During tumultuous times, shares in all sorts of businesses in all parts of the world are indiscriminately sold off. In the process, rare opportunities always present themselves to investors with a long-term horizon, who can pick up discounted shares of stable businesses that are not materially affected by the crisis du jour, boosting the earnings potential and passive cashflow of their portfolios
The crisis that is decimating markets today is a highly contagious disease that happens to be a tad too lethal to be comfortably ignored the same way we (for all intents and purpose) ignore flu and the common cold. Instead, it provoked a massive human response in many countries, impacting everything from travel and retail to restaurants, manufacturing and theme parks. At times, it seems like no part of the economy is being spared.
If we look really carefully, however, it is not impossible to find examples of a business where a stock price is unfairly punished, yet fundamentals are not in the least affected by the ongoing crisis. First Real Estate Investment Trust (SGX:AW9U) - a health care real estate investment trust traded on the Singapore Exchange - is one such example.
Large discount to NAV
First REIT's market price hugged the 1 Singapore dollar level (70 cents) for most of this year to date, which is very close to its net asset value of 99.64 cents (in Singapore dollars) per share. Then, in early March, it fell off a cliff when the Covid-19 panic got going at its earnest:
First REIT operates in an industry that is as insulated from the pandemic as it gets. Not only are real estate companies' revenue generally stickier than most, since lease rates don't fluctuate often and lease terms are usually measured in years, the real estate that First REIT owns is in the form of hospitals, which are not about to experience a fall in demand anytime soon.
At the current price of 67 cents per share versus 99.64 cents per share in NAV, investors are getting a 33% discount on the appraised value of arguably the safest type of real estate in this environment.
Master lease renewal risk
First REIT mainly owns health care facilities in Indonesia, but also maintains smaller exposures to Singapore and Korea. The company is looking to further diversify its holdings geographically.
Investors should be aware of the peculiar way First REIT structured its master lease agreement in Indonesia - contrary to typical practice in Indonesia, the rents are paid in Singapore dollars, which shields First REIT, a Singaporean company, from the foreign exchange fluctuations of the Indonesian rupiah.
This may change soon, however, because the master lease is up for renewal in 2021. Given the unusual nature of how the agreement was set up initially, I believe there is a significant chance the company will be forced to ditch the currency on renegotiation.
I see this as a minor risk. The lease structure comprises of a fixed base rate plus an annual rental escalation. Under the current master lease, given it is denominated in Singapore dollars, the annual escalation is pegged at two times Singapore CPI with a cap of 2%, plus an additional variable growth component. If the master lease is renewed with the Indonesian rupiah denomination, the rental escalation will likely peg to an Indonesia inflation component rather than Singapore. And given that long-run performance of an emerging market currency is typically linked to its inflation, this risk will be largely mitigated.
And besides, First REIT is a cash cow with a large margin of error.
Compelling valuation based on owner earnings
"These represent (a) reported earnings plus (b) depreciation, depletion, amortization, and certain other non-cash charges...less (c) the average annual amount of capitalized expenditures for plant and equipment, etc."
The way REITs report under the Singapore Financial Reporting Standards makes this exercise easier relative to, say, the U.S. generally accepted accounting principles. First, one-time items such as fair value changes are easy to spot below the net income line. Second, the typical maintenance capital expenditures required to maintain the investment properties are expensed immediately as operating expenses instead of being capitalized now and depreciated later.
The main adjustment I made to the reported numbers is to normalize the income tax with the long-run tax rate of 17%. Then in order to come to earnings available to common shareholders, we need to deduct the share of earnings attributed to its perpetual security holders. The resulting owner earnings are quite stable and predictable year over year.
Approximately 10.3 cents per share gives us an earnings yield of approximately 15% at today's price. This compares very favorably to Singapore's 10-year bond yield of 1.5%, providing a significant cushion that more than compensates for any appropriate premium for equity or real estate risk, which comes at around 4% to 8% historically.
First REIT owns health care facilities and related real estate assets that are unlikely to go out of style in this environment, but its share price is being unfairly punished along with the general market, which presents long-term investors with a rare opportunity. I initiated a position this year and will be adding to it at prices under NAV.
Disclosure: I am long First REIT.
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This article first appeared on GuruFocus.