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

Strengths

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.

Risks

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

Singapore

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.

Japan

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.

Financials

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. 

Conclusion

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.