Stay the course or give it up?
IREIT Global (IREIT) is the first
Singapore-listed real estate investment trust (REIT) established with the
investment strategy of principally investing, indirectly or indirectly, in a
portfolio of income-producing real estate in Europe which is used for office,
retail and industrial (including logistics) purposes, as well as real
estate-related assets.
IREIT’s current portfolio comprises
five freehold office properties in Germany and four freehold office properties
in Spain. IREIT is managed by IREIT Global Group Pte. Ltd, which is jointly
owned by Tikehau Capital and City Developments Limited (CDL).
In August 2020, IREIT proposed the
acquisition of the balance 60% interest in four office buildings in Spain
(Spain portfolio). The capital structure adopted for said acquisition was an
equity injection through a 454-for-1,000 rights issue. Priced at $0.490 per
unit, the announcement of the issue was met with a tumbling share price. Sell-side
equity research analysts have downgraded the stock or stopped coverage
completely (without any updates as to their recommendations).
Expectations of the REIT were high upon
CDL’s involvement in May 2019 and the distribution yield of IREIT had
compressed following the announcement.
However, in the face of a rights
issue and tumbling share price doubts have surfaced. Coupled with radio silence
from analysts, investors are unsure of what to do going forward. Will Tikehau
Capital and CDL execute well? Are there more potentially dilutive rights issue
further down the road? Should investors double down or cut loss? Should we
begin to vest?
I will touch on these questions and
present my thoughts on what lies ahead for IREIT and IREIT’s current valuation.
I see REITs as a carry trade in
disguise. A carry trade is a trading strategy that involves borrowing at a
low-interest rate and investing in an asset that provides a higher rate of
return.
Basically, this is no different from
how REITs operate. REITs seek inorganic growth through accretive acquisitions.
Accretive acquisitions result from buying over an asset with a higher yield
compared to a REIT’s cost of capital. REIT’s cost of capital in simplified
terms consist of the cost of equity and cost of debt. The lower the cost of capital
the greater the pool of assets a REIT can acquire and result in accretion for
unit holders. Understanding this fundamental operation of REIT is important for
investors to foresee what lies ahead for IREIT.
IREIT’s cost of equity is high
compared to its cost of debt. Theoretically, with a cost of debt of 1.5%
acquisition of most assets will be accretive to unit holders but a REIT cannot
hold unlimited amount of debt. REITs in Singapore are governed by a cap on
aggregate leverage. Therein lies the oft-cited need for a balance between
equity and debt when structuring a deal.
The proposed acquisition of the
Spanish portfolio is dilutive to unit holders because a decision was made to
acquire the portfolio with a higher proportion of equity to debt. A high cost
of equity (c. 7.6% pre-rights) compared to net property yield of c. 5.0%, huge
discount to theoretical ex-rights price (TERP) and market’s desire for IREIT
shares post-rights to yield 7.6% or higher resulted in a decline in IREIT’s
share price.
The merits of the rights issue are
as follow:
1. Existing unitholders are able to
subscribe to the rights units at an attractive discount to theoretical
ex-rights price and prevailing unit price of IREIT.
2. Net proceeds derived from the rights
issue will increase IREIT’s debt headroom through a reduction of its
borrowings, hence enhancing its ability to pursue potential acquisitions and
asset enhancement plans. Aggregate leverage will shift down to 35% post-rights
from 39%.
3. The rights issue will increase the total number of IREIT units and theoretically improve trading liquidity post-rights. Total issued units will rise to 933.3MM from 641.8MM.
For point 1 above, the utility to
unit holders depends on their existing cost per unit. Below I append three
scenarios:
Rights issue will be unfavorable
for units purchased after May 2020. I append below the possible average cost
per unit for major shareholder, CDL.
Should rights units be
undersubscribed by minorities, the average cost per unit for CDL will be lower
than $0.60 further raising the implied yield on CDL’s stake in IREIT. We see
support for IREIT share price at this level.
What lies ahead for IREIT?
I set out to determine the potential
quantum of IREIT’s next acquisition and the minimum property yield required for
it to be accretive. Two assumptions were made to derive the above two numbers,
the target deposited property value and target capital structure for IREIT. I
had set these two numbers at € 1.035B and 40% respectively.
The assumptions were based of a
Business Times article on CDL’s potential listing of its UK commercial
properties on a separate platform.
“I think for us we’d like to get
about £1 billion AUM; so that would be about $1.8 billion and then if you put
in about 40 per cent leverage, you will get to a market cap of about $1
billion.” – Business Times, 28 February 2020
Based on a forex rate of 1 € to 1.61 $ and working backwards from a market capitalization of $1B
with 40% leverage, I arrived at EUR 1.035B.
A detailed calculation for the
required minimum net property yield to effect an accretive acquisition is
appended below.
IREIT will need to grow assets under
management (AUM) by roughly 1.5x and source for acquisition targets offering a
property yield above 4.61%.
Is this a tall order?
I think the required property yield is
still slightly above market rates but at this level, there should be a sizeable
pool of good quality stabilized commercial office assets in the regional cities
of Spain, Germany or France to choose from. Incidentally, Suntec REIT announced
the acquisition of 50% interest in two Grade A buildings in London, England.
The net property yield is about 4.6%. This tells me that my assumption on the
investable pool of assets is reasonable.
REIT manager may also elect to
pursue opportunities arising from special situations and/or undertake
development projects (structured similar to CapitaSpring).
What are special situations?
Common characteristics of special
situations are because of the special situation property can be purchased below
market price and/or REIT manager can value add to the property. Concrete
examples can involve distressed sales, sales-and-leaseback arising from sudden
cash crunch and under-rented properties.
Properties in these categories
should typically trade at a higher capitalization rate and hence greater
accretion. The higher capitalization rate may be to compensate for the
liquidity provided to distress vendor or execution/development risks involved.
In order to capitalize on property
sales arising from special situations, manager will need to be equipped with
the correct resources (management team and readily available source of
capital). I see IREIT already equipped with the correct tools to see this
strategy through. New REIT manager CEO, Louis d'Estienne d'Orves, spent 11
years at AXA IM Real Assets, mostly recently as the co-head of European
transactions, special situations. Market should expect strong origination of
off-market opportunities and solid execution by CEO which will be backed up by
the strong financial backing of CDL.
IREIT’s current valuation
The following is the valuation of
IREIT’s portfolio.
I set out to determine the potential
total units in issue post-rights which is an estimated 933.3MM.
IREIT secured a five-year lease for
over 3,400 sqm at Il-lumina in June 2020. I worked through the financial
reports of Coruna Patrimonial SOCIMI, the vendor of the Spanish portfolio, to
determine the gross rent rate of the Spanish portfolio. From there I estimated
the possible increase in gross revenue in FY2021 arising from this new lease.
Based on FY2021F distributable
income and 8 October 2020’s closing price of $0.62, IREIT will yield 7.66%.
The market had been slowly digesting
IREIT’s latest rights issue and we can see it is inching down towards 7.6%.
Taking a step back and looking at
the rights issue again, it becomes clear that the decision to raise proceeds
from unitholders to acquire 60% of Spanish portfolio and reduce gearing sets
the stage for the next phase of growth for IREIT without another potentially
dilutive rights issue. This is a one-time pain to provide for a long-term gain.
Paradoxically, the higher the share
price for IREIT the more attractive the REIT becomes. As a higher price (and
lower required distribution yield) leads to a wider pool of investable
properties and quicker growth of IREIT’s AUM.
As market capitalization steadily
approaches $1B, IREIT will qualify for investments by most funds and attract a
steady stream of liquidity for its stock. Increasing liquidity will reduce the
liquidity premium demanded by investors for IREIT’s current small
capitalization; raise IREIT’s stock price and compress distribution yield required
by investors.
This further perpetuates the
virtuous cycle of accretive acquisitions for IREIT.
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