Hong Fok Corporation: How Much Are Its Investment Properties Really Worth?
Investment properties are a common driver of asset plays in land scarce countries like Singapore and Hong Kong, which also happen to be the financial hubs of the region. Valuing investment properties is a relatively straight forward endeavour as they are usually revalued every year by professionals. That being the case, we believe a conservative value investor should still reserve their judgement over such figures. We will elaborate more, as well as the concept of investor comfort level, through our analysis of Hong Fok Corporation.
Trading at 165% MOS
Hong Fok Corporation engages in the investment, development and construction of properties in Singapore and Hong Kong. The bulk of its value comes from its investment property portfolio which makes up 84.6% of total asset value, based on FY14 figures. As these are revalued on a yearly basis, we will assume that they are fair values for now. The intrinsic value of Hong Fok would be the residual value of its investment properties after deducting all liabilities.
Based on its market capitalisation of SGD516.6m, this gives us a hefty 165% margin of safety – a likely addition to any value investor's portfolio. However, upon deeper digging, such a valuation seems a tad optimistic.
Implied Rental Yield of 2.5%
According to Note 19 of its 2014 Annual Report, Hong Fok's investment properties generated gross rental income of SGD55.3m which corresponds to a mere rental yield of 2.5%. Such a value is unwelcoming for a conservative investor who will prefer a valuation based on a high yields rather than low yields. From another perspective, a 2.5% rental yield translates to a 40x price-to-sales and the value for price to earnings (income) can only be higher. This is a cause for further investigation.
Capitalisation Rate Higher than Rental Yield
A company usually states the inputs used in valuing its investment properties. In Hong Fok's case, the valuation models for some of its properties are based on capitalisation rates of 3.25% to 3.5% (Note 8). As capitalisation rate is based on net income (rental income minus expenses), it does not make sense to have an overall rental yield that is lower than the capitalisation rate since net income is almost always lower than sales revenue (rent in this case). While this alone does not shed any light as to why rental yields are so low, it does support our hypothesis that they are abnormally low.
Restatement the Main Cause
In 2014, Hong Fok restated the value of its investment properties based on the following change in accounting policy:
In a nutshell, it consolidated the value of investment properties held under its associates because it had significantly more voting rights than any other vote holders. The management believes this gives them de facto control over the associates. This change in accounting policy resulted in an upward revision of SGD365.9m in the value of investment properties to the SGD2193.5m FY14 figure you see on the balance sheet.
Legitimacy of control aside, this directly contradicts our belief in adjusting for consolidation effects. Simply having control over an asset does not imply that all economic benefits will accrue to the majority shareholder. After adjusting for the SGD365.9m in consolidation effect, a more accurate value for the investment properties will be SGD1827.6m.
Consequently, margin of safety is significantly reduced to 94% which is still substantial. At this value, the implied rental yield is 3.0%. Although an improvement, it is still hardly a conservative figure.
What is a Conservative Valuation?
Like the answer to an exam question, this has to be the question on most peoples' minds. The most common method would be to find the average rental yields for residential and commercial properties. According to this Colliers report, Beach Road office space rent at $8.13 per square feet per month while the average value of a Grade A Beach Road office is around $2,500 per square feet. This translates to a rental yield of 3.9%, far higher than our implied rental yield of 3.0%.
Beyond that, there are two things a conservative investor can do. Firstly, it is possible for the absolute rental amount to be abnormally low, implying that the properly value is fair at a low rental yield. However, without any further insight, it would be awfully cavalier to bet on any rental reversion.
Secondly, a conservative investor can further discount the market rental yield to a higher value, one that meets his personal expectations and comfort level. In this regard, the market rental yield matters little for it is ultimately an investor's personal expectations of returns that will determine his expectations of valuations. Regardless of what the market votes, a conservative investor might only be comfortable with a 5.0% yield. It is one, he believes, will withstand the vicissitudes of markets and pessimism. It is one which provides the true margin of safety, and one which affords him the best quality of sleep. In this regard, a good value investor is one who values his sleep more than his returns. We do not believe in Greater Fools.
We have tabulated the intrinsic value and margin of safety for Hong Fok Corporation under varying rental yields valuation.
While the original margin of safety (at 169%) seems more than sufficient, the above table indicates that it is actually highly tenuous with a mere 2.0% difference in rental yields accounting for the supposed margin of safety. This behaviour can also be attributed to Hong Fok's substantial gearing which exacerbates the variance.
Rather than dictating the appropriate value for Hong Fok's investment properties, we will leave with a question – what is your comfort level?