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. http://www.stproperty.sg/articles-property/singapore-property-news/sph-reit-attracts-strong-institutional-interest/a/128627 . 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.

Source:

http://capitamall.listedcompany.com/newsroom/20130514_175959_C38U_4FA4342B033816C448257B6B00363F02.1.pdf

http://infopub.sgx.com/FileOpen/Investor_Prestn_June_2013_Cit_Asean_Conf.ashx?App=Announcement&FileID=245672

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.