Thursday, February 6, 2014


OUE C-REIT, which comprises OUE Bayfront and Lippo Plaza, IPO at a price of $0.80. It offers investor a yield of 6.8% which is considered rather high for a non-industrial REIT. The price-to-book ratio is 0.77x which offers investor a 'discount' to the book value that is one of the largest among all the S-REITs. As always, the devil is in the detail.

Office properties are typically sold at a capitalization rate of 3.5% as compared to 5% for retail properties and 6.5% for industrial properties. However, the average dividend yield for office REIT is around 6.5% as compared to 6% for retail REIT and 7.5% for industrial REIT. Capitalisation rate is similar to PE in that it is Net Property Income (NPI) / Property Value. Obviously, something has to been done to pump up the NPI yield by 3%.

Same Old Tricks Again

Income Support is the favourite trick of all office REITs. It guarantees a minimum level of income and yield for the initial few years that will satisfy the need of the investor. The principle is that rental rate signed at the moment is much lower and is likely to grow in the future. The seller provides income support for the first few years until the positive rental reversion takes place which will render the income support useless. Income support is almost always needed whenever office REITs are looking to acquire new asset. Since 2007, most office properties acquired by REITs have income support in place. Let's examine the track record.

Figure 1 - Office Properties where income support expires

 Figure 2 - Office Properties where income support has yet to expire

From figure 1, all 3 properties fail to meet the Income Supported NPI level at the time of acquisition. The final yields were all around 3.5%. Figure 2 refers to properties with income support provision that has yet to expire. Currently, none of them achieves organic NPI yield of more than 4% after exclusion of income support. This brings into question whether income support has merely been a gimmick all these while. Notice the difference in the NPI(With Income Support) and the acquisition price for MBFC (1/3 interest) acquired separately by Suntec REIT and K-REIT (since rebranded as Keppel REIT). The difference in acquisition price is likely due to the difference in net present value of the total amount of income support (difference of 17.6 million yearly) provided. At the end of the day, does not it seem like investors are the one paying for the income support to create the illusion of a higher yield?

The way I view income support is that growth is being purchased upfront. If the forecast growth is achieved, DPU does not increase as the growth in NPI compensates for lost of income support. If the forecast growth is not achieved, investor will suffer a drop in DPU after expiry of income support. Growth in DPU is achieved only if growth in NPI exceeds that of the forecast which is already likely to be aggressive in its assumption.

Figure 3 - Implication of Income Support

Lets get back to OUE Bayfront, the property that's provided with income support to guarantee minimum Gross Rental Income (GRI) of $57 million annually for 5 years. Total amount of income support is subjected to the limit of $12 million a year and $50 million in total for the 5 years. Based on the total NLA of 37,381.8 sq m and forecast GRI of $47.3 million in 2014, this works out to be average rent of $9.84 psf. To achieve the level of $57 million, average rent of $11.81 psf is needed. Current passing rent is only $10.4 as of September 2013. With Bank of America occupying 28.7% of OUE Bayfront's GRI with a long-dated lease term till 2021 (though there will be step-up clause) and that top 10 tenants account for 76.4% of total GRI (less bargaining power), there is likely to be no growth in DPU for next 5 years and a small possible downside after 2018. Figure 4 provides a comparison of how much of the distributable comes from Income Support or Capital Return, which is a sign of how sustainable the dividend is.

Figure 4 - Income Support/Capital Return as % of Distributable Income

Management Fees payable in Units or cash can affect the amount of income distributable to unitholders. It is equivalent to paying staff using share options instead of cash and has been mentioned in an earlier post on SPH REIT. The impact can be significant as seen from the 0.69% increase in distributable income by having 100% of Management Fees Payable in Unit in Figure 5. I have also done a comparison against other office REITs in Figure 6. The key importance here is that when distributable income drops during bad time, it is those who have been paying management fee in cash that can convert them into units and hence reducing the drop in DPU.

Figure 5 - Management Fees payable in Units

Figure 6 - % of Management Fee Paid in Unit

High Gearing is used to lever up the income for distribution. The low capitalisation rate for office building is why all the office REITs are much more geared as compared to other S-REITs. A 35% gearing ratio allows income for distribution to be levered by 1.54x (100%/65%) minus the finance cost (interest rate multiplied by 35%) In the case of OUE C-REIT, the 42.3% gearing ratio provides a leverage of 1.73x minus finance cost of 1.06% (Interest Rate of 2.5% x 42.3%). Therefore, the unlevered income for distribution will be 4.5%. ( [6.8%+1.06%] / 1.73) and leverage increases dividend yield by 2.3%.

Figure 7 - Gearing Ratio of Office REITs

Something Different

However, gearing ratio ( Debt/Investment Properties ) can be manipulated by the denominator. By valuing the investment properties higher than its fair value, REIT can actually artificially depress the gearing ratio to make the balance sheet appears more healthy. In fact, this point is linked to why OUE C-REIT is trading at a 23% discount to book value. The main reason why OUE C-REIT trades at a discount to book is due to the discount over fair value that OUE and Lippo China Resources offer to sell to OUE C-REIT.

Figure 8 - Valuation of Investment Properties

Figure 9 - Unitholders' Funds

The difference in purchase consideration and value on balance sheet is the revaluation surplus and this is how unitholders get a huge discount on book value in an IPO. For OUE Bayfront, the difference in purchase consideration and value is only 100 million or 10% of the value. At a NPI yield of 3.3%, maybe the valuation on OUE Bayfront is slightly aggressive based on the value on balance sheet. We do not have conclusive evidence for this. However, does not there seem to be a huge gap between the purchase consideration of Lippo Plaza and its valuation? Why is Lippo China Resources (LCR) so generous to offer a 30% discount though LCR is not even owning any equity stake in OUE REIT?

Firstly, Lippo Plaza is a 14 years old building sitting on a 50 years land lease that will expire in 2044. Therefore, investor is buying an older building with only 30 years of lease remaining. This is unlike OUE Bayfront which has a remaining lease of 92 years. The depreciation rate for Lippo Plaza is 3.3% which means that out of the 5.2% NPI yield, only 1.9% is investment return as the rest is form of return of capital. With remaining lease of 30 years, how is the valuation worth $476 million or 3.7% NPI yield? Industrial REITs usually trades at a higher dividend yield to account for their shorter land lease period of 30 to 60 years. Industrial properties tend to be bought at capitalisation rate of 6% to 6.5% to account for the higher depreciation rate.

Secondly, Lippo Plaza Property is based in Shanghai, so it will be different as compared to a Singapore property for REIT. One key benefit of putting a property into REIT is to get tax exemption. Foreign property in S-REIT is exempted from taxation in Singapore but they are still required to pay tax in their local country. In the case of Lippo Plaza, it is supposed to pay 25% of its taxable income and 10% withholding tax for dividend paid to OUE C-REIT. This works out to be around $3.5 million in taxes each year after deducting expenses or 20% of the net property income of $17.4 million. Therefore, the effective NPI yield for a like-for-like comparison with Singapore property will only be 4.2%. If we deduct another 3.3% of capital return, investor is only getting an investment return of 0.9%. And if we take into account expenses like management fee and finance expense, one should really wonder why did OUE C-REIT take up this property and value it at $476 million?

Figure 10 - Forecast Occupancy Rate for Lippo Plaza

Figure 11- Forecast Assumption

For the appraised value, OUE C-REIT adopts the higher of the 2 valuers which is the one by Colliers. Colliers has assumed a 5% annual growth rate in rental which seems aggressive. The assumed occupancy rate of 95% for office seems high as the highest it has achieved is 92.1% in the past 3 years. This is a 14 years old building and it is unlikely to compete well against the newer building when it comes to higher rental and occupancy rate. Perhaps we should look at Lippo China Resources for some clues.

Figure 12 - Snippets from circular

Figure 12 contains some interesting opinions from the board of directors of Lippo China Resources. For LCR, Lippo Plaza is a mature 14 years old asset which requires high maintenance cost of around $6.5 million (not sure if it is one-off or annually). If LCR is realizing full value of its property at a 30% discount to valuation, then OUE C-REIT's revaluation is unjustifiable. The revaluation creates a "discount to book value" as well as reducing the gearing ratio. If we were to value Lippo Plaza simply based on its purchase price, the gearing ratio will now be 47.5% [ 681.4/ (1102+331.8) ]. This is the real incentive for having higher valuation - to disguise a much higher leverage.

This does not seem to be a rewarding deal to OUE C-REIT. LCR does not have to own any equity stake in OUE C-REIT while OUE needs to own 50% of OUE C-REIT. LCR needs not provide any form of income support unlike OUE which has to come up with $50 million for OUE Bayfront. OUE C-REIT bought a property with only 30 years remaining lease and does not enjoy tax-saving. While I do agree that Lippo Plaza only accounts for 30% of the total asset, this shows the incentive of the management. Why does not OUE C-REIT acquires both properties from OUE, instead of 1 from Lippo China Resources? The likely reason is that OUE is at the bottom of the pyramid with listed parent companies like Hong Kong Chinese Limited and Lippo Limited. The incentive is to reward the top more than the bottom. Certain management team and owner always have a consistent reputation and track record for being shareholder friendly or otherwise. It might be a good idea to take a look at the performance of some of the other Riady's companies listed in Singapore.

To conclude, a lot of work has been done to push the yield up and make it looks more attractive. The fundamental difference in office cap rate and dividend yield results in a situation where Office REITs often resort to numerous tricks. Yield accretive acquisition is also unlikely to take place with its current dividend yield and 42% gearing ratio. As with all REITs and investments,it is not about avoiding the risky one but a question of whether the current yield sufficiently compensates for the underlying risk of the REIT. Investor will probably do better to demand a much higher yield than 6.8% for OUE C-REIT.