ECM 2006: Stops and starts

IFR ECM Special Report 2006
11 min read

In the three years that Hong Kong has permitted REIT issuance, bankers have struggled to establish the product. Retail investors – the core market for any successful REIT programme – have largely shunned the instrument in search of something with a little more sizzle, and institutions have looked poorly on issuers’ inclination toward punchy valuations and aggressive structuring. Will Hong Kong ever get REITs right? Jasper Moiseiwitsch reports.

Hong Kong’s REIT programme has been surprisingly lacklustre. This is not for a lack of advantages. The government bestowed on the territory the world’s biggest REIT IPO and Hong Kong contains some of the most profitable real estate developers on the planet.

The territory’s first REIT IPO – the US$2.8bn Link float in November 2005 involving a mass disposal of government-owned properties – was the ideal transaction to kick-start the territory’s long moribund REIT programme. The float launched the REIT product and introduced the concept of yield investing to Hong Kong’s notoriously speculative retail base.

For a while, it worked. The Link unit price rose 60% in the first 2-1/2 months after listing partly thanks to reports that the London-based The Children’s Fund was aggressively buying the deal. The transaction created a flurry of interest in the product, institutional and retail, and REITs were briefly the hottest asset class in town.

This followed years of indifference. Regulators opened the Hong Kong market to REIT issuance in July 2003, but no one would touch the product in the first year and a half. The standard refrain was that the Hong Kong families that control the biggest property firms did not want to sell prized assets. Many property developers have been happy to sell minority positions in their firms via the equity markets. But REIT transactions involved 100% disposals – it was a fundamentally different selling proposition.

Those that truly looked to sell assets also had the option of tapping a liquid private market where property assets were routinely traded at a razor-thin 2% yield. Finally, potential REIT issuers faced the fact that Hong Kong offered no tax incentive to issue REITs, unlike most developed REIT markets.

But if Link’s strong initial gains sparked an initial flurry of retail interest in REITs, it was Cheung Kong’s Prosperity REIT, which shortly followed Link, that really showed issuers the potential of the instrument.

The Cheung Kong spin-off, which priced in December 2005, used an interest rate derivative to frontload earnings to give it an initial yield boost. The engineering was cosmetic. Whatever investors gained in the initial years they lost in the later years, minus the cost of the derivative.

The company also arranged for the management fee to be paid in shares instead of cash for the first two years, which also increased the initial yield. As a result, only 10% of Prosperity’s initial yield came from rental income, according to one estimate.

Bankers justified the engineering at the time by saying that the Hong Kong property market was going through a cycle of lease renewals. After hitting cyclical lows during the outbreak of the SARS virus in 2003, property leases were being renewed at 50%–70% premiums. The Prosperity REIT used engineering to smooth out expected earnings increases and to give investors a clear sense of where they expected long-term yields to lie, said bankers.

But Prosperity also gave the other developers an inkling of the potential of engineered REIT issuance. The unspoken corollary was that it gave the always-opportunistic Hong Kong property developers an inkling of how easily they could manipulate yields in these transactions.

The engineering aspect, alongside the initial enthusiasm that Link created for REITs, finally stirred Hong Kong’s property tycoons into using the market. “The Link IPO was a big public event that generated strong public sentiment for REITs. But Prosperity was more important because it showed what a savvy issuer can do with a REIT to sell an asset for a great price,” said a Hong Kong-based property banker.

Suddenly, every property developer in town was looking at REITs. Among potential issuers, major property players Sun Hung Kai, Henderson and Wharf advanced plans for deals. Chinese Estates, Chinese Estates, Regal Hotels, Far Eastern Consortium also joined the fray, among many others.

The turning-point

Champion was the first to REIT to enter marketing post-Prosperity. The HK$6.29bn (US$808.9m) transaction looked decent at first sight. Its asset, Citibank Plaza in Hong Kong’s Central district, was of excellent quality and was benefiting from the kind of post-SARS rental hikes that drove REIT marketing.

However, the deal suffered from the fact that it had just this one asset and in that the REIT’s sponsor, Great Eagle, had only a so-so reputation as a property developer. Investors, in short, did not have great hopes that this REIT would see decent future asset injections or growth.

But institutional investors also looked askance on the offer’s financial engineering. The deal involved the same kind of engineering used on the Prosperity float, a step-up interest rate swap, that gave it an initial yield of 5.46%. If the enhancements were taken away the deal initially yielded just about 2% – well below the yield levels of Singapore comparables. Champion had an excellent growth story but its deal engineering complicated its long-term yield picture.

“The face value looks OK but only after the financial engineering,” said one investor at the time of the deal's pricing. “The underlying rental yield is low relative to other REITs.”

The deal was also impacted by a US$1bn block trade from Hong Kong property developer Sun Hung Kai, which priced right in the middle of Champion’s marketing. The issue sparked some thoughts among investors that developers were calling the top of the market and exploiting the moment with opportunistic issuance.

That cynicism has some bearing in reality. Sun Hung Kai, after all, had a US$500m REIT in the pipeline (in the form of Sun Millennium) a meagre 10% gearing and was historically averse to equity dilution. There was no obvious reason to issue equity, unless the company believed that it was hitting the top of the market.

The Champion deal subsequently priced near the bottom of the indicative range. While the deal was well covered, the public offer was an anaemic six times subscribed, reflecting a building scepticism that retail investors held toward the sector. At the time of writing, Champion was trading 25% below its IPO price.

The fallout

Shortly after Champion REIT lurched to market, two other high-powered property developers attempted their own REIT floats, and failed. Henderson Land’s Sunlight REIT and Sun Hung Kai’s Sun Millennium were both pulled in June following extended pre-marketing. The deals were to have raised a combined US$1bn.

Bankers and sponsors were confronting a sharply different market. Globally, equities were entering a period of intense price volatility. Locally, at the time of these deal cancellations, the Hong Kong-dollar year swap rate had climbed about 60bp and the yield on the Prosperity REIT has climbed about 120bp. Prosperity and Champion were both below issue price and the Hang Seng Property Index had dropped about 10% since the SHK block.

More generally, bankers and issuers realised that the market just was not swallowing the yield engineering that was used on Prosperity and Champion, and which was planned for virtually all other REITs in the pipeline. Investors wanted cleaner, simpler structures and they wanted more transparency on a transaction’s true yield.

Indicative of this swing in sentiment, the Hong Kong market’s regulator SFC published a simple guide explaining REIT yield engineering just as Champion was in marketing. The guide noted some benefits to step-up swaps, but clearly explained that they provided no net benefit to investors. They added that, with such a structure, “investors were funding part of the distributions they receive from the REIT by their own subscription monies”.

Investors were discounting to nil the value of this engineering. Suddenly issuers were confronted with the necessity to price deals with a 7%-plus un-enhanced yield – that is, the yield implied by the trading level of comparables such as Champion. REITs globally traded at a range of 100bp–200bp above 10-year Treasuries, about 6.3%.

Viewed through the ultra-fine pricing parameters of the Hong Kong property developers, the REIT market was suddenly unattractive. The developers had no need for cash and this yield level did not suggest attractive pricing to them.

The situation today

Nevertheless, by late August 2006, there were signs that the Hong Kong REIT market still had life in it. A series of hotel REITs were rumoured to be coming to Hong Kong in the second half. These included Far East Consortium – which had mandated banks to sell seven hotels via a REIT structure – the much mulled Regal Hotel REIT and another Cheung Kong offer comprising serviced apartments.

There was a small irony that hotel assets were driving the Hong Kong pipeline. Hotel income is volatile and seasonal, which complicates what is a defining trait of most REITs – steady, predicable annuity streams. Interestingly, bankers said that the Far East Consortium deal would arrive with little to no structuring to manage that volatility.

But there was also an underlying rationale to that structure. Given that hotels have short leases that are measured in days or weeks, the properties fully reflect the robust conditions of today’s hotel market. This contrasts with the other REITs based on office and industrial properties, that asked investors to wait for a full rental-reversion effect to kick in. In other words, the hotel REITs are less in need yield enhancements to entice investors to buy today at the expense of dividend growth in the years ahead.

If these listings work they perhaps will be a template for future deals. Hong Kong’s retail investors have shown a mistrust of structured deals, but they have a strong risk appetite for assets with a good growth story. Hotel REITs may uncover an interest in Hong Kong for growth-focused (as opposed to yield-focused) REITs. For a market struggling to find its way after three long years, that is a hopeful development.