It’s high yielding, way cheaper than valuation and thrives in a low interest rate environment.

The humble REIT (or Real Estate Investment Trust) has come a long way in Malaysia over the last four years.

Since the listing of Axis REIT in August 2005, the market cap of Bursa Malaysia REITs has reached RM4.1 billion as of last Friday 20-Mar-09.

Interestingly the first listed REIT in Malaysia was not Axis REIT as is commonly believed. It was actually Arab-Malaysian Property Trust which was listed as far back as 1989. Through a series of corporate exercises it eventually became AmFIRST REIT and re-listed on 21 December 2006.

So far REITs on Bursa Malaysia have experienced a lukewarm response from investors. And 2009 is proving to be a year of consolidation for the sector.

A couple of REITs got off to a good start but since then the unit prices of all REITs have fallen way below Net Asset Value.

 
Huge Potential
While our REITs have come a long way, there is still so much room for growth.

The market cap of the entire REIT sector on Bursa is not even half the market cap of CapitaMall Trust in Singapore. The RM4.1 billion market cap we have is not even 1% of our overall stock market.

It will grow… it’s just a matter of time. And institutional money will eventually pour in.

If you are looking for a career, think of becoming a property funds and asset management professional. Just kidding, do something you actually love to do… if it is REIT management then fantastic

Far from Mature
So the REIT market on Bursa Malaysia is small, has low investor participation and low trading volume.  My guess is that it will take a good 15 years at least to become “mature”. This is a classic situation for mispricing due to a lack of depth and understanding. Right now we have low interest rates and high yields which is a great opportunity for investors.

Trophy Assets
Ideally the best real estate assets in the country should be placed in REITs. It would really help create an awareness of REITs. Petronas Twin Towers, Mid Valley Mega Mall, 1Utama and the likes of these… many investors would want to own a piece of these properties.

OK granted that you can own a piece of Petronas Twin Towers and Mid Valley by buying shares in KLCCP and Kris Assets but it’s not the same. Both companies pay out less than 50% of earnings in dividends and are not tax efficient as compared to holding the assets in a REIT structure.

REITs are not Stocks
Somehow I get the feeling that most investors in Malaysia don’t dig this. In reality REITs have different risk profiles. When you buy shares in say Sime Darby, you are exposed to business risks. When you invest in say TowerREIT, your income is from rental streams. It doesn’t take W Buffett to figure out that collecting rent is so much easier and safer than running a palm oil plantation, especially when you have blue chip tenants locked into long leases. There are some exceptions, for example REITs like Starhill REIT and Boustead REIT which have an element of business risk in them.

Should I Invest in REITs?
Absolutely Yes! (but not if you are a short term player). Based on current prices, they add a good yield to your portfolio. For now, collecting rent is to be preferred over operating a business

Analysis of REITs
Don’t just look at the headline yield! I will cover this in another article soon.

It seems KLCCP has included the increase in its property value into its profit figure.

OK basically I’m not in favour of such reporting.

Traditionally if property assets go up in value, companies would treat this as an asset revaluation. The increased property value goes into the balance sheet – OK fine. But the corresponding credit should go into an Asset Revaluation Reserve and not into the company’s operating profit.

The company should not be allowed to pay dividends out of the Asset Revaluation Reserve.

We have restated the Fair Value Adjustment as an Unusual Item in our database. It is excluded from our EBIT calculation and as a result KLCCP’s Interest Cover is only 4.0x which is not fantastic. I usually like to see at least 7x Interest Cover in companies I invest in, or in the case of passive property vehicles perhaps 6x. Then again, Petronas is the major shareholder in KLCCP. They are big enough to buy up the lenders.

Back to my point…. it’s great that the property has gone up in value. But they haven’t sold it yet which means they haven’t made a cent profit. Hmmm…. am I missing something here? Why should it be treated as profit and not unrealised gain?

The Australian Property Trust Experience

This reminds me of the recent Australian experience with some of their top REITs. The industry was expanding nicely for a good 10 years since 1995. Investors had a fantastic choice of top quality properties, returns were good and earnings were real.

Sometime from around 2004, the testosterone level of property fund managers began to increase at a rapid and uncontrollable rate. Fund managers were competing to buy properties, often overpaying for them and relying on financial wizardry (eg. income support mechanisms) to justify the high prices paid. To boost their equity returns, they stuck in some debt funding. Here’s a simple illustration:

Total Return = Income Return + Capital Growth

So if your net rental return is 6% and the property goes up in value by 4% – your total return is 10%. Simple enough.

OK let’s stick in some debt funding. Say your borrowing cost is 7%. Hmmm…more than your rental income but never mind, report the profit as 10% and since the funding cost is only 7%, you’re still ahead by 3% right?

Well yes… so long as you can keep increasing your rents return to justify the higher property value. But sooner or later reality catches up and we saw some violent wake-up calls for even the largest property trusts in Australia.

Fair Value Adjustment was the name of the game. Look at GPT, at its peak market cap was more than A$10 billion. Today it is A$1.9 billion.

Here’s another one, a familiar household name synonymous with quality houses in Australia – Mirvac. From a high of A$6.30 its security price is now A$1.30.

I’m not saying KLCCP is headed towards this direction. All I’m saying is that the recognition of “Fair Value Adjustment” as “Profit” in the Income Statement is misleading and shame on the auditor for its unqualified sign off.

Our REIT industry in Malaysia will take many many years to reach the kind of bubble seen in Australia.

And when it does, please remember the “Fair Value Adjustment” bubble!