Rentals Driven Up by Pricing Power of REITs

 

We have learned that REITs are listed companies that buy, develop and manage properties for rental income which they distribute as dividends to investors. In general, the modus operandi of a REIT is to acquire an undervalued property, redevelop it to enhance its value before leasing it out as a prized asset to a preferred mix of tenants and living on rental incomes as landlord. Their profitability therefore depends on their pricing power which they enhance, like any monopoly, by buying up many properties and monopolizing their supply. 

 

Within the retail industry, for example, many major malls in Singapore today is owned by one of the few retail REITs. CapitaLand Mall Trust alone owns 15 major malls. By owning the whole mall and many malls at the same time, a retail REIT monopolizes all the shop spaces in those malls so that anyone wanting to start a retail business there must rent the shop space from the REIT. As tenants, small retail businesses have relatively little bargaining power. REITs, on the other hand, have pricing power and are able to drive up their rental incomes. In recent years, REITs have been criticized for driving up rental excessively as a result of their pricing power.

 

The rising rentals in the malls not only shrink the room of profitability for retail shop owners but also curtailed their ability to pay higher wages to their workers. Even though malls create labour demand for retail assistants, many of these new vacancies are filled by foreign workers who are willing to work for lower wages. The influx of foreign workers thus depresses wages of Singaporeans working in the retail industry. The retail REITs, on the other hand, benefit from the low wages because their tenants can now afford to pay higher rental. Meanwhile, Government also benefits from the collection of foreign worker levy. In the end, as retail businesses inevitably pass on the higher business costs to consumers, prices of products and services also rise causing living costs to also rise in tandem.

 

The narrative above is not limited to the retail industry. Small and medium businesses (SMEs) in industrial and commercial sectors are also hit by high rentals. For example, flatted factories were, for decades, developed and rented out by Jurong Town Corporation (JTC) to local small and medium enterprises (SMEs) in the manufacturing sector. In early 2000s, however, JTC began to withdraw from the flatted-factory market at about the same time industrial REITs were emerging. JTC’s withdrawal facilitated the switchover of ownership of the flatted factories to the industrial REITs. Mapletree Industrial Trust, for example, acquired more than 60 properties from JTC in 2008 and packaged them as a REIT in 2011. Just as rentals in malls rose with the change of ownership to REITs, rentals for flatted factories also began to rise. The rise in business costs not only resulted in a fall in profitability and possibly higher rate of business failures. It also curtailed SMEs’ ability to invest for the future and to pay higher wages to their employees who were hit by rising living cost and housing costs. Comparatively, the SMEs were harder hit than the multinational companies (MNCs) by the higher rental because of their smaller scale and lower productivity.[1]

 

Over time, even rentals of properties not controlled by REITs are also pulled up. In other words, the rising tide of rentals affects all businesses needing a place to operate. 

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Rent Seeking Activities Resulting in Negative-Sum Outcomes

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In short, the emergence of the Singapore REITs (S-REITs) fundamentally changed the supply dynamics of retail, commercial and industrial property spaces. When flatted factories and industrial parks were developed by JTC, the goal of JTC was not profit but to promote industrial development in Singapore. Today most of these properties are owned by only a few highly organized institutional landlords whose sole objective is profit maximization. Supported by favourable rent-seeking regulatory framework, they have both the means and motivation to push up rental rates just as HDB pushed up prices of BTO flats to the upper limit of homeowners’ affordability using ‘market forces’.

 

Retail REITs, for example, were able to increase rental revenue even during the slowing economy in the aftermath of the Global Financial Crisis. Between 2008 and 2012, total rental revenue was rising at a rate of 5.8% annually according to property broker CBRE Group. For example, at Paragon, a mall managed by SPH REIT, rent increased by 12.4% for rental renewals and new leases between July and November 2013.

 

Moreover, most retail REIT landlords in Singapore also charge, in addition to base rent, a turnover rent set at a percentage of a shop’s gross turnover which they ascertain by having access to the revenue figures of their tenants. This privileged knowledge of retail shops’ sales information allows them to align rentals with actual business conditions of their tenants. For tenants that are doing well, the rental goes up at the time of lease renewal. On the other hand, tenants that are underperforming may not have their lease renewed. Doing so enables retail REITs to maximize their rental yields. The charging of the turnover rent, however, raises the question of fairness. Even though the REITs assume no risk in the running of the retail business, they get an inequitable share of a retail shop’s revenue in addition to the rent.

 

The high base rent and the turnover rent explain, at least in part, why retailers have trouble staying profitable and that tenant turnover in many malls is high. In contrast, Singapore's retail REITs performed very well over the decade since its genesis in 2002. CMT, for example, chalked up a total return of 130% or a compound annual growth rate (CAGR) of 9.5% since it launched in 2002 and up to 2011, despite the global financial crisis in 2008-2009. Similarly, commercial and industrial REITs also performed well riding on rising rentals afforded by their monopolistic pricing power.

 

Overall, despite its short history, S-REITs became the best performing in the world by 2012, chalking up returns of an average of 37%, twice that in the US, the UK and Japan. In terms of dividend yield, S-REITs offered 6.46%, considerably higher than the 4.93% in Hong Kong and 5.01% in Australia. Including dividend yields, Frasers Commercial Trust returned 57%; AIMS AMP Capital Industrial REIT 48%; and Keppel Land's K-REIT Asia, 46%. Four of the top 10 best-performing REITs with assets of more than US$250 million in the region are from Singapore.         

 

The sterling performance of Singapore’s REITs stands in stark contrast with slowing GDP growth, reduced profitability for firms, rising structural unemployment and stagnating wages. For a small resource-poor economy like Singapore, value is created not by extraction but by staying competitive in making products or providing services in demand in the international markets. Higher rental collected by REITs make our SMEs less, not more, competitive externally. Over time, the overall economy becomes progressively less vibrant and competitive.

 

Because the rent-seeking activities of the REITs create little additional new value for the overall economy, their gains are very much a zero-sum outcome coming at the expense of business owners and workers. There is a danger that their rent-seeking activities may progressively even lead to negative-sum outcomes in which the losses to the overall economy exceed the gains of the capital owners. This happens, for example, when the high business costs force businesses to relocate to other lower-cost locations. The net result is a loss for the overall economy in terms of GDP, tax revenue, and more importantly, meaningful jobs for Singaporeans.

 

To be fair, REITs can bring benefits to the economy. Besides increasing participation of general public in profitable real estate projects, they can also bring standardisation and best practices to the construction industry; channel foreign direct investment to kick-start economic activities (e.g. by building industrial parks) or to bridge a demand and supply gap in a housing sector; create employment opportunities for the masses; and providing quality living environment.[2]

 

But, the Government, to their credit, had been effectively playing those roles for decades. Singapore faced no dearth of capital or expertise in the development of residential housing, malls, commercial buildings, and industrial parks before the emergence of REITs. Relegating those roles to profit-driven REITs therefore has brought no significant additional values to Singapore other than driving up living and business costs.

 

Singapore has the National Wage Council (NWC) to recommend and put a lid on increases in wages which, to begin with, have already been depressed by the influx of low-cost foreign workers. Yet, oddly, we have no similar government agency to control increases in rents. So while wages are systematically depressed, rent is liberalized and priced based on monopolistic power of the REITs.