Liquid Real Estate, Euromoney magazine, March 2008

The Asian REIT market has weathered the sub-prime storm reasonably well, but a new deal suggests that the grim credit markets are going to lead to significantly different structures this year. Specifically, much simpler ones.

The deal involves Champion REIT, Hong Kong’s largest commercial REIT, and one of a sequence of trusts that were launched with great fanfare in Hong Kong in 2006 only to perform disappointingly. Apart from the fact that it owns only one asset, Citibank Plaza in Hong Kong’s Central district, it is also well-known for its use of financial engineering.

Champion, like other Hong Kong REITs launched that year, used interest rate swap agreements in order to boost yields in its earlier years by deferring interest payments to later in the trust’s life. The logic for this at the time of launch was that commercial assets in Hong Kong were paying historically low rents, but that they would unquestionably increase next time leases came up for renewal (This has been proven correct: rental contracts in Citibank Plaza are going at more than twice the spot price at the time of the IPO). But the approach alarmed many institutional investors, finding it opaque, and this is perhaps the biggest reason that five of the six REITs launched in Hong Kong to date are trading below their IPO prices (the exception being the first of them all, the Link REIT).

In February, Champion announced plans to acquire the Langham Place office, mall and hotel development, also in Hong Kong, for HK$12.5 billion. It’s easily the biggest acquisition ever made by a Hong Kong REIT and will transform the trust into one of the biggest in the region, Japan included. It is striking for the fact that it plans to raise almost HK$10 billion of the total through placement units, convertible bonds and debt facilities; nobody else is talking about attempting to raise such sums in the capital markets today. And it is also notable because it commits to end that controversial interest rate swap.

Part of the reason it has done so is because with current yields so artificially high, trusts using these arrangements can’t possibly buy anything that would be yield accretive – not in Hong Kong, anyway. One other financially engineered REIT, Prosperity, has tried to redress this by aiming for China property instead, but has yet to buy one. Champion’s yield will drop because of this change (from a forward yield of 7.7% before the announcement to a new absolute yield level of 5.5-6%, according to Eagle Asset Management, which runs Champion) but it will become more transparent and remove the risk of having to pay greater interest in the future that was pushed back from earlier years. Consequently price performance should improve, the discount to net asset value should narrow, the cost of capital should come down and it will be easier to grow through acquisition. 

Other Hong Kong REITs are expected to follow, and the financial engineering approach may be consigned to history, for a while at least. “I think we’ve seen the end, for the time being, of this concept of financial engineering, and we are already seeing a return to the true fundamentals in the listed real estate sector,” says Peter Mitchell, CEO of the Asian Public Real Estate Association. “That is, ignoring mechanisms to crank up distribution deals for investors, and going back to the basics: in particular the quality of management and the quality of assets.”

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