The Hong Kong government began pre-marketing its inaugural Real Estate Investment Trust (Reit) this Monday in the hope of raising $2.5 billion to $3 billion via lead managers HSBC, Goldman Sachs and UBS. The deal marks the world's largest ever Reit IPO and the first major equity privatization by the Hong Kong government since its partial sell-off of the MTR Corporation in 2000.
The Reit comprises a portfolio of retail and car parking assets owned by the Hong Kong Housing Authority, which have been placed into a trust (Link Reit) that will pay out all rental income (net of profits tax) back to investors in the form of dividends. However, unlike the pioneering Reits in Singapore, which were listed at a discount to NAV, Hong Kong's Reit is being marketed at a premium. The government's ability to do so is partially a reflection of how well the asset class has performed in Singapore, where investors have made total annual returns of 40% to 50% since the first Reits were listed in 2002.
The Housing Authority's portfolio of 151 properties includes 950,000 square metres of retail space adjoining its big public housing estates and 79,000 parking spaces. It has been valued at HK$30.8 billion ($3.95 billion) and has an NAV (Net Asset Value) of HK$21.8 billion ($2.8 billion), plus gearing of 28%.
NAV per unit stands at HK$10 and the deal is being marketed at a zero to 10% premium to this level. At the cheapest end of the range, Link Reit will run a dividend yield of 7.2% on a March 2006 basis and 6.8% on a March 2005 basis.
At the most expensive end of the range, the yields will be more like 6.48% and 6.12%. The main valuation benchmark will be 2006 forecasts since the first payment date falls only four months after listing.
The most comparable benchmarks are the two listed retail plays in Singapore - Fortune Reit, which is actually a portfolio of Hong Kong shopping malls and CapitaMall, which is owned by CapitaLand, South East Asia's largest property developer.
The former closed Wednesday at HK$5.90, up 20% year-to-date. At this level it is trading at a 10% premium to NAV and on a forward dividend yield of 5.49%. CapitaMall is up 17% year-to-date, closing Wednesday at S$1.68. At this level it is trading at a 38% premium to NAV and on a dividend yield of 5.77%.
Like for like comparisons between the two countries are complicated by the fact that Singapore's 10-year government bond is currently yielding 3.2%, whereas the 10-year government bond in Hong Kong is yielding 3.5%. In Singapore the spread differential between Reits and government bonds currently averages 270bp versus about 440bp one-year ago. To achieve a similar differential in Hong Kong, Link Reit would, therefore, need to yield at least 6.2% on a forward basis.
But some specialists believe Link Reit will be more appealing to institutional investors than the Singaporean Reits because its tax treatment is different. Retail investors escape dividend taxes in both jurisdictions, but foreign institutional investors are subject to 20% witholding taxes in Singapore.
So too in other countries where Reits are popular, such as the US and Australia, all investors are subject to dividend taxes. However in both of these countries, Reit rental incomes are free of profits taxes, whereas Hong Kong ones are not.
According to Reit specialists, the net effect is a more optically attractive yield for the Australian and US Reits. Currently, Australian Reits are said to average yields of 6.5% to 7% pre tax and US Reits about 5% to 6% pre tax.
Specialists familiar with Link Reit say it should provide a total annual return of about 10% to 12% - taking into account earnings growth and dividend yield. Key for investors will be whether they believe the growth forecasts underlying this assumption.
Key for the lead managers will be whether they can educate the Hong Kong public to look beyond their customary discount/premium to NAV calculations when valuing property companies. Some commentators have queried why local investors will be interested in Link Reit when there are already so many other property companies listed on the Hong Kong Stock Exchange.
"This deal is going to be snapped up by retail investors because it's such a no-brainer," replies one observer. "It pays a much higher dividend yield than the local property developers and has a far less volatile risk profile. It's a very simple product to understand."
And he adds, "There's a huge amount of liquidity floating around the banking system (editor's note: HK$3.6 trillion) and at a time when interest rates are still declining in Hong Kong, despite its dollar peg, the maths speak for themselves. As an investor which would you prefer: a bank deposit yielding 10bp or a Reit yielding more than 600bp?"
Hong Kong property developers with large investment portfolios are currently offering far lower yields. Hongkong Land, for example, is currently yielding 2.64% and is trading at an 11.4% premium to NAV. Sun Hung Kai Properties is yielding 2.12% and is trading at a 2% premium to NAV.
Analysts point out that there is no development risk attached to a Reit. "It has a very predictable and stable earnings stream," says one. "It's a very transparent and low risk investment vehicle."
By contrast, a property developer may decide to funnel cash into a risky new project rather than dividends. It may load up on debt to do so - Hong Kong Reits have a 35% debt ceiling. Or worse still, it may decide to funnel cash into a totally new sector such as telecoms as a number of Hong Kong property developers decided to do a few years back.
Because it is a privatization, the government is said to be keen to maximise retail participation. The deal has the standard institutional/retail split, but retail investors will receive their shares at an IPO discount. The final discount has not yet been set, but is likely to be similar to the 5.25% level of the MTR Corp privatization.
Formal roadshows will begin next Thursday, with pricing scheduled for the weekend of December 11/12. Before roadshows begin, the leads will announce the results of their cornerstone investor process.
Cornerstone investors that agree to participate will get a guaranteed allocation on the day of pricing, but will be subject to a six-month lock up. From the lead managers' perspective this is a good way of building momentum in the early stages of a deal and then ensuring secondary market stability when it trades.
In previous IPO's cornerstone investors are sometimes allocated stock at a slight discount. In this case they will not.
In addition to the cornerstone investors, CapitaMall Trust (CMT) will take a $180 million strategic stake.
On top of this there will be a Public Offering Without Listing in Japan (POWL) run by Daiwa SMBC. And alongside the leads, JPMorgan is the financial sponsor, while Citigroup and Macquarie will be co-leads and ABN AMRO, Bank of China and Cazenove co-managers.
The most unusual aspect of the transaction will be its 100% freefloat post greenshoe. This has been deliberately structured to make sure that the government cuts its links with the Reit, enabling it to make decisions on a purely commercial basis.
Unsurprisingly this has started to worry existing tenants who foresee vastly increased rentals once private managers start to run the properties. A group of 100 tenants recently petitioned Democratic legislators to push for a five-year rental freeze and subsidies to renovate some of the more dilapidated malls.
However, the lynchpin of the Reit will be its ability to grow income by increasing rental yields. Analysts' research is forecasting that net income will total HK$1.6 billion ($205 million) in FY06, rising 6% in 2007 and 6.5% in 2008. Analysts also point out that SHK's retail portfolio currently yields 2.5 times that of Link Reit.
And as one specialist notes, "The portfolio is a low grade one, but you have to figure that growth will be fairly easy over the first few years simply by managing it better."
The government has set up an internal management team led by CEO Victor So, who formerly managed the MTR's property portfolio and CFO Alfred Li, formerly of Hang Lung Properties. With most normal Reits, the manager's performance is aligned with that of the Reit and fees are often paid in the form of Reit units.
In this case, specialists say there will be a slightly different incentive structure, although it will not be announced until next week.
Reits typically grow their income through acquisitions and rental increases. Post IPO stock price performance is typically highly correlated to growth and critics believe this is the Achilles heel of the Link Reit.
One of the main reasons why the Singaporean Reits have performed so well is they have made a lot of yield accretive acquisitions. Where Link Reit is concerned, there are no obvious government assets to inject since the Reit portfolio accounts for over 90% of the Housing Authority's retail assets and car parks.
Under the Hong Kong Reit code, local Reits are also not allowed to make overseas acquisitions, although specialists are hopeful this limitation will be lifted over the next year or so.
Where rental yields are concerned, analysts also have mixed views. Some point out that retail yields have been the least affected by the property downturn, which Hong Kong is now coming out of. Others also highlight the impact of Chinese tourists, not many of whom will be shopping on housing estates in Hong Kong's New Territories.
However, in a recent research report CSFB wrote that, "It is dangerous to equate the growth in Chinese visitors with growth in retail sales, as domestic consumption is still the main source of retail sale receipts (about 22% is accounted for by visitors)."
And it concludes, "Translating growth in retail sales into rents is therefore more challenging, as retail rents have not really fallen that much since 1997 and there is additional competition for the consumer dollar from new shopping malls."
In the first eight months of 2004, retail sales rose 6.3% over the same period in 2002 (2003 is skewed by SAR's). In the year ended March 2004, Link Reit recorded revenue of HK$3.5 billion ($449 million), of which 73% came from retail and 27% from car parks.