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Tuesday, November 3, 2015

Recent Action - First Reit

Given the recent announcement made by Lippo Group that caused quite a panic amongst the retail investor, I used the opportunity to load up 8,000 shares of First Reit at a price of $1.17.


The addition was timely because you don’t often get such opportunity to add quality reits into your portfolio, unless there are some fundamentals issue or rumors that are spreading. For me, I pounce onto the latter.
 
In this post, I will not be covering on the fundamentals of the reit because I think it has been covered quite substantially by other bloggers in the past and everyone seemed to know the strengths and weaknesses of the company.
 
Based on my experience previously working for one of the two reits involved, and also given my native background, maybe I’ll offer something else that are different and may be value adding to readers.
 
Policy Changes
 
I think by now everyone is already familiar to the news that Lippo Group might be planning to delist the two Reits and move them back to Indonesia where they can potentially save on the tax breaks. You can read the news here. But let’s take a deeper dive into what that really means to the group and to investors.
 
The decision to remove the tax breaks by the Indonesian government is in fact a policy move in a bid to spur economic growth over time. This decision started with the intention for developers to revalue their assets, which many companies have not done so based on the recommended IFRS because they were using the Indonesian GAAP reporting. The policy involves encouraging companies to submit proposals for fixed asset revaluation in order to increase the firm capacity so that they get a higher valuation and can take on more leverage to boost the company’s return and hence the economy. The specific tax breaks is as follows:
 
- Companies that submit their proposal before 31 Dec 2015 would only need to pay 3% tax on the increased amount.
 
- Companies that submit their proposal in the first half of 2016 would pay 4% tax on the increased amount.
 
- Companies that submit their proposal in the second half of 2016 would pay 6% tax on the increased amount.
 
If you see across how the Indonesian developers compare against Singapore developers, you can see a vast different across how much is premium these developers are trading above their book value and how much DISCOUNTS they are trading below their RNAV. This is almost as if the company revalued all their assets, their market cap can almost double in value. In this case, property developers would almost certainly record a huge amount of accounting gains in their books once they revalued their assets.



In addition to the tax relief in asset revaluations, the latest economic policy package also removes double taxation on portfolio investors who invest in Reits using the collective investment contract system. This system would enable investors to pool funds in a collective investment vehicle, without being liable for double taxation. This is similar to the setting up of a Special Purpose Vehicle (SPV) we have in Singapore. At present, the investment method is subject to double taxation on its dividends and on the activities because the vehicle itself is considered a corporate body. You can immediately see how the Indonesian government is replicating a similar model when the same set up was done in Singapore many years ago to remove the tax breaks.
 

Borrowings and Earnings Done In Indonesia

Every investors of First Reit and LMIRT would have known that the companies made their borrowings in SGD at a rather low costs of borrowing since we are in a stagnant zero percent rate environment. The difference between the two is that First Reit earnings and assets are being earned and reported in SGD while LMIRT earnings and assets are being measured in IDR.

For the purpose of this article, I’m just going to touch on First Reit.

First Reit dividend yield based on 100% distribution are currently at 6.6% based on current price while costs of borrowings are in the range of 3% (higher because First Reit does not have credit ratings). Risk free rate in Singapore are at around 2.8%.

Now let’s think what happens if they decide to list the reit in Indonesia.

Based on the table appended below, you can see that loans made from banks are in the range of 11%. Sure, they might deviate a little amongst the different banks, but I can confirm that is the average interest rates for mortgage home loan payments taken by most Indonesians. The risk free rate, which in this case I have taken the Indonesian Treasury Bonds as reference, is currently yielding a Yield to Maturity (YTM) of around 5.3%. The fixed deposits, offered from various banks (yet to confirm on this one) is currently yielding 5% to 6% based on the table below.


Costs of Borrowings
Fixed Deposit Rates


Indonesian Treasury Bonds

Now, ask yourself this question. If you are an investor in Indonesia and are looking to invest in First Reit, given that you are able to obtain a risk free rate of around 5.3% and fixed deposit north of 6%, what is the premium yield you are looking for before you are willing to invest in First Reit? Surely, in this case, a 6.6% dividend yield would not be attractive anymore and they would have to priced it way such that the reit is yielding a dividend of around 10% to make it at least attractive for investors. Of course, Lippo could always provide an income support to these reits like what they did with OUE here with the other reits but that is not organic and sustainable. Question still remains if it is a viable option to list them down in Indonesia.

Final Thoughts

Given that the Indonesian market is not as established in the one we’ve had in Singapore, I seriously doubt if the listing would take place in the near term.
 
Based on my arguments above, there are simply too many things to consider if they decide to list the reit in the Indonesian market.
 
This is not a case where the parent is taking the company private. This is about delisting them in an established market and then list them again in a not established market. To me, at least it doesn’t look like it is going to work out for now. Maybe I’m wrong.
 
I am betting that Lippo would not take First Reit back to list them in the Indonesian market, though the scenario appears to be more likely for LMIRT because all of their assets, liabilities and earnings are already measured in IDR. Even if I am wrong, I am assuming that this will not take place in an instant and much still needs to be discussed over delisting the two Reits with a lot of floating shares around (Lippo only owned about 30% so far). At least, we could be looking beyond 2016 and 2017 before this could take place.
 
I’m betting I’m right, but don’t trust my word for it.


17 comments:

  1. Hi B,

    I am betting you are right! Not because of logic, because I always have a knack of identifying the best person for the best job.

    If I were you to make bets in these two companies, I will definitely fail. Because as a Singaporean, it is difficult for me to understand both the Indonesian government and Indonesian companies, and their policy making decisions. Its too HARD for me!


    ReplyDelete
    Replies
    1. Hi Rolf

      Ah Hah!!!

      I'm betting you're the man when it comes to O&G ;)

      I guess it's not easy to consider the foreign policy risk when we invest in companies that operate mostly outside SG, which is most often the case since the local market is so small.

      Delete
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  2. Hi B

    Thanks for the post which shines more light on the proposal. Am I right to say that the removal of the double taxation will increase payout of first reit? Or does it just reduces lippo's tax liability?

    In your opinion, if the proposal gains unit holders approval to delist, what kinds of structural change is required for first reit since it is quoted in sgd, loans in sgd and rental terms in sgd? As mentioned in your post, the rates are higher in Indonesia, short of providing artificial rental support(which eats into lippo's profits) , the more natural progression is for unit price to drop to achieve the yield demanded by investors, which hits lippo's profitability and assets since they are substantial owners.

    ReplyDelete
    Replies
    1. Hi Hong Wei

      Thanks for your comment.

      You're asking all very good questions there to think about.

      The removal of the double taxation will not increase current payout if you compare against what has already been effected in the Singapore market. But to put that in the Indonesian market context, then the answer to that is yes. I think though the benefits from the tax relief will go to the group and not the underlying reit.

      On your second question, I am guessing perhaps market valuation in the Indonesian market may be lower, which fetches higher dividends at the end. I really can't see it happening unless like you said, the tax relief is a huge thing for the parents and it makes sense for them to consider listing it in Indonesia.

      Delete
    2. Hi B
      To be honest, I have the same feeling that it's counter intuitive to move first reit back.

      Indonesia corporate tax rate is 25%. First reit has 750mio units and hence distribute approx 60mio per year. Assuming lippo owns 30%, they get 18mio a year and tax saving per year is 4.5mio.

      Purely from the fall of unit price since since the news broke, approx 10c, lippo already lost 22.5mio or 5 years of tax savings. This increased the yield to 6.8% which I would think is still too low for Indonesia.

      Makes me wonder what made the ceo issue such a statement... They are probably better off channeling their non reit hospitals that they have not yet given first refusal to first reit to create another reit in Indonesia

      Delete
    3. However, first reit have the right of first refusal for lippo's healthcare properties?

      First REIT has the right-of-first-refusal to Lippo Karawaci's healthcare properties

      Delete
    4. Yup, which is why I mentioned those that have not been given first refusal. In any case, first refusal should be easier to unwind compared to the loans and rental etc

      Delete
    5. Hmm, that's a good idea I have not pondered along. Lippo could have set up a new structure Reits where they could inject more of their hospitals into the reit but they choose not to and are thinking of using First Reit as a medium. Given that the latter have the right of refusal, it might be wise to create more reit under their wings.

      Delete
  3. Hi B,

    Thanks for shading some lights on this.

    ReplyDelete
    Replies
    1. Hi David

      No problem, you're welcome.

      Delete
  4. Hi, thank you for the analysis. What bothered me most is what exactly is in the mind of the sponsor. It has been more than 8 days and there is no follow up. The sponsor should know very well that he needs minority holders' support if he wants to delist. What he is doing is strange.

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