Real Estate Finance

Real Estate Investment Trusts in Hong Kong

Design, Financial Engineering and Investments

K. S. Maurice Tse
The University of Hong Kong
E-mail: ktse@hku.hk

k s tse 1
 Contents
◼ Overview of REITs in Asia
◼ What is REIT and how it works
◼ Investing in REITs
◼ Key Features of REITs in Hong Kong
◼ Financial Analysis of REITs
◼ Financial Engineering
◼ Risks Related to REITs

k s tse 2
 REITs in Asia
◼ Number of REITs and Property Funds in Asia

k s tse 3
 REITs in Asia
◼ Asian REITs as of end of December 2010
Stock Index No. of Avg.
Stock 10-Yr Gov’t REIT Market
Market Change from Listed Dividend
Market Index Bond Yield Cap (USD M)
End Jun 2010 REITs Yield*

Japan 10,228.92 9.02% 35 4.98% 1.13% 45,630

Singapore 3,190.04 12.50% 24 5.88% 2.71% 29,266
Hong Kong 23,035.45 14.44% 8 4.96% 2.86% 12,167
Malaysia 1,518.91 15.59% 14 6.81% 4.00% 3,408
Thailand 1,032.76 29.53% 29 7.41% 3.73% 2,737
Taiwan 8,972.50 22.42% 8 3.58% 1.54% 2,123
South Korea 2,051.00 20.77% 5 8.13% 4.52% 1444
*Weighted by market capitalization

k s tse 4
 REITs in Asia
◼ Likely Factors for the Growth of REIT markets in Asia
1. Low level of securitization of investment grade real
estate in Asia
2. Much of the investment grade real estate in Asia are
still being privately owned through the company’s
balance sheet, which may not be sustainable in the
long run.
3. The quantity of investment grade real estate
continues to grow in the emerging markets in Asia,
which will add to the pool of assets available for
securitization
◼ China and India ??
k s tse 5
 Contents
◼ Overview of REITs in Asia
◼ What is REIT and how it works
◼ Investing in REITs
◼ Key Features of REITs in Hong Kong
◼ Financial Analysis of REITs
◼ Financial Engineering
◼ Risks Related to REITs

k s tse 6
 What is REIT and how it works
◼ Traditional Developer-Landlord Model
Sell some of the
Developer properties
acquires lands
and builds Properties leased out
Hold some of the
properties properties as landlord for rental income

Developer
Cash Debt
Properties Equity

◼ The proportion of “sell” versus “hold” depends on the property

market conditions and other factors pertaining to the developer.
7
k s tse
 What is REIT and how works
◼ REITs as “Asset-Light” Strategy for Developer

• Debt Financing
Developer needs
CASH to launch other • Equity Financing
projects in say a • Sell properties in the market
foreign market
• Sell properties to a REIT

◼ Why sell to a REIT?

8
k s tse
 What is REIT and how it works
◼ REITs as “Asset-Light” Strategy for Developer
◼ Why sell to a REIT?
◼ Can sell at a relatively higher price because investors are
likely to pay a premium price for steady and stable income
◼ Can still keep control of the properties by retaining a stake,
typically around 30%
◼ Can build up two new sources of fee income:
◼ Fees for managing the REIT-the trust (Manager’s Fee)

◼ Fees for managing the properties (Property Mgt Fee)

◼ Can please developer’s own shareholders by lifting the

return on assets recorded by the company
9
k s tse
 What is REIT and how it works
◼ Example: Nopay Ltd is a developer and currently owns an office
building. Consider the following transactions:
Nopay Ltd (Developer) Transactions
Cash $100 Debt $300 1. Use the $100 cash
to set up a REIT
Office $300 Equity $100 2. Borrow $100
3. Raise Equity $100
Nopay REIT 4. Sell the Office to the
Borrow $100 REIT for $300
Office $300
Equity $100 + $100< -- Nopay + External
Shareholders
Nopay Ltd (Developer) Outcomes
Cash $300 Debt $300 1. Direct Property
Asset = 0
Nopay REIT $100 Equity $100
2. Equity stake in the
trust = $100 10
k s tse
 What is REIT and how it works
◼ Example: Nopay Ltd is a developer and currently owns an office
building. Consider the following transactions:

Nopay Asset Management Company Transaction

Management Property • Set up an Asset
of REIT Management Management
Company to manage
Fee Fee Nopay REIT for fee
incomes.

Nopay REIT • Return on Nopay’s

Borrow $100 $100 equity stake
Office $300
Equity $200 in the REITs?

11
k s tse
 What is REIT and how it works

◼ What can Nopay Ltd do with the $300 cash?

◼ Finance higher returning development
◼ Pay down debt
◼ Buy back equity
◼ Incubate properties with the intention to sell to
Nopay REIT or others.

12
k s tse
 What is REIT and how it works
◼ Example: CapitaLand in China 2005
◼ A shopping mall in China cost $500 million, and an 8%

yield would imply an income of $40 million a year.

◼ If the income is capitalized at a yield of 5.4%, that

would imply a new valuation for the shopping mall of

$740 million (=$40/5.4%).
◼ So CapitaLand would make a $240 million profit, or

48% of its initial investment.

◼ Asset Light Strategy:

◼ Buy the property, improve it and sell it to its REIT.

◼ Yield difference of 2.6% is the reward to

CapitaLand
13
k s tse
 Contents
◼ Overview of REITs in Asia
◼ What is REIT and how it works
◼ Investing in REITs
◼ Key Features of REITs in Hong Kong
◼ Financial Analysis of REITs
◼ Financial Engineering
◼ Risks Related to REITs

k s tse 14
 Why would investors invest in REITs
◼ REITs own real estate, but, when you buy a REIT, you’re
not just buying real estate, you’re also buying a business.
◼ REITs are the easiest way for individuals to own
commercial real estate and allow for the greatest
possible real estate diversification.
◼ REITs offer the liquidity of being publicly traded.
◼ REIT stocks are equities and are subject to the prevailing
winds blowing across the investment world.
◼ REITs’ total returns over reasonably long time periods
have been very competitive with those provided by the
broader market.

k s tse 15
 Why would investors invest in REITs
◼ Investors may wish to invest in the property market.
◼ Investors may wish to invest for stable income, but
wish to earn a return higher than the return on fixed
income securities.
◼ Investors may also wish to derive part of their
investment return from the appreciation of the
market value of properties.
◼ REIT by the nature of its rental cash flows is
somewhere between fixed income and equity.

k s tse 16
 Why would investors invest in REITs
◼ REITs’ higher yields raise the overall yield of the
portfolio, thus minimizing volatility and providing stable
cash flows even in major bear markets.
◼ REITs’ higher current yields often act as a shock
absorber against daily market fluctuations.
◼ REITs offer diversification to your investment portfolio
because they don’t correlate well with the rest of the
market.
◼ Analysts who follow REITs are normally able to forecast
quarterly results quite accurately, thus minimizing the
chances for negative surprises.
k s tse 17
 Performance of REITs before 2007
◼ REITs’ total returns over reasonably long time periods have been
very competitive with those provided by the broader market.
◼ US REIT Returns versus Stocks and Bonds

Small Stocks

Equity REITs

Large Stocks

Bonds

0.00% 2.00% 4.00% 6.00% 8.00% 10.00% 12.00% 14.00% 16.00%

k s tse 18
 Performance of REITs before 2007
◼ Return and Risk for Three US Investment Portfolios
Stocks and Bonds With 10% REITs With 20% REITs

10% 10% 10%

T-Bills T-bills
T-Bills 10%
40% 40% REITs 40% 20%
Bonds REITs
Stocks Bonds Bonds
Stocks
50% Stocks
40%
30%

Return 10.7% Return 10.7% Return 11.4%

Risk 11.0% Risk 10.7% Risk 10.4%
Sharpe Ratio 0.42 Sharpe Ratio 0.46 Sharpe Ratio 0.50

◼ REITs’ higher yields raise the overall yield of the portfolio, thus minimizing
volatility and providing stable cash flows even in major bear markets.

k s tse 19
 Performance of U.S. REITs 2005-2015
◼ Returns on US Stock Indices
Figure 4: Average Return on REITs and Non-REITs
40.00%
31.54%
30.00% 24.31% 25.49% 25.17% 26.04%
17.10%
20.00% 16.47%
9.89% 22.17% 8.90%
8.62%
10.00% 14.66% 13.80% 3.05%
0.50% 11.54%
0.00% 5.41% 3.25% 2.10%
-0.98%
-10.00% -6.63%
-8.75%
-20.00%
-30.00%
-40.00% -44.59%
-50.00% -48.56%
-60.00%
2005 2006 2007H1 2007H2 2008 2009 2010 2011 2012 2013 2014 2015
S&P500 Non-REITs REITs

◼ Working Paper by K. S. Maurice Tse 2016

k s tse 20
 Performance of U.S. REITs 2005-2015
◼ Risk of US Stock Indices—Total Risk
Figure 5: Total Risk (Annualized Standard Deviation)
80.00%
68.08% 64.84%
70.00% 64.04%
61.82% 62.49%
60.00%

50.00%

40.00% 35.32%
30.00%

20.00%

10.00%

0.00%

Pre-Crisis Crisis Post-Crisis

◼ Working Paper by K. S. Maurice Tse 2016

k s tse 21
 Performance of U.S. REITs 2005-2015
◼ Risk of US Stock Indices—Semi-Standard Deviation
Figure 6: Average Daily Semi-Standard Deviation
3.500% 3.059% 2.951%

3.000% 2.815% 2.824% 2.904%

2.500%

2.000%

1.500%

1.000%

0.500%

0.000%

Pre-Crisis Crisis Post-Crisis

◼ Working Paper by K. S. Maurice Tse 2016

k s tse 22
 Performance of U.S. REITs 2005-2015
◼ Risk of US Stock Indices—Market Risk (beta)
Figure 7: Market Risk (b) for REITs and non-REITs Indices
2.0000
1.8000 1.7148 1.7376
1.5954 1.6330 1.6512
1.6000
1.4000 1.2609
1.2000 1.1327
1.0499 0.9869 0.9449
1.0000 0.8480
0.8000 0.7293
0.6604
0.5749
0.6000
0.4000
0.2000
0.0000 Vanguards S&P500 Dow Jones MSCI US CONS CONS FINANICAL HEALTH INDUSTRI MATERIAL
ENERGY INFO TECH TELECOM UTILITIES
REITs REITs REITs REITs DISCRET STAPLES S CARE ALS S
Pre-Crisis 1.0064 1.1275 1.0430 1.0954 1.0499 0.7025 1.2609 1.0293 0.7785 0.9869 1.1558 1.2634 0.8480 0.8643
Crisis 1.5954 1.7148 1.6330 1.6512 1.0499 0.5749 1.2609 1.7376 0.6604 0.9869 0.9449 1.1327 0.8480 0.7293
Post-Crisis 1.0064 1.1275 1.0430 1.0954 1.0503 0.6286 1.2600 1.2533 0.8431 1.0977 1.0287 1.1746 0.6624 0.6077

Pre-Crisis Crisis Post-Crisis

◼ Working Paper by K. S. Maurice Tse 2016

k s tse 23
 REITs in Hong Kong
◼ Correlation Coefficients of REITs in Hong Kong
Sunlight Link Prosperity GZI Champion Regal Huixian HS Index
Sunlight 1
Link 0.256 1
Prosperity 0.525 0.284 1
GZI 0.419 0.199 0.466 1
Champion 0.328 0.246 0.452 0.380 1
Regal 0.347 0.229 0.395 0.360 0.381 1
Huixian 0.308 0.233 0.334 0.417 0.375 0.323 1
HS Index 0.406 0.380 0.439 0.456 0.445 0.411 0.713 1
Date: November 6 2007 to September 9 2011
• Correlation coefficient between Hang Seng Index for Properties and Hang Seng Index is 0.89
• Correlation coefficient between Hang Seng Index for Finance and Hang Seng Index is 0.92
• Correlation coefficient between Hang Seng Index for Utilities and Hang Seng Index is 0.63

◼ REITs offer diversification to your investment portfolio because

they don’t correlate well with the rest of the market.
k s tse 24
 Correlation Coefficient & Diversification
◼ Consider a simple two-asset portfolio: EXCEL TEMPLATE
Asset 1 Asset 2 Weight 1 Weight 2 E(Return) Port. SD
Expected Return 12% 6% 0 1 6.00% 8.00%
Standard Deviation 10% 8% 0.1 0.9 6.60% 7.46%
Correlation Coefficient (r) 0.2 0.2 0.8 7.20% 7.08%
Portfolio Weights 0.2 0.8 0.3 0.7 7.80% 6.86%
0.4 0.6 8.40% 6.84%
Portfolio Mean Return 7.20% 0.5 0.5 9.00% 7.00%
Portfolio Standard Deviation 7.08% 0.6 0.4 9.60% 7.34%
0.7 0.3 10.20% 7.84%
Risk-Return Tradeoff 0.8 0.2 10.80% 8.47%
14.00% 0.9 0.1 11.40% 9.19%
12.00%
1 0 12.00% 10.00%
Expected Return

10.00%

E(return) = w1E(R1 )+w2E(R2 )

8.00%
6.00%
4.00%
2.00% s port
2
= (w1s 1 )2 +(w2s 2 )2
0.00%
0.00% 2.00% 4.00% 6.00% 8.00%
Standard Deviation
10.00% 12.00%
+2r (w1s 1 ) (w2s 2 )
k s tse 25
 Contents
◼ Overview of REITs in Asia
◼ What is REIT and how it works
◼ Investing in REITs
◼ Key Features of REITs in Hong Kong
◼ Financial Analysis of REITs
◼ Financial Engineering
◼ Risks Related to REITs

k s tse 26
 Key Features of REIT in Hong Kong
◼ Highly regulated in Hong Kong
◼ SFC (Securities and Futures Commission) approval
◼ Must be authorized by the SFC under the REIT Code.

◼ Separate authorization applications for the REIT, the

trustee, the Manager and the “responsible officers”

of the Manager.
◼ SEHK (Hong Kong Stock Exchange) approval
◼ REIT also needs approval from the Hong Kong Stock

Exchange for listing of units.

k s tse 27
 Key Features of a REIT in Hong Kong
◼ Key Restrictions on REITs under the REIT Code
◼ Must be set up as a unit trust

◼ Can only invest in real estate which generates recurrent rental

income
◼ No active trading of real estate and must hold properties for at

least 2 years
◼ Investment in vacant land or property development activities,

stocks and investment funds no more than 10% of gross asset

value.
◼ Borrowing limit of 45% gross asset value

◼ Must distribute at least 90% net income to Unitholders

◼ Restrictions on transactions with connected persons

◼ No New Tax Incentives Offered: REITs in Hong Kong are taxed

like conventional corporates.

k s tse 28
 Key Features of a REIT in Hong Kong
◼ General REIT structure
Unitholders

Investment in REIT Distributions

Acts on behalf
Management Fee
of unitholders TRUSTEE
REIT (holds
MANAGER
REIT properties for
the benefit of
Management Trustee Fees unitholders)
Services
Purchase assets Trustee Fees

Property Assets

Rental Income

k s tse 29
 Performance of REITs in Hong Kong
◼ Overview (Prosperity = 泓富產業 ; Fortune = 置富產業 ; Hui Xian= 匯賢產業)
◼ 30th June 2017
Unit Market Cap NAV Dividend
REIT SECTOR
Price ($m) per unit Yield
Link (823) Retail 63.70 141,100 54.24 3.64%
Prosperity (808) Office & Ind. 3.40 4,970 5.15 5.18%
Yuexiu* (405) Commercial 5.00 14,680 7.47 6.41%
Champion (2778) Office & Retail 6.01 34,870 8.69 3.81%
Sunlight (435) Office & Retail 5.18 8,484 8.26 4.76%
Regal (1881) Hotel 2.45 7,948 4.15 6.29%
Fortune (778) Retail 9.71 18,300 12.95 5.04
Hui Xian* (87001) Commercial 3.20 17,680 4.85 8.58%
RREEF* (625) Commercial 4.35 NA NA NA
Spring* (1426) Office 3.53 4,405 NA NA
New Cent* (1275) Hotel 2.44 2,339 NA NA
k s tse 30
 Contents
◼ Overview of REITs in Asia
◼ What is REIT and how it works
◼ Investing in REITs
◼ Key Features of REITs in Hong Kong
◼ Financial Analysis of REITs
◼ Financial Engineering
◼ Risks Related to REITs

k s tse 31
 Financial Analysis of REITs
Rent $
II. Asset Market: I. Property Market:
Valuation Rent Determination

D(R,Economy) = S

Price = Rent/i
i = Cap rate

Price $ Stock (sq m)

◼ Cap rate (Capitalization rate)? Capitalization rate is taken as

◼ There are 4 elements:
◼ Long-term interest rate in the economy
◼ Expected growth in rent
◼ Risks associated with the rental income
◼ Tax treatment of real estate (if any??).
exogenous in the sense that it’s
based on interest rates and
returns in the broader capital
market for all assets (stocks,
bonds, short-term deposits and
so on).

k s tse 32
 Snapshot of parts of Sunlight Portfolio
◼ As of 30 June 2011
NPI* NPI** Cap Rate Cap Rate Appraised
Property Location
(HK$000) (HK$000) Retail Office Value
248 (Grade A) Wanchai 109,004 92,754 4.20% 4.00% 3,225,000
Bonham （Grade B） Sheung Wan 20,522 18,944 4.20% 4.00% 684,000
Righteous （B） Mong Kok 13,569 13,423 3.80% 4.10% 479,000
Winsome （C） Central 12,966 12,372 4.20% 4.00% 407,000

Sheung Shui Centre Sheung Shui 95,689 89,317 4.40% NA 2,836,000

Metro City I Tsang Kwan O 79,732 71,836 4.5% NA 2,094,000
Kwong Wah Yuen Long 21,052 20,548 4.00 4.00 668,000

*FY2010/11 • Financial Model ??

**FY2009/10

k s tse 33
 Financial Model
◼ How to Derive Distributable Income ?
+ - - - - =
Rental Property Financing
Rental Manager Net
Related Managem cost Tax
Income Fees Income
Income ent Costs (Interest)

Net Distributable
+ Adjustments =
Income Income

k s tse 34
 Financial Model
Case: Sunlight REIT
*Other Direct Costs
◼ Building Management Current Profit Projection ($000): FY2013/14
Expenses Rental Income 547,820
◼ Rental Commissions License Fee 3,222
◼ Advertising and Antennae Income 1,351
Promotional Expenses Car-Park Income 29,546
◼ Maintenance and Total Turnover 581,938
Repair
◼ Salary Total Rental Related Income 106,967
◼ Professional Services (Rates Revenue, Promotional Rev, Mgt Fee, Air Con Fee)
◼ Registration fee, Property Management Fee (3% Rental) (16,572)
company charge, Government Rent and Rates (26,487)
stamp duty Car Park Expenses (8,682)
◼ Insurance fee Other Direct Costs* (102,100)
◼ Etc Total Direct Costs (153,840)
◼ What about
Interest costs? Total Net Property Income 535,065
k s tse 35
 **Manager Fee
Financial Model • Was 100% paid in units.
• Now 50% cash 50% units
Actual Profit: FY2013/14 • Base fee: Up to 0.4% of Property Value
Other Income • Variable fee: 3% of NPI 3,678
Consideration Adjustment Payments 0
Manager's Fee** (77,614)
Trustee Fee (3,963)
Trustee Related Expenses (13,258)
(Decrease)/Increase in Fair Value of Investment Properties 961,041
Total Financing Costs (Interest Expenses) (114,510)
Profit from Ordinary Operations before Taxation 1,290,438
Profit Tax for Current Period/Year (45,021)
Deferred Taxation (15,370)
Net Income 1,230,047
◼ Major chunk of Consideration Adjustment Payments used to come from the rental
guarantee by the vendor for two years (up to June 30, 2009) after listing. If the rental
income was less than the assured minimum, the vendor will pay the difference to the
REIT subject to a cap: $405.4m (June 30 07) , $429.4 (June 30, 08), $454.9 (June 30, 09)
◼ Variable interest costs swapped into fixed interest costs
k s tse 36
 Financial Model
Actual Profit: FY2013/14

Net Income 1,230,047

Adjustments (887,231)
Total Distributable Income 342,815
Distribution per unit (DPU) HK cents: 100% Payout 21.10
Distribution per unit (DPU) HK cents: 90% Payout 18.99

◼ Adjustments
◼ Minus Gains (losses) from valuation
◼ Plus REIT fund management base fee paid in units
◼ Plus REIT performance fee paid in units
◼ Plus Amortization of Swap
◼ Plus Amortization of debt establishment fees
◼ Plus Deferred taxation k s tse 37
 Use of FFO for Analysis
◼ Significance of Funds from Operations (FFO) and Adjusted Funds
from Operations (AFFO)

◼ Investors in common stock generally use net income as a key

measure of profitability.

◼ But FFO is more often used for REIT for the following reasons:

◼ Net income is after depreciation.

◼ FFO excludes gains or losses from sales or valuation of

property, plus depreciation and amortization.

◼ AFFO is FFO adjusted for recurring expenditures that, though

capitalized, are for maintaining the quality of the underlying
properties AND do not enhance the value of a property.
k s tse 38
 Use of FFO for Analysis
• Operating Expenses
• Write-offs
All Revenues • Depreciation
Net
(incl. Capital - • Amortization =
Income
Gains) • Interest Expense
• Gen. and Admin
expenses

- • Capital Gain from Real

Net
Estate Sales = FFO
Income
+ • Real Estate Depreciation

◼ AFFO = ??
◼ Value creation for REITs ??
k s tse 39
 Use of FFO for Analysis
• Normal and Recurring Capital
Expenditures
• Amortization of Tenant
Improvements and Leasing
FFO - = AFFO
Commissions
• Adjustment to remove straight-
lining and any gain/loss on the
early extinguishment of debt

◼ Value creation for REITs comes from generating

growth in FFO and AFFO (look at FFO growth on a per-
share basis)
k s tse 40
 Use of FFO for Analysis
◼ Value Creation for REITs

FFO GROWTH
Internal External FFO
+ =
Growth Growth Growth
• Rental Increases
• Percentage Rent • Acquisitions
• Rent Bumps • Development &
• Tenant Upgrades + Expansion = Value
• Property (IRR > WACC) Increase
Refurbishments • Non-rental
• Capital Recycling: Revenue Sources
Sale & Reinvestment
k s tse 41
 Use of FFO for Analysis
◼ Value Creation for REITs through Acquisitions
◼ Two ways to achieve it:
◼ Acquire properties with cash at positive spreads, utilizing the

arbitrage between cost of capital and the yield of property

Cost of
Yield of
Capital of <
Property
REIT

◼ Swap shares in the REIT for interests in properties.

◼ Advantage is minimal cash requirement

k s tse 42
 Financial Analysis
◼ Net Property Income and Yield per unit

31-Dec-08 30-Jun-09 31-Dec-09 30-Jun-10 31-Dec-10 30-Jun-11

Annualized net property income 354881 350678 357575 369907 396600 407371
Engineered Earnings Yield per unit 7.37% 9.92% 5.61% 5.93% 7.02% 7.30%
Clean Earnings Yield per unit 5.30% 5.09% 4.66% 4.93% 6.04% 6.28%

k s tse 43
 Financial Analysis: NAV
◼ What is NAV (Net Asset Value)?
◼ What does it mean when a REIT’s implied property value is
trading below or above NAV?

◼ Net Asset Value is the net “market value” of all of a

company’s assets, including but not limited to its
properties, after subtracting all its liabilities and
obligations.
◼ When a REIT is trading above NAV, it is more likely to find
attractive cash spreads than when it is trading below NAV.

◼ When yields (prices) are very close, it may not be wise to

acquire properties in this fashion because of the costs
associated with securing capital.
k s tse 44
 Financial Analysis: NAV
◼ Discount to Net Asset Value (HK$ ‘000)
◼ Implied Property Value = Enterprise Value – Net Current Asset
14,000,000
Implied Property Value
12,000,000 Appraized Property Value
10,000,000

8,000,000

6,000,000

4,000,000

2,000,000

-
31-Dec-08
30-Dec-04 30-Jun-09
29-Jun-05 31-Dec-09
30-Dec-05 30-Jun-10
29-Jun-06 31-Dec-10
30-Dec-06 30-Jun-11
29-Jun-07

Implied Property Value 7,624,948 7,569,678 7,649,439 7,688,620 7,664,761 7,682,388

Appraised Property Value 9,125,000 9,364,000 9,701,000 10,722,100 11,111,300 12,222,200
Discount to Imp Property Value 16.44% 19.16% 21.15% 28.29% 31.02% 37.14%

k s tse 45
 Financial Analysis: NAV
◼ Premium/Discount to NAV
◼ Enterprise Value = Market Capitalization + Debt – Cash & Cash Eqs
80,000
HK$ millions
Enterprise Value
70,000
Appraised Property Value
60,000

50,000

40,000

30,000

20,000

10,000

-
Sunlight Link Champion Prosperity GZI Hui Xian Regal Fortune

Premium/ Sunlight Link Champion Prosperity GZI Hui Xian Regal Fortune
(Discount) -39.97% 5.73% -40.91% -39.03% -18.74% -30.51% -30.76% -45.42%

k s tse 46
 Financial Analysis: DPU Yield
Net Property Income
◼ Property Yield and DPU Yield Implied Property Yield =
Enterprise Value
10.00%
Implied Property Yield
9.00%
Engineered DPU Yield
8.00%
7.00%
6.00%
5.00%
4.00%
3.00%
2.00%
1.00%
0.00%
Sunlight Link Champion Prosperity GZI Hui Xian Regal Fortune

Sunlight Link Champion Prosperity GZI Hui Xian Regal Fortune

Implied Property Yield 5.55% 5.12% 4.84% 5.19% 6.19% 8.80% 5.92% 7.68%
Engineered DPU Yield 7.65% 4.03% 5.52% 7.04% 6.48% 6.20% 5.64% 6.92%
Clean DPU yield 6.58% 4.03% 5.52% 7.04% 6.48% 6.20% 5.64% 6.92%
Payout Ratio 90.5% 100.0% 91.0% 100.0% 100.0% 100.0% 99.7% 100.0%
k s tse 47
 Contents
◼ Overview of REITs in Asia
◼ What is REIT and how it works
◼ Investing in REITs
◼ Key Features of REITs in Hong Kong
◼ Financial Analysis of REITs
◼ Financial Engineering
◼ Risks Related to REITs

k s tse 48
 Financial Engineering
◼ At the bottom of a property cycle and in the
early stages of an upswing, REITs might also
resort to financial engineering to try to lift
yields for investors.
◼ The aim is to raise yield in the short term and
pay for it later when rents are higher. The
purpose is to smooth out the REIT’s yields over
a period of time.
◼ Financial Engineering tactics?
k s tse 49
 Financial Engineering
◼ The objective of financial engineering is to maximize the
dividend yield to outside shareholders, HOW???
Nopay Asset Management Company
Management Property
of REIT Management

Fee Income
Fee Fee

Nopay REIT
• Borrow $100 Debt

Rental Office $300 • Equity

Nopay $100
External $100 Equity

50
k s tse
 Financial Engineering
◼ 1. Step-up interest rate swap arrangement
◼ E.g. Prosperity REIT, Champion REIT, and lesser extent
Sunlight REIT
◼ A trust will pay to a counterparty a lump sum upfront, and then fixed and
gradually rising interest rates for a certain number of years.
◼ In return the counterparty agrees to pay the trust’s floating rate interest
payments to its lenders.
◼ The upfront fee is amortized over the term of the loan, but will not affect
distributable income to investors
Floating Floating
Counter REIT
Party interest interest Lender
(Swap REIT Bank
Bank) Trust
Upfront Fee + Floating Rate
Fixed Interest Loan
k s tse 51
 Financial Engineering
◼ 1. Step-up interest rate swap arrangement
◼ Disadvantages
◼ If the upfront is paid from money raised in IPO, the
investors are in effect paying for the higher yield
from their own pockets.
◼ If rents do not rise as expected, there is a danger
that distributions can end up declining.
◼ If interest rate falls, the yield to the investors may
become less attractive when compared to REITs
that do not use interest rate swap
k s tse 52
 Financial Engineering
◼ 2. “Distribution Entitlement Waiver”
◼The seller of a property to the trust accepts payment
in REIT units but with a “distribution entitlement
waiver.”
◼The seller could be the sponsor who retains a large
share of the trust’s units after its IPO, or the landlord of
a single asset bought by the trust.

k s tse 53
 Financial Engineering
◼ 2. “Distribution Entitlement Waiver”
◼ If the seller agrees not to accept a dividend for a year
or two, other shareholders will get a greater share of
income, and therefore a bigger yield than usual.
◼ When the seller takes up the right to a dividend, the
yield to other investors will be diluted, but by that
time rents hopefully will rise sufficiently for no
impact to be felt.
◼ Disadvantage: Is the REIT paying too high a price for
the property ?
k s tse 54
 Financial Engineering
◼ 3. “Rental Guarantee”
◼ e.g. Sunlight REIT

◼ Sunlight REIT gave investors a rental guarantee for

almost three years to make up for leases that had not
yet been negotiated to market rates.

◼ Danger: The risk is that the yield would drop quickly

after the guarantee expired.

k s tse 55
 Financial Engineering

◼ 4. Management firm receives units rather than cash.

◼ This can inflate yields in the short-term.

◼ It can also work as an incentive for the managers to
perform well, but it gives the impression more cash is
available for distribution than is really the case, while
diluting the shareholding of investors.

k s tse 56
 Financial Engineering
◼ 5. “Sale-leaseback” Agreement
◼ The former landlord agrees to pay a higher rent in
return for a high purchase price for a building.
◼ The building may give a healthy original yield, but if for
any reason the tenant has to vacate the premises, it
will probably be impossible to find a new tenant willing
to pay such an elevated rent.
◼ No REIT would subscribe to this tactic, but under
pressure to grow the trust’s portfolio, a manager might
be persuaded to enter such a deal by a seller who is
desperate for capital.
k s tse 57
 Financial Engineering
◼ Conventional REIT without Financial Engineering
Minus Operating
Expenses Plus Debt
9 Minus Trust Leverage
8 Expenses

7
6
5
4
3
2
1
0
Gross Property Net Property EBITDA/EV Distribution
Yield Yield Yield Yield
k s tse 58
 Financial Engineering
◼ Financially Engineered REIT
Plus
9 Distribution Waiver
8
7
6 Plus
Minus Interest Rate
5
Operating Swap Boost
4 Expenses Minus
Upfront fee for
3
Interest Rate Swap
2
1
0
Gross Property Net Property EBITDA/EV Earnings Distribution
Yield Yield Yield Yield Yield

k s tse 59
 Contents
◼ Overview of REITs in Asia
◼ What is REIT and how it works
◼ Investing in REITs
◼ Key Features of REITs in Hong Kong
◼ Financial Analysis of REITs
◼ Financial Engineering
◼ Risks Related to REITs

k s tse 60
 Key Market Risks Relating to REITs
◼ REIT code: Gearing ratio < 45% of Asset Value
◼ Objective is to set the threshold value and manage the property value above
the threshold.
Value

Asset

Risk-Free Loan

Watch Safety
Danger Zone Zone Zone

0 L oan Asset Value

$45b $100b $130b

◼ Asset Value < Loan

◼ Asset Value > Loan
◼ REIT is Insolvent/Bankrupt
◼ REIT can pay off the bank loan
◼ Value of Bank Loan = Asset Value k s maurice tse 61
 Key Market Risks Relating to REIT
◼ All REITs are subject to three principal risks:
◼ Weak space markets

◼ Rising interest rates

◼ Declining commercial real estate prices

Risk Impacts
• Whereas a recessionary economy sometimes results in a
temporary decline in demand for space, the excess supply that is
brought on by overbuilding often will be a larger and longer-lasting
problem.
Weak Space
Markets • Investors must try to distinguish between a mild and temporary
condition of excess supply or insufficient demand and one that is
much more serious and protracted; in the latter case, a REIT’s
share price may decline and stay depressed for a year or two.

k s tse 62
 Key Market Risks Relating to REIT
◼ All REITs are subject to three principal risks:
◼ Weak space markets
◼ Rising interest rates
◼ Declining commercial real estate prices

Risk Impacts
• Whether correct or not, if investors even perceive that rising
interest rates will negatively affect a company’s profits, then the
Rising stock’s price will vary inversely with interest rates—when interest
rates drop, and dropping when interest rates rise.
Interest
Rates • Higher interest rates are generally not good for any business, as
they depress customers’ purchasing power and can eventually lead
to recession.
Declining
• Any significant decline in the value of its underlying real estate
Real Estate properties is likely to negatively affect the share price of a REIT.
Prices
k s tse 63
 Sunlight REIT’s Management Strategy
◼ The Manager intends to optimize the performance and enhance
the overall quality of the portfolio through various business and
investment strategies:
Active operational management and asset
enhancement strategy:
Active operational management and asset enhancement
initiatives to improve the long-term value of the portfolio.
Investment and acquisition growth strategy:
Drive acquisition growth by identifying, evaluating and acquiring
income-producing investment properties which have the potential
to contribute to sustainable growth in distributions by Sunlight
REIT and long-term enhancement in value of the portfolio.

k s tse 64
Sunlight REIT’s Management Strategy
Capital management strategy:
Efficient capital management framework to support
the Manager’s operational and acquisition growth
strategies.

Business management strategy:

Ensure a quality work force, sound corporate
governance practices, systems and infrastructure to
support the Manager’s fund management and asset
management activities.

k s tse 65
◼ End
◼ Reference: http://www.sunlightreit.com/

k s tse 66