S-Reits Alright For Long-Term Gains

Source : The Business Times, March 27, 2008

Investors with capital to deploy should take advantage of the high yields on offer, and get paid by waiting, says MARK EBBINGHAUS

OVER the past few years one of the greatest drivers behind the positive performances of the region’s market was liquidity. Now, following a change in the financial environment, which began around August 2007, the negative market performance that the markets are experiencing is being driven, in part, by illiquidity. As a result there has been an increase in volatility in Asia’s equity markets, with the S-Reit market being one of the sub-sectors significantly affected by these changes. And despite the volatility lasting for over seven months, there is still a lack of clarity as to when this is likely to abate.

In the first seven months of 2007 there were net capital inflows in excess of US$20 billion into Asia’s equity markets but this abruptly ended towards the end of July, with a significant reversal of market liquidity. Since then we have seen over US$40 billion of net outflows from Asia’s markets, after a period of near record equity issuance. As a result, liquidity has been sucked out of the system and markets have become extremely volatile.

We are now in an environment where volatility, as measured by the volatility index (VIX), is at record highs. In addition, risk aversion is also running at high levels, as measured by the emerging markets bond index (EMBI) plus sovereign spread.

From the data, it’s clear that the market is firmly in bearish territory, having moved rapidly from the previous years’ bullish sentiment. Much of what has occurred has been out of the region’s control, being driven instead by global capital markets and the significant re-pricing of risk. However, the knock-on effect has been that those markets perceived as being riskier, including the S-Reit market, have suffered a lot over the past seven months.

Not since the early days in the development of the S-Reit market, which was established in July 2002, have we seen distribution per share (DPS) yield spreads widen to over 350 basis points, which compares to the market’s peak in July last year where the spread was closer to 100 basis points. For some individual S-Reits we have seen the spread blow out far wider, with many S-Reits trading at a high single digit/low double digit DPS yield compared to the long bond in the mid two per cent range. That’s among the widest spreads in the world.

‘Institutional investors are sitting on near-record cash weighting and at some point we will see a tipping point where the global financial malaise washes through the system and investors regain confidence to deploy capital. When this occurs, we are likely to see a run of funds flow into the region and with it a significant rally in the markets.’

The perplexing issue for many is that we have not seen a deterioration in earnings quality of the mainstream S-Reit sector. What we have seen, however, is significant price volatility. It’s probably fair to say that the sector is not currently being driven by fundamentals but more by momentum. It’s probably also fair to say that momentum was largely what led the sector to all-time highs last year and that the sector probably ran too hard too fast. Today, to some extent, the S-Reit sector is paying the price for the excess in-flow of money in prior periods, combined with more discriminating investor appetite that is looking for value in many places, but wary of the illiquidity induced volatility.

Looking at the global Reit marketplace it really depends on what your reference point is in assessing value opportunities and justifying activity or inactivity alike. If your benchmark reference point is discount to net asset value (NAV) or absolute earnings yield then the S-Reits do not look particularly cheap. However, if you look at the distribution yield spread to the long bond or notional risk free rate, then the S-Reits look like some of the best value opportunities in the world, particularly when you combine this with base earnings stability and strong earnings growth prospects. When the market was attracting a lot of attention last year, investors were willing to factor in yield, organic growth and, importantly, acquisitive growth into their required rate of total return from an S-Reit investment. S-Reits were required to have an identified asset pipeline, if you didn’t you would not get credit for acquisitive growth. For those with a pipeline the market drove down the DPS yield in part due to the high earnings accretive effects of acquisitions. This resulted in an increase in the accretion of the growth.

Today’s pipeline is not viewed as positively by investors, mainly because it’s all about funding and if you have a pipeline the first thing an investor will ask is how you are going to fund your acquisitions. So, to some extent, S-Reit investors’ total return expectations have not changed significantly in the last year, but today the requirement is to deliver it through yield and organic growth only, excluding acquisitive growth. As such, the yield has had to effectively compensate for this, which has driven this metric up to near all-time highs, despite the risk-free and debt rates actually moving in the other direction, widening spreads on both counts.

This brings us to debt. Many investors feel - and there is sympathy with this line of thought - that in some instances capital management practices in the sector have been behind the pace in a rapidly changing global credit market environment. We have seen gearing levels gradually rise from the low 20 per cent range to over 30 per cent and we have seen debt providers become a lot more cautious in terms of refinancing and extending debt facilities.

Reit investors have witnessed real estate in the western world, notably the US, UK and Europe, revalued downwards, in some cases significantly, resulting in gearing levels increasing beyond what could be considered prudent and in some situations this has been deadly.

In a market where investors often shoot first and ask questions later capital management has been a major focus and another trigger issue significantly influencing investors’ trading activity. In short, illiquidity and capital management have combined to be major influences on the performance of the S-Reit sector, currently being driven - at least in trading activity - by generally non-traditional Reit investors, exacerbating volatility levels.

In the main, the fundamentals of the S-Reit sector are in reasonably good shape. There is very limited earnings risk and there are promising organic earnings growth prospects. The demand and supply metrics in the physical asset market remain generally sound and there are unlikely to be any significant shocks to the system from that quarter. It’s generally not so much about earnings but the pricing is being driven by illiquidity and increased global risk premia.

Having said that, there are a number of messages that institutional investors are sending to S-Reits, with the bottom line being: ‘If you do not listen to us we will not buy!’

Institutional investors are sitting on near record cash weighting and at some point we will see a tipping point where the global financial malaise washes through the system and investors regain confidence to deploy capital. When this occurs we are likely to see a run of funds flow into the region and with it a significant rally in the markets.

In the meantime, for those with something longer than a monthly investment horizon and wishing to deploy capital, buy S-Reits, take the high yields on offer and effectively get paid to wait for the rally.

At the end of the day, quality investments are likely to yield the right results over the longer term. However, in the case of S-Reits, both asset and management quality are paramount and getting this right from an investor’s point of view is critical.

Mark Ebbinghaus is managing director, head of real estate, lodging and leisure, Asia, UBS Investment Banking Department