Monday, July 22, 2013

SPH REIT - A Lesson on Financial Engineering 101

SPH REIT is a spin-off from SPH, comprising of Paragon Mall and Clementi Mall, offering an annualised yield of 5.58% for FY 2013. At this income supported yield, it offers a 0.5% higher yield than CMT and 0.2% lower than Fraser Centrepoint Trust. Retail REIT has always been a favourite of REIT investor due to their defensiveness and ability to squeeze extra rental cost from the tenant.

However, why is it that they delayed their listing on 24th June 2013 before lodging their prospectus on 9th July 2013? In a mere 3 weeks, an unattractive IPO is now the hottest thing on the market, with an indication of interest from institutional investor being 42x the placement tranche. . At the end of the day, many investors define the attractiveness of a REIT based on the yield. This prompts me to look at what forms of financial engineering have been used to increase the yield. Shall start the analysis with the most obvious and end with the hidden trap. The hidden trap is what that allows SPH REIT to be priced at 0.5% higher yield than CMT.

99 Years Lease. Similar to K-REIT, SPH sold a 99 years lease of Paragon Mall to SPH REIT while retaining the freehold ownership of Paragon Mall in our prized Orchard Road. According to the Knight Frank valuation certificate on the circular by SPH, Paragon mall is worth $2.61 billion as a freehold property and $2.5 billion as a 99 years leasehold property. The Freehold Lease is worth only $110 million, which is ridiculous. Who will not want to pay an extra 4% of their property value to upgrade their property from a 99 years lease to freehold? 99 years lease represent a 1% depreciation each year, which means the payback is theoretically 4 years to secure the freehold right. Of course, it is likely that maintenance and capex will be needed for an asset past 99 years.

Income Support. SPH has guaranteed that Clementi Mall will produce $31 million in NPI for the next 5 years. The reason is that Clementi Mall is a relatively new mall and that the current rent signed is lower than the market rental. Income support is common for such new property, but does SPH really lose money from providing income support? According to the valuation report in the prospectus, the $570 million Clementi Mall is only worth $550 million without the income support. Projected NPI from Clementi Mall is $26.7 million in FY 2014. On the conservative assumption that it remains the same for the next 5 years, SPH will provide a total income support of $4.3 million x 5 = $21.5 million. Thus, SPH is unlikely to have to fork out more money by providing the income support on a net basis (it earns extra $20 million from selling at $570 million). Yet, investor can be sold on a higher dividend yield though it is a partial capital return of the IPO investor. In addition, given the income support for 5 years, it means that growth for Clementi Mall will already be factored in for the unitholders unless they can grow their NPI beyond the income support mark of $31 million.

Lower capitalisation rate in valuation. The gearing ratio of 27% looks attractive and helps to alleviate fear of rising interest rate. However, gearing ratio can be engineered through a change of the property valuation which is the denominator. A cap rate of 4.75% and 5% have been used to value Paragon Mall and Clementi Mall (the income support has been taken into account) respectively. In comparison, CMT uses an average cap rate of 5.4% to 5.85% while FCT uses an average cap rate of 5.50% to 5.75% to value their properties. Some might argue that as 99 years leasehold asset, they should be worth a much higher valuation than the 70+ or 80+ years remaining leasehold asset. However, Atrium@Orchard with 94 years remaining lease and Yee Tee Point with 92 years remaining lease do not have a lower cap rate. This reflects how conservative or aggressive a management has been in valuing the property and thus tweaking the gearing ratio.


Lower interest rate. According to the prospectus, SPH REIT has been assumed to pay a constant 2.35% interest rate on its loan. The $850 million loan is to be repayable 1/3 each in 3,5 and 7 years time which gives an average loan maturity of 5 years. s of 31 March 2013, the effective interest rate for FCT and CMT are 2.73% and 3.3% on average term to maturity of 3.35 years and 4 years respectively. How did SPH REIT manage to secure a lower interest rate of 2.35% and higher term to maturity of 5 years when the fear is that interest rate is going to rise in the near term? Firstly, I cannot find the exact interest rate charged on the loan in the prospectus and the 2.35% has been quoted as an assumption. Thus the actual interest rate might be much higher than the assumed 2.35%.

Even if the assumption is true, how did SPH REIT do it? They actually got a secured loan over Paragon Mall which accounts for 80% of their total value. CMT's unencumbered assets as % of total asset is 76.7% and FCT is 43% compared to 20% for SPH REIT. (Unemcumbered means the asset has not been mortgaged. A secured loan is cheaper than an unsecured loan. However, when financial crisis comes, an unsecured asset might be what that will give the bank the confidence to lend you money. Thus, by taking a secured loan up to 80% of their total asset, SPH REIT is taking a higher refinance risk as compared to CMT and FCT just to inch out a lower interest rate and hence 0.19% higher dividend yield. On the other hand, it is likely that CMT will not face much refinancing issue given their unencumbered assets and well-spread debt profile.

The Finale

This is the most important point to take note of on how SPH REIT actually financial engineered a 0.5% higher dividend yield than CMT using an old, legal and similar technique of option expensing.

The Manager's management fee is $15.2 million in FY 2014 and they have chosen to be paid 100% in units. This is equivalent to taking a stock option, which convert employee's cash expense into 0 though it actually results in dilution in EPS the subsequent year. The $15.2 million to be paid in units is equivalent to 11.6% of the Income Available for Distribution. In contrast, the proportion of management fees paid in unit as percentage of Income Available for Distribution is only 1.5-2.5% for CMT and FCT.

Looking at the DPU sensitivity yield above, if SPH REIT were to take 100% of management fee in cash, the annualised yield for SPH will drop to 4.93% and 5.15% for FY 2013 and 2014, which will price it at a lower dividend yield than CMT. This is but a financial engineering move as the dilutive effect and selling of shares will weigh on the share price in the long run. The reason why the management fee is such a high percentage of distributable income is because SPH charges 0.25% of asset value and 5% of NPI as a REIT Manager and 2% of Revenue and 2% of NPI as a Property Manager.

To conclude, it is certainly not fair to simply compare the dividend yield of the REIT and determine how attractive it is. As always, the devil is in the details and I believe the market is a weighing machine in the long run.

Monday, July 1, 2013

Random Thoughts on Investing

Ever since I got started in Sep 2011, I have been in the market for close to 2 years. I have had many thoughts about investment but have yet to pen them down. This will be random thoughts about investing and the lessons that I have learnt. I can't find a way to categorise them, so there's no structure and it's pretty messy.

Value investment is not about buying something at ridiculously low PE/PB nor buying a company with a sustainable competitive advantage. Neither is it about buying low nor selling high. Who purchases an equity share without believing that he is buying low and selling high? Or rather who buys the share of a company believing that he is buying high and will be selling low? No one, but belief and action often diverge in the market.

Whether it is buying Graham's net-net or buying Buffett's strong moat company, these are merely manifestation of the underlying value investment philosophy. It is easy to be confused that anyone buying the same "value investment kind" of company as Buffett, Seth Klarman and e.t.c. are value investors. One might even buy the exact same companies at the exact same price as the renown value investors are, but that will not make you as successful as they are.

The 2 key principles that define a value investor lies in Mr Market and margin of safety. They are mentioned in the famous chapter 8 and 20 of The Intelligent Investor. Mr Market is the fluctuation in prices of securities and mood of the market. One can profit from the maniac of Mr Market if he is able to control his emotion and avoid being a slave to Mr Market. Understanding the existence of Mr Market entails that price fluctuation and volatility is part and parcel of the market. Price can move in either direction and intensity regardless if you have made the right decision. However, by making the right decision, you know you will come up right in the long run.

Margin of safety is about protecting your downside and reducing the risk. This is often quoted as buying something worth $1 for $0.50. There're many reasons for it:
1) We might make an error in our judgement of its fair value
2) We do not have perfect information to make a good judgement
3) There's no way we can predict the future with 100% accuracy
4) It might be fake/fraud
5) Black Swan ( Anything that you can't think of - that's why it's called black swan)

Margin of safety is demanded in areas other than the price. Diversification is needed because you do not want to let a single mistake or black swan wipe you off the game. However, the problem is that people often diversify for the sake of diversifying, which increases their risk instead of reducing it. Diversification should be done only if one can find a company that can offer similar or even better risk return profile than the portfolio.

Investing is a game of probability or even a gamble. Before the outcome is out, there's no way to know if we will win or lose. In a casino game, the edge is always with the house and statistically we will lose money in the long run. However, the game in the market differs from the casino as the autonomy is with us. We get to decide the probability of the game by choosing which hand we are interested to play. If we consistently choose to play a game where the risk reward ratio is not attractive, we are likely to lose money in the long run. If we choose to play a game only when the odd is highly tilt to our favours, we are likely to profit in the long run.

Over a long period of time, the law of large number will ensure that your investment return will track the kind of odds that you play with. However, in the short run, it is easy to assume that early success equates ability to spot games with asymmetrical risk return profile where others are not capable of. Success in investing does not come from out-performance in the market, though that is the easiest method of evaluation. Instead, an investor should focus on the analysis and decision that he has made.

As it is a game of probability, excellent analysis and decision made does not equate to a rise in share price. Even if the share under-performs, an investor should not blame himself if he knows that he has made the right analysis and decision at that point in time. Instead, he should continue making the same kind of decision if he knows that he did not make any mistake. Do not let a good decision gone wrong becomes a baggage for you in the future. In a game of probability, we can never be right 100% of the time even if we made the right decision 100% of the time. Similarly, if you have profited in a situation where you made an erroneous analysis or decision, be glad that it didn't cost you a penny but remind yourself that you should not repeat the same mistake.

While a fan of Buffett might not be interested in cigar butt or a fan of Graham will not be interested in investing in an excellent business at fair value, they are not contradictory in nature. One is buying at a discount to future value while another is buying at a discount to present value. Benjamin Graham knew that he cannot predict the future with much accuracy and feel that it is much safer to look at the current state of the company than future profitability. Warren Buffett's experience with Berkshire Hathaway as a textile business taught him that finding great companies that are able to consistently deliver return above the cost of capital is likely to present a more attractive option. Both are great and they play the game according to their personality, style and area of competency. It is not the style that matter but the underlying philosophy and principles that drive their decision.

Investing is never easy but there will always be people that try to convince you that by obeying a set of rules and formulas you can easily outperform the market and compound your wealth. Because the famous investor has been using it, copying them will allow you to reach the level of wealth and competence they have. Before you can get your hand onto it, you will have to pay a significant fee to attend the course or even buy some robots.

Investing is not easy as it is often a zero-sum game. A trade constitutes a buyer and a seller who have similar motive in making profit but whose action contradicts one another. Either the buyer or the seller is right, it is rare to have both correct. How do you know that you are on the correct side of the trade? You can try to increase the chance that you are right by asking yourselves what insights do you have about this company that others do not? It is not about possessing insider information, but forming your own independent opinion and analysis about the company. If everybody thinks that Myanmar is going to experience fast growth, obviously this will have been factored into the price of the stock and there will be not be significant upside potential other than speculation.

Investing is when you buy an asset at a discount to its fair value and expect that the fair value can be realised or the fair value can grow. On the other hand, speculation is when you buy an asset in the expectation that a greater fool is going to buy it from you one day. It is often hard to distinguish investing from speculation merely by looking at the stock purchased or the price paid. Famous phrase like "This Time is Different" is often used to justify the act of speculation. Perhaps, only the investor/speculator will know whether he is investing or speculating, that's if he has been able to control his emotion and think rationally.