IREIT Global

 

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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