Hong Kong stocks too cheap to ignore (part 1)

Prosperity REIT (808) - 9.8% yield assuming further distribution cuts

Some basic facts:

·         Listed in 2005, Prosperity REIT owns 7 properties in Hong Kong, all located outside of Central. It labels 3 properties as ‘Grade A office’, though these are of lower quality than the city’s premier locations. 1 building is for commercial, 1 for industrial, and 2 are mixed industrial/office. In sum, gross rentable square footage is 1.3 million. In terms of revenue, the mix is 58% Grade A office, 21% industrial/office, 17% commercial, and 4% industrial.

·         The portfolio has changed little since the REIT was formed. It acquired a property in 2014, disposed of one in 2017.

·         Investment property is accounted for at estimated fair value. This results in large swings to earnings. Because FV gains/losses are non-cash, they have no impact on distributions.

·         The tenant base is diversified.

·         Leases are short duration – as of 2022, 45% expire in 1Y, 37% in 2Y, and 18% >3Y.

·         Leverage is low with net debt-to-equity at 32%. This is in contrast to US office REITs, where most large players have net debt-to-equity of 50-120%. The debt is variable rate though via swaps it has hedged a portion of the interest rate risk.   

·         The share count has expanded by ~20% since the listing as the manager has exercised its option to receive its fee in shares. Since 2021 Prosperity has annually bought back some shares, partially offsetting the gross additions.

·         It has historically paid unitholders 100% of distributable income. Distributable income is profit and add-back of non-cash items (primarily FV gains/losses on investment property and the manager’s fee). Distributable income also includes adjustments for cash interest paid and deferred taxes.

Market trends:

·         Office rents in Hong Kong peaked in mid-2019. Depending on the area, the decline from top to bottom has been 25-30%. Recent data suggests stabilization.   

·         The office vacancy rate sits at 14.9%, high by historical standards, but a couple of ticks lower from July.

·         Commercial rents peaked in early 2019 and declined 15% through spring 2022. Since then they have risen 6%.

·         Industrial seems to be faring the best of the three, though the data is less transparent.

The top-down data matches Prosperity’s revenue trends in 2022 and 1H 2023. On a YoY basis, Grade A office declined 7% and 3% in these two periods. Industrial was +1% and +4%. Commercial declined to a lesser extent than Grade A Office.

Outlook and scenarios:

·         Reading through analyst reports, seems the consensus is for another 5-10% decline in office rents in 2024. Partially offsetting this, industrial and commercial may be +5%. For Prosperity, a simple weighted average suggests -5% rental income in 2024. Recovery may be likely in 2025, assuming the office market bottoms out.

·         Overall, income available for distribution may be -17% in 2023, -6% in 2024, before recovering from 2025.

·         Assume a 20 m increase in the share count annually.

·         This suggests distribution per share of 13 HK cents for 2023 and 12 HK cents for 2024. This compares to 16 HK cents in 2022 and 18 HK cents from 2015-2021. From 2025 a recovery is likely.

Valuation:

·         To the 12 HK cents, the yield is 9.8%. Since listing it has traded on a median yield of 6.7%.

·         Price-to-tangible NAV is 0.3x.

·         A couple years out Prosperity REIT could easily be trading at HKD 2.20 (+75%), and with a couple years of distributions, the total return would be ~95%.     

Disclaimer: The information contained in this report is for general informational purposes only and does not constitute investment advice or a recommendation to buy or sell any securities or other financial products. The opinions expressed in this report are those of the publisher and are subject to change without notice. Readers are advised to conduct their own research. The publisher does not guarantee the accuracy, completeness, or reliability of any information in this report, and disclaims any liability for any losses or damages arising from the contents of the report.