Sunday 21 February 2021

Will ARA US HT Carry Out a Rights Issue?

The financial reporting period for REITs has almost come to a close. One of my biggest worries in the COVID-19 fallout is the devaluation of assets held by REITs, which could lead to their aggregate leverage ratios rising above the regulatory limit and needing to carry out massive rights issues. So far, this worry has not materialised. The 2 REITs that had to carry out massive rights issues are Lippo Malls and First Reit, both of which are related to financial difficulties at their sponsors, Lippo Karawaci. 

Among the various REIT asset classes, hospitality trusts (HTs) are at most risks because international tourism has largely been decimated by border closures to control the spread of COVID-19. Both occupancy and room rates took a dive, resulting in significantly reduced revenue. Ancilliary facilities like restaurants, banquet halls and convention rooms, etc. did no better as governments imposed lockdowns and stringent safe distancing measures. To survive, some hotels serve as quarantine centres for visitors and residents returning from abroad. Nevertheless, in terms of asset devaluation, the HTs that have announced full year results have not performed too badly, with the exception of Eagle HT, whose troubles are widely known. The table below shows the devaluation that the HTs had to take in their full-year financial results (for Eagle HT, the results are for 3Q2020).

Counter Devaluation Properties % Devaluation
Ascott $379,092 $6,096,138 6.2%
CDL HT $185,523 $2,513,235 7.4%
Eagle $534,234 $1,267,480 42.1%
Far East HT $121,219 $2,645,700 4.6%
Frasers HT $145,985 $2,330,332 6.3%



Excluding Eagle HT, asset devaluation ranges from 4.6% for Far East HT to 7.4% for CDL HT. One reason for the lower asset devaluation for Far East HT is because all its hotels and serviced residences are under master leases whereas the other HTs have management contracts and franchises in addition to master leases. In a master lease, the owner (i.e. HT) leases the hotel to an operator in return for a pre-defined fixed or variable rent. In a management contract, the owner engages an operator to run the hotel and receives the profit/loss from hotel operations. In a franchise, the owner runs the hotel using the franchisor's brand and receives the profit/loss from hotel operations. Thus, when the hospitality industry is in a recession, master leases will be less impacted. See Not All Hospitality Trusts Are Created Equal for more details.

The remaining HT that has not reported its full-year financial results is ARA US HT. It is due to report results this coming Wednesday, before market opens. How much will its asset devaluation be, and will it be required to carry out a rights issue?

As at Sep 2020, its aggregate leverage ratio is 43.0%. A 14% devaluation will bring this ratio to the regulatory limit of 50%. It is already in breach of loan covenants but has obtained a 12-month waiver from the banks from Apr 2020 till Mar 2021.

Not only that, its cash balance is also running low. As at Sep 2020, its cash balance is only USD19.6M. This is a drop from USD45.2M in Dec 2019, USD22.0M in Mar 2020 and USD21.5M in Jun 2020. On 18 Dec 2020, it announced that it had obtained USD10.0M in unsecured revolving credit facilities to partially refinance operating expenses. 

Will ARA US HT carry out a rights issue? Considering the potential asset devaluation, low cash balance and breach of loan covenants, my opinion is that it will. 

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Sunday 17 January 2021

Should First Reit Be Given a Second Chance?

First Reit had been a good investment for me over the years. It had provided good distributions regularly and also some capital gains. The reason I sold it away was because its Debt-to-Equity ratio had exceeded my comfort zone of 50% or less. For investments that I do not have time to monitor regularly, it is best that their debts are low in the first place.

Last year, First Reit's share price had been dropping since the COVID-19 outbreak and the announcement by its sponsor, Lippo Karawaci (LPKR), to restructure the master leases of the hospitals that it lease from First Reit. The low share price attracted my attention, but when First Reit announced that the rents would be paid in Indonesian Rupiah (IDR) instead of Singapore Dollars (SGD) in future, I was no longer interested. Having the rents paid in IDR instead of SGD would subject it to foreign exchange risks. Not only that, the assets would be devalued in line with the depreciation of IDR while the liabilities would continue to be in SGD. This would lead to a sharp drop in Net Asset Value (NAV). This was exactly what happened to another REIT with Indonesian assets, Lippo Malls Indonesia Retail Trust, when IDR depreciated sharply against SGD in 2013. First Reit, however, was not affected then as its rent revenue was pegged to SGD instead of IDR. See A Tale of 2 Indonesian REITs for more details.

Arising from the lease restructuring, First Reit's revenue in FY2019 will drop from SGD115.3 mil to SGD77.6 mil. 73% of this revenue (SGD56.7 mil) will be paid in IDR. NAV will also drop from $1.00 to $0.52. Leverage will correspondingly rise from 34.5% to 47.9%. In addition, lenders are uncomfortable with the sustainability of First Reit's capital structure and decided to only refinance SGD260 mil out of the SGD400 mil loan, of which the first tranche of SGD196.6 mil will mature on 1 Mar 2021. First Reit has proposed a 98-for-100 rights issue at a heavily discounted price of $0.20 to bridge the funding gap of SGD140 mil. Post rights issue, NAV will drop to $0.36 while leverage will drop to 33.9%.

While I do not own First Reit, my family has it. Thus, a key question we have been discussing is whether to subscribe for the rights and give First Reit another chance. Will it be throwing good money after bad, or will it be a rare opportunity to invest more money in a REIT that had provided good, regular distributions for the past 13 years?

As part of the lease restructuring, the Base Rent for hospitals leased to LPKR and Metropolis Propertindo Utama (MPU), a related company to LPKR, will be reset from SGD92.2 mil in FY2019 to IDR613.1 bil (equivalent to SGD56.7 mil at an exchange rate of SGD1:IDR10,830) in FY2021. The Base Rent will increase annually at a rate of 4.5%. In addition, there will be a Performance Based Rent pegged at 8% of the hospitals' Gross Operating Revenue. The rent payable will be the higher of the Base Rent and the Performance Based Rent, on an asset-by-asset basis.


Although the rents for the Indonesian hospitals will be paid in IDR instead of SGD in future, the Performance Based Rents are likely to provide some upside. Fig. 1 below shows that the revenue of Siloam International Hospitals, which leases the hospitals from LPKR, MPU and First Reit as the end user, has been increasing since 2011.

Fig. 1: Revenue of Siloam Hospitals International

Siloam also reports the revenue of its major hospitals in its annual reports. Fig. 2 below shows the total revenue and rent paid by LPKR to First Reit for hospitals which revenue data is available from FY2014 to FY2019.

Fig. 2: Revenue and Rent Paid to First Reit for 6 Hospitals

The figure shows that the revenue in IDR has increased at an annual rate of 12.2% from FY2014 to FY2019. When converted to SGD, the revenue has increased at an annual rate of 10.4%. Over the same period, IDR has depreciated against SGD by an average of 1.6% annually. In contrast, the rent paid to First Reit has stayed constant.

Assuming revenue in IDR in FY2021 recovers to the same level as FY2019 after COVID-19 and continues to grow at an annual rate of 10% from FY2021 to FY2035, the Base Rent and Performance Based Rent in IDR will be as shown in Fig. 3 below.

Fig. 3: Projected Base & Performance Rent in IDR

From Dec 2006 when First Reit was first listed till now, IDR has depreciated against SGD at an average rate of 4.3%. Assuming this historical depreciation rate continues, when converted to SGD, the Base Rent and Performance Based Rent in SGD will be as shown in Fig. 4 below.

Fig. 4: Projected Base & Performance Rent in SGD

Based on Fig. 4, the projected Base Rent in SGD will largely stay flat as the annual rent increase of 4.5% barely outstrips the historical IDR depreciation rate of 4.3%. Performance Based Rent in SGD is projected to exceed the Base Rent in 2031. It is projected to reach SGD73.3 mil in FY2035 when the leases expire, 20% short of the existing Base Rent of SGD92.2 mil in FY2019. If this revenue growth materialises, it will provide some upside to the Distribution Per Unit (DPU) in the last 5 years of the 15-year leases. 

Without the revenue growth, DPU will be around 2.59 cents immediately after the lease restructuring and rights issue. Maintaining the DPU at this level requires other risks not materialising in future.


There are plenty of risks with this investment. The first and foremost is whether LPKR and MPU will continue to face financial difficulties and default on the rents payable to First Reit. If that is the case, all bets are off. Its Indonesian assets which are leased to LPKR, MPU and Siloam, including those not subject to the current lease restructuring, comprise 95% of its assets post-restructuring. These assets will be significantly impaired. First Reit will likely default on its loans.

The second risk is the currency mismatch between its assets of which 81% are valued in IDR and loan liabilities which are in SGD. This is the same problem encountered by Lippo Malls when IDR depreciated sharply against SGD in 2013. It is important to monitor whether First Reit will take steps to minimise the currency mismatch by converting the SGD loans to IDR loans. Entering into forward contracts to hedge the IDR receivables into SGD is another option, but there is a limit to the no. of years you can hedge. Hopefully, there is no sharp depreciation around the time loans mature and First Reit enters into discussions with banks for refinancing.

The third risk is that after the current SGD400 mil loan has been refinanced with the rights issue, there remains another SGD100 mil loan due in May 2022. The concern is whether First Reit is able to refinance this loan in full. If it is unable to, there is risk of another rights issue. 

However, I am not too concerned with this loan. The existing SGD400 mil loan was a syndicated loan from OCBC while the SGD100 mil loan was from OCBC and CIMB jointly. The new SGD260 mil loan to partially refinance the SGD400 mil loan is also from OCBC and CIMB jointly. That means that the 2 banks have considered First Reit's ability to repay the SGD100 mil loan when they decided to offer the new SGD260 mil loan to First Reit. My guess is when it is time to refinance the SGD100 mil loan, both OCBC and CIMB will come together again.

Having said the above, the ability to refinance the SGD100 mil loan depends greatly on whether there are any other adverse developments affecting First Reit's ability to collect rent from its assets, such as whether LPKR's and MPU's financials continue to deteriorate further, or whether there is a sharp depreciation in IDR that is unhedged.

The fourth risk is there is a SGD60 mil perpetual securities that is due to reset its distribution rate on 8 Jul 2021. Usually, companies will choose to redeem the perpetual securities and issue new ones to replace them. However, given First Reit's financial conditions, it will likely not redeem the perpetual securities when the distribution reset date comes. Non-redemption does not constitute default. Furthermore, given the low interest rate environment, the distribution rate will likely be lower after reset. The current distribution rate is 5.68%. The distribution rate will reset to 5-year SGD Swap Offer Rate (SOR) + 3.925%.

Distribution on the perpetual securities is also discretionary. Non-payment of distribution does not constitute a default. However, distributions on the Reit units will need to be stopped. The annual distribution on the perpetual securities is SGD3.41 mil.

The fifth risk is besides the 14 Indonesian hospitals that are subject to lease restructuring, there are other assets whose leases are due to expire. The lease on Sarang Hospital will expire on 4 Aug 2021. The current annual rental is USD0.7 mil. Although there is an option to renew for another 10 years, likely it will be renewed at a lower rental rate. The hospital was purchased for USD13.0 mil in 2011. The latest appraised value is only USD4.6 mil in 2020, which suggests lower rental rate going forward. First Reit has also flagged that there will be upcoming capital expenditure, and further marked down the value to USD3.1 mil.

As mentioned in last week's blog post on What Siloam's Financial Reports Can Tell Us About First Reit's Lease Restructuring, there is another Indonesian hospital which is leased directly to Siloam which could be subject to lease restructuring or lower rental when the lease expires in Dec 2025. The annual rent for this hospital is SGD4.2 mil.

The sixth risk is that after the lease restructuring, the leases of the 14 Indonesian hospitals will be extended to Dec 2035. Fig. 5 below shows the new lease expiry profile.

Fig. 5: Revised Lease Expiry Profile

An unintended consequence of this lease extension is that there is now a concentration of lease expiry.  66% of all leases by GFA will now expire in Dec 2035 instead of being fairly distributed. If First Reit is not able to buy new properties to diversify the geographical, tenant and lease expiry concentrations, there will be another round of concern when Dec 2035 comes near.


The lease restructuring is a painful exercise for existing shareholders. However, there are silver linings in the form of higher rents through Performance Based Rent towards the end of the 15-year leases. Nevertheless, even if the restructuring and rights issue go through smoothly, there are still road bumps and risks down the road for First Reit.

Should First Reit be given a second chance? I cannot advise you what you should do, but for us, we are inclined to give it a small second chance. We will monitor how First Reit manages the risks identified above, and if it does well, increase the chance given to it.

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Sunday 10 January 2021

What Siloam's Financial Reports Can Tell Us About First Reit's Lease Restructuring

On 28 Dec 2020, First Reit dropped a bombshell by announcing a major rights issue at a heavily discounted price. This caused the share price to dropped significantly. The main reason is the proposed restructuring of master leases that First Reit have with Lippo Karawaci (LPKR) and Metropolis Propertindo Utama (MPU). First Reit leases hospitals to LPKR and MPU which in turn lease them to Siloam International Hospitals. The proposed lease restructuring would reduce the Base Rent of LPKR-leased hospitals from SGD80.9 mil to SGD50.9 mil and that of MPU-leased hospitals from SGD11.3 mil to SGD5.8 mil. These represent a reduction of 37% and 49% respectively.  Not only that, the rents will be paid in Indonesian Rupiah (IDR) instead of Singapore Dollar (SGD) in future. As a result of the reduced revenue, First Reit's lenders have decided to only refinance SGD260 mil out of the SGD400 mil term loan, of which the first tranche of SGD196.6 mil will mature on 1 Mar 2021.

To sweeten the deal, the restructured master leases would include a fixed rental escalation of 4.5% per year, instead of 2 times Singapore's Consumer Price Index (CPI), but capped at 2% per year. In addition, there will a Performance Based Rent pegged at 8% of the hospitals' Gross Operating Revenue. The actual rent will be the higher of the Base Rent and Performance Based Rent. 

Siloam is listed on the Indonesia Stock Exchange, hence its financial reports are publicly available. As the Indonesian hospitals are all leased to Siloam as the end user, and we can cross check the information from Siloam's financial reports to understand better the proposed lease restructuring.

Siloam's Annual Report for Financial Year 2019 documents the rent that Siloam pays to LPKR and MPU for the hospital leases. See Fig. 1 below. For the 14 hospitals that are subject to lease restructuring, Siloam paid a total of IDR156.8 mil to LPKR and MPU in FY2019. In contrast, the total existing and proposed commencement Base Rent paid by LPKR and MPU to First Reit is IDR997.6 mil and IDR613.1 mil respectively. The rent paid by Siloam is only 15.7% of the existing Base Rent and 25.6% of the proposed commencement Base Rent. This shows that post-restructuring, LPKR and MPU are still subsidising Siloam's rent and/or topping up First Reit's revenue. Since the hospital leases are not revenue neutral to LPKR and MPU even after lease restructuring, there is a risk that LPKR and MPU could seek another lease restructuring in future.

Fig. 1: Siloam's Rent to LPKR and MPU as % of Existing & Restructured Base Rents 

Siloam's annual report also documents the Gross Operating Revenue (GOR) generated at some of its major hospitals. See Fig. 2 below. Pre-restructuring, the GOR as a percentage of existing Base Rent ranges from 7.5% to 40.7%. Post-restructuring, the GOR as a percentage of proposed commencement Base Rent ranges from 6.7% to 14.8%. For hospitals which data is available, the weighted GOR is 18.7% of existing Base Rent and 11.6% of the proposed commencement Base Rent.

This information also tallies with the information provided by First Reit during the investor dialogue on 7 Jan 2021. To a shareholder question, First Reit replied that the proposed Base Rent in aggregate is in the range of 10% to 15% of the GOR for LPKR-leased hospitals in FY2019.

Fig. 2: Existing & Restructured Base Rents as % of Hospital Revenue

Under the proposed lease restructuring, the actual rent will be the higher of the Base Rent or Performance Based Rent, which is pegged to 8% of the GOR, on an asset by asset basis. Based on the financial performance of the hospitals in FY2019, a slightly higher rent could be expected from a few hospitals, namely Kebon Jeruk, Surabaya, Purwakarta and Sriwijaya. However, take note that this is based on the financial results in FY2019, which does not include the impact of COVID-19. COVID-19 has affected the hospital revenue significantly as patients defer their visits to hospitals to avoid exposure to COVID-19.

Amid the uproar regarding the proposed lease restructuring for 14 Indonesian hospitals, one other Indonesian hospital is actually not subject to lease restructuring. The hospital is Lippo Cikarang. This hospital is leased directly from First Reit to Siloam. Siloam's annual report also shows that it is paying much higher rent on this hospital compared to those on the other 14 hospitals, i.e. there is no rent subsidy and/or top-up by LPKR and MPU. 

A check on the history of the lease of this hospital shows that the hospital was acquired by First Reit in Dec 2010. At the time of purchase, the hospital was purchased from and leased back to a subsidiary of LPKR. Some time from then till now, Siloam acquired the subsidiary. Hence, Siloam is paying rent on Lippo Cikarang directly to First Reit, unlike the other 14 hospitals.

The key question to the lease restructuring is what are the true market rents for the Indonesian hospitals? Is it close to the rent paid on Lippo Cikarang which is comparable to the existing Base Rent of the other 14 hospitals, or close to the proposed commencement Base Rent of the 14 hospitals? If it is the former, the proposed lease restructuring is disadvantaged to First Reit as it will now receive below-market rent. If it is the latter, LPKR and MPU have been topping up the rent for First Reit's benefit and the restructuring might be more equitable to all parties, although painful for First Reit. It also suggests that Lippo Cikarang might have to undergo a lease restructuring at some time in future.

Siloam's annual report also shows the net profit at its major hospitals. See Figs. 3 and 4 below. Take note that the net profits are based on the rents Siloam paid to LPKR and MPU and not the top-up rents paid by LPKR and MPU to First Reit.

Fig. 3: Revenue and Profit at each Hospital (Part 1)

Fig. 4: Revenue and Profit at each Hospital (Part 2)

The figures show that the net profit at Lippo Cikarang is the lowest among all the major hospitals. Its net profit margin is only 1% of revenue. This is likely due to the high rent that Siloam pays to First Reit. The operating expense is 96% of the gross profit. In contrast, the same ratio for the other hospitals ranges from 38% to 81%, with a weighted average of 50%. A hospital that has similar revenue and gross profit as Lippo Cikarang is Purwakarta. The operating expense is 55% of gross profit and net profit margin is 10%. The information does suggest that the existing Base Rent might be unsustainable for LPKR, MPU and Siloam, and some lease restructuring might be necessary.

By right, the hospitals are very secure assets to ensure Siloam fulfils its rent obligations. Termination of the leases would lead to Siloam not being able to continue its business, which is a very serious implication. However, this does not apply to LPKR and MPU, as they have other businesses besides Siloam's business. Also, using Lippo Cikarang as an example, Siloam is not making much profit from the hospital. If First Reit insists on LPKR and MPU fulfilling their rent obligations, there is some probability of them breaching the lease agreements, as there is not much profit to be made anyway. At some point in time, LPKR, MPU and Siloam will seek a restructuring of the leases to be more sustainable. This includes Lippo Cikarang, which, while not subject to lease restructuring currently, is due for lease renewal in Nov 2025.

Another key question of this lease restructuring is whether LPKR and/or MPU will seek another restructuring if they continue to encounter financial difficulties in future, since they have already sought one now. It is very difficult to answer this question as very few persons can tell how LPKR's and MPU's businesses will perform in future. However, using Lippo Cikarang as an example, by reducing the Base Rent to a more sustainable level, there is more money left on the table to keep LPKR, MPU and Siloam from walking away.

The proposed lease restructuring is a very painful exercise for First Reit's shareholders who have been accustomed to it paying good distributions regularly. However, based on the information gleaned from Siloam's financial reports, it suggests that the rents that First Reit collect from LPKR, MPU and Siloam might not be sustainable. Reducing them to a more sustainable level might be a more equitable outcome for all parties in the long run.

This episode shows that investing in REITs is not a buy-and-forget activity. It also shows the importance of knowing your customers well. 

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Sunday 3 January 2021

Will Suntec Reit Carry Out a Rights Issue?

It is the new year already, and in another 3 weeks' time, REITs will start to report their financial performance. For REITs with December as their Financial Year-end, they will also have to update their property valuations. With COVID-19 having caused significant changes to the way people live, work and shop, one of the key risks to REITs during this period is whether property values will decline significantly. This could lead to breaches in Aggregate Leverage limits, leading to rights issues at unfavourable prices.

One of the REITs that caught my attention is Suntec Reit. It owns offices, retail spaces and part of the convention centre in Suntec City. It also owns part of One Raffles Quay, Marina Bay Financial Centre and 9 Penang Road (formerly known as Park Mall). In recent years, it has diversified into Australian properties. 2 weeks ago, it bought a 50% stake in 2 office buldings (Nova) in London. The acquisition was fully funded by debts and perpetual securities. Post-acquisition, the Aggregate Leverage limit would rise from 41.3% as at 30 Jun 2020 to 43.5%. An Extraordinary General Meeting was held on 4 Dec 2020 to seek shareholders' approval for the acqusition. One of the questions that shareholders asked was "what is the level of Aggregate Leverage Ratio (ALR) the board would be comfortable with?". Suntec Reit's reply was "the target ALR is between 40% to 45% with the appropriate interest coverage multiples". Thus, although REITs are allowed to raise their ALR to 50%, Suntec Reit would not be comforable if the ALR were to rise above 45%.

In the latest business update for 3Q2020, Suntec Reit reported that the committed occupancy for its Singapore offices dropped from 99.1% in 4Q2019 (pre-COVID) to 98.1% in 3Q2020, while that for the Singapore retail spaces dropped from 99.5% in 4Q2019 to 93.4% in 3Q2020. Footfall in Suntec City Mall is down by 53% in 3Q2020, although tenant sales are down by only 21% over the same period. The occupancy for retail spaces is more greatly affected as people work from home and as travel restrictions and safe distancing measures limit the number of exhibitions held at the convention centre. If you have not been to Suntec City for a while, you should visit the row of shops where "llao llao" is (at Level 1, near the entrance of Esplanade MRT station), to witness the impact on retail occupancy.

Over at its Australian properties, the committed occupancy for offices dropped from 97.8% in 4Q2019 to 94.0% in 3Q2020. The occupancy figure was dragged down by a new office buiding (21 Harris St) acquired in Apr 2020, although there is rent guarantee on vacant spaces for its Australian office buildings. For retail spaces, the committed occupancy dropped from 92.8% in 4Q2019 to 91.7% in 3Q2020.

As at Dec 2019, the total value of its properties was $10,204 mil. By Jun 2020, the total value is estimated to have increased to $10,446 mil, contributed by the AUD$295 mil acquisition of 21 Harris St, but offset by a fair value loss of $66.6 mil on Suntec Singapore (convention centre). Aggregate Leverage as at end Jun before and after acquition of Nova was 41.3% and 43.5% respectively.

For 3Q2020, the URA Property Price Indices for Office and Retail Spaces show there is a Year-on-Year decline of 8.4% and 0.7% respectively. Applying these drops in value to the Singapore offices and retail spaces, the total value of the properties would have dropped by 4.1%, leading to Aggregate Leverage increasing from 43.5% to 45.4%, which is just above the target range for Suntec Reit.

Given that the Aggregate Leverage is above the target range of 40% to 45%, it is possible that Suntec Reit could carry out a rights issue to bring down the Aggregate Leverage to 40% or below. Lowering the Aggregate Leverage to 40% would mean raising approximately $580 mil in cash, equivalent to $0.21 per existing share (e.g. 1-for-7 rights issue at $1.44 per share).

Alternatively, since the Aggregate Leverage is only slightly above the target range, the REIT manager could opt to receive its fees in units of Suntec Reit instead of being paid in cash. It could also allow shareholders to opt for scrip dividends instead of cash dividends. This would reduce the Aggregate Leverage over time.

In conclusion, Suntec Reit's Aggregate Leverage has been increasing prior to COVID-19. With the acquisition of Nova that is fully funded by debt, it has increased further. Any revaluation loss during the annual revaluation exercise would likely tip the Aggregate Leverage over the target range that Suntec Reit is comfortable with. To lower the Aggregate Leverage, Suntec Reit could carry out a rights issue, or allow its REIT manager and shareholders to be paid in units instead of cash for their fees/ dividends.

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Sunday 20 December 2020

Possibly The Worst Time to Invest – 6 Years On

This year's blog post on the same series comes out later than usual, as I wanted to see how the rest of 2020 would pan out for my passive portfolios. In fact, my plain vanilla passive portfolio has just past the 7-year mark while my spicy passive portfolio is 5.5 years old.  You can read more about them in The Passive Portfolio and The Anti-Fragile Portfolios.

In Mar this year, the unrealised profits of my 2 passive portfolios dropped by nearly half. Prior to Mar, my plain vanilla portfolio had an unrealised profit of 57.7% since inception while my spicy portfolio had unrealised profit of 54.8%. Almost half of that profit accumulated painstakingly over 5-6 years vapourised in just 1 month! Is that it, the crash that I had been waiting for in the past 5-6 years? Would stock prices revisit the lows during the Global Financial Crisis in 2007-2009? Looking back at the lost profits in Mar, I wondered if I should have rebalanced and locked in some of the profits in Feb while the Dow Jones Industrial Average reached a new high (yet again, for the past 6 years). 

No, stocks did not go into an unrelenting free fall. 5 months later, by Aug, the value of the 2 passive portfolios recovered to their highs in Feb. This time round, I carefully considered whether I should rebalance out of the equity funds into fixed income funds. But the rules that I set for rebalancing at the start of the portfolios had not been reached. The rules call for rebalancing whenever allocation to the equity portion reaches either 62% or 78% (i.e. +/-8% margin from the initial allocation of 70% to equities and 30% to fixed income). Equity allocation for the plain vanilla portfolio reached only 73% while that for the spicy portfolio reached only 77%, just a tad shy of the rebalancing trigger. In the end, I decided to stick to my original rules and not rebalance.

The portfolios dipped slightly in Oct, but recovered after the US presidential elections in early Nov. To-date, the 2 portfolios have reached new highs. Unrealised profit on the plain vanilla portfolio is 65.2%, while that of the spicy portfolio is 62.6%. I am glad that I had not tinkered with my rebalancing rules when the portfolios recovered to their Feb highs in Aug. To-date, neither portfolio has reached the rebalancing threshold, with equity allocation for the plain vanilla portfolio at 74% and that for the spicy portfolio at 77%.

COVID-19 is a major public health crisis, with significant economic impact on many sectors such as aviation, hospitality, tourism, retail, etc. Stock markets sold off sharply in Mar, but thanks to the massive fiscal and monetary responses from governments around the world, stock markets have recovered from their steep declines in Mar to post new highs. We are still not out of the woods yet, as vaccination from COVID-19 would take many months to complete, and there are reports of mutation of the COVID-19 virus. Nevertheless, this episode shows that we should not stop investing because we are worried of market crashes, so long as there are good defence mechanisms in the portfolios to manage them. 

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Sunday 15 November 2020

Banks' Operating & Financial Metrics Explained

Recently, the 3 local banks reported a better set of results than expected. Banks have a unique set of operating and financial metrics that are different from other industries and their financial statements cannot be analysed based on the usual metrics. This blog post attempts to explain the various metrics used in banks' financial statements. I will use DBS' financial statements as examples for the metrics, but they are applicable to the other 2 banks.

Net Interest Income

At the core of a bank's operations is its business of taking short-term deposits and making long-term loans. Banks charge higher interest rates for the loans and pay lower interest rates for the deposits, thereby profiting from the difference in interest rates. This difference is known as the Net Interest Margin (NIM). The higher the NIM, the more profits the bank generates from its lending operations. In the last 6 months, the NIM of banks have come off steeply as the US Federal Reserve lowered interest rates sharply to stave off an impending recession caused by the COVID-19 pandemic. For DBS, its NIM has dropped from 1.86% in Dec 2019 to 1.53% in Sep 2020.

Many factors affect the NIM. One of them is the Loan-to-Deposit Ratio (LDR). This ratio indicates how much deposits are lent out as loans. The higher the LDR, the more loans are made from the deposits. However, it is never a good idea to lend out 100% of the deposits, because if depositors were to withdraw money from the bank at short notices, the bank would have to find other sources of funds to replace them. These alternative sources of funds are usually more expensive than customers' deposits. Due to the COVID-19 recession, depositors have flocked back to the safety of the 3 major banks. For DBS, its LDR has dropped from 89% in Dec 2019 to 83% in Sep 2020 as it receives more deposits than it could loan out.

Another factor is the Current Account Savings Account (CASA) Ratio. Banks obtain their funds from current accounts, savings accounts, fixed deposits, bank bonds, shareholder equity, etc. This ratio describes the percentage of deposits that are from current and savings accounts, which have the lowest cost of funds among all funding sources.Thus, the higher the CASA ratio, the lower the interest rate paid to depositors and the higher the NIM would be. For DBS, the CASA ratio went up from 58.9% in Dec 2019 to 69.5% in Sep 2020. This is likely due to the low interest rates offered on fixed deposits, which discourage depositors from renewing their fixed deposits. 

Credit Costs

Although banks profit from the Net Interest Income, there are also loans that might potentially go bad and have to be written off, which reduces the lending profits. The key metric is the Non-Performing Loan (NPL) Ratio. This ratio describes the percentage of loans that might potentially go bad. Note that this ratio reflects the total amount of outstanding NPLs at a snapshot in time and not new NPLs incurred during the reporting period. For DBS, the NPL ratio has largely stayed constant, from 1.5% in Dec 2019 to 1.6% in Sep 2020.

How banks deduct losses from bad loans is by setting aside allowances in the income statement. Note that these allowances do not necessarily mean that the bad loans are irrecoverable. If the economy recovers and the companies do well again, the bank could write-back the past allowances made, thereby increasing the profit in future reporting periods.

There are 2 types of allowances -- general provisions and specific provisions. General Provisions (GP) are for potential bad loans in the industry as a whole, while Specific Provisions (SP) are for bad loans of specific companies. For example, retailers are facing significant challenges from e-commerce and COVID-19. Banks might set aside more general provisions for loans to retailers. On the other hand, Robinsons' closure means that banks that are exposed to it have to set aside more specific provisions for loans to Robinsons.

In recent years, banks have adopted the Expected Credit Loss (ECL) model, which requires banks to estimate the expected amount of credit losses from the loans. There are 3 stages in the ECL model. ECL Stages 1 and 2 correspond to GP while ECL Stage 3 corresponds to SP.

For 3Q2020, DBS set aside $236M in GP and $318M in SP. As a percentage of total loans on an annualised basis, the SP credit cost is 0.31% or 31 basis points. The GP credit cost works out to be 23 basis points.

Thus, for 3Q2020, DBS made NIM of 1.53%, but had to set aside credit costs of 0.31% in SP and 0.23% in GP. After deducting the credit costs, DBS made 0.99% from its lending operations.

From another perspective, DBS' NPL ratio is 1.6%, which is close to the NIM of 1.53%. In other words, the Net Interest Income that DBS makes in 1 year is nearly sufficient to write off all the existing NPLs.

Allowance Reserves

The GP and SP set aside in each reporting period go to the allowance reserves. When the loan eventually cannot be recovered, the loan amount is deducted from the reserves. There is no further impact on the income statement.

There is another reserve known as Regulatory Loss Allowance Reserve (RLAR). Allowances for RLAR are set aside from retained earnings instead of from the income statement, i.e. profits are not reduced by the amount set aside for RLAR, unlike GP and SP. However, there is no free lunch. When the loan eventually cannot be recovered, the loan amount is deducted from RLAR and from the income statement.

Together, the GP and SP reserves and RLAR form a pool of allowance reserves to cover Non-Performing Assets (NPA). NPAs are similar to NPLs, but include other NPAs in the banks' non-lending businesses, such as wealth management, brokerage, etc.. The (Total Allowance & RLAR)/NPA Ratio indicates the percentage of NPAs which is covered by the total allowance reserves. For DBS, this ratio is 107% in Sep 2020, which means that all NPAs are fully covered by the reserves. If this ratio is less than 100% and if all NPAs were to be irrecoverable, any shortfall will have to be deducted from the income statement. If this results in a loss, it will reduce the bank's capital, which might affect the stability and liquidity of the bank (see next section). Thus, the total allowance reserves provide a cushion for bad loans before the income statement and bank's capital are impacted. Having said the above, there is no requirement for the ratio to be above 100%, since not all NPAs will end up being irrecoverable.

Some NPAs are secured by collaterals. For these loans, banks could take over and sell the collaterals to recover the loans. Hence, there is a corresponding ratio that considers only unsecured NPAs. This is the (Total Allowance & RLAR)/Unsecured NPA Ratio. For DBS, this ratio is 200% in Sep 2020, which means that the allowance reserves are sufficient to cover unsecured NPAs by 2 times. The high ratio helps to cushion instances whereby the collaterals are worth less than the loan amount.

Stability & Liquidity

Banks are systematically important to the economy and failure of a bank could lead to disastrous consequences. To guard against such scenarios, banks are required to have sufficient capital reserves to absorb loan losses. This is measured by Capital Adequacy Ratios (CAR). Capital can be classified as Tier 1 or Tier 2, with Tier 1 being more reliable than Tier 2. Tier 1 capital comprises share capital and audited retained earnings, while Tier 2 capital comprises unaudited retained earnings and general loss reserves. CARs are measured by dividing the specific tier of capital over Risk-Weighted Assets (RWA). Different types of loans have different risks (e.g. secured/ unsecured), and RWA considers the likelihood of the assets going bad.

The most important CAR is the Common Equity Tier 1 (CET1) Ratio. This ratio is most keenly watched by investors, as it has implications on the amount of dividends the bank can declare. If the CET1 ratio is too low for regulators' comfort, regulators could ask the bank to stop dividends so that earnings could be retained to build up the CET1 capital. Similarly, banks could also raise capital via rights issues.

In Sep 2020, DBS' CET1 ratio is 13.9%, which is above the bank's target ratio of 12.5% to 13.5%. For reference, the last time DBS carried out a rights issue was in Dec 2008, at the height of the Global Financial Crisis (GFC). Its Tier 1 CAR then was 10.1%. Post-issuance, the Tier 1 CAR rose to 12.5% in Mar 2009.

The GFC saw governments stepping in to rescue major banks that were at risks of failing. Since then, regulators have introduced 2 additional measures to ensure that banks would not fail again. The Liquidity Coverage Ratio (LCR) measures how much High Quality Liquid Assets the bank has to meet estimated total net cash outflows over a 30-day stress scenario. The Net Stable Funding Ratio (NSFR) measures the amount of available stable funding relative to the amount of required stable fuinding. The LCR and NSFR measure the short-term and mid/long-term resilience of the banks respectively and must be above 100%. For DBS, the LCR and NSFR are 135% and 123% respectively in Sep 2020.

The Leverage Ratio measures the amount of loans relative to the bank's equity. It is similar to the Debt-to-Equity ratio for other industries. For DBS, the leverage ratio is 6.9 times in Sep 2020.

Other Ratios

Other ratios include Return on Assets (ROA) and Return on Equity (ROE). These ratios should be familiar with investors since they also apply to other industries. Another ratio is the Cost-to-Income Ratio, which measures how efficient the bank is in controlling costs relative to income. Some banks also report the Non-Interest Income to Total Income Ratio, which measures how much income the bank generates outside its lending business. A higher ratio means that there is great diversity in the income sources.


This blog post explains the operating and financial metrics that are relevant to banks. With this information, hopefully investors will be able to understand the financial performance of banks better.

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Sunday 14 June 2020

Things Don't Look Good for Retail Landlords

The massive sell-down in Mar brought many REITs to rare, multi-year lows. This re-ignited my interest in REITs, as I have been out of them for many years due to their increasing debt levels and decreasing yields. However, I passed up the opportunity while I analysed what could be the impact of COVID-19 on REITs. Despite the massive government interventions, things do not look good for retail and F&B companies. And when tenants struggle, their landlords will also suffer. In this blog post, I will examine the potential impact of COVID-19 on 2 retail companies and 2 F&B companies.

Before we begin, it is good to recap what are the measures the government has taken to cushion the impact on retail and F&B companies. 

Wage Support

Through 4 extraordinary budgets, the government will provide support to wages via the Job Support Scheme (JSS). The level of wage support varies across industries. The JSS will last for 10 months. For the first 2 months, it will cover 75% of $4,600 of wages of all local employees for all companies. The 75% support level will continue if companies are not allowed to operate during the gradual lifting of Circuit Breaker, until Aug. For the remaining months, the wage support will be as shown in Fig. 1 below.

Fig. 1: JSS Support for Remaining Months

Thus, both retail and F&B companies will get the following wage support:
  • 3 months of 75% wage support (assuming they are allowed to reopen in Jul)
  • 7 months of 50% wage support
This translates to 48% reduction in annual wage costs for FY2020 (assuming that all wages of employees are at $4,600).

Rental Relief

In addition to wage support, the government has also implemented measures to help companies cope with rental costs. The Government will provide property tax rebates and cash grants equivalent to 2 months' rent for qualifying commercial properties and 1 month's rent for industrial and office properties for Small and Medium Enterprises (SMEs) with annual turnover of less than $100M. On top of that, the government also passed a law requiring landlords to waive 2 months' rent for commercial properties and 1 month's rents for industrial and office properties for SMEs that have seen a significant drop in their monthly revenues. The total amount of rental relief for SMEs in commercial and industrial/ office properties is summarised in Fig. 2 below.

Fig. 2: Rent Relief for SMEs

Thus, retail and F&B SME companies will get up to 4 months of rental relief, translating to a 33% reduction in annual rental costs for FY2020.

Revenue Hit

COVID-19 has stopped people from shopping and dining out, either because of government-mandated lockdowns or fear of contracting the virus. It is anyone's guess how soon people will go back to their normal lifestyles after shops and F&B outlets are allowed to operate. China is the first country to exit the lockdown and provides the first glimpse of how consumers would react in a post-COVID world. Figs. 3 and 4 below from Capitaland Retail China Trust's (CRCT) investor conference in May shows that shopper traffic is only picking up gradually after the end of the lockdown. Year-on-year, total shopper traffic and tenants' sales in 1Q2020 declined by 37.6% and 42.5% respectively.

Fig. 3: Shopper Traffic at CRCT Malls in 1Q2020

Fig. 4: Tenants' Sales at CRCT Malls in 1Q2020

For the revenue hit on retail and F&B companies, I assume the following:
  • 3 months of closure during Circuit Breaker: 0% revenue
  • 2 months of gradual re-opening: 50% revenue
  • 7 months of recovery: 80% revenue
This translates to a 45% decline in annual revenue for FY2020. Will retail and F&B companies survive this kind of harsh business conditions? Let us take a look at 2 retail companies and 2 F&B companies.

Retail Companies

Company F

Company F is a barely profitable retail company. In FY2019, it generated net profit of $0.2M. See Fig. 5 below for its income statement for FY2019.

Fig. 5: Company F's Income Statement for FY2019

It is insightful to note that of the gross profit of $64.7M, staff costs ($21.4M) take up 33% of the gross profit and rental costs ($22.3M) take up another 34% of the gross profit. In total, staff and rental costs take up 68% of gross profit. It is no wonder that the government had to act quickly to relieve the pressure of staff and rental costs on companies!

Applying the estimated declines in revenue, staff and rental costs above (plus some other assumptions for other costs), Company F might see its net profit turn from positive $0.2M to negative $5.4M. See Fig. 6 below for the computation.

Fig. 6: Estimated Impact of COVID-19 on Company F

As at end FY2019, Company F had cash of $7.8M. The estimated loss of $5.4M is equivalent to 69% of its cash and 10% of its equity.

Company C

Company C is a fairly profitable retail company. In FY2019, it generated net profit of $17.7M. Applying the same analysis as Company F, Company C might see its net profit reduced from $17.7M to $9.1M. See Fig. 7 below for the computation. Company C will likely have no problem going through the COVID-19 situation.

Fig. 7: Estimated Impact of COVID-19 on Company C

F&B Companies

Company S

Company S is a barely profitable F&B company. In FY2019, it generated net profit of $0.8M. See Fig. 8 below for its income statement for FY2019.

Fig. 8: Company S's Income Statement for FY2019

Like retail companies, staff and rental costs take up a large portion of the gross profit of F&B companies. Staff costs ($14.3M) take up 43% of gross profit and rental costs ($7.9M) take up another 24% of gross profit. In total, staff and rental costs take up 66% of gross profit.

Applying the same analysis, Company S might see its net profit turn from positive $0.8M to negative $2.6M. See Fig. 9 below for the computation. The estimated loss is equivalent to 32% of its cash and 27% of its equity as at end FY2019.

Fig. 9: Estimated Impact of COVID-19 on Company S

Company J

Company J is a fairly profitable retail company. In FY2019, it generated net profit of $10.9M. Applying the same analysis as Company F, Company J might see its net profit reduced from $10.9M to $1.9M. See Fig. 10 below for the computation. Company J will likely have no problem going through the COVID-19 situation.

Fig. 10: Estimated Impact of COVID-19 on Company J


We have run through the estimated impact of COVID-19 on 2 retail and 2 F&B companies. Staff and rental costs consistently take up around 2/3 of gross profits. When there is no or poor business due to government-mandated lockdowns or fear of contracting the virus, the impact on the bottom lines of retail and F&B companies is very significant. As in all crises, stronger companies with leaner cost structures and/or significant retained earnings will be able to weather the storm while weaker ones will end up in losses, despite the extraordinary government interventions. 

The companies I analysed above are all listed companies. How about unlisted companies? Would they have stronger financials than listed companies? Some food for thoughts.

Last week, Department of Statistics released the retail and F&B sales figures for Apr 2020. Fig. 11 below shows that retail sales declined by 13.3% in Mar (before Circuit Breaker) and 40.5% in Apr (during Circuit Breaker) on a year-on-year basis. Almost all sectors were impacted, with the exception of Supermarts & Hypermarts, Mini-marts & Convenience Stores, and to some extent, Computer & Telco Equipment.

Fig. 11: % Changes in Retail Sales

Fig. 12 below paints a similarly bleak picture for F&B sales, with a decline of 23.6% in Mar and 53.0% in Apr on a year-on-year basis. No F&B sector escaped the decline.

Fig. 12: % Changes in F&B Sales

Lastly, Fig. 13 below shows the tenant mix at Frasers Centrepoint Trust's Malls.

Fig. 13: Tenant Mix at Frasers Centrepoint Trust's Malls

F&B accounts for 38% of Gross Rental Income. Fashion takes up 14% while Beauty & Health accounts for 11%. All these sectors will be impacted by COVID-19. The only sector that has a roaring business during COVID-19, Supermarts & Hypermarts, contributes only 5% of the Gross Rental Income.

In conclusion, COVID-19 has resulted in a very challenging business environment for retail and F&B companies. When tenants struggle, landlords will also suffer. Things do not look good for retail landlords.

P.S. I am vested in Capitaland.

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