Blog #22 A REIT Nightmare

In my previous blog, I showed that S-REITs as a group have delivered exceptional returns compared to the Singapore stock market. But take note of the important qualifier “as a group”. The returns of S-REITs shown in that blog reflect the performance of a diversified index of all S-REITs. The performance of a single REIT or even a small group of REITs can be very different from that of a well-diversified portfolio. The story of Sabana REIT serves as a cautionary tale of what can happen if you put all your eggs in one reit basket.

The full name for Sabana REIT is Sabana Shari’ah Compliant Industrial Real Investment Trust but for brevity, I will just call it Sabana REIT.

Sabana REIT is an industrial REIT, one of many that dominate the S-REITs space in numbers and market capitalization. Industrial REITs own properties such as factories, warehouses, logistic buildings and business parks. They provide investors with exposure to manufacturing, both here and abroad.

Sabana REIT has the dubious distinction of being the worst performing S-REIT over the past six years. The chart below shows the price performance of Sabana REIT (in red) compared to the price performance of the FTSE ST REITs Index, which covers all S-REITs on the SGX.

A dollar invested in the index in Q1 2012 increased to 194 by Q3 2017, which translates into an annual rate of price appreciation of almost 12%. By contrast, if you had invested in Sabana REIT, you dollar would have shrunk to 62.8 cents, or a loss of 37%!

Datastream_Sabana_Price.jpg

What went wrong? What lessons can investors learn from Sabana?

To be sure, part of the poor returns of Sabana REIT was simply because it was in the “wrong” sector. The last six years have been tough going for most industrial reits due to the tepid economy and the toll that business restructuring has taken on small and medium-sized enterprises

That said, Sabana’s problems were brought upon by REIT’s managers who paid themselves hefty fees even as shareholders were suffering a double whammy of declines in both the dividend per unit (DPU) and share price.

To understand the reasons for the DPU cuts, we have to look at the way Sabana acquires properties and lease them.

REITs often purchase income-generating assets with the help of bank borrowings and/or seasoned equity issues.  Whatever debt ratio a REIT manager chooses must be justified by a return on assets that comfortably exceeds the cost of capital. Otherwise, the REIT is destroying shareholder value.

Sabana’s debt-to-assets ratio averaged 37% over the six-year period. This was slightly higher than the 33% debt ratio of Soilbuild, another industrial S-REIT which owns mainly assets located in Singapore.  Soilbuild’s price performance in recent years has been lacklustre but nowhere as bad as Sabana’s.

The problems at Sabana are largely a result of the reit manager’s incompetence. It starts with asset acquisitions.

An easy way to destroy shareholder value is to acquire assets at inflated prices. Many of Sabana’s properties were acquired at valuations that were unsustainable because they were artificially boosted by “sale-and-leaseback” deals and master lease agreements with rental support or guarantees.

Now, master lease structures are not necessary bad.  A financially strong master lessee can provide the landlord with recurring stable income. But there are downsides to master leases too.

First, because the landlord “sub-contracts” the task of finding and managing tenants to a third party, this reduces the REIT’s direct control over the quality of tenants. Moreover, because the master lessee has the right to sub-let the space under similar terms and conditions as the current lease without negotiating a new contract with the landlord, it reduces the ability of the REIT to raise rents from the sub-tenants. Third, in the worst case scenario, the master lessee may wind up, leaving the landlord stranded with the problem of finding replacement tenants. This is problematic if the property has to be cut up into smaller spaces to attract tenants. The problem is worse when there is demand for industrial properties is weak.

As it turned out, Sabana REIT experienced all of the above setbacks and they show up in the DPU and share price. Sabana’s DPU peaked in Q1 2013 at 2.41 cents. Bt the fourth quarter of the same year, DPU was cut to 2.19 cents, bringing the DPU almost back to the level in Q2 2011.  Putting on a brave face, Sabana’s managers made the following statement in their 2013 Annual Report:

“During the year, we continued to build on our strengths, growing our portfolio with good quality properties. We remained guided by our values and actively managed our portfolio. Above all, we continued to deliver what we said we would. To us, that’s the most important value of all.”

Subsequent developments in the REIT did not justify this optimism. The DPU for Q1 2014 fell by 14% to 1.88 cents as four of Sabana’s master-tenanted properties lost individual tenants and the REIT’s managers have to take over the leasing. The Q1 2014 results  is shown below:

Sabana Results for Q1 2014.jpg

No shareholder likes to see their DPU cut, least of all, REIT investors.  Two quarters of steep DPU cuts should raise alarm bells.

True to form, things got worse. In November 2014, Sabana announced that it managed to renew only two out of three master leases that are expiring in 2014 and that it will take over in finding tenants for the third property to lease (the actual wording is that the vacant property will be converted into multi-tenanted property). By then, Q3 2014 DPU was down to 1.78 cents.

Sabana dropped a bigger bombshell – that for 2015, eleven master leases will be expiring. Of these eleven leases, five were leased to Sabana’s sponsor, SGX-listed Vibrant Group. Eventually, three of the properties leased to Vibrant were renewed at 16% lower rentals than projected in the IPO.  Another red flag: these renewals were for only one year compared to the industry norm of three years. And if this wasn’t a loud enough signal, investors got a thumping confirmation that things were going south when Sabana released its results for Q4 2015 with the pronouncement that DPU for that quarter will be further cut to 1.50 cents.

The DPU trend from 2011 to 2016 is summarized in the chart below:

 

Meanwhile, even as shareholders were losing money on the stock, Sabana’s managers were paying themselves higher fees. Fees rose from $5.07 million in 2013 to $6.23 million in 2015 before falling to $5.33 million in 2016.

Years of poor returns and high management fees proved to be the last straw for the reit’s beleaguered investors.  In April 2017, 66 shareholders managed to requisition an EGM to vote out the incumbent managers and install a new management team.  But share ownership in the reit was too fragmented to dislodge the manager. In the end, the voting minority shareholders were outvoted by the REITs sponsor, Vibrant Group.

At the time of writing (August 2017), a white knight in the shape of e-Shang Redwood (a logistics developer) is in advanced talks to buy the Sabana REIT. Hopefully, this will provide a lifeline for the Sabana’s hapless shareholders.

In summary, Sabana’s woes were not just a matter of poor occupancy and low rental yields in the industrial space. Inept management plus poor corporate governance also contributed to the erosion of shareholder value.

Could REIT investors have avoided the fate that befell Sabana? Absolutely – it’s called diversification. Holding a portfolio of REITs can never be riskier than owning just one REIT. Diversification is now more affordable on SGX, as the lot size has been brought down to just 100 shares. Alternatively, you can purchase exchange traded funds that focuses on REITs and other high dividend yield stocks.

Investors who still believe owning a few REITs should not just focus on REITs with the highest dividend yield (DY) as this may be due to a low share price and not because the market is giving a “free lunch”.  The following chart shows that the FTSE ST REITs Index has a consistently lower DY than Sabana, yet far higher total returns because the index avoided the full price impact of the worse performing REITs.Datastream_Sabana_DY.jpg

Finally, here is a list of questions that should be asked before you invest your hard earned money in any individual REIT.

  • Is the REIT operating in a growth industry?
  • Is the REIT benefiting or hurting from the current business cycle?
  • What is the extent of concentration risk in the REIT? [1]
  • Will the REIT face serious refinancing risk when its debts mature?
  • How likely will rising interest rates reduce net income available for distribution to shareholders?
  • Has the REIT manager shown that it has the skill and experience to steer the reit in good times and bad times?
  • Is the manager transparent with shareholders on business risk issues such as lease structure, income-support agreements, property valuations and refinancing risks?
  • Does the manager provide timely information to shareholders regarding material changes in the REIT’s business?
  • Is the manager’s compensation justified by its track record of managing the REIT?
  • Are there qualified board members who oversee compensation and other corporate governance matters? [2]

 

Notes:

[1] If most of a REIT’s income is derived from a few assets and those assets perform poorly, there is little to cushion shareholders from loss of income. Concentration risk also happens when a REIT relies on a few tenants for most of its income, as is the case with Sabana due to the master lease structure.

[2] Most S-REITs are managed by an external manager whose main shareholder is also the REIT’s sponsor. This is problematic from a governance viewpoint because it is the manager’s shareholders and not the REIT’s shareholders that appoint the board of directors. Hence, boards which include independent directors who oversee governance matters are thus a big plus for REIT investors.

 

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2 thoughts on “Blog #22 A REIT Nightmare

  1. There is no doubt that conspiracy for Manager and sponsor to collude. Most sponsors will know their assets worth better than most retail investors. Most sponsors are also master-leasees. One method of valuation is to appoint its own valuers or valuers too hard-up for jobs at price of the sponsor’s volition. Most of these valuers would use the amount of rent ( which the master-leasee is happy to oblige) to determine asset price. That way, the assets are sold at high prices( over-valued)at the expense of retail investors.

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