Link Reit: Deja Vu

Roadshows begin for second attempt to complete world's largest Reit IPO.

Roadshows begin today (November 10) for a HK$18.7 billion to HK$19.8 billion ($2.4 billion to $2.5 billion) IPO by Link Reit, Hong Kong's inaugural Real Estate Investment Trust. Under the lead management of Goldman Sachs, HSBC and UBS, presentations will continue until Friday November 18, before the offering is priced over the weekend and listed on Friday November 25.

The transaction will have a base deal size of 1.926 billion units and a greenshoe of 211.6 million units. On full completion the deal will have a 100% freefloat.

This has been deliberately structured to make sure the Reit's links with the government are cut and decisions can be made on a purely commercial basis. Should the greenshoe fail to be exercised, the Hong Kong Housing Authority (HKHA) will continue to own 9.9% of the Reit, but will not have board representation.

The price range has been set at HK$9.70 to HK$10.30 per unit. This equates to a forward dividend yield of 6% to 6.37% (March 2007 year-end) and a valuation range spanning -3% to 3% above Net Asset Value (NAV).

The portfolio of retail and car parking spaces has been assigned a valuation of HK$33.8 billion ($4.3 billion) and an NAV of HK$21.4 billion ($2.7 billion). Gearing stands at 36%.

As the deal is a Hong Kong government privatization, it has been heavily tilted towards retail investors. Similar to the last government privatization of MTR Corporation in 2000, retail investors will receive a 5% discount. Last year they were offered a 3% discount.

At the outset, retail will be allocated 30% of the deal and institutions 70%. Should retail books close more than 15 times covered and less than 25 times covered, the lead managers will allocate at least 40% to retail. If the retail order book is more than 25 times covered, the leads will allocate at least 50% to retail.

The two clawbacks exclude strategic investor Capitaland. Similar to 2004, the Singapore property developer will invest $180 million in the IPO. However, in a departure from last year, the Reit manager can scale this investment back to $120 million at its discretion.

In a second change, there will be no cornerstone investors. In 2004, nine cornerstone investors committed to buy 18.7% of the deal.

There will still be a POWL (Public Offering Without Listing) in Japan run by Daiwa SMBC.

The main reason for altering the allocation process is to try and ensure a more favourable weighting for institutions. Last year, institutions and corporates ended up being allocated just 9.9% of the deal after a $75 billion order book ensured significant retail take-up, with a large chunk of what remained promised to cornerstone investors.

The new deal structure also incorporates "withdrawal rights." These will enable retail investors to secure a full refund if there is a legal challenge to the Reit between the publication of the public offering prospectus and the day of listing.

In December 2004, the Reit fell apart between pricing and listing because of a legal challenge lodged by two HKHA tenants. Their one remaining lawsuit was finally thrown out by the Court of Final Appeal on July 20 this year.

In the interim period, there have also been slight changes to the underlying portfolio, which comprises 950,000 square metres of retail space and 79,000 parking lots adjoining the HKHA's public housing estates.

The underlying valuation has risen 9.6% from HK$30.8 billion ($3.95 billion) in December 2004, while the NAV has dropped 2% from HK$21.8 billion ($2.8 billion). The main reason for this differential is that property values have risen, but rental yields have not because Link Management have remained constrained by government control.

This factor is the lynchpin to the whole deal and its major selling point. Lead managers will argue that the Reit's transformation from a public to a private entity will be the major growth driver of increased dividends per unit (DPU).

In this respect Link Reit will provide a slightly different investment proposition to its closest comparables - Singapore-listed retail Reits such as CapitaMall Trust (CMT) and Fortune Reit. In both cases, share price performance has been largely a measure of each Reit's success in making yield accretive acquisitions.

Indeed, the leads will argue that Link Reit offers the ultimate defensive investment in a sector, where this characteristic is valued almost above all else. This is because its rental yields are completely out of whack with the Hong Kong average - with growth driven by playing catch up rather than chasing market upside. Even in the event of a market correction, Link Reit should still be able to increase its profitability.

Syndicate research reveals that Link Reit's portfolio averages a monthly rental of HK$23 per square foot. This is about 70% below the Hong Kong average. Over the first seven months of this year, Hong Kong rentals also averaged a 7.4% increase, versus just 1% at Link Reit.

One of investors' key decisions will, therefore, be how quickly and effectively Link management will be able to raise rental yields and how close they can ever truly come to commercial levels. One major constraint is the fact that a portion the Reit's portfolio is rented by schools and welfare centres.

Over the long-term, investors will also need to judge how aggressively Link Reit will be able to expand its portfolio in either Hong Kong or abroad. Once it has re-worked its existing portfolio, future DPU growth will inevitably have to depend more heavily on acquisitions.

Analysts agree that the best performing Reits are nearly always those, which offer the highest total returns. This is a valuation metric that encompasses a Reit's initial yield (its bond like characteristic) and its ability to grow DPU (its equity like characteristic, which translates into share price performance).

Syndicate research is forecasting that Link Reit's DPU over the three years from March 2007 will average about 8%. At the low end, analysts forecast a DPU CAGR of 4.5% and at the high end nearly 12%.

When combined with a forward dividend of 6.37% (cheap end of the indicative range), Link Reit will offer a total annual return of about 14%. This is high relative to the listed Asian Reit universe and second only to CMT, which has an estimated total return of about 16%. This latter calculation encompasses a forward yield of roughly 5%, a DPU CAGR of 9.7% and 1.3% as a result of its stake in CapitaRetail Fund.

By contrast, Fortune Reit has a lower estimated total return of about 7%. This embraces a forward yield of about 5.8% and a DPU CAGR of 1.1%.

CMT and Fortune have witnessed divergent share price performances so far this year. CMT, Singapore's largest retail Reit, has climbed roughly 33%, while Fortune is down about 10%. Both have fallen since early August.

CMT is currently trading at a premium of about 44% to NAV, while Fortune is trading at a discount of about 15%.

Analysts attribute a number of reasons to Fortune's poor performance.

In many ways the Cheung Kong vehicle is something of an orphan stock in Singapore given that its asset base is composed of Hong Kong-based retail malls. Like the Link Reit, most of these malls are suburban and non-prime. Management have previously floated the idea of a dual listing in Hong Kong, but the idea is believed to have run aground because of regulatory issues.

Secondly, management have also said they will focus their acquisition strategy on Singapore's Suntec Reit rather than Fortune Reit. Since listing in 2003, Fortune has made just one acquisition - in June this year, it purchased nine malls, bumping the Reit's portfolio valuation up to $863 million compared to $400 million at the end of 2004.

By contrast, CMT currently has a portfolio valuation of $2 billion, up from $411 million at listing in 2002. Link Reit stands at $3.95 billion.

So too, Fortune's June acquisition was not very yield accretive. Indeed, analysts say it was only yield accretive because the Reit increased its leverage to pay for it. The Reit's difficulties highlight a number of problems besetting the Hong Kong market.

One concerns the high degree of concentration in property ownership, which makes acquisitions of any kind more difficult than other countries. A second concerns the interest rate environment.

Short-term interest rates have spiked dramatically in Hong Kong, with three-month Hibor rising from 0.6% in December 2004 to 4.47% currently. In Singapore, the increase has been less pronounced, with short-term rates rising from 1% to 2.2%. over the same time period.

Because Reits distribute all their income as dividends, an increase in short-term rates has a material impact on the bottom line thanks to increasing interest expense. It also makes it more difficult to find yield accretive acquisitions as the cost of debt capital also rises.

Fortune Reit tried to forestall the problem by locking in more fixed rate debt at the beginning of 2005 - the overall percentage rose from 50% to 75% of total debt. Analysts believe its cost of debt stands at 4%.

Link Reit has a 4.85% cost of debt out to March 2007, with a further 1% rise forecast over the following financial year because of the maturing short-term loans. Its gearing has risen from 28% in 2004 to 36% currently, versus a regulatory ceiling of 45%.

Analysts say Reits tend to underperform the market in a rising interest rate environment. Partly this is because investors have other high yielding instruments to choose from.

In Hong Kong and Singapore, the problem has been somewhat mitigated by relatively flat yield curves. In Singapore, 10-year government bond yields have contracted from 4% to 2.9% over the past year or so, while 10-year government bond yields in Hong Kong have risen from 3.6% to 4.4%.

Investors that believe long-term rates will spike as sharply as short-term rates are less likely to buy Link Reit. Based on the Reit's current dividend range of 6% to 6.37%, it is offering a premium of about 160bp to 180bp over government bonds. In Singapore, CMT is trading at 210bp over versus 323bp at listing.

Alongside a deteriorating interest rate environment, Link Reit will also have to contend with weaker equity markets than 2004. Both factors may dampen overall demand, but as specialists point out, Hong Kong is still awash with liquidity looking for a higher yielding home than bank deposits (currently yielding up to 3.5%).

Link Reit will also offer the kind of scale and liquidity that no other listed Asian Reit can match.

¬ Haymarket Media Limited. All rights reserved.
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