Thursday, February 21, 2019

Is Tenant Concentration A Risk To Your Reits Portfolio?

Following my last article which I wrote on Ireit Global, there’s been a good amount of discussion from readers regarding the concern on tenant concentration that surrounds Ireit’s leasing activity over the past couple of years. 

I am here to provide my own thoughts based on my working knowledge and a good balance discussion of both the advantages and disadvantages which I see and will use several case studies on it.

The tenant concentration concern has been brought up several times during the AGM and the management has also taken steps to abate the concern when they bought the Berlin property in order to “diversify” their tenets of tenants spread across their 5 portfolios. 

But there's more to that reason alone.

Here are my further thoughts:

1.) David vs Goliath 

Ireit Global is a relatively “small” Reit which has a market cap of less than $1b. 

In fact, as of 31 Dec 2018, their 5 portfolios combined has a market appraised valuation of around € 500m, which translates to about S$770m. 

These buildings combined, adds up to less than 1 OUE Downtown which OUE Commercial Reit recently bought for S$908m, which works out to be at $1,713 psf and has a remaining land tenure of 48 years. 

If we compare the size of Ireit against the bigger leader of commercial Reit, e.g Capitaland Commercial Reit (CCT) or OUE Commercial Reit (OUECT), they are similar to the analogy of David vs Goliath.

CCT and OUECT size of assets are at least 4-5x bigger and this lead them to have a capacity to “diverse” their tenants selection at a much larger spread amongst their many buildings.

Another way to look at this is vis the net lettable area.

Ireit’s overall asset portfolio has a net lettable area of 200,609 square meter, which translates to about 2,159,337 square feet. 

If we take bigger MNCs tenant who employs tens of thousands of employees into their premises, such as the likes of Singtel or DBS in our local blue chip analogy, the total lease out area would require almost at around 1.2m square feet, which took up 50% of the overall Ireit’s net lettable area.

This is what happens with the case on Deutsche Telekom and Deutsche Bund, which took up 51.9% and 34% of the overall concentration mix on Ireit’s portfolio, which brings about the concern to investors.

The percentage looks big because the overall net lettable area of Ireit is small. 

When they eventually expands the size of their AUM, the concentration mix of tenants will get lower.

This is natural.

If we think about it, it'll be weird on the other hand if say a big company like Deutsche Telekom comes to you wanting more space for their businesses but the Reits manager declined simply because they want to diversify their tenant mix.

Unlike retail which has reasons to diversify the tenant mix (i.e you cannot possibly have all full F&B concentrated for instance), leasing activity in commercial requires much lesser specifics on tenant requirements.

2.) Quality vs Quantity 

That brings us to the next question and that is quality over quantity.

The quality of the tenants you get would make a big underlying difference to what you are going to get in terms of the risk. 

The idea is to get high quality tenants and diversify as much as possible but if that is not possible, then the next priority would be to quantify quality over quantity.

The biggest underlying risk to a landlord apart from making sure the occupancy level is filled up would be a default on non-payment. 

If the tenant concentration is a small SME that might go bust anytime, then as landlord you might need to even think twice about renting it to them. 

You might have remembered a case back in 2016 and 2017 where NK Ingredients Pte Ltd defaulted on their payment to Soilbuild Business Space Reit. 

NK Ingredients Pte Ltd was the sole tenant for 2 Pioneer Sector building and one of the top tenants (5.8%) for Soilbuild back then. 

In the case of Ireit, while there are still likelihood that Deutsche Bund or Deustche Telekom might default on their payment, the probability is much lower. 

In this regard, the quality of the tenant concentration mix prevails as a solid quality blue chip tenant in Germany.

If they default, chances are we will see much more default occurrence by the smaller companies.

The problem as in the case of Ireit, is when your big tenant wants to reduce their space because of their business needs, for e.g to downsize or streamline certain operations.

The Munster campus is one good example, where they vacated one floor and the occupancy drops to 93%.

The challenge for them now would be to find a tenant who is willing to occupy only one space floor.

This is likely to be smaller tenants with possibly higher risk.

3.) Negotiation during renewal phase

The biggest challenge (and also reward) when you have such a big concentration of tenant is how you negotiate during the renewal phase and I think this is something I have learned quite a bit in my working knowledge handling such cases in the recent months. 

The catch with the Europe and London standard leasing practice is that the lease tends to be signed over a long number of years, usually minimally between 7 to 10 years. 

So once the contract is signed by both parties, the next few years are going to be a breeze in terms of your WALE and occupancy. 

The downside of having such a long lease however is you might miss out on the rental reversion when the rental market picks up, assuming there are no variable rental escalation. 

But this is looking both ways, so you might end up in favorable or unfavorable position.

Typically, during the negotiation process, the landlord would also try to maintain the notional occupancy rates (which includes rent, services and facility management) similar to what the general market offers. 

The negotiation comes in the rent-free period. 

Typically, the standard rent-free period in Singapore is 1 month free for a 1 year long lease. 

I think this is what happens in the HK market as well.

In Europe, the standard rent-free period usually stretches to 24 months free for a 10 years lease. 

In UK, because of Brexit and there's plenty of uncertainties right now, you might even get an option clause to break.

The variable portion in the rent-free period used to be the key driver for landlords to make the negotiation because it is used to be kept secret and confidential but since the introduction of IFRS16, companies are required to account for these off-balance sheet items and report this cashflow difference in their book. 

Take Sabana Reit for instance, in their most recent quarterly results, the management managed to renew their leases with some of the tenants by providing a higher rent-free period. This resulted in a higher occupancy and longer WALE but lower comparable net property income year on year.

At the end of the day, it's a variable that the property manager has to decide.

You either get occupancy or you get your high rental yield but usually it's unlikely to be both, unless you are at the peak of your super cycle.

Final Thoughts

I hope the above gives sufficient perspectives on how to look at tenant mix concentration and the process thought when landlords comes into negotiating their lease renewal with their tenants. 

As much as possible, commercial tenants tend to be sticky for as long as the notional occupancy rates offered are competitive against the market as it will cost companies a huge sum of money for reinstatement and relocation, not to mention relocating all their data centers with them, assuming that is held in the same building. 

Concentrations can bring about as much risk/reward as diversification and it is usually not that straightforward.

Thanks for reading.

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  1. Small commercial reit - go for quality concentration.

    Big commercial reit - can go for diversification.

    Retail reit - can go for diversification as "shoppers" need some variety.

    Does it work this way?

  2. Thanks for sharing detailed information on these different types of REITs. I agree concentrations can bring about as much risk/reward as diversification.

  3. Great information found here on Reits Portfolio !!! I'll be enchanted to greatly help due to what I've learns from here.I like the quality of your blog.
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