Thanks for staying tuned to REIT-it despite the long hiatus. It has been 4 months since the IPO of Sasseur REIT and with a few banks issuing buy calls on Sasseur REIT, REIT-it thought it is a good time to share some analysis done on Sasseur REIT a couple of months ago.
Just a quick overview of Sasseur REIT. Sasseur REIT’s IPO was launched in March 2018 at an offering price of S$0.80 per unit. Since then the price has gone south, declining by a whooping 11.25% from its initial offering price within a mere 4 months. Yield-chasers who were attracted by Sasseur REIT’s 7.5% dividend yield must be licking their wounds suffered from the rapid drop in Sasseur REIT’s share price.
In REIT-it’s opinion, Sasseur REIT is a classic case of poor product being offered to the public under the guise of high yield. While many may think that REITs is a “risk free” investment product, Sasseur REIT serves as a warning to unsuspecting investors that investment in REITs still requires a keen sense in fundamental analysis on the subject REIT.
With the current price drop, many would ask if value has emerged. REIT-it personally feels that with due consideration on the risk profile of Sasseur REIT, value remains a distant adjective to be applied on this REIT. In addition, REIT-it also thinks that Sasseur REIT is not a suitable investment for investors who are seeking low risk investment return.
More details can be found in the report below, written in March for the IPO.
Many reports have sang praises of this IPO, so let’s take a look to see if Sasseur REIT is really a top-grade Mao Shan Wang.
IPO Prospectus can be found on MAS Opera: https://eservices.mas.gov.sg/opera/Public/CIS/ViewProspectus.aspx)
NOTE: Remember always that prospectus is a marketing material and should be read with care. Do not trust everything revealed in the prospectus at face value as the story behind the numbers may tell a different story.
SECTION 1: Revenue Drivers
REITs investing is essentially individuals buying into properties. As such, the first thing that we should look at in a REIT IPO Prospectus would be the section on Information of the Properties. You can usually find tables like this:
Source: Sasseur REIT IPO Prospectus
By investing in REITs, people usually expect stable income stream for a long long time in the form of dividends. For the dividends to be stable, the REIT’s ability to maintain high occupancy and continuous growth in rental is important. Below are some important things to note in a prospectus:
From this table, the first thing to look at would be the occupancy of the assets in the table to quickly ascertain the desirability of the assets.
Occupancy refers to how much of the space available in the assets (commonly known as Net Lettable Area/NLA) are leased – which most of the time means that these spaces are generate some income. A higher occupancy rate is always preferred and reflects on the surface if the asset is desirable to space users. A low occupancy rate may reflect problems on the assets and more investigation should be done when low occupancy rate is encountered.
Out of the 4 assets, we can see that one of the assets was at 85.6% which may sound an alarm for the desirability of the asset by tenants but may not necessarily be a bad thing if the asset is fairly priced (discount to market price).
The portfolio occupancy also increased from 91.8% to 95.1% between Sep 2017 and latest practicable date (likely Feb 2018), which means there are a marked increase within a short period of time. From my conceivable mind, there are 2 possibilities of what happened:
- The location became very desirable and new tenants came in at a market rate (Signifies growth prospect of the REIT)
- Sasseur wants to prop up the occupancy prior to IPO and get tenants to come in at a very low rate + long rent-free period (Potential red flag)
From point b, we can understand that high occupancy, on the surface, may seem like the property is doing well. However, on closer look, high occupancy can be achieved by giving very low rental rates or even no rent to prospective new tenants. This requires more in-depth investigations.
WALE (Weighted Average Lease Expiry)
Weighted average lease expiry measures how long the current existing leases will continue for before renewal of leases takes place. This indicator is important as it tells us how long will the existing cash flow from rental runs till before negotiation for new leases have to take place. During the renewal/ negotiation phase, existing tenants may decide to shift out of the building and this will then affect the stable cash flow that we desire when investing in a REIT.
Lease expiry is a key risk to our desired cash flow and hence the longer the WALE, the more stable the cash flow of a REIT is.
In Sasseur’s case, the WALE by NLA (net lettable area) is 3.2 years which as compared to the market (usually leases in Singapore runs for 3 years) is considered healthy.
However, when we look at the line below, which shows the WALE by Property Income, the number we got is a much shorter 1.2 years. This is a potential red flag that we should catch as this may mean that the bulk of the tenants who are paying higher rents will have their leases expire within 1 year or so, leaving behind tenants who are paying very low rents or no rents.
This may support our suspicion in point 1b that the occupancy has been artificially shored up by Sasseur within the last 6 months by getting in low rent/no rent tenants. This observation applies to 3 out of 4 of Sasseur’s properties, which makes it a serious red flag to take note of. What this may mean is that the tenants are actually unwilling to pay market rent for the various outlet malls held by Sasseur REIT and the latter may have difficulty maintaining the dividend payout in the next few years.
Dwelling further, the income of outlet malls in Sasseur REIT comes in the form of sales-based leases. According to Sasseur’s IPO, “most of the tenants have entered into short term sales-based leases, whereby the rent is determined solely based on turnover as opposed to a fixed rent”. This adds a lot of volatility to the cash flow of the underlying assets.
Rental Revenue/Management Agreement
However, the volatility of the cash flow is mitigated by Sasseur REIT entering into an Entrusted Management Agreement (“EMA”) with the Manager to have a Minimum Rent payable to the REIT. This means that if the businesses in the outlet malls do not do well and hence the rent received is lower than the Minimum Rent, the REIT Manager will have to top up the shortfall.
Such arrangement is commonly known as Rental Guarantee, which gives stability to the income and is in line with the objective of REIT investors like you and I.
With such agreement, if there is no end date, the key analysis should be done on how much dividend per share are we getting if only the Minimum Rent is achieved to understand the downside protection of this REIT.
In this case, the Minimum Rent from FY2019 will be RMB 611.4 million (S$ 124.0 million assuming exchange rate of 1 SGD: 4.89 RMB), which would give us a guaranteed yield of 6.9% (assuming market cap of $944.2 million according to The Edge).
|Projection Year 2019 (S$’000)|
|EMA Rental Income||124,000|
|Manager’s management fees||(8,181)|
|Other trust expenses||(1,410)|
|Total Return attributable to Unitholders||65,077|
Source: Sasseur REIT IPO Prospectus
In the EMA, it is also important to note that there is an annual step-up of 3% on the Fixed Component (RMB 425.2 million = S$87.0 million) over the term of the EMA. This will provide an organic growth component to the rental income of Sasseur REIT assuming no deterioration of the variable component of its rental income (4.0% – 5.5% of total sales). This total amount, when fall below the Minimum Rent (see above), will be topped up by the Entrusted Manger.
Please note that even when the rental income is guaranteed, the ability of the “guarantor” to pay the sum should be considered and will be covered more in the full analysis. Default on Rental Guarantee has happened before on Jackson Square held by Viva Industrial Trust and this scenario should be carefully considered.
The first 3 points dealt with the analysis on the certainty of revenue, with more in-depth analysis such as market research required to ascertain the growth that can be achieved on the revenue.
SECTION 2: Valuation of Properties
Valuation of the properties is one of the most important value to examine when investing in REITs. The valuation of the properties is the underlying foundation of investment in REITs as any decrease in valuation would cause our investment to go south.
While independent valuation may be employed to determine the value of the portfolio, the assumptions made by the valuers have to be scrutinized as such assumptions may have been managed by the Sponsors.
For valuation, there are 2 common approaches employed by valuers: (i) Income Approach – Discounted Cash Flow; (ii) Income Capitalization.
2 valuers are employed by Sasseur REIT for this IPO evaluation – Savills and JLL. The approach used by Savills and JLL in valuing the 4 assets for Sasseur REIT is (i) Income Approach – Discounted Cash Flow (“DCF”) due to the lack of market comparable. Such an approach is the most susceptible to management’s interference as the inputs of the valuation is relied highly on:
- Forecast given by the Sponsor
- Discount rate applied on the Discounted Cash Flow Method
After reviewing the Independent Property Valuation Summary Reports (Appendix E of Sasseur REIT IPO Prospectus), what is disappointing is that the discount rate and terminal rate applied on the DCF was not made available. This has made the valuation of the properties very opaque and should you be interested in investing in Sasseur REIT IPO, this is a risk to keep in mind.
Nevertheless, REIT-it has attempted to back-solve the assumptions in the valuation. The discount rate was derived by assuming that growth on the EMA Resultant Rent for Sasseur Chongqing was maintained at a sustainable rate of 2.7% as seen in the assumption used by Savills (which only provides 3-year forecast). A 13.1% discount rate was derived and applied towards all other outlets for valuation purpose.
The Fixed Component of the Resultant Rent is based on management’s estimate with a step up rate of 3.0% per annum (meaning that the base rate will grow 3.0% every year).
Table 2.1: Fixed Component of Resultant Rent
|Property||Fixed Component 2018
Source: Sasseur REIT IPO Prospectus
Since the Fixed Component is in every sense of its name, fixed, the key focus of the analysis on valuation should be focused on the reasonableness of the projected growth rate of the Variable Component in order to achieve the stated valuation.
Table 2.2: Valuation of Sasseur Chongqing
In order to achieve the valuation stated by the 2 independent valuers, the Variable Component of Sasseur Chongqing would need to grow by 2.0% every year, which in my opinion, is reasonable on a long term basis. As such, the valuation of Sasseur Chongqing can be said to be largely reliable.
Table 2.3: Valuation of Sasseur Bishan
In contrast, Sasseur Bishan’s growth assumption on its Variable Component is of double digit for the 10 years shown in this valuation. Such growth assumption, in my opinion, is deemed to be aggressive and unsustainable. As such, Sasseur Bishan’s valuation may have been overvalued.
Table 2.4: Valuation of Sasseur Hefei
Similarly, Sasseur Hefei’s growth assumption on its Variable Component is also of double digit for the 10 years shown in this valuation. As such, Sasseur Hefei’s valuation may have also been overvalued with such unsustainable growth assumptions.
Table 2.5: Valuation of Sasseur Kunming
While Sasseur Kunming’s growth assumption on its Variable Component is of single digit of 7.5% to 8.4% for the 10 years shown in this valuation, such growth rate may not be achievable for a sustained period of 10 years and has a high chance of falling short as well. As such, Sasseur Kunming’s valuation may have also been aggressively valued.
REIT-it’s Conclusion: The valuation of the 4 outlet malls held by Sasseur REIT may have been managed up by the management team by giving high sales growth estimates to the valuers. The valuers would not be able to verify the management estimates as valuers does not possess the necessary expertise in the operation of outlet malls. Meaningful sanity checks would not be possible as well given that the niche market of China outlet malls lacks comparables. As such, REIT-it would like to caution readers on the potential of over-valuation of Sasseur REIT’s properties which would in turn result in the investors overpaying for subscription to the REIT’s IPO issuance.
Section 3: Capital Structure
Gearing Ratio (Debt-to-Asset Ratio)
S-REITs are regulated by MAS under the Property Fund Guidelines to have no more than 45.0% in debt-to-asset ratio (derived using total debt divided by total asset on balance sheet). By rule of thumb, S-REITs usually keep their gearing ratio below 40.0% to be viewed favourably by investors as a reasonably levered company that does not take on excessive risk.
Sasseur REIT has obtained Onshore Facilities of approximately RMB 1,960.0 million (~S$400.8 million) and Offshore Facility equivalent to approximately S$125.0 million. The Onshore Facilities currently has a floating interest rate based on the People’s Bank of China’s benchmark one to five years lending rate per annum (estimated 4.75% per as at the Listing Date).
Based on the average Portfolio Valuation of RMB 7,353.0 million, the gearing ratio of Sasseur REIT is estimated to be 35.0% at IPO, which is well within the safe zone expected by investors. However, investors have to keep in mind that gearing ratio will change every year during the annual mandatory re-valuation of Portfolio. Should the valuation of Sasseur REIT decline rapidly in any year, it may face the problem of exceeding the limit gearing and have to raise equity to pay down current debt, which will in turn dilute shareholders’ return.
In Sasseur’s case, the debt covenant (a promise with the banks) for the Onshore Facility also state the following:
- Property Interest Cover Ratio of 3.5 times: Current Property Cover Ratio is at 5.02 times which is healthy.
- Loan-to-valuation ratio of less than 35.0%: This is the debt covenant that calls for concern if the valuation of the assets were to drop drastically as the sales at the outlet malls experience a sudden sharp decline. A breach of this covenant will result in a technical default on the loan and the banks may force Sasseur REIT to pay back the loans immediately. A REIT usually does not have spare cash and the REIT may have to either raise new equity from investors (more capital commitment without more returns) or sell some assets to pay out these loans.
- Each of the properties shall maintain a minimum occupancy rate and an annual EMA Rental Income: The required EMA Rental Income for the debt covenant are below the figures projected for Year 2018, which provide some comfort. However, do note that 77.2% of Sasseur REIT’s portfolio are derived from percentage of sales, which makes its underlying income volatile despite the EMA agreement guaranteeing the Resultant Rent. More analysis of this risk will be done in the next section.
Table 3.1: Estimated Resultant Rent for Year 2018
|Property||Projected Resultant Rent 2018
Source: Sasseur REIT IPO Prospectus
As mentioned in previous post, interest expense is one of the biggest expense in an S-REIT. A quick look at the table below would tell us that Sasseur REIT is borrowing at the higher end of the range as compared to peers and does not have an advantage in low cost borrowings. However, this is not a call for concern as long as it does not affect the returns of the REIT.
Table 3.2: All-in Interest Cost for REITs with predominantly China assets
|Property||All-in Interest Cost 2018
|CapitaRetail China Trust||2.5%|
|EC World REIT||5.3%|
|BHG Retail REIT||3.7%|
Source: Sasseur REIT IPO Prospectus
Do note that what is of concern is that the current borrowings are all on floating rate, which means that any interest rate hike would adversely affect the interest expense of Sasseur REIT and eat into the profitability of the REIT despite having Minimum Rent in place as interest expense comes after the Minimum Rent payment in the Income Statement.
Section 4: Key Risks
Risk of Entrusted Manager not being able to maintain Fixed Component of Resultant Rent
The Fixed Component of rental, though fixed, may not be reliable after all after examining the breakdown of Property Income by Lease Structure.
By looking at this chart, we can see that there is a mismatch in the fixed nature of the REIT’s payout as compared to the nature of the lease structure of the underlying assets. Only 22.7% of the Property Income is “guaranteed” while 77.2% of the leases are variable component based on turnover of tenants. The turnover is highly volatile and understanding that the location of the outlet malls are at fringe sub-urban areas, the obsoleting of any of the outlet malls will create a rapid decrease in rental revenue. While there is a performance reserve of RMB 100.0million set aside, the amount is small as compared to RMB 264.9 million projected EMA Resultant Rent, which necessarily means that the amount can only cover 6 full months of rental shortfall.
Risk of Entrusted Manager’s ability to pay Guaranteed Sum of Minimum Rent
While it sounds good that the rental income is guaranteed, the quality of the “guarantor” must be assessed as the “guarantor” may default on the payment at some point in time (Example: Jackson Square in Viva Industrial Trust was on Rental Guarantee but default happened).
In the case of Sasseur REIT, a performance reserve of RMB 100.0million to Sasseur REIT (“Performance Reserve Amount”) has been set aside. This amount is only sufficient to pay less than 2 months of annual Minimum Rent of 611.4 million. The amount set aside does not provide sufficient comfort that the guaranteed Minimum Rent can be sufficiently covered despite the agreement.
Risk of business downturn after Minimum Rent falls off with 2 consecutive years with stellar performance
The Minimum Rent arrangement will fall off if the Sasseur outlet malls are able to deliver Resultant Rent better than the Minimum Rent of 611.4 million per annum. Should there be any 2 years where this low barrier is crossed, the Minimum Rent arrangement will cease, and the volatility of the earnings in the REIT will increase significantly with sales being the predominant driver of profitability in Sasseur REIT.
Interest Rate Risk
As mentioned in Section 3, 100% of the current loan is on floating rate and hence the interest rate risk poses a significant risk on the return of the investors. The REIT would have to enter into hedging instruments with the banks to hedge 100.0% or partially the borrowing costs to ensure stable returns to the unitholders. Investors should continue to monitor this situation after IPO to ascertain extent of this risk.
Exchange Rate Risk
Considering that this listing consists of assets in China, the rental income would be collected in Chinese yuan (RMB) and converted to Singapore dollars before distributing dividends to shareholders in Singapore dollars. This process may cause some exchange losses that may affect the return on investment of this REIT especially when RMB weakens against Singapore dollars.
To mitigate this problem, a REIT with income denominated in foreign currency may purchase a hedging instrument from the banks to fix the exchange rate. However, it is important to note that such hedging instruments do have a cost chargeable to the REIT and may hence have affected the return on the REIT.
In the case of Sasseur, by borrowing in RMB, the matching of currency of interest payment and the currency of rental income creates a natural hedge against exchange rate risk in the repayment of interest payment (E.g. borrowing in Singapore dollars and having a weakening RMB may cause the interest payment on the borrowing to be more costly).
However, for the distribution to unitholders, the exchange rate risk has not been mitigated and Sasseur REIT mentioned the possibility of it “entering into currency forward contracts to hedge foreign currency income received”. Investors will have to monitor update on this hedging post-IPO to ascertain the risk.
SECTION 5: Conclusion
Sasseur REIT, at 7.5% yield, provides an attractive return for investment in an S-REIT. However, REIT-it notes that the return is mainly dependent on the income support (known as Minimum Rent) given by the Entrusted Manager, who has not presented sufficient assurance in its ability to uphold this guarantee with only a Performance Reserve of RMB 100.0 million set aside for drawdown.
The Minimum Rent, which falls off after 2 consecutive years of outperformance on the Minimum Rent, also have limited protection on the stability of long term return in Sasseur REIT.
REIT-it also notes that the underlying income of the properties is more volatile than stated in the Prospectus with 77.2% of the income derived from sales on short leases. The Fixed Component, though in place, may not be fulfilled should the underlying experience a sharp drop.
Concerns remain on the validity of the growth assumptions in the valuation of the IPO Portfolio, which may have inadvertently propped up the valuation of the IPO Portfolio.
In consideration of all the risk factors stated above, REIT-it would like to conclude that a 7.5% dividend yield is insufficient for such an investment vehicle that offers a highly volatile outlook as compared to usual REIT vehicles. Hence, the Sasseur REIT IPO is more like the hard durians from Thailand, which taste more like sweet potatoes. Definitely not a bao jiak Mao Shan Wang.
Hope you learnt something from this extensive analysis on REITs. Should you have any queries or would like to learn more about evaluating REITs, please email Caleb at firstname.lastname@example.org.
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Disclaimer: This report reflects only the sincere opinion of the writer. Reader should exercise personal discretion when deciding on any investment in Sasseur REIT.