Spiced-up reits may lose their flavour

Hong Kong real estate investment trusts are borrowing from the future to spice up rental returns from office buildings that are not earning enough to attract buyers at today's inflated property prices.

It is legal and investors have been warned. It is there in black and white in the prospectus of Champion Reit, a spin-off of Great Eagle Holdings. But it is a telling sign of how risk-hungry Hong Kong investors are and it means that the staid, steady old reit has been jazzed up into a tool for punters who want to speculate on Hong Kong's rent market, which means more risk.

'[Rental yields] are expected to increase going forward but interest costs will also be higher. So if rents don't go up, you could see an earnings gap as you go out,' said Milton Low, a portfolio manager at Prudential.

Reits came into being in the United States when property owners had trouble getting financing because banks were undervaluing real estate. So the owners sold the property on the public market to get a better price and smart investors realised that the rent from the properties would deliver a steady return on investment at those selling prices.

In Hong Kong, the exact opposite is the case. Property prices are high in relation to rents so companies wanting to sell their buildings on the public market are forced to devise a short-term solution to make their yields more attractive.

'What's disturbing here in Hong Kong is the need for financial engineering to get a high enough yield because yields in Hong Kong are so low,' said Steve Buller, the global head of Fidelity Investments' property funds. 'To get a competitive yield you may have to do it with financial engineering, which is borrowing from the future to pay a higher dividend.'

Sellers have added turbo-boosters to the reits. They are using a financial instrument called a swap, where they strike a deal with banks to pay lower interest rates in the early years of the reit, which makes those rental dollars look a lot more inviting relative to the big price tag of the building.

In return, they agree to pay more interest in the future in the hopes that rental yields will improve. The reit pays for that privilege with the funds that it raises from investors in its initial public offering.

'You pay in $100 and get $20 back each year for five years, but the problem is that that $20 really isn't recurring income,' one analyst said.

And what happens if rental yields do not improve?

'In a worst-case scenario, there may not be any distributions from the reit and the reit's ability to service such finance costs may be adversely affected,' the Securities and Futures Commission said in an advisory recently posted on its website.

An investment banker working on reits in Hong Kong said the swaps structure made sense because rents were 33 per cent to 50 per cent of current market value and once those underpriced leases were re-signed, yields would improve. Some of those renewals have already been signed.

He said the bottleneck of rental demand versus the dearth of new property coming on to the market backed expectations for higher yields over the next two to three years.

Hong Kong is no different to reit markets around the world, with reit investors putting more emphasis on returns from capital appreciation and less focus on rental yields. Interest-rate swaps are also used in other reit markets to hedge financing costs or to help smooth dividends when properties are being redeveloped and do not contribute earnings. But in Hong Kong, the use of financial engineering has been taken to a new level.

'This is quite far really. I don't really know how much further it could be pushed,' said Vivian Lam, a partner at law firm Paul, Hastings, Janofsky & Walker who advises reits.

Champion Reit has been the most high-profile case of financial engineering in Hong Kong so far, although Prosperity Reit also used swaps and lawyers working on other reits in the pipeline say most of the deals will follow Champion's example.

Champion offers a yield of 5.46 per cent but its prospectus says about 89 per cent of the yield is coming from the enhancements made to give the offering more sparkle, not actual rents. It used a 'step up' interest-rate swap, which means financing costs will increase over the next five years.

The effect of other sweeteners, such as key partners waiving their dividends, will also diminish in the future, meaning investors will have to rely on higher rental incomes to make up for the higher payout early in the reit's life.

'The hope of positive rentals more than compensating for the triple negative impact of reducing return on equity, waiver of distributions and rising cash finance costs is unlikely to last in the longer term ... resulting in a significant drop in [dividends],' Morgan Stanley analyst Kenny Tse said in a research report.

Reit yields are commonly compared to the risk-free return on government bonds. With Hong Kong's 10-year bond yield at 4.95 per cent, reits need to offer a little more gravy to make the risk worthwhile. Prosperity Reit is trading at about 5.5 per cent, GZI Reit is trading at a 6.5 per cent yield and Link Reit, whose unit price is up almost 60 per cent since its initial public offering, is trading at a 3.8 per cent yield. By comparison, yields in the more mature markets of Japan and Singapore average a 150 to 200 basis-point premium to their respective government bond markets.

'The interest-rate swap is necessary to give investors a yield which is common for reit investments while the fact of the increase in rents works its way into the reit over the next few years,' said Great Eagle assistant director Adrian Lee Ching-ming.

Hong Kong reits are under pressure from several fronts to juice up their yields. Soaring property prices mean rents must also rise in order to maintain yields. Willingness among investors to bid up the unit price of newly offered reits, such as Link, in the hope for a capital gain only further undermines yields.

In addition, reits are typically exempt from dividend taxes, so their high payouts become even more attractive. However, in Hong Kong, dividend income carries no tax so reits do not enjoy the tax advantage they do in other markets.

And that is how Hong Kong reits have come to be structured as bets that even though rental income is not great today, it will get better tomorrow.

'In this case, it looks like a great deal for Great Eagle which does not mean it has to be a good deal for investors,' Mr Low said. 'It all depends on your view of office rents in Central.'

And if the investors do not complain, who will? Investment bankers are making a handsome profit securitising Hong Kong property, as are corporate lawyers and anyone else playing a bit role in the deals.

'The swap people are very happy with all of this. Suddenly, they are doing all this interest-rate swap business, so it means more income for them,' Ms Lam said.