ARA Update

I still do not have time to write up a summary of the lengthy ARA analysis. My apologies.

I have time, however, for a quick update. On 13 Jan 2010, the Business Times reported that ARA is going to set up a REIT with CWT. This was mentioned in passing in a short paragraph in an article that is almost totally irrelevant (it was about the future of SGX as a listing ground). Makes you wonder if it was a deliberate leak. I take that back, lest I get sued.

On 14 Jan 2010, ARA and CWT came out and clarified that they are planning to put together a logistic REIT but nothing is firmed up. SGX has yet to provide the approval. But given that SGX is desperate to get more listing fees (especially since few Chinese co. are listing here, many are planning to go HK and the newest sign of desparation - proposing to allow SPAC (essential a backdoor vehicle for an SGX listin) on the exchange), this is unlikely to get in the way. The deal is more likely to fall through if ARA and CWT can't agree on the terms between themselves.

The potential listing of this REIT was first highlighted in the previous posting(s). And you know that favourite pet phrase they use on TV? I am going to say it - And You Heard It First on wIy.blogspot.com!

Stock has gone up in tandem since the announcement. Makes you wonder why it didn't move when they annouced the cooperation with Regency Group. Was it already all priced in before the annoucement? (someone knew someone who know someone who knew and had all bought the stock?) Or did the lack of price movement merely reflect an inefficient market and the price should move up further to price that in?

Something to mull on - investment food for thought.

The Fallacy of Debt/GDP

If you read the news, you will often read about economists, politicians and god knows who opining on countries having excessive debt/GDP ratio and it is all unsustainable because a debt/GDP ratio is bad. Now before you accept that and go down the street with a placard saying that the world is going to end, hang on and think - does it make sense?

What does debt/GDP ratio measure? GDP is akin to the income that a country makes annually - not unlike what my annual income is to me, which by the way is pathetic. So debt/GDP = debt/annual income.

To see why the debt/GDP ratio does not make sense, let us draw a parallel to a common situation that many of us have found or will find ourselves in. Let's say you want to borrow some moola from the bank. What does the bank look at when assessing whether to lend you some money? The bank will look at your debt/asset ratio. The bank will also look at your interest coverage ratio - income/interest payment. But does it look at your debt/income level? No! Because it doesnt make sense. The comparison is flawed because there is no basis of comparison between the numerator and denominator.

The correct way to see it is to look at the debt of a country versus its assets. But admittedly, it will be hard to identify and place a value of the asset. An alternative is to look at the debt payments versus the tax revenue of the country - a much easier analysis. And undoubtedly a more correct one. Moroever, this measure makes more sense, because when we talk about sustainability, we also bring into the concept of solvency - the ability to meet payments. A interest coverage ratio for the country shows that. A debt/GDP ratio does not.

I have yet to done the requisite work to prove this but I am pretty convinced that if we measure sustainability by a debt/asset or a debt payment/tax revenue method, we will see that many countries that are deemed to have a non-sustainable debt level is actually pretty much sustainable.

To include an additional dimension to the analysis, let us expand on the concept of sustainability. Sustainability does not just include the concept of interest coverage and leverage but also the ability to roll over debt. And also equally important - at what terms does the debt get rolled over at? Unlike an individual or a corporation, the government/country is in a unique position to influence the cost of debt. This is because the cost of debt is partially determined by the market (investors) and by the existence of alternative investments which price or return is partly determined by the country's monetary policy. And many a times, the reason why a country's debt gets to roll over may not be based solely on sustainability of the country's fiscal position but could very much be contingent on other factors not dissimilar to factors that influences a bank decision to lend more to existing high risk clients - e.g. a country is too big too fail.

In conclusion, I put forth the hypothesis that many countries have a sustainable debt level if measured by the correct measure. And if that is true, all these concerns by renowned economists are over-hyped. And if the markets move in fear of such concerns, that will represent a golden opportunity to profit at the misinformation of the masses.

Summary of "The General Theory of REIT Investment"

· Best REIT to buy is the one that can make yield accretive investments (raise DPU across time)
1. Discount to P/B
2. Sufficient cash on book so that they do not need to raise eqty to make acquisitions
3. Gearing is low so that don’t have to raise eqty to bring gearing down in order to make acquisitions
4. Able to secure low cost of debt and high leverage

· In circumstances where it is the best time to buy REITs, it is generally good for any real estate stock. So you are better off buying higher beta real estate stock in this environment.

· If you are buying REITs for yield, a REIT may be inferior to a fixed income product.

· Bond + developer stock may give a better risk/reward proposition than REIT+ developer stocks

· Angle 1: LT Hold – Buy when DPU is at a level below the average LR average level and is going up.

· Angle 2: ST Hold – Buy REITs when they are super depressed P/B wise and you buy to get an income stream while waiting for a recovery in the real estate/eqty mkt so that the share price moves up

The General Theory of REIT Investment

What is the Best REIT to Buy – The REIT That Can Make Yield Accretive Investments
Ceteris paribus, a REIT that can only make yield accretive investment is the one where div yield < leveraged asset yield. And that’s only possible when P/B >1

But it doesn't make any sense to buy something at P/B>1. Might as well go buy actual asset (if you can afford).

When P/B <1,> leveraged asset yield. Unless they make investment without raising new eqty.

Buying asset at discount is good (i.e. P/B <1).

But if REIT wants to make acquisitions and they do it via eqty raising (because they don't have enough cash), then it will bring yield down

We assume that book is asset – debt = eqty. There might be some random stuff within assets which is not the property.

So the best REIT to buy is the one that can make yield accretive investments (raise DPU across time)
1. Discount to P/B
2. Sufficient cash on book so that they do not need to raise eqty to make acquisitions
3. Gearing is low so that don’t have to raise eqty to bring gearing down in order to make acquisitions
4. Able to secure low cost of debt and high leverage

When is the Best Time to Buy REIT – When DPU will increase for the overall market
So far, we have been assuming ceteris paribus. So what is it that we have been holding constant?
1. Cost of debt
2. Amount of debt (Leverage)
3. Yield on assets
4. Capital values

Asset acquisitions may give a leveraged asset yield > dividend yield if
1. cost of debt continues to go down,
2. amount of leverage possible go up,
3. yield on new assets higher than existing assets
4. capital values going up

Capital values affect debt capacity. So when capital value go up, leverage possible can go up. Or when the credit market is looser – when banks are ready to lend more as % of asset.

Yield on assets increases when rents are expected to go up or when capital values are falling but rents are falling proportionately less because of mitigating factors such as long-term leases in place/rent escalation clauses, etc. (the latter don't hold because the capital value that matters is the price u paid for)

The best time to buy REIT is when
1. Cost of debt is expected to stay low or go lower
2. Credit environment improves – leverage % increases
3. Yield on assets are expected to go up - rents are going up
4. Capital values going up

But in circumstances where all these applies, it is generally good for any real estate stock. So you are better off buying higher beta real estate stock in this environment.

Why You Want to Buy REIT
Hence, the only reasons you want to buy REITs are
1. You want something with supposedly less volatility (REITs may not be less volatile?);
2. You have a yield objective that higher beta real estate stocks like developers can’t provide.
In the long run, you should only be able to achieve the average asset yield enhanced by the average level of leverage at the average cost of debt (aka the average leveraged asset yield)

· Because you buy REIT mainly for the income, you have to MIN[capital risk].

· Because this is a stock, not a fixed income product, you may not get back your capital at the end of the day, depending on the stock price.

· So in fact, REITs may be a less attractive proposition relative to some high-grade corporate bonds, where you face lower risk of default, better chance of getting something back if they default because you are a debtor not an equity holder, you are assured of your capital after X year and you may enjoy a higher return. Plus, your yield (DPU/your entry price) is not secured because of potential capital raising (your yield is volatile)

· The downside of bonds is that you may have no, if limited, capital upside. Movements in REIT’s share price arguably give you a capital gain component. But remember, the time when it is positive for REIT is when it is good for the general real estate sector. So buy higher beta stocks if you want to benefit from the upside. REITs are only good for income? --> I guess the other angle is to buy REITs when they are super depressed P/B wise and you buy to get an income stream while waiting for a recovery in the real estate/eqty mkt so that the share price moves up (i.e. get dividend stream when waiting) --> REIT are good in a depressed eqty mkt.

· The downside of bonds is that it is not inflation-adjusted. Rental stream of real estate arguably is. But may not be true because if you look at the rental levels of real estate, it has not been going up across time (e.g. SG office rent). However, one may say inflation is take into account using the rental escalation clauses. But this only works if you have such clauses. Such clauses do not exist for office market

Hence, a REIT may be inferior to a fixed income product. So you may want to consider corporate bonds instead.

REITs may be combined with real estate developer stock to give you a better risk/reward proposition. But in view of the above analysis, bond + developer stock may give a better risk/reward proposition. Diversification works better across asset classes (eqty + fixed income) May not work well in the same asset class and especially same industry class.

But if you still really really want to buy REITs……

When Is REALLY The Best Time to Buy REITs
Angle 1:
Given that you want to min capital risk, you need to buy in at a level where you are most unlikely to face capital dilutive issues.

Hence, you need to buy in at a level where
1. yield is sustainable,
2. leverage is sustainable,
3. cost of debt is sustainable
4. rental rates are least volatile – govt regulations involved

AND THIS WILL ONLY WORK IF YOU HOLD FOR THE LONG-TERM (10,20years?)

· So idea is not max yield but max sustainable yield.
· Buy in at a level where DPU is sustainable in the long run and expected to keep going up – Imagine a curve where DPU oscillates across time like.
· So best to buy when DPU is at a level below the average LR level and is going up. The ideal is bottom of DPU curve.

Angle 2:
Buy REITs when they are super depressed P/B wise and you buy to get an income stream while waiting for a recovery in the real estate/eqty mkt so that the share price moves up (i.e. get dividend stream when waiting)

Therefore, REITs are good in a depressed eqty mkt where you wait for the upturn.