ARA Analysis - Part III

Part III

Now that we understand the risks we face, let's get comfortable with the risks.

1. Ability to raise funds

Rasing new real estate funds
ARA's ability to raise funds has somewhat been affected by the downturn in the real estate market. But despite the downturn, ARA has been able to raise US$1.13b worth of capital commitments for its ARA Asia Dragon Fund - US$716m in 2007 and US$400m in 2008. On top of this US$1.13b, there is a US$500m co-investment opportunity with one single investor and which could boost the total AUM managed. The recently announced Shariah-compliant fund to be established with Qatar-based Regency Group and which could eventually house $1b worth of asset, is again a testament to ARA's ability to raise fund. Hence, despite the financial crisis and the poor performance of the real estate market, ARA has been able to demonstrate its strenght in raising funds. When the real estate market recovers, it is likely that ARA's odds of raising funds should improve and the pace of fund-raising should increase. Note also that, this is contingent on ARA's ability in not just being a REIT manager (which is more passive) but being also a capable active fund manager (i.e. good performance in its private fund)

However, this growth in funds will be constrained by the "conflict of interest between funds" which we talked about. Hence, expect ARA to venture into more niche areas such as healthcare assets, hospitality assets, carparks, industrial, etc, to grow its AUM. This can be made possible by hiring resources who have experience in this field and is not an unlikely scenario.

Increasing AUM of Existing Funds
Expect ARA to also increase the AUM by acquiring more assets via its existing funds. We can look at Fortune REIT's announced acquisition of 3 retail assets in HK. Despite the fact that the acquisition was non-yield-accretive, ARA managed to get the acquisitions approved. Moreover, the rights issue for the acquisition was 15.8% over-subscribed. The acquisition increases Fortune REIT's AUM from HK$9m to HK$11m - a 22% increase.

ARA has also faciliated acquistions of Suntec Convention Centre for Suntec REIT (S$25m) and partial interest in The Summit Subang USJ for AmFirst REIT (RM11m). Admittedly, besides the Fortune REIT's acquisitions, these other transactions are not meaningful in terms of size. Furthermore, with yields of the REITs being where they are now, not many REITs (ARA-managed REITs included?) will be able to acquire any assets without diluting unitholders' yield. Hence, increasing the AUM of existing funds will not be easy. Nonetheless, we note the potential to raise AUM of existing funds, even in the face of a yield-dilution exercise as evidenced by the Fortune REIT's transaction.

In conclusion, ARA's ability to raise funds even in tough time allows us to seek comfort on the level of risk involved. Nonetheless, there run a risk that ARA's private fund fails to perform and affect its fund-raising ability. Therefore - low to medium risk.

2. Rental Rate Risk
This is a real risk. Rents have fell since late 2008. Properties in ARA-managed REITs may only start experiencing the rental revision now as they may previously have been protected by rental contracts that were made at higher rates. The risk is quantifiable and should be quantified.

3. Capital Value Risk
This is also a real risk. In the past year, rental rates have fallen while cap rates have expanded. Both factors lead to a fall in capital values. However, capital values have fallen less than expected as owners of real estate were "strong hands" and were able to hold onto their investment, unlike "weak hands" which have to sell at depressed prices. In the Singapore office market, capital values are expected to remain depressed with anticipation of new supply coming online and demand being insufficient to absorb the new supply. However, unless demand dropped sharply (an unlikely event since it has already dropped significantly in the light of the financial crisis), it is likely that the downside risk has already been priced in, and surprise remains largely on the upside. (i.e. the likelihood of capital values moving up from here is high). Analysis of the Singapore retail, HK retail, HK office and Malaysia commercial will be necessary to fully understand and quantify (if possible) the risks. However, as a high level analysis, it would not be wrong to say that the possibility of real estate market moving up is much higher than the odds of it moving down, giving the low base which we are right now (depressed state due to the weak economic conditions).

Given that ARA provides quite a significant exposure to capital values by virtue of its base fee structure and the returns it could potentially get via ADF (both as an investor into ADF and via the carried interest structure), a buyer of ARA needs to get very comfortable on this risk. And comfort on underwriting this risk comes only if you have a positive view of the general real estate sector.

It is likely that we going to see some downward movement before an upward trend is re-established. The "we are starting from a low base" argument holds only if ARA-managed funds have revalued their properties to this "low base" (to verify). If not, there runs a risk where we see the AUM being reduced significantly as these funds are forced to revalue their assets. Likelihood of that? Uncertain. It is likely that they had to revalue when they got their bank loans refinanced but surprisingly nothing of that sort was reported. They might be forced to revalue during the preparation of annual accounts - i.e. the year end.

4. Ability to Acquire Assets
With the backing of Cheung Kong, offices across Asia and experienced professionals such as CEO, Mr. John Lim, ARA's ability to acquire assets are unquestionable. Hence, this is a low risk.

5. Demand for REITs/Ability to Raise Equity/Equity Market Risk
Demand for REITs remains robust. Share prices of REITs have moved up with the general market up-trend. Rights issue by REITs have been over-subscribed. In particular, rights issues for ARA-managed REITs were all over-subscribed (check?). Demand for REITs should remain robust as yield-seeking retail investors who can't gain access to fixed income products will look towards REITs for a stable, yielding investment. In more developed markets, REITs have become a common product in the marketplace (check trading volumes?). Hence, REITs are here to stay and demand for REITs is expected to be robust or at the very least - stable.

Ability to raise equity is proven by the same point - rights issue by REITs have been over-subscribed. Plus, the equity market have seem to recover to some form of normalcy.

Equity market risk associated with REITs' share price is perceived to be low as many are still trading at below book values - hence bad news seem to be priced in already and upward movements of prices are more likely than downward movements.

In view of all these factors, this is placed as a low risk.

6. Ability to Raise Debt
ARA's ability to raise debt for its funds is remarkable. For instance, Suntec REIT was able to refinance its loan at a cost of only 3.75%. Fortune REIT was also able to raise debt at <4%.>

As interest rates rise, the ability for ARA to finance acquisitions will be harder as the cost of financing will go up (makes it harder for acquisitions to be yield accretive) and the amount raised will become smaller (as cashflows are unable to support as much debt - interest cover drop). However, the low interest rate environment is expected to persist, even as credit-lending improves - a sweet spot.

Hence, this is a low risk for now.

7. Conclusion
In conclusion, 2 risks out of the 6 are risks that needs more work to get comfortable on - rental rate risk and capital value risk. Rental rates reversion is likely - the question is how much. Capital values require more analysis before we can get comfort on it. However, the high level analysis put this as a risk worth undertaking (i.e. positive outlook on asset prices). A check on revaluations performed by the REITs is also necessary.

We might also need to assess the probability of success for ARA's flagship Asian Dragaon Fund. The rest are deemed to be low risks - risks that we are comfortable to underwrite.

~ To Be Continued ~