The lowdown on shipping trusts

[d.o.g.]

I understand that the lease for industrial properties tend to last for 40-60 years while retail properties last for 99 years. Does this means that their assets are depleting as well albeit at a much lower rate or can they renew the leases with minimal capex ? I understand that Indonesian leases can be renewed at extremely low prices according to First REIT CFO and they have renewed leases for 2 plots of land since listing with minimal capex. Is it the same for local properties ?

In Singapore industrial land is leased for 30 years with the option to extend for another 30 years. After that the land reverts to the state. Since Singapore is only 45 years old, no land has reached the end of its second 30-year lease so nobody knows what will happen.

For commercial properties the standard lease term is 99 years but some leases have been successfully topped up to a fresh 99-year lease by paying a premium.

Governments put a limit on leases to ensure that the lessees play ball e.g. create jobs, pay taxes. The threat of non-renewal is a useful bargaining chip, especially when the lessee has already invested significant amounts of money into buildings and fittings.

All things equal, governments would prefer to renew a lease. But conditions - and governments - change. Land that was in a deserted area may now be in the heart of the business district. The shopping mall may be in the way of the train station. And so on. A pro-business government may be replaced by one that is less friendly. A clean government may be replaced by a corrupt one.

When the decision is made to take back a lease the government has a few choices. It may be nice and pay compensation. If it is smart it will time its plans to coincide with lease expiry so that no compensation need be paid. If it is ruthless it will simply take back the lease by eminent domain. In Singapore the equivalent is the Land Acquisition Act which allows the government to take any land they please if it is to be used for the public good. And if you piss off the government they can rezone your precious mall as a road, THEN take it (and pay you the road's market value of $1 for it).

While the prudent thing to do is to factor in the depreciation of a leasehold property, in practice, unless there are less than 30 years to go it doesn't make much difference. If there are 50 years on the lease, the annual depreciation is 2% which is dwarfed by movements in market value. But with 20 years or less to go, the annual cost is 5% which cannot be ignored.

Ships only last 25 years on average so from day one you lose 4% annually. If you own one for long enough you will still see the swings in market value through the business cycle. Astute operators buy new ships towards the end of a bust, when prices are lowest, and shrink their fleet during the mid-late periods of a boom, when prices are highest. That is how shipping fortunes are made - by trading ships, not operating them.

Is KGT operating as a self liquidating trust ?

Yes. If you study the KGT prospectus you will notice that no money is being allocated towards renewing the leases in future. In condominium parlance, there is no sinking fund. So when the last lease expires in 2034, that's it - the trust's value goes to zero. The trust has a 90% payout policy which won't allow it to accumulate a meaningful sum. Sometime before the first lease expires in 2024 it will have to do a fundraising to renew that lease, which of course means the unitholders end up giving back all the "income" they received in previous years. Same thing applies for the other 2 leases expiring in 2029 and 2034.

I also noticed that quite a number of Western shipping companies tend to pay high yielding dividends.
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Granted that their dividends will fluctuate since shipping rates are always on the move, are such companies better than a shipping trust as a yield investment ?

Dividends are a function of profits, which are a function of freight rates, which are beyond the owners' control. So investing in a shipping company for the yield is not a good idea - the dividend will vary from year to year and may even be omitted in bad years. If the company is not well managed it may also call for a rights issue in a crisis (see: NOL).

If you are after yield it would be better to look in industries where revenues and profits are fairly steady.

[newborn1000]

I understand what dog is implying, but using depreciation to calculate is technically wrong.........

Because, the depreciation is on the current fleet which is bought years ago based on past prices.......eg, $30m

Strictly speaking, the cost of replacing the fleet is equal to today's/future prices which maybe vastly different.........eg, $10m $50m

But dog is right on one thing, sooner or later it will need to call for rights issue.......

[Nick]

Ships only last 25 years on average so from day one you lose 4% annually. If you own one for long enough you will still see the swings in market value through the business cycle. Astute operators buy new ships towards the end of a bust, when prices are lowest, and shrink their fleet during the mid-late periods of a boom, when prices are highest. That is how shipping fortunes are made - by trading ships, not operating them.

I noticed this trend as well - the only way for a shipping company to truly make above average returns is to time its entry and exit in the very volatile shipping cycle well. An average company would employ the 'dollar cost averaging method' by ensuring that its balance sheet is always ready to seize any opportunity. Hence this company would be purchasing ships in both bear and bull cycles. Eventually it will balance out the cost and returns. A poor company on the other hand will over-commit at the wrong end of the cycle and might end up with a very expensive vessel servicing a low margin contract which will put pressure on its weak balance sheet. If they are still alive, they will go begging for rights.

Locally, most shippers can be termed as the 'normal shippers'. Mercator Lines announced another vessel acquisition today (third one this year) to increase its owned fleet to 14 vessels. Courage Marine (net cash position) has been expanding its DWT capacity aggressively this year. NOL is an enigma...its too big for me to judge. Golden Ocean is another enigma - very unique way of operating. Seems to enjoy trading vessels...recently it has started to sell vessels to a US listed shipping trust for shares + cash deal. Quite an opportunistic company...guess Norwegians run their ships differently !

With regards to shipping trust, the key lies in asset returns. Buy high, charter high may yield the same profits as buy low, charter low. However the latter means less LTV risk and counter-party risk (which may lead to buy high, charter low). But shipping trust balance sheets are weak more often than not - so opportunistic acquisitions will be rare. FSLT has yet to make its first post-crisis acquisition despite raising cash in Sept 2009 so I guess bankers are not very happy with it.

Is KGT operating as a self liquidating trust ?

Yes. If you study the KGT prospectus you will notice that no money is being allocated towards renewing the leases in future. In condominium parlance, there is no sinking fund. So when the last lease expires in 2034, that's it - the trust's value goes to zero. The trust has a 90% payout policy which won't allow it to accumulate a meaningful sum. Sometime before the first lease expires in 2024 it will have to do a fundraising to renew that lease, which of course means the unitholders end up giving back all the "income" they received in previous years. Same thing applies for the other 2 leases expiring in 2029 and 2034.

I guess since its counter-parties are NEA and PUB, its yield should match that of SGS bonds hence the real yield of KGT should lie in that range.

You have made a very persuasive case of REITs being a dumping ground for property developers. Hence, there has been a recent trend to list property developer trust (latest one is Treasury China Trust) which develops its own assets for investments or sales. I noticed that financing is a key problem in this sector since business trust are paying interest today for an asset which may generate cash in the future so unit-holder distributions are never truly stable. In your opinion, does this create a better property trust model as opposed to a low growth but more stable REIT ? Whether the Management can stick to the model and make sound investments is another matter altogether !

[Drizzt]

when it comes to asset replacement costs i have a query. since like newborn says the replacement cost could be lower due to technological enhancement, it is difficult to judge right? its even more complex if the lifespan of the asset is vastly different.

take the case of Starhub, which people are saying it pays more than its earnings, thus it is eating into its assets. so it must be sinking into oblivion, but unlike trusts, it is making expenditure and replacing and the thing i see is that the equpiments have large capacity compare to those in the past, and that drives down the replacement cost. dun u think this is a factor as well?

[d.o.g.]

NOL is an enigma...its too big for me to judge.

At the top of the market, they paid a big dividend and expanded the fleet. When the crisis came they did a rights issue. Enough said.

I guess since its counter-parties are NEA and PUB, its yield should match that of SGS bonds hence the real yield of KGT should lie in that range.

The Senoko plant dominates the revenues so the weighted average life of KGT is probably somewhere between 17-20 years. Call it 20 years. That means you have to take back 5% per year just to account for your original capital. Whatever is left from that is the actual return. 20-year SGS are currently yielding about 3%. So KGT has to yield at least 5% + 3% = 8%, otherwise the investor is better off just buying the 20-year SGS, whose counterparty is the entire government and not only NEA and PUB.

take the case of Starhub, which people are saying it pays more than its earnings, thus it is eating into its assets. so it must be sinking into oblivion, but unlike trusts, it is making expenditure and replacing and the thing i see is that the equpiments have large capacity compare to those in the past, and that drives down the replacement cost.

For Starhub the key is the fixed broadband network. The replacement cost is very high because nobody wants to grant approvals to dig up roads etc to replace the fibre optic cables. Actually for Starhub they were smart and mostly used sewage lines to run the cables. But it still cost a fair bit of money.

The cables can also be upgraded by replacing the signal boosters with multiplexers which can increase capacity by as much as 160 times. So the economic value of the network far exceeds its book value. Thus the depreciation charged is not accurate and Starhub is willing to pay out cash in excess of earnings.

However this will not continue forever, because the new broadband network will carry even more capacity and has been mandated to allow many more competitors. Starhub will have to lower fees aggressively in order to compete, and its earning power and ability to pay out cash will decline accordingly. As to exactly when this will occur, nobody knows. But the writing is on the wall and investors should be prepared.

[mrEngineer]

Thanks d.o.g for sharing the wealth of knowledge. I learned a quite deal from your exchange with Nick. I am vested in Mercator Lines and are impressed in the Management team and how the business are managed. They had just received award from ICIC bank as top Indian company. Recently, the share price declined substantially and I am considering whether to add more capital on it.

However, I just would like to know whether are they are hidden risks that I might not be able to detect at my current level of investment competence. The ROE declined to 10% last year and would probably be maintaining at this level for this year given that there will no surprises in shipping rates. Given the latest additions and expansion to the fleet, I expect recurring income will rise slightly but potential catalyst is when the shipping industry upturns, it will be able to dispose the ships for a handsome profit. Their dividend are quite stable and there is strong emphasis by the Management for strong balance sheets