Retail investors of Reits should take a closer look at corporate governance
‘A dumping ground for underperforming real estate (assets)’. That was what a lawyer friend uttered when our lunch conversation topic turned to Reits, a relatively new investment vehicle that was introduced to the Singapore capital market at the turn of the century. He chuckled, “the big boys unload these properties onto unsuspecting retail investors”. He is right if corporate governance is weak.
Beyond looking at dividend yields propelled by distribution per unit, investors should take a closer look at corporate governance practices. Corporate governance is deemed relatively weak in Asia by many. A private equity analyst once remarked that he prefers looking at European targets as the financial numbers in many Asian companies are suspect. So, what is the state of corporate governance in Reits? And more importantly, how does it safeguard investor interests?
S-Reits’ success story
The Singapore Reit (S-Reit) market is a success story. From ground zero in 2002, the S-Reit market capitalisation today is one of the biggest in the world after pioneers and frontrunner countries such as the US, UK and Australia. Singapore also has the distinction of Reits holding a diversified portfolio of real estate out of Singapore in far-flung geographical areas such as North America, Europe, Pan-Asia and Australia. The holdings of real estate in other countries and income receipts in foreign currencies have an added plus to investors as a form of diversification – S-Reits offer one of the highest dividend yields and lower volatility compared to Reits in other jurisdictions and indexes, according to a REITAS report.
The S-Reit market kicked off with the successful listing of CapitaLand Mall Trust – the Reit for shopping malls Singaporeans grew up frequenting from young and still visiting today. Despite the scepticism in 2002, investors had a very visual understanding of CapitaLand Mall Trust which arguably helped elevate trust in the new investment vehicle. It also helped that the manager of the Reit was an indirectly wholly-owned subsidiary of CapitaLand Limited, a household name in Singapore. The successful listing of the Reit operator was followed in the same year by Ascendas Reit. Thereafter, the Reit market in Singapore grew from strength to strength.
Continued growth of S-Reits comes with caveats
We argue that there will be continued growth of S-Reits provided we do not have “too many” incidences of shenanigans that knock Reit investors’ confidence. Retail investors will not take kindly to allegations of elevated valuations in properties. In late 2016, the Reit manager of Sabana Shari’ah Compliant Reit wanted to acquire an industrial building from a subsidiary of the Reit’s sponsor. Disgruntled minority shareholders slammed the alleged overvalued purchase price of the building despite three valuers concurring on the valuation. The unhappy unitholders managed to convene an extraordinary general meeting to attempt to oust the Reit manager but were unsuccessful. If they had managed to vote out the incumbents, the issue would then become one of finding an alternative licensed manager to take over immediately, which would be a formidable barrier in practice.
The trouble at Eagle Hospitality Trust (EHT) – a stapled trust comprising Eagle Hospitality Reit and the currently dormant Eagle Hospitality Business Trust – has challenged the perception amongst many mom-and-pop investors on the safe status of Reits. The owner of Queen Mary, an ocean liner converted to a hotel, is the first Reit domiciled in Singapore to be suspended 10 months after listing without distributing a single cent to unitholders. The suspended shares tanked. Investors will naturally ask if there had been any missteps on the part of the Eagle Hospitality Reit manager including the IPO’s financial adviser and issue manager.
Look beyond dividend yield and projected DPU growth
Investors zero in on dividend yield and projected distribution per unit (DPU) growth including the pipeline of real estate, which is fine. But we suggest that retail investors look behind the numbers and examine corporate governance as good governance should lead to strong business performance and long-term benefits to Reit investors. For some, it is a risk assessment tool.
In assessing the stability and sustainability of yield, an investor should assess the extent of income dependency on a tenant or group of tenants, as well as the financial position of these tenants. One may ask if there were proper and adequate disclosures made prior to EHT’s IPO.
The prospectus of EHT disclosed that fixed rent from master lease agreements accounted for 66 per cent of rental income while variable rents from master lease agreements accounted for 71 per cent of EHT’s gross operating revenue for (the then forecasted) FY20. Each master lessee was defined to be an indirect wholly-owned subsidiary of the sponsor. It was also disclosed that the sponsor has a hand in supporting a significant proportion of EHT’s yield, which was forecasted to be 8.2 per cent and 8.4 per cent in FY19 and FY20 respectively. Despite high forecasted yields, EHT’s IPO’s public offer was under-subscribed. This may be an indication that certain market participants (in performing their due diligence) understood that the high yield was strongly supported by the sponsor.
In the event that a company is highly dependent on a sponsor (eg for more than 50 per cent of its historical or future rental income), a sponsor may wish to disclose its key financial numbers. These could include debt coverage ratio, net current assets position, historical financial performances, near term liquidity requirements, etc.
With these indicators, potential investors can assess if the sponsor may be able to fulfil its rent payment when it falls due. It also signals the willingness of the sponsor to be transparent, reflecting robust corporate governance practices in the company. More importantly, good governance translates to a high level of confidence in future income streams.
Valuation process of real estate under master leases
When the Reit manager acquires a property, valuation of the real estate has to be done according to sound corporate governance guidelines. The Reit manager has to obtain two valuations performed by independent qualified valuers. Variance between both valuations has also to be within a specified range.
Whilst the valuers should be independent of the buyer and seller in the transaction, valuations made on assets with master lease arrangements are based on the rental income under the lease arrangement. It is often a challenge to assess if the rental under the master lease arrangement is at arm’s length due to low comparability across individual real estate assets.
Investors should pay attention to the quality of these disclosures to determine if their interests are being looked after.
Alignment of interest between shareholders and managers
Talk is cheap. The action of aligning interests of Reit managers to investors speaks louder than words. All things being equal, performance management fees that benchmark performance based on DPU should be viewed favourably. Having disproportionately high-base management fees or acquisition and divestment fees may result in Reit managers acquiring sub-par properties and disposing “jewels” for the sake of bumping up their own remuneration. Instead, the focus should be on acquiring jewels and growing DPU.
But there remain challenges
The board is responsible for representing investors who are owners of the Reit and for holding management teams accountable for running the Reit in the interest of investors. Many if not all Reits adhere to best practices when it comes to the diversity, composition and duties of the board of directors. This is indeed a plus.
But it is not easy for investors to separate the boards that are outstanding compared to the rest of the pack. How would an investor determine if there is robust discussion in the boardroom? Or if beauty parades to select valuers are not gamed? Or that, despite the presence of corporate governance guidelines, the board and employees merely tick the boxes but do not in fact act in the best interests of unitholders? In practice, good corporate governance can be difficult for outsiders to discern.
Nevertheless, we still suggest that retail investors take a close look at corporate governance practices of Reits before investing as good practices underpin the stable income stream that we have come to expect from Reits.
Chong Li Min, CFA, looks after market integrity through volunteer work with CFA Society Singapore. She also shares her insights in investing and promotes financial literacy amongst retail investors in Singapore. Chan Fook Leong, CFA, is executive director, advocacy, at CFA Society Singapore.
Source: The Business Times