My thoughts on Elite Commercial REIT

Elite Commercial REIT is the first REIT listing in Singapore in 2020. I know this article is a little late as the REIT is currently already trading. However, if you are still considering buying units in the open market, here are some factors to consider.

THINGS I LIKE ABOUT THE REIT

Let's start with a quick rundown of some of the positive characteristics of the UK-based REIT. There are many points to go through here so I will be as brief as possible for each point.

MULTI-PROPERTY PORTFOLIO

Based on the prospectus, Elite Commercial REIT has an initial portfolio of 97 commercial properties in the UK. While the properties are all located in the United Kingdom, the large number of properties means that the REIT is not overly-reliant on any single property.

The properties are also well-spread across the entire UK, with properties situated in Northern Ireland, Wales, Scotland and England. 

Another thing to like is that all except for one property is free-hold. Even the sole property that is not free-hold has a very long land lease of 235 years.

RELIABLE TENANT

Perhaps the most appealing aspect of the REIT is that all of its properties are leased to the UK government, specifically the Department for Work and Pensions. 

As it is virtually impossible that the UK government will default on its rent, there is very little tenancy risk.

LONG LEASES

The weighted average lease expiry for the properties stands at a fairly long 8.6 years. Given the long leases, investors can rest easy knowing that the distribution will be fairly consistent for the next few years. 

However, investors should note that some properties have a break option in 3.6 years. Assuming these options are exercised, the portfolio's weighted average lease expiry will drop to 4.89 years.

THE PROPERTIES ARE IMPORTANT TO THE UK GOVERNMENT

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80 of the 97 properties in the portfolio are used for front-end services such as JobCentre Plus. Furthermore, 86.3 per cent of these JobCentre Pluses do not have an alternative JobCentre Plus within a 3-mile radius.

This is important as investors need to know that there is a high likelihood that the Departement for Work and Pensions will renew its leases when the current contracts expire in 2028.

TRIPLE NET LEASES

The UK government has signed triple net leases for the properties. What this means is that it will cover all operational costs, property taxes and building insurance. The triple net leases provide the REIT with more visibility on cost for the period of the remaining lease.

LOW GEARING

Another thing to like about the REIT is its low gearing of 33.6 per cent. That is well below the 45 per cent regulatory ceiling, giving it room to make acquisitions in the future.

DECENT YIELD

The REIT's IPO price of £0.68 (S$1.22) represents a price-to-book ratio of 1.03 based on Collyer's valuation report. In addition, the indicated distribution yield of 7.1 per cent is higher than the average distribution yield of Singapore-listed REITs.

WHAT I DISLIKE

There are certainly a lot of things I like about Elite Commercial REIT. On the surface, it looks like a very stable REIT with a reliable tenant and the potential for acquisition growth. However, looking under the hood, I found unsavoury characteristics that might put off some investors.

ALL EXPIRE AT THE SAME TIME

The previous owners of the property negotiated to lease the properties back to the UK government with all leases expiring on the same day- 31 March 2028. I much prefer a staggered lease expiry profile as it gives the REIT time to find new tenant should existing tenants fail to renew their leases.

Another concern is whether the UK government will indeed renew all contracts with the REIT when their leases expire. While the REIT is quick to point out that the UK government is likely to renew its leases, things could easily change in the future.

If the UK government decides not to renew a few of its leases, the REIT will need to find a quick solution to prevent a rental gap.

INFLATED MARKET VALUE

Another thing that I got alerted to by a fellow blogger's article was that Collyer's valuation of the portfolio was based on current rental leases. The existing leases are slightly above market rates and could suggest that the market value is somewhat inflated.

Likewise, as market rent is below the current rent, we could see rental rates reduce come 2028 when new contracts are signed.

SPONSOR FLIPPING THE PROPERTIES AFTER PURCHASING IT JUST ONE YEAR AGO

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Another red flag is that Elite Partners Holding are selling the portfolio to the REIT just a year after buying the property. The sale price represents a 13.1 per cent gain for Elite Partners Holdings.

More worryingly, Elite Partners Holding is selling its entire stake in the portfolio and will not be participating in the IPO. Moreover, they are retaining the management of the portfolio.

First off, I would like to see some alignment of interest between sponsors and REITs by having at least some skin in the game. Second, Elite Partners Holding will still be the managers of the property and yet not have a stake in the company. This creates a conflict of interest between managers and unitholders.

FLOATING RATE DEBT

The REIT has taken a floating rate loan. While floating-rate loans tend to have lower rates when it is first negotiated, it can also rise in the future. Even though rates have been dropping the last year, things could change in the future. Higher interest rate payments will result in lower distribution yield for investors.

BREXIT CONCERNS

The United Kingdom has just finalised its exit from the European Union. There are so many uncertainties regarding its exit. How will this impact its economy, property prices and even the value of the pound?

All of which could potentially impact distribution and rental rates in the UK.

THE GOOD INVESTORS' TAKE 

Elite Commercial REIT has both positive and negative characteristics. The indicative 7.1 per cent yield and backing by the UK government are the main draws.

However, the fact that all leases expire on the same day, the uncertainty surrounding Brexit and the potentially inflated market rate of the properties, plus the sponsor's unwillingness to participate in the IPO are things that investors should be concerned about.

Given all these concerns, I think the 7.1 per cent indicative yield is still not attractive enough for me. As such, I will likely be staying on the sidelines for this one.

This article was first published in The Good Investors. All content is displayed for general information purposes only and does not constitute professional financial advice.