Singapore Industrial REITs - DBS Research 2020-09-18: An Eye On Falling Land Leases


Singapore Industrial REITs - An Eye On Falling Land Leases

Industrial S-REITs face unique challenge of NAV deterioration as land leases run low.

  • We believe investors should take note of the impact on NAV as industrial properties in Singapore sits on shorter land lease tenures of c.30 years, particularly after more than a decade of listing history. More so when c.5% of overall industrial S-REIT properties will see leases running below 20 years (9% of portfolio in 5 years’ time).
  • Based on our analysis, such properties could experience average valuation declines of c.5.1% per annum as land tenures fall below the 20-year mark. While there is no impact on distributions, NAVs will decline over time if not actively managed. Industrial S-REIT managers’ response to this is to diversify to other jurisdictions with freehold land tenures and we expect this trend to continue.
  • Based on our estimates, Ascendas India Trust (SGX:CY6U) and Frasers Logistics & Commercial Trust (SGX:BUOU) have the longest portfolio land tenures.

Industrial landlords have a myriad of options to deal with assets with short land tenures.

  • That said, we believe that the optionality for a lease extension is high, assuming no changes in master-plan parameters and with further investments by owners. Key assets (ALOG Commodity Hub and Viva Business Park) that sit within ARA LOGOS Logistics Trust (SGX:K2LU) and ESR REIT (SGX:J91U) portfolios with short leases but deemed as strategic industrial assets should be renewed, in our view.
  • For non-core properties, we expect industrial S-REITs could look to divest these assets (to end users) and recycle proceeds to higher yielding properties in Singapore or overseas, tapping on their respective pipelines.

Are investors adequately compensated for holding on to S-REITs with shorter leases.

Do land lease tenures matter?

Industrial land tenures in Singapore was halved to 30 years in 2012.

  • To make industrial property more affordable to genuine industrialists and give the government more flexibility for land redevelopment, the Ministry of Trade and Industry had halved the maximum tenure for industrial sites under its government land sales programme to 30 years.
  • This move has helped to curb speculative builds of industrial properties. At the same time, this has made prices of existing properties, with 60-year tenures or longer, more valuable, enabling these properties to trade or transact at higher valuations given the longer time to generate returns over the tenure of the land.

Industrial S-REITs have shortest land lease tenures.

  • Unsurprisingly, by virtue of Singapore’s land tenure policy, the portfolios of industrial-focused S-REITs tend to have shorter remaining land leases as compared to S-REITs that invest in other property types. On average, industrial REITs have a remaining land lease of c.54 years compared to c.80-85 years for retail and office REITs, and c.70 years for hotel REITs.
  • There are possible consequences for longer term investors when considering the annual return on capital due to the depreciation of asset values over time as leases become shorter. Based on our estimates, the average capital return for industrial S-REITs is 1.8%, which is roughly about 0.5ppts higher than the other subsectors which range between 1.2% to 1.4%.

Market has historically priced industrial S-REITs at a yield premium to the sector average.

  • We have seen that industrial S-REITs have traded at a higher historical average 10-year yield of c.6.7% vs the S-REITs average yield of 6.1%. This differential however has compressed recently given the increased investor allocation into the industrial sector (especially logistics and data-center focused S-REITs).

Overseas properties make up c.46% of the portfolios of Industrial S-REITs.

  • Given the impact of declining land lease tenures on valuations and NAVs, industrial S-REITs have been heading overseas for growth opportunities. Australia and Europe are key destinations given these countries’ buoyant investment market and freehold land tenures. On our estimates, approximately 46% of the portfolios of industrial S-REITs are made up of overseas assets. Only ESR REIT and Sabana REIT (SGX:M1GU) are pure-play Singapore industrial REITs as of writing.
  • Industrial REITs with overseas assets tend to have longer portfolio land lease tenures as these properties typically sit on freehold land. Excluding overseas assets, the average remaining land lease for industrial REITs would be significantly shorter, from c.54 years to c.33 years.
  • Industrial REITs with larger overseas exposure would have longer land tenures, for example, Frasers Logistics & Commercial Trust with c.80% of its portfolio in overseas assets has a remaining land tenure of 95 years, while Mapletree Logistics Trust (SGX:M44U) with c.70% of its portfolio in overseas assets has a remaining land tenure of 80 years.
  • Based on just the Singapore portfolio, ARA LOGOS Logistics Trust and Keppel DC REIT have the shortest portfolio remaining land tenure of 28 years and 29 years respectively. However, including their overseas freehold assets, the portfolios of both REITs have a longer remaining tenure of 51 years and 57 years, in line with the average for the industrial REITs sector. It is also interesting to note that Mapletree Logistics Trust’s overall portfolio remaining land tenure has been more than doubled to 80 years with the inclusion of overseas assets, while its Singapore portfolio only has a remaining tenure of 33 years.

Income diversification and WALE extension.

  • In addition to extending the remaining tenure of portfolios of industrial REITs, overseas properties have also enabled these REITs to extend the portfolio WALE and diversify their income streams. Industrial leases in Singapore are typically 3-5 years and rental rates are usually fixed at the commencement of the lease. However, industrial leases in some of overseas markets tend to be on longer terms, and rental escalations are put in place to account for inflation and rental growth.
  • The added merits of investing in industrial assets overseas is evident in the portfolios of:
    1. Frasers Logistics & Commercial Trust’s Australian portfolio, which has a WALE of 5.3 years and average annual rental escalation of 3.1%;
    2. Ascendas REIT’s UK portfolio, which has a WALE of 9.2 years with rentals marked to market or pegged to index inflation; and
    3. Mapletree Industrial Trust (SGX:ME8U)’s US portfolio, with a WALE of 7.4 years and average annual rental escalation of 2.0% or more.

Uncomfortable truth - Impact on valuations as land lease runs down

Decline in valuations generally seen when land tenures fall below 20 years.

  • Valuations of industrial properties typically fluctuate with market rents and cap rate movements or when properties transition from a single-tenanted to a multi-tenanted property due to changes in underlying cash flows. In general, industrial properties would see price appreciation in the long-term, similar to other property types. However, based on our analysis, the inflection point in valuation of an industrial property begins when the asset’s remaining tenure falls below 20 years, when valuations creep down with the passing of time.
  • We did an analysis on how valuations of several industrial properties changed as their remaining tenures ran down below the 20-year mark. Overall, we see that property valuations start to decline when the remaining land tenure falls to 19 to 20 years, and the decline is consistent across the various industrial property types such as single-user or multi-user factories and warehouses.
  • Current economic conditions and rental trends for industrial properties will also have a substantial impact on the rate of valuation decline. We note that valuations for industrial properties with a remaining land lease of 19 years and below tend to decline by c.5.1% per annum on average. In some cases, if a long-term lease is signed or if substantial capex is spent to improve the property, valuations may hold up better and the decline would be less steep.

Industrial REITs with larger exposure to Singapore properties are over penalized.

  • Six industrial REITs have properties with remaining land tenures less than 20 years, and their exposure ranges from 2-30% of total asset values. Among them, ARA LOGOS Logistics Trust and ESR REIT have the largest exposure to properties with short land tenures, at 30% (c.S$380m) and 20% (c.S$650m) respectively. The high portfolio exposure to properties with short tenure is mainly contributed by a single property that has a disproportionate weightage on its portfolio.
  • ARA LOGOS Logistics Trust’s Commodity Hub with a remaining land tenure of c.15 years contributes more than 22% to its portfolio, while ESR REIT’s Viva Business Park with a remaining tenure of c.11 years accounts for more than 9% of its portfolio.
  • Although Mapletree Industrial Trust and Mapletree Logistics Trust each have more than S$400m worth of properties with remaining land tenures of less than 20-years, they only make up 8% and 5% of the respective portfolios. Their exposure to properties with short land tenure have been diluted by their large exposure to overseas freehold assets that often help to mitigate the decline in valuations of these properties.
  • In five years (i.e. 2025), the percentage of properties with land tenures of less than 20 years will increase significantly for Mapletree Industrial Trust, Keppel DC REIT and AIMS APAC REIT. However, these three REITs currently have a significant portion of overseas assets in their portfolios. As such, the impact to their overall portfolio’s remaining land lease tenures and portfolio valuations will be mitigated by their freehold overseas assets.
  • While there is no impact on distributions, we should be aware of the potential erosion in NAV if these S-REITs do not actively look to either diversify their exposures out of Singapore or engage the authorities for a possible extension of lease tenures.

How are landlords proactively managing assets on short land leases

Landlords may seek extension of land leases from JTC if there are no changes in the master plans.

  • As land tenures of industrial properties run down to 10 years or less, landlords have the option of engaging JTC to extend the land lease for another term provided that the site is not affected by redevelopment plans or change-of-use in land. We understand that if landlords are able to provide JTC with their plans to improve the intensification of land use of the property and if the use is in line with prevailing economic priorities, there may be a possibility of topping-up the land lease.

A case study - ARA LOGOS Logistics Trust

  • In the case of ALOG Commodity Hub, the property is nestled in the Jurong Industrial Estate which is a key logistics cluster in close proximity to seaports and is unlikely to be re-zoned for other purposes in the foreseeable future. Moreover, it is one of the largest modernized ramp-up warehouses in Singapore with NLA of c.2.2m sqft.
  • Going forward, we believe that the property will continue to feature heavily in the Jurong Industrial Estate to serve the logistics industry, and ARA LOGOS Logistics Trust may have a case to seek for an extension in land tenure from the JTC. However, as the property has a remaining land tenure of c.15 years, such engagement with the JTC will likely only take place when the land tenure runs down to the 10-year mark.
  • We acknowledge that the declining land tenure at ALOG Commodity Hub will remain an overhang for ARA LOGOS Logistics Trust in the near future, especially given that it constitutes more than 22% of ARA LOGOS Logistics Trust’s portfolio. However, given that ALOG Commodity Hub is well entrenched in the Jurong Innovation District, we believe the overhang on ARA LOGOS Logistics Trust will be temporary and fade once it is able to engage JTC on a possible extending of the asset’s land lease.

Trading up for a better quality asset - Soilbuild REIT

  • In 2019, Soilbuild REIT completed the divestments of KTL Offshore and 72 Loyang Way, two underperforming assets within its portfolio where the master tenants at both properties were facing financial difficulties.
  • Nonetheless, Soilbuild REIT was able to divest:
    • KTL Offshore for S$55.0m recognising a S$1.7m gain on divestment; and
    • 72 Loyang Way for S$34.1m, at an exit yield of 4.1%.
  • At the time of divestment, 72 Loyang Way had a remaining land tenure of c.19 years.
  • In the same year, Soilbuild REIT purchased 25 Grenfell Street for S$127.4m, a freehold Grade-A office building in Adelaide, Australia. The initial NPI yield on the property was c.7.7% with a WALE of 5.0 years and annual rental escalations of 3.5- 3.75%. This demonstrates Soilbuild REIT’s ability to divest its older underperforming assets and utilise the proceeds to trade up for higher yielding properties while also extending the land lease of its overall portfolio.
  • Given the capabilities and support from their respective Sponsors, industrial REITs have a range of options they can utilise in managing properties with short land tenures.

Income yield vs. Return of capital

REITs with shorter remaining land tenures have higher return of capital.

  • We see the distribution yields of industrial REITs as a combination of income yield and return of capital. While most investors have not really looked at this given its long-term horizon, we believe that it is important to consider this aspect. In the next five years, there is a larger proportion of assets with land leases heading below 15 years, and the case for a renewal may involve fairly substantial capex (for land rent payment to the authorities).
  • The income yield measures the returns that an investment generates for capital contributions and in this case, it is the rental income generated from the REIT’s investment in the industrial properties. Return of capital on the other hand measures the portion of original investment that is returned back annually (straight line deprecation in our case) given that as the land lease tenure of industrial properties gradually winds down towards expiry, the value of the asset goes down to zero.
  • As expected, return of capital for industrial REITs with shorter portfolio remaining land tenures are higher than those with longer land tenures.
  • Generally, industrial REITs with shorter remaining land tenures should generate a higher dividend yield as their return of capital is higher. For example, return of capital for ESR REIT and Sabana REIT is c.3.2% and c.3.0% respectively. This is at least three times higher than Ascendas India Trust’s and Frasers Logistics & Commercial Trust’s return of capital of c.1.0%.

Pure-play Singapore industrial REITs have been unfairly penalised.

  • Despite the shorter portfolio remaining land tenures of some industrial S-REITs, we believe that ESR REIT and Sabana REIT have been unfairly penalised for this. Several other industrial REITs peers have in fact lower remaining land tenures for their Singapore portfolios, but have been compensated by their overseas assets that are mostly on freehold land tenures. We understand that ESR REIT is open to acquiring overseas freehold assets, and this would immediately extend its portfolio remaining land tenure.

Mid-cap industrial REITs are generating high return on capital as well.

  • Based on our previous report, Singapore Industrial S-REITs - DBS Research 2020-06-25: Making Up Lost Ground, we highlighted that valuation multiples between mid-cap and large-cap industrial REITs have diverged. Investors expect higher returns from mid-cap REITs due to their lower income diversification and perceived higher portfolio risks.
  • However, the higher income yield for the mid-cap REITs coupled with the higher return of capital for selected names offers good value in our view.
  • In addition to ESR REIT and Sabana REIT that are generating high dividend yields due in part to their high return of capital, we believe that Ascendas India Trust, ARA LOGOS Logistics Trust, Soilbuild REIT, AIMS APAC REIT and EC World REIT (SGX:BWCU) are also trading at very attractive valuations that should not be ignored. These four additional REITs are generating a forward income yield of between 5.8 – 6.7%. The return on capital alone is higher than the forward total distribution yield of the large-cap industrial REITs that average at 4.4%.

See recent reports on Singapore Industrial REITs:

Dale LAI DBS Group Research | Derek TAN DBS Research | https://www.dbsvickers.com/ 2020-09-18
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