Fortune Real Estate Investment Trust - Proceeding with acquisition and rights issue

FRT will proceed with acquisition and rights issue: All resolutions for the proposed acquisition of the three properties and one-for-one rights issue were duly passed at the EGM held on 11 September.

One-for-one rights issue at HK$2.29: Book closure date for rights entitlement is set at 17 September 5pm. The commencement of "nilpaid rights" trading period is yet to be determined but is expected to be no later than 23 Sept. (see Table 1 for indicative timetable).

Under-gearing still better than over-paying: The three new assets would be acquired at an average net yield of 5.1%, which looks fair. We believe this acquisition is much better than previous acquisitions done by other REITs where the sponsor sells assets at a high price into the REIT and uses a combination of financial engineering and aggressive gearing to initially maintain a high yield –it only delays the pain of overpaying for assets. Fortune REIT's proposed acquisition is simple and straightforward, though the gearing level might even be considered a bit too conservative, in our view. The blended yield post acquisition would be still be high at 7.5% for FY10E and 7.3% for FY11E. Theoretically, investors could gear up externally (and buy more of the REITs) to engineer a higher yield on equity, though it may not be a viable option in reality.

Maintain OW, Jun-10 PT HK$3.4: In our previous note dated 24 Aug 2009, we had already incorporated the contributions from new assets and also the dilution from the rights issue. Our Jun-10 NPV post acquisition and rights issue is HK$3.4/share. We maintain our ex-rights PT at HK$3.4/share, which is on par with the new NPV. Our price target is based on a discount rate of 6.57% and LT growth rate of 0.4%. Risks to our PT include higher than expected vacancy rates and prolonged economic recession.

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Fortune Real Estate Investment Trust - Steady operational performance, waiting for liquidity discount to narrow

1H09 results largely in line with expectations: Fortune REIT announced a 1H09 DPU of HK$0.196, up 5.9% Y/Y, and just 1.1% below our estimate. Gearing was a healthy 25.7%. Despite the tough environment, rental income remained fairly stable in Fortune REIT’s portfolio. Investment properties were revalued up by 3.5%, mainly on cap-rate compression of around 50bp (cap rates at 5.25-6%).

We turn slightly optimistic about the retail rental market outlook: With early signs of stabilization in the retail market, and a slightly better economic outlook for 2010, we now only assume a 6% decline in FY09 spot rents and a 3% recovery in FY10 (compared to -10% in FY09 and 0% in FY10). As a result, we tweak our DPU forecast by -1% for FY09 to account for higher maintenance costs alongside some renovation projects, while we raise our FY10 DPU forecast by 6%. Our NPV also increases by 22.5% as a result of the higher DPU estimates, higher longterm growth rate (from 0.1% to 0.2%) assumption, and lower discount rate (from 7.72% to 6.95%) assumption.

Valuation still looks appealing: The stock is still trading at a clean yield of 8.3% for FY09E-FY11E, which is still high relative to other Hong Kong REITs which are trading at an average clean yield of 5.6%. We believe there is room for further re-rating of the stock in the current low-interest-rate environment. The yield spread between Fortune REIT and 10-year HK Exchange Fund notes is wide at 680bp versus its longterm average of 384bp since its listing in 2003. We believe the liquidity discount on Fortune REIT should gradually narrow.

Maintain OW, raise our Dec-09 PT to HK$4.9: We increase our Dec-09 PT by 22.5% to HK$4.9, on par with our DDM-based NPV estimate. We used a discount rate of 6.95% and a long-term growth rate of 0.2%. Risks to our PT include sharper-than-expected rental declines, higherthan-expected vacancy rates, and a prolonged economic recession.