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Is it the right time for REITs?

With the exception of Australia, Asia's property market has been struggling in recent months as shares of property companies are selling at considerable discounts. VG Kulkarni of the AVCJ asks whether private equity firms should muscle in and secure some of the distressed real estate? The answer appears to be yes, but not yet.

Old colonial sahibs wax biblical when talking about Hong Kong: ‘Upon this rock we built a city.' As do the boosters of Stamford Raffles, who turned Singapore from a swamp into a thriving port. Aside from free trade, bricks and mortar have been the building blocks of East Asian capitals where banks, developers and business services have seen their coffers bulge.

But real estate's glow is fading in these Asian financial centres. Shares of property companies have been selling at hefty discounts to their net asset values since the bubble burst in the 1997 financial crisis and beyond. As for Tokyo, where artificially inflated land assets have been standard collateral for banks, the air blew out of the balloon more than a decade ago. The sole exception in the Asia-Pacific region is the booming Australian market. Everywhere else, property has become an illiquid asset with low yields and a none-too-rosy outlook.

So isn't it time for international property funds and private equity firms to muscle in and take over some of the distressed real estate from over-lent banks? Or shouldn't there be a rush to form real estate investment trusts (REITs) so that assets can be priced based on their yields and, in the process, bring some liquidity to the market?

Transparency lacking
Well, yes, but not yet, seems to be the answer. The major hurdle, according to Rob Blain, President and CEO Asia for property consultants CB Richard Ellis, is that ‘property is still priced high and transparency as the benchmark in the valuation process is lacking.' Property conglomerates are hoping and waiting for an upswing in the equity markets that could sustain their high valuations. Struggling banks are still largely unwilling to write down the value of their property collaterals and force the clients to top up the difference or renegotiate the loans.

As for property investment funds, they have been few and far between in East Asia thanks to land ownership restrictions for foreign entities, lack of tax incentives and the volatile equity markets in recent years. That said, the few big names in property funds have not been totally inactive. Morgan Stanley Real Estate Fund International V (MSREF V) closed at $2.5bn late last year, roughly half of which is earmarked for Asia. David Bednar of Morgan Stanley in Hong Kong is fairly optimistic about prospects in the region. Recent investments: an $85m JV in Thailand with Golden Land Property Development and another worth $100m in China.

Also, the Macquarie Group of Australia has recently tied up with Schroder Property Asia Advisors, which has some $30m left over from an earlier fund. In a JV with Chinese parties, Macquaire has invested $20m in Shanghai residential property - some 3,000 apartments in all. The group is basically positioning its assets in Japan, taking over B grade office buildings in Tokyo and turning them around. But all this is a mere drop in the Asian property ocean.

Infrastructure needed
So why haven't REITs built up a strong presence in East Asia even after a decade-long strong performance in the West? Foreign investment banks and law firms have been lobbying the authorities, but progress has been slow. Tom Lenox, a lawyer with Mallesons Stephen Jaques, says the tardiness is a matter of education; regulatory authorities, stock exchanges, the property industry and investors in the region have to be explained and convinced of the benefits of REITs.

And that is bound to be slow, as legislation has to be put in place, institutional mechanisms organised, and the REITs formed and listed. Legislative aspects are the most difficult and time-consuming obstacles, since governments and parliaments have to be convinced of the necessity of giving tax incentives. Politics, with all the pulls and pressures of vested interests lobbying for fiscal concessions and populist grandstanding, also comes into play.

Even after legislation is in place, the hierarchy of stock exchanges governed by brokers' interest groups - small and big, foreign and domestic - have to be nudged to see that they can all benefit from the new investment product. Last, but most important, is the milieu of investors - individual and institutional - which has to accept the usefulness of REITs. Investors will not put in their money until they are educated on the difference between a property company and a trust: what is pure property play and what is not.

Japan Inc leads
Given all these constraints and despite the economic sluggishness of recent years, the birth process of REITs in East Asia - dating only to last year - is quite revealing. Japan was the first Asian country to come up with J-REITs, points out Robert Morikuni, Associate Director of Ikoma-CB Richard Ellis in Tokyo. Currently, there are five listed J-REITs, with more in the making.

Japan Inc's ubiquitous presence in the domestic market is such that all the participants in the listed J-REIT funds are Japanese companies from the banking, insurance, corporate conglomerates and real estate sectors. The sole exception so far is UBS Asset Management, the UBS unit, which is the most active in promoting REITs in East Asia. J-REITs have been aggressively competing to buy quality properties, but there are not many to be had.

Prime real estate in Tokyo is largely owned by property companies or insurance companies, which rarely put these on sale, says Morikuni. The two J-REITS listed last September are trading at a 3 per cent discount to their original offer price, while Nihon Retail Funds, listed in March, has appreciated by 1.1 per cent. Not a bad start for a new investment vehicle.

Sale in Singapore
On 1 July, Singapore's property giant CapitaLand unveiled the city-state's first S-REIT, after a failed earlier attempt in September last year. Named CapitalMall Trust, it is offering 192 million units to the public and 21.3 million units to people connected with CapitaLand. About a quarter of the units on offer have been snapped by ING REI Investment (Asia), Dutch pension fund PPGM, Australia's BT Funds Management and NTUC Fair Price - the retail arm of the National Trades Union Congress of Singapore. CapitalMall, with its three shopping malls, is offering a 7 per cent plus yield and trading is set to begin on 17 July.

A second S-REIT, a clutch of industrial properties, is in the making with the participation of Australia's Macquarie Goodman Group and Ascendis, a Singapore government-linked company owning factory buildings. Industry analysts expect the venture to be finalised within the next couple of months.

Enabling Korea
South Korea has no property companies listed on its bourse. Earlier this year, enabling legislation was passed to form asset management companies, which in turn can launch REITs. The aim of the law is not to encourage domestic companies to simply sell their holdings to the public, but to attract foreign investment once AMCs are formed. As the Korean private property market is quite vibrant, with low vacancies, long leases and good yields, Tony Choi of CB Richard Ellis in Seoul anticipates a strong potential for REITs after a market comes into being.

Hong Kong lags
Ironically, property-obsessed Hong Kong has been the laggard in the REITs game. The Securities and Futures Commission of Hong Kong has belatedly agreed to begin consultations with market participants on the feasibility of REITs on the local bourse.

The government, as the owner of all land in Hong Kong, and the major property developers who influence government policy have their own vested interests to consider. Instead of realistically evaluating their assets, the developers might want to wait for a market revival before REITs are launched. The whole process of consultation, legislation, institutional mechanisms and the launch of property trusts could take anything up to two or more years, if past experience is any guide.

Despite the tardiness of Hong Kong and South Korea on REITs, and although Morgan Stanley's fund is not into traded property trusts, preferring majority equity control, Bednar is quite optimistic about the bricks-and-mortar sector of East Asia over the medium term. REITs, however slowly, might give it the long-needed fillip.

Why property trusts?

Over the past decade, REITs, also known listed property trusts (LPT), have emerged as a popular real estate investment vehicle in the US and Australia. While property trusts have been around since the 1960s, their growth has been impressive since the 1987 market crash, the resulting recession and subsequent boom and bust. The capitalisation of US-listed REITs rose by nearly 13 times to $155bn during 1991 and 2001. In Australia, LPTs account for about ten per cent of the total worth of listed stocks.

With Asian stock markets so heavily weighted toward property stocks, it's legitimate to wonder if another real estate vehicle is really necessary? Prime office and commercial space in Asian cities is largely owned by big developers or corporate conglomerates. Sales transactions are scarce, making the assets less than liquid, and the developers' focus is divided between rental yields and profits from new developments. In any case, prices of major property shares are weighed down by what is called ‘conglomerate discount.'

Heavy capital commitment
To acquire a piece of prime-grade property, an investor has to make a heavy capital commitment over a long time frame or be content with property stocks. A REIT offers an attractive alternative: a simple structure of good quality pooled property - office, industrial, retail or hotels and resorts - focused on yield.

Shares of a listed REIT are traded like any other stock. Unlike property companies and other corporates, REITs are characterised by low levels of gearing and have to distribute as dividend almost all (90 per cent to 100 per cent) of their pre-tax cash to share holders. Thus REITs ‘transform a lumpy, illiquid investment into a liquid, tradable security with higher yields and more tansparency than regular property stocks,' says Tom Lenox of Mallesons Stephen Jaques, an international law firm.

Also, REITs are required by law to release more detailed information on acquisition costs, occupancy rates, rental levels and lengths of lease of all their properties, allowing investors a clearer picture of potential yields. On the other hand, property companies - though listed - need not divulge all such details under existing regulations. Being listed trusts that pass on all or most of their net profit, REITs do not pay corporate profit tax on that income. Instead, the unit holder pays the tax, which is usually lower than the fixed corporate tax rate.

REITs rising down under

Out of a bust comes a boom. General Property Trust, listed in 1971, was Australia's first REIT, or limited property trust (LPT) as these are known in that country. But it was not until the early 1990s that the LPT sector took off, more or less coinciding with the rise of the US REITs.

The burgeoning of LPTs had its roots in the prolonged recession of the late 1980s. From the early 1980s onward, many property funds had been formed as unlisted property trusts but most of them fell victim to the 1987 economic crash when falling asset prices led to panicked investors redeeming their units. In the early 1990s, the strong ones that were left and a few new ones came on the market as LPTs.

And they have not looked back since then. In the decade from 1992 the total market cap of LPTs has risen from A$5bn to just under A$44bn, representing 6 per cent of S&P/ASX 300 index. In 1971, there were only 11 LPTs. By now there are 36, ranging in size from A$20.5m to A$6.3bn. To put it differently, out of an estimated A$120bn Australian LPT worth of institutional property in the country, LPTs own almost half.

While US REITs are mostly internally managed, Aussie LPTs are externally managed and hence more transparent, as investors can even vote out managers in the case poor performance. The small investor is attracted to the LPTs because a typical minimum investment is a mere A$500 and it affords access to quality property segments not usually accessible to retail investors. Bulk of the LPT investors - pension funds and senior citizens - look for high yields. ‘As a result LPT managers are highly focused on providing consistent, low-risk, high-yielding returns with a good distribution growth profile,' Gregory Goodman, CEO of Macquarie Goodman Group, wrote recently.

The bottom line: LPTs Down Under have shown positive returns for almost two decades and outperformed the stock market index.

Copyright © 2002 AVCJ

VG Kulkarni is a journalist with the AVCJ.

This article first appeared in the Asian Venture Capital Journal, July 2002.

The Asian Venture Capital Journal is the region's leading publication on private equity and venture capital. With readers worldwide, AVCJ provides monthly coverage of fund raising, investments, exits and the people behind them. For more information please visit www.asianfn.com