, CALC is more sensitive to changes in USD bond yields and interest rates such as LIBOR. Although US interest rates have been rising for the last 3 years, the Federal Reserve will not raise rates much further than its current level of 2.50%. As global economic growth is slowing and with rising market expectations of a recession over the next 2 years, we can expect US interest rates to stay flat for the next one year before declining gradually. This bodes well for CALC's debt costs, given the company's heavily leveraged balance sheet. Also, given the recent measures by the central government to encourage banks to lend to the private sector, this will result in lower borrowing costs for CALC.

Financial Analysis

The rapid expansion of CALC's fleet size has translated into an even more rapid growth of its revenue and profits. This trend is expected to be sustained in the coming years given the sizeable order backlog. However, it should be noted that CALC is a recipient of government subsidies, which accounted for a third of CALC's 2017 profits. The subsidies are given as part of the government's initiative to promote the development of China's airline industry. Nevertheless, subsidies peaked in 2016 at HKD 261 million, and have been declining as a percentage of profits since 2015. While accounting for 2/3 of net profit in 2015, subsidies declined to 1/4 of net profit by 2017 and we can expect this figure to become less significant as CALC's underlying revenue and operating profit growth continues to rise rapidly.

Since the company is able to match its recurring lease income against the bank borrowings required to service the asset, this allows the company to lock in its margins at the point of the lease's inception. This has resulted in a remarkably stable and hefty profit margin for CALC, in contrast with the volatile revenue and profit margins of its customers. The chart below shows the extraordinary profit margins of CALC since its IPO. The wider profit margins is assurance that CALC will be able to maintain its profitability even as government subsidies have been falling since 2016. 

As a result of steady overall growth, dividends have been rising steadily over the years. The company has maintained a dividend payout ratio of 55% for the last 3 years. As the company's fleet of planes expand rapidly, we expect revenue to continue growing, and dividends to follow suit.

More importantly, for a dividend stock, we have to analyse the cash flow to assess the company's real capability to pay out dividends. The company's operating cash flow has turned positive since 2016, indicating that the business is generating cash from its day-to-day business. More importantly, the dividends that are being paid out constitute a fraction of operating cash flow, indicating that the company has ample headroom to raise its dividends in the coming years. That does not mean that the company will necessarily do so, since it has committed to a payout ratio of 55%, tying its dividend growth to profits rather than operating cash flow. Nevertheless, we can treat this healthy stream of operating cash flow as a cushion for dividends in the event that the company hits a speed bump in terms of profit growth.

Market Valuation

CALC's valuation are quite attractive, given the sell-down in the Hong Kong market following the outbreak of the US-China trade war in early 2018. Since the commencement of the trade war, CALC has been trading at a PE of 7x only, with a dividend yield of about 8%. Taking into account the strong growth momentum of the business, I expect the dividend yield to rise above 9% in 2019 at current market price of HKD 8.20. 

CALC is an excellent proxy to the rapidly growing China airline industry. Owing to its business model of leasing aircraft at a pre-determined lease yield, this allows CALC to enjoy remarkably wide and stable profit margins. Its rapid revenue and profit growth has translated into rising dividends since 2014, with plenty of headroom for growth in the coming years. The trade war has given markets an excellent opportunity to pick up such a gem at a bargain-basement price.

Tuesday, January 8, 2019

Parkway Life REIT (SGX:C2PU)

I personally view Parkway Life REIT (PLife REIT) as a benchmark REIT when evaluating not just the SREIT sector, but also when looking at MREITs and HKREITs. It is one of the few healthcare REITs available in the region, and by far the best in terms of asset quality and DPU outlook. Its earnings and dividends are very stable due to the nature of its leases.

Summary of Investment Thesis

  1. DPU growth is like clockwork - NPI grows at a minimum of 0.6% per annum on average
  2. Very long lease profile ensures stability- Singapore leases are on a 15+15 years basis (commencing 2007) while Japanese assets have an average lease tenure of 12.64 years
  3. Strong demand for premium healthcare in the region - Singapore is a leading medical tourist hub for the region's high net worth individuals.
  1. Japanese asset prices/rental rates may suffer from deflation
  2. DPU may be affected in 2022-2023 when hedges related to the JPY exposure are rolled over

What does PLife REIT do?

PLife REIT holds Singapore's premium healthcare facilities, a private Hospital in Malaysia and nursing homes in Japan. Its Singaporean assets account for the bulk of revenue, followed by its stable of Japanese nursing homes. Its sole Malaysian asset contributes less than 0.4% of NPI for 2018, and I will exclude it from my analysis due to immateriality.

It's Singaporean hospitals, primarily Mount Elizabeth and Gleneagles, cater to the affluent segment of Singaporean society, expats and medical tourists from South East Asia and beyond. PLife REIT has signed a lease agreement with IHH for 15 + 15 years with effect from 23 August 2007 on a triple net lease basis. CPI + 1% rent review formula for Singapore Hospital Properties guarantees minimum 1% growth annually (CPI deemed as zero if it is negative). This arrangement ensures that the Singaporean assets have an occupancy rate of 100% and rental growth of at least 1% per annum for the entire duration of the lease period.

The operational statistics below, while bearing no direct impact on the REIT due to the triple net lease structure, points to the role of PLife REIT in its Sponsor's (IHH Healthcare Berhad) growth trajectory. Thus we can be assured that the Sponsor's business interest is aligned with the REIT, and that an eventual non-renewal of the lease by the Sponsor is highly unlikely given the importance of the REIT's assets to the Sponsor.

The Japan portfolio consist of long-term leases with weighted average lease term to expiry of 12.64 years as of September 2018. The portfolio has exposure across Japan, consisting of 1 pharmaceutical product distributing and manufacturing facility and 45 private nursing homes. PLife REIT has been gradually expanding its footprint across Japan since 2012.

Macroeconomic Outlook

Rising affluence in South East Asia provides a growing customer base. Singapore is a healthcare hub for South East Asia, attracting medical tourists from the affluent segments of the region. The rapid growth of this segment in South East Asia as a whole provides an expanding customer base that PLife REIT is well positioned to capture. The chart below is derived from Credit Suisse's Global Wealth Report 2018 on the rise of the wealthy in Asia, which augurs well for PLife REIT in the longer run.

Benign but positive inflation outlook. As the Parkway Singapore master leases are tied to the Consumer Price Index (CPI), it is important to understand the factors that drive the CPI. Over the last few years, the overall index paints a picture of rather weak inflation and we shall take a quick peek under the hood to better understand the factors that drive inflation.
Generally, the bulk of variability in the CPI can be attributed to changes in the Housing & Utilities (yellow) and Transport (green) components. Further digging reveals that the housing & utilities component is closely correlated to rental rates while the transport component is linked to changes in the premium of a Certificate of Entitlement (COE). The other components, such as food and education form the base for a consistent source of inflation pressure of about 0.6% over the last few years, which I would deem to be a rule-of-thumb indicator of long-term core inflation.

Residential rental rates are starting to rise. Due to a reduction in expats from the traditionally well-paying financial and oil & gas sectors, this has resulted in rental rates falling across Singapore. While the actual number of foreigners have increased over the years, the composition of workers have undergone a shift, with fewer highly paid expats in the market. This has translated into gradually declining residential rental rates. As housing cost is calculated using the imputed rent method for measuring inflation, even if you are living in your own property, your housing cost is deemed to have decreased if the overall rental rates fall. As such, there is a very strong correlation between the URA Rental Index and CPI Housing & Utilities component. It appears that changes in the rental market has a much stronger impact than increases in utilities. Following the peak in 2014, the URA Rental Index has been on a steady decline but it appears to have bottomed out in 2017 and climbed modestly in 2018.

Are COE premiums bottoming out? Although COE premiums have been trending downwards over the last few years, this is largely due to the increase in COE supply due to the deregistration of existing vehicles. It appears that the deregistration of existing vehicles will fall off sharply between 2019-2020, and if no new growth of vehicles is permitted, COE premiums can be expected to start rising again in 2019. However, the impact of changes in COE premiums on the CPI Transport component has weakened since 2014, which indicates that there was probably a change of weights when the CPI Index was re-balanced in 2014.

Strange as it may sound, PLife REIT's rental reversion ultimately hinges on two totally unrelated variables- residential rental rates and COE prices. The outlook for residential rental rates appear to be on a mild uptrend, though no acceleration should be expected given the lukewarm economic climate. Meanwhile, COE premiums are likely to turn higher in 2019 due to a the expected cyclical fall in vehicle deregistration. A combination of rising rental rates and COE premiums will exert upward pressure on the CPI up for 2019 and 2020, which bodes well for PLife REIT's DPU growth over the next two years.


Aging demographics. As the most aged country in the world, Japan has a median age of 47.3. On the surface, it may seem like an unbridled positive given PLife REIT's portfolio of nursing homes in Japan, in reality it is a doubled-edged sword. Why does deflation matter? Because it exerts downward pressure on rental rates and asset prices in general. Unlike Singapore, Japan struggles with structural deflation due to its aging population that is expected to shrink at an accelerating rate.

Despite that, inflation in Japan has remained positive due to the Bank of Japan's monetary policy in the form of massive money printing, known as Quantitative and Qualitative Monetary Easing (QQE) program. While the scope of Japan's monetary policy is too complex and lengthy to be discussed here, it should be sufficient to stave off deflation in Japan for the foreseeable future, though not by a large margin. While PLife REIT's Japanese assets have downside risk protection, which protects unitholders, there is little upside for rental rates either. As of 3Q18, only 13.2% of the REIT's Japan's assets by revenue are subject to market revision while the rest are downside protected. My view is that since the Bank of Japan has been pursuing its goal of 2% inflation rate quite doggedly over the last few years through massive monetary stimulus, though with limited success. we can expect inflation to remain above 0% in the longer term.

Company Analysis

Sponsor - IHH Healthcare Berhad (IHH)

PLife REIT is backed by IHH, a leading healthcare group in South East Asia, and is dual listed on the Singapore Exchange and Bursa Malaysia. The group has recently undergone changes in terms of its largest shareholders in November 2018. The largest shareholder, Khazanah Nasional Berhad (Khazanah), Malaysia's sovereign wealth fund, sold 16.0% of its stake to the second largest shareholder, Mitsui & Co Ltd (Mitsui), a Japanese conglomerate, leading to a swap in their shareholding positions. Post-transaction, Mitsui's stake rose to 32.9% while Khazanah's shareholdings was reduced to 26.05%. I do not expect the transaction to impact PLife REIT's strategic direction, since both the companies have been long-term shareholders of IHH. This disposal is in line with the new Malaysian government's decision to pare down its stake in its major shareholdings, rather than as a statement of its view of IHH. In the same vein, Singaporean investors would have noticed that Axiata (majority owned by Khazanah) has decided to sell its stake in M1. Ultimately, what matters most to unitholders is that the Sponsor has not acted in any way that is detrimental to unitholders since its IPO in 2007.


Due to the long leases of all its assets, PLife REIT's financials are remarkably stable. The NPI breakdown shows that the Singaporean hospitals form the bedrock of the REIT, with its relentless and stable growth while the Japanese assets show some variability.

A steadily rising NPI has translated into an uptrend for DPU, though the DPU for 2015 and 2017 were bumped up by the distribution of realized capital gains upon disposal of some Japanese assets. DPU growth for the Singaporean assets are driven by the rental reversion factor of CPI + 1%. As the Singaporean assets contributes to 60% of NPI, we can expect growth for the overall NPI to rise by 60% X (CPI + 1%), leading to a minimum annual growth of 0.6% of NPI if the CPI is zero or negative. As the 'core' inflation for Singapore stemming primarily from Food and Education components discussed above has averaged 0.6% per annum, we can assume an average inflation rate of at least 0.6% in the long run. Based on this assumption, I expect the Singapore assets NPI to grow by 1.6%, and for overall NPI to rise by approximately 1.0% per annum. Likewise, DPU growth should track the underlying NPI growth. However, due to proactive management with acquisitions/disposals of various assets in Japan, this has led to DPU growth outpacing the automatic rental escalations imputed into the Singapore leases.

Comfortable and sustainable debt. Although the REIT has sizeable JPY debt, the management has utilized various swaps to hedge currency and interest rates exposure. As of September 2018, the REIT has hedged its JPY exposure until the first quarter of 2023, ensuring minimal interest and currency risks until the hedges are rolled over (industry jargon for renewing a hedge) then. The REIT has an average debt maturity of 3.1 years and a low average cost of debt, 0.94%, due to the low interest rates in Japan. At the point when the hedges have to be rolled over , depending on prevailing exchange and interest rates at that point, the REIT could incur considerably higher or lower interest expense then. Until then, interest expense is will remain very stable, though the REIT will not benefit if interest rates decline in the event of an economic slowdown or recession. The REIT's gearing level has remained below 40% over the last few years. 

REIT Management Fee Structure
  1. Management Fee-
    • Base Fee: 0.3% p.a. trust property value
    • Performance Fee: 4.5% p.a. of trust's net property income 
  2. Acquisition Fee - 1.0% of the value of real estate investment purchased or acquisition price 
  3. Divestment Fee - 0.5% of the value of real estate or sale price 
  4. Property Management Fees - 5.0% of capex for projects of capex less than S$1.0m, 3.0% of capex for projects of capex more than or equal to S$1.0m
PLife REIT's management fee structure does not fully align the interest of unitholders and that of the REIT management because the management incentive fee is based on NPI growth, rather than DPU growth. Under some circumstances, such as an absence of accretive opportunities, the management may be tempted to undertake DPU dilutive acquisitions just to boost DPU at the expense of unitholders. However, as PLife REIT has demonstrated a solid track record of managing this REIT and has not pursued any deals that have been detrimental to unitholders, I am not overly concerned by the fee structure. 


This is one boring REIT which will rarely spring a negative or positive surprise in its quarterly earnings. Its DPU ticks upward annually in an almost clockwork fashion due to the Singaporean assets' rental escalation of CPI + 1%. If you are looking for an investment with income (dividends) that is almost bond-like, but with some growth, look no further. I believe that PLife REIT deserves a place in any REIT or dividend portfolio to provide a stable and growing dividend stream.

For market data on this REIT and comparison against the market, please refer to my compilation of REITs here.

Disclaimer: I hold a position in this REIT at the point of writing. 

Tuesday, January 1, 2019

Ascendas India Trust (SGX:CY6U)

Ascendas India Trust (AIT) is an underrated gem in the Singapore REIT space. While I understand that certain investors might have some apprehension about having Indian exposure, due in part to the volatile and constantly depreciating currency, the bright growth prospects and strong sponsor has been more than enough to offset these risks. Although this REIT tends to draw less attention than the blue-chip REITs under the Mapletree and Capitaland stables, I personally feel that this REIT deserves a place alongside them.

Summary of Investment Thesis

  1. Bright growth prospects driven by favourable Indian demographics and global offshoring trends
  2. Strong sponsor support - Ascendas-Singbridge is backed by Temasek and JTC
  3. Clear pipeline of assets under development - Strong earnings growth visbility thanks to robust pipeline of buildings under development
  1. Structural Indian Current Account Deficit - This causes the INR to be on a persistent and long-term depreciating pathway against major currencies, which erodes DPU growth in SGD terms. In years of severe depreciation, DPU in SGD terms may fall

What does AIT do?

AIT is a real estate investment trust (REIT) that holds 7 IT Parks and 6 warehouses across India. This REIT is a play on India's growing role as a Global IT center and leading offshoring hub for service. For example, AIT announced in May 2018 the acquisition of a building in Hyderabad, aVance 6 that is 98% leased to Amazon. The REIT has a strong growth pipeline, as it has properties under construction that will contribute to the REIT's NPI upon completion over the next few years.


Macroeconomic Analysis

Steady and bright growth outlook. In a world of slowing economic growth, India stands out as an increasingly important growth driver. While China will continue to grow, its best years of breakneck economic growth is likely behind it. Also, India's demographic profile is considerably more favourable than China, which points to decades of strong growth ahead. In comparison, the full impact of China's One Child Policy enacted decades ago will weigh on economic growth in the coming decades. Also, given the relative isolation of the Indian economy (being less integrated into the global economy as compared to the heavily export-oriented nations of the Far East), this growth is less likely to be affected by global economic disruptions. 

Strong economic growth usually translates into rising demand for commercial real estate, which in turn pushes valuations up and drives positive rental reversion. Also, it implies a growing pie, which is beneficial for all players involved, lowering the degree of competition in the market. India's strong economic outlook bodes well for AIT which is well positioned to benefit with its long pipeline of assets to be added.

Offshoring of global IT services to India. India has positioned itself as an offshore hub for IT services. The primary driver behind this offshoring trend is the large supply and lower wages of IT personnel in India. According to PayScale, the average IT programmer commands an annual salary of USD 6,215, compared to USD 6,813 in the Philippines and USD 61,176 in the US. As indicated by the pie chart below, American corporations dominate with a 59% share of AIT's rental income, followed by French corporates at 9%. Local corporations account for less than a quarter of AIT's rental income.

While there has been strong push-back in the US against the offshoring of manufacturing to the Far East, there has been virtually zero political backlash against the offshoring of services to Asia. This is likely because the segment of labour being displaced is more mobile (educated/skilled) and less likely to demand for populist measures at the ballot box. As such, there is unlikely to be any political impediment towards this trend of American and European based corporations shifting their IT operations to India.

Structural Current Account Deficit. Lacking a strong manufacturing base, India has been running a Current Account Deficit for decades as a result of its imports far exceeding its exports. In the long run, this structural current account deficit has resulted in a persistent depreciation of the Indian Rupee (INR). The chart below demonstrates the relationship between the Current Account Deficit and the INR. It can be seen that when the Current Account Deficit widens, the INR tends to weaken and stabilizes during periods when the Current Account Deficit improves.

Between 2009 and 2013, when the Current Account Deficit worsened sharply, the INR depreciated in line. This impacted AIT's earnings during those years, though the strong rental income growth offset the weaker INR. Since 2013, the Indian government has taken steps to curb the Current Account Deficit, such as raising import duty on gold, a major source of the Current Account Deficit. While the Indian government has had some success in reducing the Current Account Deficit, I do not expect it to be eliminated in the next few years. This implies that the INR is expected to continue depreciating gradually, though nowhere nearly as severe as experienced in 2009-2013.

This factor is arguably the largest headwind for AIT since its income is 100% denominated in INR while all distributions are repatriated to unitholders in Singapore Dollars (SGD), and is likely a reason for many potential investors to gloss over this name. From a macroeconomic perspective, investing into AIT is a wager that the rental income growth (in INR terms) will significantly outpace the expected FX losses due to INR depreciation.

Company Analysis

Sponsor (Ascendas-Singbridge Group)

Ascendas-Singbridge is jointly owned by Temasek Holdings and JTC Corporation. Both entities are wholly-owned by the Government of Singapore and their REITs have been well managed over the years. Among the chief concerns plaguing S-REITs have been management pursuing Mergers & Acquisitions (M&A) deals that have been non-accretive to REIT unitholders, or at worst, dilutive to investors. While some IPOs in recent years have been attempting to discourage such behaviour by aligning the interest of unitholders and REIT managers, I am of the view that the character of the Sponsor is key in preventing such behaviour. 

While AIT's incentive structure for management is not quite aligned with unitholders (discussed further below), the management has not undertaken any DPU dilutive deals since their IPO in 2007. I personally feel that having a strong sponsor is a vital ingredient in sustaining growth in the long-term.

Growth Outlook

AIT has grown steadily, in terms of property acquired/constructed since its IPO. As of September 2018, the REIT has a total commercial space of 12.6 mil square feet, and is poised to rise to 20.1 mil square feet over the next few years. This points to a strong NPI and DPU growth outlook over the next few years.

AIT has sufficient debt headroom to finance this gradual expansion. Its gearing ratio stands at 32% presently, quite comfortably below the 45% limit set by the Monetary Authority of Singapore (MAS). The REIT has an average debt cost of 6.1%, based on borrowing ratio of 62% in INR and 38% in SGD as at 30 September 2018. As Indian interest rates are expected to decline as the economy develops gradually, AIT's borrowing costs can be expected to gradually fall in the long run.

Income Analysis

AIT has demonstrated a strong track record in terms of generating Net Property Income, particularly in INR terms (red bars below). In SGD terms, the REIT's NPI has been somewhat less impressive particularly through the years of 2008 and 2012. This is largely due to the reasons mentioned above regarding the macroeconomic environment driving the SGD/INR, and not factors specific to the REIT.

In terms of distributable income, AIT fared poorly through the period of 2008-2012 due to a combination of higher interest costs, higher dividend distribution taxes. However, distributable income has shown steady recovery since 2013 as the negative factors that weighed on the REIT in the earlier years receded. Also, the REIT reduced its distribution from 100% to 90% since 2013, which allows the REIT to gradually strengthen its balance sheet via income retention. 

REIT Management Fee Structure
  1. Management Fee-
    • Base Fee: 0.5% p.a. trust property value
    • Performance Fee: 4% p.a. of trust's net property income 
  2. Acquisition Fee - 1.0% of the value of real estate investment purchased or acquisition price 
  3. Divestment Fee - 0.5% of the value of real estate or sale price 
  4. Trustee Fee - 0.02% p.a. of trust property value 

AIT's management fee structure does not align the interest of unitholders and that of the REIT management because the management incentive fee is based on NPI growth, rather than DPU growth. Under some circumstances, such as an absence of accretive opportunities, the management may be tempted to undertake DPU dilutive acquisitions just to boost DPU at the expense of unitholders. As India's property yields remain high by global standards, the risk of AIT's management undertaking dilutive acquisitions is low for the forseeable future.


AIT is a play on several very positive long-term growth drivers, notably India's bright growth prospects, and the offshoring of IT services by MNCs. However, the risks include India's persistent Current Account Deficit, which has led to a long-term depreciation pathway for the INR and higher interest rates. In years of particularly severe depreciation such as in 2012, the depreciation may outweigh NPI growth, leading to lower DPU in SGD terms. On the other hand, having a strong sponsor with a solid track record helps to mitigate the challenges of operating in an Emerging Market like India.

For market data on this REIT and comparison against the market, please refer to my compilation of REITs here.

Disclosure: At the point of writing, I am long AIT. I intend to hold this position for the long-term.

Sunway Real Estate Investment Trust (KLSE:5176)

Sunway Real Estate Investment Trust (SunREIT) is a diversified REIT underpinned by one of the best performing shopping malls in Malaysia, Sunway Pyramid. The strong performance of this mall has turned this REIT into one of the best performing REITs in the Malaysian REIT (MREIT) space. Unfortunately, the bulk of the other assets have been mediocre at best, with some severe non-performers such as an office building, Sunway Tower which has struggled with an occupancy rate of 20% over the last few years.

Summary of the Investment Thesis

  1. Sunway Pyramid is a major growth driver as a prime mall in Klang Valley and anchors the REIT's overall DPU growth
  2. Sponsor has a pipeline of assets to be injected, which will sustain long term growth
  1. Glut of office and retail assets in Klang Valley- low occupancy and/or falling rental rates of office and non-prime retail assets have been a drag on the REIT's earnings.

What does the company do?

SunREIT is a diversified REIT that is backed by Sunway Berhad, a Malaysian conglomerate involved in construction, property development, hospitality, education, healthcare and etc. Geographically, more than 90% of the REIT's assets by revenue and net property income are located in the Greater Kuala Lumpur region, commonly referred to as the Klang Valley.

SunREIT is heavily skewed towards retail malls, underpinned by its crown jewel, the Sunway Pyramid mall which accounts for 55% of revenue and 58% of net property income. The retail segment (in shades of gray below) accounts for about 70% of  net property income, followed by hospitality at 20% (red) with the balance consisting of a diverse pool of healthcare, office and industrial assets. The management announced on 24th December 2018 that it has acquired from its Sponsor a clutch of education-related assets, which will further diversify the REIT's asset base.

Macroeconomic Analysis

Consumption driven growth remains intact. The Malaysian economy remains a story of rising consumption growth. Income levels in Malaysia has been rising at a steady pace, with official government statistics pointing to an average of 9.1% growth on average between 2009-2016 for Malaysia. In Selangor and Kuala Lumpur, the growth rate has been 7.7% and 10.9% over the 8 year period.

Supply glut of office and retail space in the Klang Valley. Due to supply outpacing demand, rental rates for office and retail space have been impacted, particularly for the less prime properties. Vacancy rates for shopping malls have been rising since 2015 while the office vacancy rates have remained very high over the last few years, with no signs of the situation improving anytime soon.

Klang Valley's Big Five prime shopping malls are Suria KLCC, Pavilion, One Utama, Mid Valley Megamall/The Gardens Mall and Sunway Pyramid (owned by SunREIT). Despite this glut of retail space, the prime shopping malls have seen rental rates rise steadily over the years. Rising vacancy rates and falling rental rates have plagued primarily older and less prime malls.  On a related note, the surge of the T20 (top 20% percentile of income earners) in terms of income and wealth growth has helped support traffic footfall to the prime malls. The steady growth of demand for luxury cars over the last few years versus mid-range Japanese brands paints a very clear picture of the state of each socioeconomic strata in Malaysia.

Company Analysis

Review of Assets

Sunway Pyramid

The crown jewel of the SunREIT. I am of the view that this REIT would have performed better if this REIT only contained Sunway Pyramid as most of the other assets have detracted from performance. As one Klang Valley's Big Five prime shopping malls, this has allowed Pyramid to maintain a close to full occupancy rate and steady rental reversion in spite of the glut of shopping malls in the Klang Valley. This mall has remained the anchor of the REIT since its IPO and the primary source of DPU growth, as can be seen below. In the long run, the addition of new assets into the REIT will gradually erode its contribution to the REIT. The mall has experienced steady growth in traffic footfall (industry jargon for number of mall visitors) over the years, with a reported 5% growth in car count for 2017. The management's active effort to increase the number of parking bays available for visitors has sustained this growth rate, as limited parking bays have been a growth bottleneck for the prime malls of Klang Valley.

Other Assets

SunREIT's hospitality assets have been unsatisfactory in my opinion, though not surprising for its asset class. The contribution of the hotels have been volatile on a quarterly basis, and in the long run, stagnant as hotel room rates have not increased significantly over the years, unlike retail rental rates. The office buildings have been performing even worse, largely due to the office supply glut in the Klang Valley. According to Savills, the office vacancy rate is currently between 20-25% and is expected to persist there until 2022.

On the other hand, Sunway Medical Centre has been a positive acquisition for the REIT as it was done on a triple net lease basis, meaning that all costs are borne by the hospital while the REIT collects a fixed rent with annual escalation of 3.5%. SunREIT's recently announced acquisition of education assets are also fixed rent terms, subject to annual escalation, which I deem to be a positive as this will provide NPI growth and stability to the REIT. As these leases are long term (Sunway Medical Centre's lease was done on a 10 + 10 years basis while the education assets will be leased on a 30 + 30 + 18 years basis), the risk of non-renewal or renewals at lower rental rates is not there.

Income Analysis

Long term DPU growth. SunREIT has demonstrated a steady track record since its IPO in 2010, due in no part to the strong performance of Sunway Pyramid and acquisitions of new assets funded through borrowings. Sunway Pyramid has been able to raise rents successfully while preserving a close to full occupancy rate over the years. Suria KLCC, Pavilion, Mid Valley Megamall and The Gardens Mall have average rental rates of RM 24 psf, RM 26 psf, RM 17 psf and RM 16 psf respectively.

As a result of more acquisitions, the REIT's gearing ratio (total debt to total assets) has been creeping upwards over the last few years years, and will rise to 42.8% following the recently announced acquisition. This is still comfortably below the Securities Commission's prescribed gearing limits of 50%, and will give the REIT some headroom to acquire further assets without needing to raise new equity or issuing perpetual bonds. While most REIT's employ a fair amount of leverage to boost unitholders' returns, SunREIT is unique relative to the MREIT space in that it relies exclusively on short-term financing, which I will discuss further below.

Sensitive to interest rate changes. Unlike most of the other MREITs that rely on medium term financing, SunREIT relies exclusively on short term funding. Implicitly, SunREIT's interest expense is sensitive to changes in Bank Negara Malaysia's (BNM) Overnight Policy Rate (OPR), relative to other MREITs. According to SunREIT's 3Q18 financial report, it has MYR 2.913 billion of short term borrowings, consisting of short term bonds, commercial papers and revolving loans. As a result of relying on short-term financing, SunREIT's cost of debt is approximately 4.0%, somewhat lower than the other MREITs. IGB REIT's borrowing cost is 4.5%, KLCC REIT - 4.8%, CMMT - 4.8% and Pavilion REIT - 5.2%.

On the other hand, the price of relying on short term financing leaves SunREIT vulnerable to liquidity shocks in the banking system and broader financial ecosystem. Under extreme liquidity scenarios such as the Asian Financial Crisis of the late 90s, or more recently the US at the height of the Great Financial Crisis, SunREIT could struggle to roll over its short term debts, or may end up paying exorbitant rates in times of crisis.

Taking into account the new debt of MYR 550 million for the acquisition of Sunway's education assets, SunREIT's new debt load will stand around RM 3.5 billion. A 0.25% reduction in the OPR and corresponding fall in SunREIT's cost of debt translates into a lower interest cost of RM 8.6 million. This translates into a full year DPU boost by 0.29 cents, or about an increase of 3% to the last four quarters worth of DPU. Conversely, an increase of the OPR by 0.25% will directly translate into a corresponding decrease. This is in contrast to the other major REITs that issue 3-10 year bonds with fixed coupons, or take out loans on fixed interest terms, causing the earnings to be less sensitive to short term fluctuations of interest rates.


SunREIT's DPU growth should remain positive despite the challenging situation affecting the retail and office rental markets, owing the strong performance of Sunway Pyramid. I deem the addition of education assets as a strong positive, as it will reduce the volatility of DPU on a quarterly basis as well as provide predictable and stable growth going forward.

As of 31 December 2018, this REIT has generated capital gains of 96.6% since its IPO, and 62.5% of post-tax dividend return for a total return of 159%. This translates into an approximate annualized return of 11.8%. In comparison over the same period, the KLCI has generated 29.5% of capital and 27.6% of dividend returns, for a total of 56.9% or an annualized rate of 5.6%.

For market data on this REIT and comparison against the market, please refer to my compilation of REITs here.

Disclosure: I have been holding this REIT since its IPO in 2010, and have no plans to liquidate my position in the foreseeable future.