by David Faulkner
Valuation and Growth Challenges for REITs
With debate over the valuation of REITs arising in several markets in the Asia region in recent years it is a good time to revisit the reasons for REITs and what their real value is.
REITs in Asia were borne out of the 1997 Asian financial collapse as an investment product was sought that would give investors more stable returns and bring more transparency to the real estate investment sector. Japan lead the way in 2001, followed quickly by Korea, Singapore, Hong Kong and Thailand, with Malaysia and Taiwan following in 2005. While India and Pakistan have both recently launched a REIT and the Philippines is about to do so, the main centres for REITs are Japan, Singapore, Malaysia and Hong Kong.
The concept behind a REIT is that it generates regular income, which is largely paid out to investors as dividends, and so the valuation is based on its income producing potential. In a region that has historically invested mainly for capital growth this has presented a valuation challenge for many years. The early REITs did well as we saw substantial yield compression during the first decade of the 21st century, which had a substantial impact on capital values. This was gradually recognised during the regular half yearly valuations such that REITs, like all property vehicles, were showing record high valuations during the early part of the current decade. I would argue that this has attracted investors who take a shorter view of the investments returns than REITs are intended to be, which has led to further valuation challenges.
Implications of record high valuations
Valuations need to be supported by the current income stream and the growth potential. Growth can only be achieved through more active management of the assets by the REIT management team, buying assets that will increase the yield or through a rise in the general market. These are of course no different to the challenges faced by other property investment companies, except that REITs are required to limit their exposure to development situations and their leverage is capped at a relatively conservative level, both of which have generated good returns for property companies in recent years.
The side effect of the record high valuations is that REITs are faced with moving into new sectors and regions to enhance their returns. REITs that focus purely on offices or retail are looking at new geographies either within their own market or overseas, while those with a wider brief are exploring hospitality, leisure, healthcare, data centres and more specialised assets.
How to overcome valuation challenges?
So, what are the key valuation challenges? When an asset is first acquired, most REITS will implement an asset enhancement programme (AEP). This can include capital costs in remodeling the asset, a phased reshuffling of tenants, repositioning and rebranding the asset. The key question is how big an uplift in income this will generate and when and how it should be reflected in the valuation. This normally results in an above average growth in income during the years immediately following the AEP, before growth reverts to the market average.
Another major challenge is how future income and expense growth should be reflected in a valuation. The discounted cash flow model makes explicit assumptions which can be tested and challenged by investors, but is generally only sound if the assumptions are based on market data. Historical trends are of course not an accurate prediction of what will happen in the future, but for established property sectors historical trends combined with supply/demand analysis should be sufficient to apply a reasonable level of market growth. Adjustments may still need to be made for specific property types and locations. However, the trend in many markets is to move to a more straightforward income capitalisation model where current market rents are capitalised at an all risks yield. This shorter valuation format provides less information to investors but is easier to apply in markets with limited data availability. Many investors believe that because it uses current market rents this methodology does not take future growth into account. This is not correct. The potential for income growth is reflected in the yield (cap rate) applied. Higher growth potential should be reflected in a lower yield and vice versa.
The increase in the number of multi-market REITs, particularly in Singapore also leads to valuation challenges because of the various local practices in Asia. This can best be overcome by using recognised international standards such as the International Valuation Standards published by IVSC, the global valuation standards published by RICS and the International Property Measurement Standards published by the IPMSC.
About the author:
David Faulkner has over 40 years of experience in the real estate field and has worked in Asia for over 30 years. He is a Fellow of the Royal Institution of Chartered Surveyors (FRICS), Trustee of the Urban Land Institute (ULI), Member of the Best Practices Committee of the Asia Pacific Real Estate Association (APREA) and Practising Member of the Academy of Experts (MAE). David has advised on a variety of major projects in Hong Kong, China and elsewhere in the Asian region including valuations, feasibility studies and development consultancy. He covers all the major sectors including residential, commercial, retail, industrial, hospitality and leisure. He also acts as an independent expert in making determinations in commercial rent disputes and has advised on a number of complex property valuation issues.