This article first appeared in The Edge Malaysia Weekly, on July 11 - 17, 2016.
MALAYSIAN real estate investment trusts (M-REITs) are touted as safe haven assets for investors seeking safety in dividend yields post-Brexit. But unit holders will need to get smarter fast as M-REITs — favoured and marketed as a low-risk passive investment vehicle with a high certainty of cash flow from rent derived from lease agreements — will soon be allowed to take on construction risks to enjoy development profits.
Projects in the developmental stage may add to a REIT’s future income but they would first reduce the amount of earnings available for dividends. REIT managers have long lobbied for this flexibility as it has become harder to make yield-accretive acquisitions, and the Securities Commission Malaysia (SC) may soon allow them to have up to 15% of their REITs’ total assets comprise development projects and vacant land, say industry sources.
Whether the move would prove propitious for REIT unit holders in the longer run remains to be seen. But they should comb through their portfolio for REITs that may need a fresh cash injection due to a high leveraged position, and those that may have the flexibility to take on sizeable development projects.
Indicative yields for M-REITs range from 4.67% to 9.92%, Bloomberg data show at the time of writing.
Five of the 17 M-REITs have debts that are more than 40% of their assets — close to the 50% gearing ceiling. The five are YTL Hospitality REIT, AmFirst REIT, Hektar REIT, Al-’Aqar Healthcare REIT and MRCB-Quill REIT (see table).
While the 50% gearing cap can be exceeded with approval of unit holders, it is understood that the SC is looking to remove this cap soon — a move that is in line with Singapore’s recent decision to have a 45% leverage limit by removing the option for 60% leverage by having a credit rating.
Of the five, MRCB-Quill REIT is seeking regulatory waiver to be allowed to place out more than 20% of its existing fund size to pay for the RM640 million acquisition of Menara Shell, which would expand its total assets to RM2.27 billion from RM1.6 billion currently. It also wants to be allowed to give more than 10% of the placement shares to the seller and its sponsor Malaysian Resources Corp Bhd (MRCB).
In terms of capacity to take on construction projects, the largest when it comes to asset size is KLCCP Stapled Group, whose over RM17 billion assets include the Petronas Twin Towers, Suria KLCC and Mandarin Oriental hotel in Kuala Lumpur. It is different from the other REITs as its management company, KLCC Property Holdings Bhd — that can already undertake major construction works — is stapled to the REIT, which has investment properties worth RM9 billion.
Other iconic mall owners, Sunway REIT, Pavilion REIT and IGB REIT, have RM5.1 billion to RM6.5 billion worth of assets. A 15% cap would allow them to take on between RM750 million and RM1 billion worth of development projects. Of the three, Sunway REIT’s gearing is the highest at 33% compared with 24% and 26% for IGB REIT and Pavilion REIT respectively.
But Sunway REIT is already looking ahead. In June, it sought a waiver from the SC to buy a vacant parcel — now being used as a car park — next to its Sunway Carnival Shopping Mall in Penang from its parent for RM17.2 million, or 0.27% of its total assets, for a mall extension.
While the purchase price is a small percentage of its total assets, it is not immediately clear from its announcement if Sunway REIT will be building the extension itself and how much that would cost. In the June 20 announcement, the REIT says the acquisition itself is not expected to have a material effect on its earnings for the year ended June 30, 2016 (FY2016).
It was silent on the earnings impact for FY2017 but did say that the proposed acquisition for the expansion of Sunway Carnival “is expected to contribute positively to the performance of Sunway Carnival and hence, the earnings of Sunway REIT in the long term”.
Between FY2011 and FY2015, Sunway REIT’s net property income grew by an average of 8.71% a year from RM244 million to RM340.8 million. Income available for distribution grew at a four-year compound annual growth rate of 9.76% to RM256.6 million in FY2015, even as annualised distribution per unit rose from 6.71 sen to 8.73 sen, implying a decent yield of 5.4% to 6% during the period.
Back-of-the-envelope calculations using FY2015 numbers and a 2.94 billion share base show that a 10% drop in earnings would reduce distributable income by about RM26.5 million or just below 1 sen per share to 7.82 sen, which implies a 4.6% yield on its RM1.69 close on July 5. There is no way of telling how accurate the numbers are without guidance on how much a REIT plans to spend on property development. Even then, as with all construction works, there are factors outside its control, such as delays and potential cost overruns.
One way of mitigating income loss is having the REITs’ sponsors provide income support. Here, experts say investors should take note of the certainty of the income support and whether the income support significantly distorts the real value of the asset and its income generation potential.
It is worth noting that the increased flexibility for REITs to rejuvenate their portfolio — 11 years after the first M-REIT was listed under the current guidelines — comes as rental growth for office and retail space is facing pressure from excess supply, not just in the Klang Valley but also in major cities such as Penang and Johor Baru.
For instance, Hektar REIT — whose RM1.09 billion portfolio of shopping malls include Subang Parade in Selangor and Mahkota Parade in Melaka — told unit holders in its latest 2015 annual report that it expects “2016 to be Hektar REIT’s toughest year over its 10-year history” and warned of lower revenue as rents come under pressure.
“The retail outlook in 2016 is very lacklustre and retailers continue to be skittish. A significant number of our loyal retailers are seeking our support to reduce their rent until the tide turns. These are not fly-by-night retailers. They have been with us for many years and have never objected to rent increases before. I feel it is now time for us to demonstrate our loyalty to them during this extremely trying period. Bear in mind, though, that by acceding to these rent reductions, Hektar REIT may experience dips in revenue in 2016,” its chairman and CEO Datuk Jaafar Abdul Hamid wrote.
Already, existing retail space is set to grow by 40% between 2016 and 2018, with 30.9 million sq ft of retail space coming on the market from the 55 malls being built in the country (35 of which are in the Klang Valley, Penang and Johor), Bank Negara Malaysia says in its 2015 annual report, citing data from the National Property Information Centre.
Similarly, vacancy rates for office space in the Klang Valley were 20.4% last year, above the 16.3% national average and 6.6% regional average. Some recently completed Grade A office buildings in Kuala Lumpur have not achieved satisfactory occupancy rates, despite the city’s prime office space fetching the lowest rent among regional cities of only US$2.60 per sq ft. In fact, several office buildings completed between 2011 and 2014 only had 50% to 75% occupancy rates, Bank Negara says, citing Savills Research’s May 2015 Property Market Overview Report.
The central bank adds, “Over the next few years, the significant incoming supply of large projects could aggravate the oversupply situation in the Klang Valley’s office segment. According to the 4Q2015 Quarterly Property Market Report by Jones Lang Wootton, a total of 63 new office buildings are scheduled to be completed in the Klang Valley over the next three years, where an average of 4.9 million sq ft of new office space will be added to the market each year. This is significantly higher than the historical average of 2.8 million sq ft.”
That is another food for thought for REIT unit holders, especially those who may soon be asked to vote on proposals for the REITs to take on construction and development risks.