Internalisation not the answer for S-REITs

Eng was instrumental in kick-starting the REIT market in Singapore with the listing of CapitaLand Mall Trust (CMT) in 2002. Since then, she has brought some 40 REITs and business trusts to list here. Almost all of the $85 billion in market capitalisation of S-REITs can be attributed to Eng.

Instead of just internal versus external, Eng advises investors to look at sponsored REITs versus non-sponsored REITs. “In the last two years, sponsored REITs had a return of 133% and non-sponsored REITs, 108%. Sponsored REITs have more liquidity and acceptance, and they have traded above NAV [net asset value],” she says.

Unlike their peers in the US and Australia, the two deepest REIT markets globally, S-REITs have stuck to an external manager model. This is one in which a developer “sponsors” the REIT by divesting income-producing properties into the REIT and then, on IPO, takes a substantial stake in the REIT. CapitaLand kicked off the S-REIT market with CMT, which was listed at 96 cents. CapitaLand owns its REITs’ asset managers and property managers. With the knowledge and expertise developed over the years, it is now managing assets for third-party mall owners and serviced residence owners.

Soon after the listing of CMT, Ascendas (now Ascendas-Singbridge) followed with Ascendas REIT. (CMT and Ascendas REIT are still the two largest and top-rated REITs in Singapore.) Subsequently, Mapletree Investments listed Mapletree Logistics Trust, Mapletree Industrial Trust, Mapletree Commercial Trust and Mapletree Greater China Commercial Trust.

On Jan 16, MGCCT announced that it was expanding its mandate to include Japan. On March 28, MGCCT announced the proposed acquisition of a 98.74% stake in a portfolio of six freehold commercial properties in Tokyo, Yokohama and Chiba for ¥60.93 billion ($753.4 million). Japan provides MGCCT with attractive acquisition opportunities because of its largely freehold land tenure and at relatively higher yield spreads against local cost of funds, attributes which are not present in MGCCT’s existing markets.

After the completion of the acquisition, MGCCT will be renamed Ma pletree North Asia Commercial Trust.

Frasers Property also adopted the sponsored REIT model, and is now sponsor and major shareholder of Frasers Centrepoint Trust, Frasers Commercial Trust (FCOT), Frasers Hospitality Trust and Frasers Logistics and Industrial Trust.

“For sponsored REITs, we prefer external managers. If the manager is internalised, there is no incentive for the sponsor and the REIT cannot leverage its expertise,” Eng says.

Investors take comfort in the fact that sponsored REITs have strong shareholders that stand by their REITs and backstop any acquisitions and fundraisings that need to take place.

“It makes a lot of sense for the sponsor to externalise the manager because there is accountability and ownership. The sponsor incentivises the REIT to grow AUM [assets under management] and DPUs [distributions per unit]. The reputation of the REIT is then linked to the reputation of the sponsor, which could also get rerated if the REIT does well,” Eng explains.

An internalised manager would make the REIT no different from any other company, and the sponsor would be like any other shareholder. Is there an incentive for sponsors to work with their REITs, stay committed to them, show them a pipeline of properties and make sure they grow if the manager is internalised? Eng asks.

Control premium, proof of alignment

Eng refers to the alignment of interests, where the sponsor owns the manager and a significant stake in the REIT, as control premium. For some of the REITs, the external manager is less aligned than in others. Rather than look at whether a REIT adopts an internal or external model, investors should study whether the interests of a REIT, its sponsor and its manager are aligned. If the sponsor owns the manager and a significant portion of the REIT, control premium exists and interests will be aligned.

Control premium also implies that should the sponsor wish to divest of the manager and its stake in the REIT, it can command a higher valuation. For instance, the valuations paid by Frasers Property for FCOT and its manager, and by YTL Corp for Starhill Global REIT and its manager should not be compared with the price paid by unitholders of Croesus Retail Trust (CRT) for its trustee-manager because the trustee-manager had no control premium.

In 2016, CRT, a business trust, announced that it planned to internalise its trustee-manager, Croesus Retail Asset Management. CRT would acquire CRAM for $50 million. Based on the circular issued to unitholders in June 2016, CRAM’s revenue for the 12 months to June 2015 was just ¥634.3 million ($8 million). Its net profit was a mere ¥32.5 million ($406,000). According to this circular, on a pro forma basis, CRT would see annual cost savings of ¥322 million ($4.3 million). At the time, the shareholders of CRAM argued that internalisation would help align interests and reduce costs, especially as the amount saved from fees was supposed to be paid as dividends to unitholders.

“I believe the internalisation was used as a selling point by the trustee-manager’s shareholders, who had their own interests in mind. It is questionable whether the shareholders did believe in their pro-forma increase in DPU shown at the time,” says Patrick Lecomte, an academic and associate professor of real estate at Henley Business School, Centre for Global Enterprise and Cloud Analytics, University of Reading (Malaysia).

Not surprisingly, CRT unitholders were up in arms. How could a trustee-manager with no real stake in the business trust sell itself for $50 million to its unitholders? But there just were not enough unitholders voting against the resolution.

The argument by CIMB, the independent financial adviser, was that ARA Asset Management’s price-toearnings ratio was 16 times and so this was a reasonable valuation for CRAM as well. The IFA also crosschecked the valuation with other valuations using enterprise value/Ebitda and EV as a percentage of AUM.

ARA Asset Management had AUM of more than $36 billion and was not a comparable, Eng points out. By contrast, CRT’s AUM was just $1.4 billion.

On June 30, 2016, 66% of unitholders present or by proxy voted for the internalisation resolution. CRT funded this acquisition with funds raised from a $60 million four-year bond, $10 million cash and a preferential share offering that raised $22.1 million.

“How could the trustee-manager’s shareholders justify the cost of acquiring the trustee-manager (financed by issuing new equity and using the proceeds of fixed-rate notes by saying that savings could be garnered from the absence of acquisition and divestment fees? What was the cost of capital of this purchase? How much would they have needed to buy/sell to recoup that cost in fee savings?” Lecomte asks.

To convince investors that their interests were aligned, the major shareholders of CRAM committed to buy $16 million of CRT units after the internalisation. By June 2017, CRT’s internalised manager confirmed that it was in talks to sell the trust to Blackstone Group, which eventually paid a premium to unitholders.

Unitholders must exercise their rights

Unitholders have a lot more rights than they have exercised over the years. “REITs are regulated and unitholders have a lot of say. It’s a question of whether they want to exercise their rights,” Eng says.

It was only last year that minority unitholders of Sabana Shari’ah Compliant Industrial REIT were sufficiently incentivised to requisition an extraordinary general meeting (EGM) in which one of the resolutions was to vote out the manager. Sabana REIT’s DPU had fallen for a few years, yet management fees did not fall in tandem with DPU. The final straw was a dilutive rights issue and the proposed acquisition of non-accretive properties at valuations that were perceived to be higher than their underlying rent implied.

While the resolution to vote out the manager was not passed, unitholders voted against the granting of the general mandate. Without a general mandate, the manager is unable to issue units, acquire properties or lower gearing should it approach more than 40%. Lack of a general mandate effectively shackles the manager.

“The checks and balances within the listing rules from a compliance perspective are very robust and the recourse for minority unitholders to exercise their rights exists,” Eng insists.

For instance, Cambridge Industrial Trust’s unitholders voted against granting their manager a general mandate in 2015. Unitholders also lobbied for the REIT to change its fee structure and for fees to be linked to DPU growth rather than the performance of an index. Last year, e-Shang Redwood acquired a stake in the REIT and bought the manager, for which it is reported to have paid an extremely modest amount. CIT has been renamed ESR-REIT.

The method by which ESR acquired ESR-REIT and its manager could be adopted by investors looking at other non-sponsored REITs, market watchers suggest. In this model, an interested investor buys up a stake in the REIT and then virtually takes the manager for next to nothing. “The REIT manager in these non-sponsored REITs has a very small stake. So, by buying up a lot of units, investors with a stake of 2% to 3% can call for an EGM and change the mandate,” Eng points out. It is interesting to note that ESR has acquired 7% of Sabana REIT.

Lessons from CRT

Lecomte recalls that analysts at the time were enthusiastic about the internalisation of CRAM. “DBS Vickers was very positive (‘a step in the right direction’, its report said) and encouraged smaller REITs to follow suit,” he said. That may have been the general feeling at the time, when internalisation was seen as something desirable, while external managers were viewed as growing their AUM to garner more fees.

CRT had enough buy-in from its existing pool of investors, but it still had to go through the voting process. The resolution was passed by 66% of unitholders, which demonstrated that there were investors who were not happy with it.

If there were unitholders who disagreed with the resolution, they should have attended the EGM and voted against it, Eng stresses. She acknowledges, though, that the EGM process could be tightened. “What could be enhanced further is the process. For instance, it’s very difficult for investors to read circulars and prospectuses within 17 days. If the resolutions are not in the ordinary course of business, the REIT manager should take time to explain the resolutions to investors.”

It was what happened after CRAM’s internalisation that upset many unitholders. In June 2017, CRT announced the sale of the trust to Blackstone. Did CRAM’s shareholders have an inkling of this in 2016? Were they looking to sell the trust? What would the value of CRAM have been without CRT?

“CRT is an example of what can go wrong when governance is used as a cover-up. It would have been simpler for the managers to forgo their right to investment/divestment fees if they cared so much about corporate governance. I am surprised that financial analysts did not raise that point at the time,” Lecomte observes.

Interestingly, Sabana REIT’s unitholders were aware that CRAM was overpriced. In the resolutions for the EGM to vote out the manager last year, internalisation was carefully crafted in Resolution 2. It said that if the resolution to remove the manager was passed, then unitholders would instruct Sabana REIT’s trustee to incorporate a wholly-owned subsidiary for the purpose of internalising the management function of the REIT and search for qualified candidates to be appointed as directors of the internalised REIT manager.

Advantages of internal management

For all the flak that internalisation Singapore-style has received in the past two years, it is a proven model in developed markets.

“In the case of an external REIT manager, you are likely to expect the REIT manager to structure its fees in such a way as to include a certain profit margin for the benefit of the REIT manager’s shareholders. On the contrary, in the case of an internalised REIT manager, any profit made by the REIT manager would stay within the REIT for the benefit of the unitholders,” explains Florian Leber, an attorney at Luther LLP, a Singapore-based German law firm. He thinks there are cost efficiencies and savings in an internalised model. “An internalised REIT manager might be set up more efficiently, since only the unitholders’ interests are involved and they would wish to maximise their returns.”

Leber, who is also a unitholder of Sabana REIT, helped study its trust deed so that the minority unitholders could put forward their resolutions last year. He says a conflict of interest can arise between a sponsor, the manager and the REIT.

“The REIT manager will have to act in the interest of the unitholders, who would want injected into the REIT only such properties as would have a positive effect on the overall performance. But at the same time, the REIT manager will, of course, also take into account its own interests and be influenced by its shareholder, the sponsor, who is interested to inject its pipeline of properties. Such inherent conflict of interest does not exist for internalised REIT managers,” Leber points out.

In Sabana REIT’s case, unitholders claimed that the sponsor was injecting its property in Changi South at an artificially high price because it was being valued at its master lease rent and not at the market rent, which was much lower. “We had broadly discussed conflict of interest in the context of Sabana REIT,” Leber recalls.

Generating a constant flow of income from managing a REIT via its own REIT manager might be a huge incentive for sponsors to set up a REIT in the first place, Leber continues. However, developers such as CapitaLand, Mapletree Investments and Frasers Property often inject their best income-producing properties into their REITs.

The “promoter” of a smaller REIT is more likely to want more fee income from the REIT and constantly inject properties into the REIT for the sake of growing AUM and then recycle old assets to get divestment fees. A promoter is the shareholder of the manager of a non-sponsored REIT.

“If it’s a non-sponsored promoter with no institution behind it that wants to [own the manager for its fee income], it should internalise the manager. This is so the promoter has skin in the game,” Eng says. “There are still pros and cons to an internalised manager, but it makes a lot of sense for these non-sponsored promoters to internalise. From the experience we’ve had, which includes feedback from investors, other REITs and the regulators, we would advise them to internalise the manager.”

At any rate, with the Securities and Futures (Amendment) Act 2017, REIT managers have to prioritise the interests of the unitholders and will need to act first and foremost in their interest.

“Internal management is not about the process of internalisation (which was messy in the case of CRT), but about the quality of management in the long run. Alignment of interests is more obvious in the case of internal management than external management. Both regimes present pros and cons in the Singapore context,” Lecomte points out.

Sponsored REIT model looks superior

After the experience with non-sponsored REITs and trusts such as CIT, Sabana REIT and CRT, REITs sponsored by local property developers appear far superior. Investors have found that management quality, the ability to lease the property and the ability to produce or source for a good product are some of the ingredients that make for a quality portfolio. A REIT manager’s capital management strategy and the ability to obtain lower cost of debt are other ingredients that attract investors, particularly institutional investors. A good credit rating also helps keep costs contained.

At any rate, Singapore has had listings from jurisdictions with deep and well-established REIT markets such as the US and Australia, an indication that the external S-REIT model is superior.

“The sponsored REIT model that comes with external management can now [be seen by investors as] superior insofar as it allows for a long-term vision of what is best for unitholders, that is, future-proofing S-REITs’ portfolios of income-producing properties. It is in their best interest and in the country’s best interest, given that real estate is such a big part of Singapore’s wealth/reputation both domestically and internationally,” Lecopmte says.

What to look out for when buying a REIT

What should investors consider when buying a real estate investment trust? Generally, they would look at distribution per unit, net asset value and the ability of the REIT to generate stable DPU, as well as DPU growth. Other metrics to check are occupancy rate, occupancy rate compared with market, weighted average lease to expiry, rental reversions, gearing, weighted average debt to maturity, interest cost and the ability to service debt.

In addition to these factors, professional asset managers also assess the quality of the manager. “The quality of the manager and the quality of the portfolio are important,” says Havard Chi, director of Quarz Capital, a Swiss family office. “Retail shareholders are quite agnostic to liquidity. They look at the quality of the property, the manager and the sustainability of DPU.”

Meanwhile, investors looking to buy into a REIT manager should look at whether the manager has a control premium, that is, the REIT manager and sponsor own a substantial percentage of the REIT. If the REIT manager does not control the REIT, the manager’s valuations are likely to be much cheaper.