Champion sets out to improve its image

The unwinding of its financial engineering measures could be a boost both for Champion and the Hong Kong Reit sector as a whole, observers say.
The proposal by Champion Real Estate Investment Trust to acquire Langham Place from its sponsor for HK$12.5 billion ($1.6 billion) is interesting from a financing perspective since the trust is planning to raise 79% of the funding, plus the HK$300 million transaction cost, from the capital markets at a time when markets remain highly volatile. And when Reits in both Australia and Singapore are under intense pressure. Secondary capital raisings have also been something of a rarity in the Asian equity markets so far this year.

In addition to that, some analysts argue that the purchase price for the Langham Place retail mall and office tower, at an 11.8% discount to the appraised value, is on the expensive side, and that this asset is likely to see slower rental growth in the years ahead than the Citibank Plaza office and retail assets that make up ChampionÆs current portfolio. This could potentially make investors û both those who are asked to put up the financing and the existing unitholders û less inclined to support the deal.

The key to making it work is the managementÆs decision to unwind its interest rate swap agreements, which have enabled Champion to pay a below-market interest rate (although a gradually rising one) on its existing debt since its listing in May 2006. The agreement, commonly referred to as ôfinancial engineeringö has allowed Champion to retain more of its income for dividend distributions and thus helped to artificially boost its yield.

Initially put in place by most of the Hong Kong Reits as a way of bridging the gap between the low net property income yields in Hong Kong and the dividend yields that investors were looking for at the time they listed, financial engineering û in all forms û has become a phenomenon that is highly disliked by investors. Partly as a result of this, five of Hong KongÆs six Reits (apart from Link Reit) are still languishing below their IPO prices, which has pushed the initial yields even higher. Before the announcement of the Langham Place acquisition, Champion was trading at HK$4.31 for a forward yield of about 7.7%, which compares with an IPO price of HK$5.10 and a forward yield of 5.46% at the time it was spun off from Hong Kong property developer Great Eagle Holdings.

But more importantly, because their current dividend yields are so high, it is almost impossible for these trusts to make accretive acquisitions as you simply cannot find buildings in Hong Kong that yield more than what they are currently valued at û unless you structure the new asset in a similar way to the original portfolio. Prosperity Reit is trying to solve this by looking for potential acquisition objects across the border in China where yields are higher, but so far this has not resulted in an actual deal.

By unwinding its swap agreements, Champion will make its distribution policy a lot more transparent and while it will result in a lowering of the absolute yield level to around 5%-6%, according to analyst estimates, it will allow it to trade at a ôclean yieldö, which should make it more attractive to investors. If successful, observers hope that this could mark the beginning of a revitalisation of the Hong Kong Reit market, with several other Reits following suit and doing away with their financial engineering measures as well.

ôThis is a very good move for the industry. It makes the Reit a lot more transparent and it will mean that a whole new set of investors will start to look at the vehicle,ö says one Asian property analyst. ôInvestors, particularly in the current market environment, donÆt like to look through smoky mirrors. They like to know the genuine outcome and anything that is over-engineered or too complex gets viewed very sceptically.ö

ôIt will be positive for Champion and it will be positive for the Hong Kong Reit market, because itÆs just stuck as it is now. IÆm sure the other Reits will look at whether they will be able to do something similar,ö adds a real estate banker.

Adrian Li, the CEO designate of the Champion Reit manager, Eagle Asset Management, says the financial engineering is no longer needed since ChampionÆs underlying rental income from Citibank Plaza has increased to a level where the clean yield will be sufficient to satisfy investors. Having been as low as HK$25 per sqf for part of the building at the time of the IPO û when the spot rate was about HK$50 û rental contracts at Citibank Plaza are now being signed at HK$110 per sqf.

ôBy unwinding the financial engineering investors will see what the true income is. And with that financial transparency we are confident that the price performance will be much better down the road and that it will help to narrow the discount to net asset value,ö Li told FinanceAsia in an interview last week. ôThen, with a lower cost of capital, Champion will be able to set out on an acquisition path.ö

In order to start with a clean slate Champion is also unwinding a dividend waiver that has seen the sponsor forfeit a portion of the dividend payments that it would have been entitled to. In the first year after the listing, Great Eagle didnÆt take any dividends at all, in 2007 it declined the dividends for 55% of its holdings and this year would have said no to 20% of its entitled payouts. Again, this arrangement was meant to result in greater dividends for other unitholders.

The unwinding of the swap agreement will result in a one-off payment from the swap counterparties to Champion of about HK$350 million, while Great Eagle will have to pay HK$97 million to cancel the dividend waiver will. Champion will pay out about HK$400 million of this, or 11 HK cents per unit, to unitholders as a special dividend. This will essentially compensate them for the lower dividend that they will receive over the next few years.

Including this special dividend, the Champion management expects to pay a total dividend of 37 HK cents for 2008. According to the calculations laid out it a Champion circular to its investors, the acquisition of Langham Place will increase the dividend to roughly 26 HK cents per unit this year from 24 HK cents, making the acquisition about 8.6% accretive.

These numbers assume a blended net property income yield of 4.3% for Langham Place, compared with about 3.6% for Citibank Plaza.

According to a Hong Kong property analyst, it wonÆt be that easy for other Hong Kong Reits to just copy what Champion is doing, however, as most of them havenÆt seen the same robust growth in rental incomes in relation to their property values. This means their yield could drop well below 5% from as high as 8%-10% now if they were to remove the financial engineering, and that would be comparatively more challenging for investors to accept.

ôI think Champion is a special case,ö the analyst says.

Li says Champion Reit will be looking for quality income-producing property both in Hong Kong and in the rest of the region if opportunities arise. The ability to seek yield accretive acquisitions outside of Hong Kong was approved by shareholders earlier this year. It seems the trust is leaving itself some financing flexibility for future transactions by raising only HK$1.7 billion of fresh debt to pay for the Langham Place acquisition, which will take its gearing ratio to about 35%. Hong Kong Reits are allowed a gearing or 45%.

However, it would be reasonable to expect that it will take some time for Champion to digest the Langham Place acquisition, before it attempts another shopping spree given the pure size of this deal which will see Champion step up from being a single-asset Reit to a more diverse vehicle in terms of location (Langham Place is situated outside Hong KongÆs prime Central area), tenant base and income streams. It will also increase its asset value by 52% to about $5.3 billion from $3.5 billion make Champion Reit the third largest Reit in Asia outside Japan, measured by market capitalisation. The only two that will be larger are Hong KongÆs Link Reit and Singapore-listed CapitaMall Trust.

According to Li, Langham Place has good growth potential in terms of rental income as it is it is becoming a more and more popular mall. He also notes that the current economic environment is ôconducive to asset appreciation with negative interest rates setting in, so the sooner this acquisition can be completed, the better for unitholders.ö

ôThis is not an acquisition where Great Eagle is passing a mature asset to Champion. ItÆs an exercise to transform Champion so that it can create value for the shareholders of both companies,ö he adds.

The management has left itself some flexibility with regard to the fund raising package, but has outlined a base structure that it feels would be the most optimal with regard to dividend accretion and cost of capital. Under this proposal, the trust will raise HK$3.2 billion from the sale of new units, HK$5 billion from a convertible bond and HK$1.7 billion from a bank loan. The remaining HK$3 billion will come from a separate sale of new units to Great Eagle. Depending on the financing climate at the time, the equity portion may be increase to up to HK$4.5 billion, the CB could be increased to HK$5.2 billion and the debt portion may swell to as much as HK$3.6 billion.

Citi is the sole arranger for the entire financing package and also acts as the financial adviser to Eagle Asset Management on the Langham Place acquisition. The acquisition and the financing package will need approval from shareholders at an extraordinary shareholders meeting on March 6. After that, Citi has until June to raise the financing.

Great Eagle may support the transaction beyond the HK$3 billion of equity units that it is already buying by also taking on some of the equity units that are targeted at institutional investors or part of the CB. It hasnÆt said how much it would be willing to buy, leaving open for the possibility that it could buy the majority of these assets if other investors arenÆt interested. However, the real estate banker notes that Great Eagle would probably not be too keen to increase its stake in the Reit to above 50% as this would mean it would have to re-consolidate the trust into its accounts. Great Eagle currently owns 48.5% of the trust, which means perhaps its direct support may not be as forthcoming as some market watchers expect.

The initial response in the market has been mixed. The share price fell 4.87% to HK$4.10 the day after the announcement, as investors most likely focused on the large amount of new supply and suggestions that the acquisition was too pricy. It then moved up to a high of HK$4.38 over a couple of sessions as the implications of the interest rate swap removal started to weigh in and the management embarked on an investor roadshow to talk about its strategy. It has since moved lower again and on Friday closed at HK$4.29 - two cents below where it was before the announcement.
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