Acquisitions are widely used by REITs to grow their asset size and revenue base. There is, however, a big difference between acquiring an asset at market price, which just about anyone can do, and getting a true deal. Most Singapore REITs have unfortunately not proven to be great deal makers.
Virtually every acquisition put forward by a REIT manager is said to be “yield-accretive”. What does this really mean?
In simple terms, yield-accretive means that after the acquisition, unit holders will end up with a higher DPU as compared to before the acquisition. In other words, the net income from the acquired property will more than make up for the incremental cost of financing (if debt is used for acquiring) and dilution from new units issued (if equity is used). Sometimes the results are not apparent immediately but the long-term internal rate of return (IRR) of the acquired property should be higher than the cost of capital if the acquisition is truly yield-accretive.
The important point to recognise is that an acquisition needs to be truly yield-accretive (at least 5% increase in DPU in my view) to offset the likely increase in leverage and uncertainty associated with turning around a property (if applicable). Marginally accretive acquisitions are of no use to the unit holder; they only benefit the REIT manager and the army of bankers, consultants and advisors working on the deal.
Let us study a couple of examples to understand this better.
CMT acquired Iluma in March 2011 for S$299 million (purchase price + all fees). The property had an NPI of S$11.1 million (at an occupancy rate of 83.7%) for 2010, giving it a yield of just 3.7%. The acquisition was completely debt-funded. Is this a good
yield-accretive acquisition?
Let us look at some numbers first. The all-in cost of debt for CMT has been approximately 3.5% for the past few years. So if we use this as the cost of debt, then the acquisition is barely yield-accretive as the cost of debt is almost equal to the property yield.
If the interest rates shoot up at some point, this debt would have to be refinanced at a higher cost, probably 4% plus, which would make this a value destroying acquisition (assuming the property yields stay the same). The 3.7% property yield of Iluma at purchase is also lower than the around 5% implied property yield (net income divided by the value the market attributes to the properties based on the share price) of CMT’s portfolio, thus dragging down the overall property yield of CMT. So, based on the initial numbers, the acquisition does not seem yield-accretive.
However, this is an incomplete analysis and assumes that the property yield will remain at 3.7%. Let us look at the deal more broadly and understand the rationale behind CMT’s acquisition. Anyone who has visited Iluma would know that it is a poorly performing mall despite its excellent location. Its occupancy of 83% is much lower than any mall owned by a REIT. CMT’s Bugis Junction just across the street does a roaring business. CMT also has a proven track record of improving the performance of weak malls and it has acquired Iluma to do the same.
So although based on the current performance of the mall the acquisition does not create much value for shareholders, it does have strong asset enhancement potential which is why CMT bought the mall, thus a long-term CMT investor who is willing to wait a year or so and give CMT the benefit of the doubt, could still get sustainable yields of 5% plus which would make the acquisition yield-accretive. CMT has proven this before with malls such as IMM, Raffles City and Junction 8.
The risk for investors is also limited. The value of Iluma at S$299 million out of a S$7.9 billion portfolio works out to be less than 4%, so even if the mall does not pick up as quickly as originally expected, the overall impact on DPUs to the unit holder will be limited. This will give CMT time to set things right or consider other options. This is one of the advantages of having scale; you can do bite-size acquisitions and gradually create value for investors without risking too much on a single acquisition. Had another REIT with no track record paid such a price for Iluma, the deal would have been much riskier and the evaluation of the deal different. Acquisitions need to be evaluated in a holistic way to appreciate whether they will create or destroy value.
Let us now look at another acquisition, that of Ocean Financial Centre by a major office REIT in December 2011. The REIT announced an acquisition during the height of the euro zone crisis in late 2011 when the financial markets were in complete turmoil, there was huge upcoming office supply over the next few years and the financial sector was facing en masse layoffs. This was no small acquisition but a massive S$2 billion purchase of a new 80%-occupied office tower from its sponsor. The size of this property represented close to 60% of the total asset base of the REIT. The REIT planned to fund the acquisition with debt and equity in the form of a discounted rights issue. To justify the valuations, rental support was offered by the seller for five years and the cost of debt assumed was at an ultra-low rate of 2.28%. After such aggressive assumptions, and an increased leverage of 41.6%, the DPU accretion that unit holders could expect for 2012 was only 2.3%. Considering the risks, is this
tiny DPU accretion enough of a reward for investors?
This is not an isolated case. Many REITs have used aggressive assumptions to make an acquisition seem yield accretive. Diligent investors should look behind the words and try to understand the risks and the real long-term value created by the acquisition.
Here is a checklist for investors to go through when evaluating acquisitions:
• Is the acquisition DPU-accretive from the start or is there a need to turn around the asset?
There is nothing wrong with buying an asset with a plan to turn it around and increase yields. Investors need to be sure though that the REIT manager is up to the task and has a track record of successful turnarounds.
• What are the risks of the acquisition? Does it lead to a significant increase in leverage?
• Is the acquisition accretive only because of low-cost debt? For example, one cannot consider an asset yielding 3% bought with debt at 2.5% as a yield-accretive acquisition.
Debt-funded acquisitions are easiest to make accretive given the low interest cost environment of the past few years but consider the effect of increased gearing and a change to interest rates.
• Is the cost of debt funding and the property cash flows in the same currency? It is quite easy to borrow in Singapore dollars and acquire in, let us say, India, Australia or Indonesia given the spread between the Singapore dollar cost of debt and the property yields in local currency in these countries. This does not neccessarily make the acquisition yield-accretive. Risks for the investor are high if the local currency starts depreciating against the Singapore dollar (recall what happened to USD debt taken by Southeast Asian countries during the Asian crisis).
• What is the tenure of debt and is it variable or fixed rate? Short-term variable debt is the cheapest of all debt and also the riskiest so this cannot be used as the true cost of debt.
Debt should be fixed for at least three years. Use the REIT’s all-in cost of capital over the past three years or so as a proxy for interest rate, recognising that this still represents a very low level of funding cost from a historical perspective.
• Does the acquisition require any financial engineering? Investors should take a critical look at financial engineering such as rental supports. A strong and stabilised asset should not require any form of support. Rental supports are usually used to get around weak existing rentals and justify better valuations. As reiterated several times in the book, understand the true earnings power of the asset across business cycles.
• Are the valuations “real”? Investors should use the valuer’s report only as a starting point and critically look at the assumptions made (this is discussed in the next chapter). Make your own conservative estimate of the value of the property.
• Is the acquisition being done during times of distress? Beware of acquisitions done during turbulent times at market prices without any discount for the uncertainty.