Saizen REIT@valuebuddies

The following is a compilation of forum posts mostly by d.o.g., a respected forumer on valuebuddies forum, on Saizen REIT.

In general, he isn't too optimistic about it. On a sidenote, I'm much more optimistic, and have taken the opportunity to add another 40 lots of Saizen at $0.155 during last week's selldown.

This less optimistic and very very well written and thought out post serves to act as an alternative viewpoint.



The forum thread is here: http://www.valuebuddies.com/Thread-Saizen-REIT?page=3



Printing money should cause the yen price of Japanese assets to increase. It is not clear that the actual price in SGD would change. In theory, the currency should depreciate at the rate that it is being printed. In practice, the 2 rates may not be the same, and either effect could dominate for some time.

If Japan prints money slowly enough it could pay off its debts without too much currency depreciation. But this would not please the big companies. If Japan prints quickly enough to depreciate the yen significantly, other countries could follow suit, in which case all the exchange rates revert to their previous levels since all the currencies depreciate roughly the same amount.

Also, if Japan prints money too quickly it could set off hyperinflation, where the currency depreciates faster than it is being printed. This would bring about the collapse of the economy (see: Zimbabwe). Japan is still a rich country with lots of credibility among foreign investors, so this is admittedly an unlikely scenario.

So far, Japan has chosen the safe route of a slow death via deflation.

Deflation in the Japanese real estate market has meant that property values have declined for 19 years in a row. Land values are now about half of 1980s peak values. While it is true that property prices are nearer "bottom" than in the past 36 years, it is not clear just where that "bottom" is.

For the property market to bottom out and start going up, Japan must quickly return to "normal" growth rates of perhaps 2-3% per year. Given the poor demographics, this is an uphill challenge. In the short term, anything can happen. But there do not seem to be any long term catalysts for a Japanese recovery.

Japan retains a technology edge in its exports. But the Japanese giants with this technology are investing in China. Sooner or later, their technology will be transferred, sold, licensed, duplicated or simply stolen. Then what?

A lot of technology was transferred in the past to Singapore. But Singapore was too small to ever pose a threat, and the government also played nice in protecting intellectual property rights. China's manufacturing capacity far surpasses Japan's, and the Chinese government has shown little interest in protecting foreigners' intellectual property.

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The Economist table referenced measures over/undervaluation with respect to "long-run average of price-to-rents ratio". A more recent table is here:

http://www.economist.com/node/17311841?s...d=17311841

According to the Economist, as of 21 Oct 2010, Japan is 35% undervalued. But the Economist's measure fundamentally assumes that the long-run average of price-to-rent ratio is rational. We know that Japanese real estate was overvalued in the 1980s. That means the price-to-rent ratio was very high i.e. not rational. For the last 19 years, property prices have been declining. Assuming rents were stable, the price-to-rent ratio has been declining. That would make Japanese property undervalued - if you assume the inflated price-to-rent ratios of the last 19 years were in fact rational.

The reality is that rents in Japan have been falling. Property prices have fallen even faster. However, Global Property Guide claims that as of Apr 2010, gross apartment rental yields in Tokyo were 5.1-6.2%. This doesn't look like a deeply undervalued market to me. Rather, it indicates how bad the bubble was, that after 19 years the yields are still not all that great.

Given the poor economy, I think rents are more likely to fall than rise. A property where the rent is falling is inherently worth less than the current yield implies, since future rents are lower before you even factor in the time value of money. So Japanese property may not really be undervalued. It could be a value trap: you buy cheap, and it gets cheaper, because returns (rents) keep going lower.

As usual, YMMV.

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Current and potential Saizen REIT unitholders might find the following document interesting:

http://www.reinet.or.jp/docs/outline/toh_20100401.pdf

It is the Japan Real Estate Institute's survey of real estate investors. It is done every April and October. The April issue shows the latest cap rates and expected rent changes for various types of properties in different cities. Some things stand out:

1. Office rent expectations are basically flat or declining. The only areas expected to see rent growth are a couple of wards in Tokyo, and even then the most aggressive expectation is for rents to go up 3% in 5 years and 5% in 10 years(!).

2. Residential units in Tokyo are valued at a cap rate of about 6%. Outside Tokyo it's 7-8%.

The picture is basically one of stagnation. No meaningful economic growth expected for the next 10 years, as measured by office rents. And residential units yielding 7-8% are no bargain - this is the market rate.

Since Saizen specializes in residential units in secondary cities, on a 100% cash pass-through basis it should yield at least 7-8% if all its properties are generating free cash. Saizen's last distribution was 0.26cts, for 2 months' cashflow. Annualized, this is 1.56cts, but adjusted for warrant dilution it is 1.04cts. Against the current price of 16cts, the yield is about 6.5%.

The YK Shintoku portfolio generates no cash, but only accounts for 9% of NAV. Assuming it gets refinanced, it might add 10% to distributions. That gets us to about 1.15cts, or a yield of about 7.2% on a diluted basis. This is what a normal, undefaulted portfolio of residential properties outside Tokyo should yield.

In other words, the price of Saizen REIT already assumes that the YK Shintoku portfolio will be refinanced i.e. there is no discount for risk. We also know that recent lease renewals have been at lower levels, 4.3% less. So future distributions from Saizen will be lower.

At the current price, unitholders are getting a current yield of 6.5-7.2% on a diluted basis, and this yield will decline in the future. There does not seem to be any margin of safety.

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9.75% is on an undiluted basis. Since the warrantholders are in the money (exercise price: 9cts) it is likely that most if not all the warrants will be converted. The warrants represent 50% of outstanding units, so upon conversion there will be 1.5 times as many units. Same cash distribution dividend by more units = lower DPU. 9.75% / 1.5 = 6.5%.

The warrants expire on 2 Jun 2012. Realistically speaking, there will probably be only 3 more distributions before the warrants expire/convert: for the periods ending 31 Dec 2010, 30 Jun 2011 and 31 Dec 2011. If the managers are nice, they may do an interim distribution for the 5 months to 2 Jun 2012.

So at most, a unitholder today will get 9.75% yield for 23 months, and after that he will get 6.5% - assuming that distributions (on an absolute basis) remain flat.

Given the flat or declining outlook in the real estate investor survey, future renewals and thus distributions will probably be lower. Saizen's recent renewals were 4.3% lower, even worse than suggested by the real estate investor survey.

It would be sensible to expect future distributions (in absolute yen terms) to be at least 3-4% lower than the most recent distribution. This is before factoring in any decline in the Japanese yen, which looks increasingly likely given the domestic debt load and exporter pressure on the government.

There are plenty of arguments out there about why the yen is likely to depreciate in future. I would be very interested to read a coherent counter-argument on why the Japanese yen should appreciate in future. If nobody can come up with anything that supports the strong-yen argument, maybe it would be wise to expect that the weak-yen scenario is likely to happen i.e. Saizen REIT unitholders should expect lower future distributions in SGD terms.

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I checked the 4Q10 statements. It turns out that a lot of the cash generated was used to pay down debt. So the 1.56 cents of annualized distribution is not a correct measure of the actual pass-through distributions. For FY10: Distributable Income: JPY 1,366,947 Units Issued: 953,203 Implied DPU @100% payout: JPY 1.434 JPY / SGD: 62.46 DPU (SGD): 0.0230 So we actually do get approximately the 2.4 cents that a 6% yield on 40 cents of NAV would imply. On a fully diluted basis: Units: 1,429,805 DPU (SGD) @100% payout: 0.0153 Assuming they eventually stop paying down debt and resume normal distributions, it seems that Saizen REIT can eventually pay out 1.53 cents, about a 9% yield on a fully diluted basis at the current price of 15 cents. The policy is to pay 90%, so the likely future yield is about 8%. Does this now make Saizen REIT a good investment? Certainly, it's not as bad as I initially thought. I would still hesitate to say that there is a big margin of safety. I actually think the more interesting detail is that Argyle Street Management (chaired by V-Nee Yeh, co-founder of Value Partners) has a deemed interest of 16% and has appointed 2 of its officers (Chan Kin and Angie Li) to the board. That alone would probably merit further study. ASM is now the biggest owner (and thus the biggest loser if Saizen REIT blows up) so they should have done a good amount of homework.

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I looked through the IPO prospectus. It turns out that V-Nee Yeh / Argyle Street Management was present from the start - he / they helped create Saizen REIT to begin with. At IPO, ASM owned over 11%, and the 2 Japan High Yield Funds (managed by the REIT manager) owned 44%.

The 2 High Yield funds have since distributed their holdings to their investors, leaving ASM as the biggest owner. ASM has exercised all its warrants, so we can safely assume that they believe Saizen REIT is worth more than 9 cents on a diluted basis (duh). But 9 cents is a long way off from the current price of 16 cents. So caveat investor.

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