Prosperous times for Hong Kong Reit issuers

GZI and Prosperity Reits hope to benefit from the halo effect of the Hong Kong government''s Link Reit.

Two new Hong Kong Reits have been launched on accelerated timetables in the hope of cashing in on the sector's current high standing with investors. Prosperity Reit is scheduled to price first after launching its Hong Kong public offering yesterday (December 5).

Under the lead management of JPMorgan and Merrill Lynch, the Cheung Kong vehicle is issuing a lucky 888 million units on a range of HK$2 to HK$2.16. The HK$1.7 billion ($227 million) to HK$1.9 billion ($245 million) IPO will price on Friday and list on December 16.

It has the standard 90%/10% split between institutional and retail investors and is also subject to the usual clawbacks, which could see retail allocated up to 50% in the event of the public offer tranche closing more than 100 times subscribed. In addition to the public offer tranche, existing Cheung Kong investors are entitled to one new Reit unit for every 32 shares held. This 44.4 million preferential tranche has been incorporated within the overall 799.36 million institutional tranche.

On top of this, Cheung Kong and Hutchison Whampoa will purchase 29% of the Reit, leaving 71% in freefloat post greenshoe.

In terms of valuation, the IPO is being marketed on a discount to Net Asset Value (NAV) of 7.6% to 11.9% and a forward yield of 5.73% to 5.31%. This represents an equivalent spread to Hong Kong government bonds of 126bp to 84bp. Unusually, the group is also guaranteeing a minimum first year dividend pay-out of at least 5.3%.

The listco comprises a portfolio of seven industrial and commercial properties with an appraisal value of HK$4.5 billion. The seven are primarily located in the non-prime business districts of Hung Hom and North Point and have an aggregate gross rentable area of approximately 1.2 million square feet.

Average occupancy for the eight months to August was 94.6% embracing 501 tenants, of which the top ten accounted for 19.8% of total rental income. Grade A buildings accounted for 52.2% of the total.

One of the Reit's biggest selling points is the fact that just over half the portfolio's rentals are up for renewal in 2006. Almost all of these rentals were last fixed during a market trough spanning SAR's in 2003. According to Savills' research, rental rates of Grade A and Grade B office space have respectively increased by 92% and 25% in the interim period.

As a result of this, syndicate analysts are forecasting strong rental reversions and a correspondingly strong rise in net property income over the coming few years. Having recorded net income of HK$116.6 million in 2004 and HK$60.5 million during the first half of 2005, analysts are forecasting a jump to HK$155 million in 2006.

Some believe the Cheung Kong brand will also constitute a major selling point. The group is one of the biggest property developers in Hong Kong and deals from the KS Li stable have historically well rewarded investors.

In recent years, however, the group has incurred a reputation for bringing questionable deals that do not perform well. So too, it will have won itself few brownie points with the government for trying to slip into the market ahead of its own deal for Link Reit. Prosperity Reit will, therefore, provide an interesting litmus test of local investors' continuing faith in the man who has for so long symbolised Hong Kong Inc.

In making their investment decisions, investors will have two benchmarks. The most favourable is the deal's immediate predecessor Link Reit, which has outperformed all expectations since listing on November 25 and is currently up 30%.

The whole Asian Reit sector has performed well over the past three weeks and re-gained upward momentum following remarks by outgoing Federal Reserve chief Alan Greenspan concerning a topping out of the US interest rate cycle.

This momentum has also benefited Cheung Kong's existing Reit vehicle, Fortune Reit, which is listed in Singapore. Since November 23, the stock has risen 7%, although it still remains down 9% year-to-date. The retail-oriented Reit is currently trading on a forward yield of 5.9% and at a 22% discount to NAV.

The Reit's underperformance relative to its Singapore listed peers has been attributed to a number of factors, some of which will also apply to Prosperity Reit. Two constraining factors have been the stock's listing in Singapore where it is less well known with investors and management comments about placing more emphasis on growing the retail portfolio of a second Singapore-listed vehicle, Suntec Reit.

However, some analysts also believe Fortune Reit has been penalized for failing to live up to expectations where acquisitions are concerned. Since listing in 2003, the Reit has made just one acquisition this summer, which boosted its asset base from $400 million to $863 million.

This tardiness has not stemmed from a lack of acquisition opportunities. Rather the difficulty has been finding yield accretive acquisitions given that property yields are lower in Hong Kong than Singapore and interest rates are higher.

This has meant that Fortune Reit has been trading on a higher dividend yield than the market's underlying property yields. Thus the only way the Reit could execute a yield accretive acquisition was to increase its gearing to pay for it.

In doing so, however, it also increased its interest costs at a time when local interest rates have been rising sharply. Analysts say Prosperity will suffer from the same issue unless the IPO performs well and its yield compresses to a level where acquisitions become yield accretive again.

In order to mitigate the effects of high local interest rates, the group has engineered an interest swap that fixes the Reit's funding costs and improves the upfront yield. Under the terms of the HK$1.9 billion ($244 million) five-year deal, the group's cost of debt will average 1.4% and its gearing will stand at 39%.

In 2006, it will pay interest of 0.3%, rising to 0.9% in 2007, 1.08% in 2008, 2.15% in 2009 and 2.58% in 2010. By contrast, Link Reit's cost of debt out to March 2007 is 4.85%.

Following on the heels of Prosperity Reit is a $150 million to $200 million IPO for GZI Reit led by Citigroup, DBS and HSBC. Having begun pre-marketing last Thursday, the deal will launch roadshows this Thursday and is scheduled to price on December 15.

The transaction represents the first Reit by a Mainland entity and marks a spin-off by Guangzhou Investment, which will retain a 31% post listing, post greenshoe. Over the past month news of the Reit has spurred stock price performance by the parent, which has risen from HK$0.70 to HK$0.95.

Its new Reit has been assigned an appraisal value of HK$3.97 billion and is being marketed at a steep discount of 35% to 22% based on an NAV range of HK$2.6 billion to HK$3.1 billion.

It will also set to be priced at a generous forward dividend yield of 6.4% to 7.8%. The main reason for this is the Reit's mature income stream and investor concerns about the volatility and transparency of the Mainland property market.

Analyst research, for example, is projecting a relatively low distribution CAGR (Compound Annual Growth Rate) of 4.3% over the next four years. The underlying portfolio comprises four properties in Guangzhou with a gross lettable area of 160,000 square metres of which 56% is commercial space and 44% retail.

Analysts believes rental income will witness only marginal increases over the next few years and may come under pressure thanks to an influx of new properties. According to DTZ research, total grade A office space in Guangzhou is set to rise 51% this year from 0.98 million square feet to 1.48 million. A further one million square feet is also due over the coming five years.

Rental yields for office space in Guangzhou are also said to be lower than other tier 1 Mainland cities such as Shanghai and Beijing. This is largely because the city has not attracted the same level of investment by multinationals, with a majority of tenants comprising domestic entities.

However, analysts also say that rental yields in Guangzhou are more stable than the other two cities. Having experienced an earlier boom-bust cycle back in the mid-1990's, it has not been subject to the same level of speculative investment in recent years.