To complicate matters, companies are assessing their office space needs as the work-from-home and work-from-office hybrid model becomes entrenched even after the pandemic. As a result, traditional offices built in the 1980s or 1990s will need to rethink the use of space, Kimble says.
US property-based Manulife US REIT (MUST) was listed here in May 2016, followed by the IPO of Keppel Pacific Oak US REIT (KORE) in November 2017 and Prime US REIT in 2019, during periods when US funds and private REITs such as Nuveen’s were sidestepping US office assets. For instance, KORE was seeded with assets divested by private REITs managed by US commercial real estate investor KBS.
Fast forward to Dec 30, 2022. On the morning of the last working day of the year, MUST alerted analysts and media to a 10.9% decline in its portfolio valuation, driven largely by a building in downtown Los Angeles that was part of its IPO portfolio — Figueroa. While the valuations of all the properties fell, none were as dramatic as Figueroa’s 33.1% decline.
“To maintain a sustainable capital structure, the manager is exploring options to reduce the aggregate leverage of Manulife US REIT,” states MUST in its Dec 30, 2022 announcement. This would include divesting of a property, stakes in properties or entire properties.
Meanwhile, Manulife, the sponsor of MUST, has pivoted towards forestry assets and is reportedly the largest investment manager of forestry assets. In December 2022, Manulife Investment Management announced the launch of Manulife Forest Climate Fund.
Because of MUST’s need to lower its gearing in relatively short order, Tripp Gantt, CEO of MUST’s manager, has indicated that its sponsor could help in MUST’s “disposition” of property. For this to materialise, an EGM is required if the “disposition” is greater than 5% of NAV.
“We are more engaged with our sponsor. We are somewhat limited on the size of the transaction and there aren’t any assets at a price low enough to stay under that EGM threshold. And we can’t sell to the sponsor at a price lower than book value so any transaction has to be based on book value,” Gantt says.
See also: SGX gives approval-in-principle to FHT to delist
Recycling capital
Divesting properties to recycle into higher-yielding, possibly DPU-accretive acquisitions is not a bad way to manage a portfolio during periods of rising interest rates. This is a path followed by several REITs.
The REITs sponsored by Mapletree and CapitaLand Investment (CLI) have undertaken divestments with monies earmarked for higher-yielding acquisitions. Elsewhere, ESR-LOGOS REIT (E-LOG) has announced $450 million of divestments to be recycled into properties with higher yields and longer land leases. Among the US REITs, both KORE and United Hampshire US REIT have divested properties.
KORE’s IPO portfolio was valued at US$829.4 million, growing to US$1.42 billion ($1.90 billion) as at Dec 31, 2022, or 1.7 times its IPO portfolio. During that period, KORE’s manager had only two equity offerings, in 2019 and 2021. In 2021, KORE acquired two properties, Bridge Crossing and 105 Edgeview, which were completed in August 2021, and divested two assets, Northridge Centre I & II and Powers Ferry, in FY2022.
Under MUST’s previous manager, MUST’s AUM (assets under management) tripled from US$777 million at its IPO in May 2016 to US$2.2 billion as at June 30, 2022. As at Dec 31, 2022, MUST’s property portfolio had receded to US$1.95 billion. The expansion was financed by a combination of equity and debt. In fact, MUST had raised equity four times with the latest placement in December 2021.
KORE’s expansion was a lot more measured than MUST’s following its IPO in 2017. As at Dec 31, 2022, KORE’s all-in average cost of debt was 3.2%. Aggregate leverage as at Dec 31, 2022 and ICR for the 12 months to Dec 31, 2022 were 38.2% and four times respectively, giving KORE a lot more wiggle room than MUST.
On the other hand, KORE probably faces similar challenges in that capex and tenant initiatives could take a toll should it acquire tenants with long leases. Still, David Snyder, CEO of KORE’s manager, is a lot more circumspect than MUST’s previous management when asked about growth.
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“In terms of the acquisition front, there’s not much out there. And if you consider prices, issuing units at that significant discount is probably not ideal. So, on the acquisition front, I don’t think for both reasons, that is something we’re going to see a lot of this year,” Snyder said in a recent results briefing.
“We sold the two Atlanta assets and actually had a small gain versus the valuations that we had in place. We made the decision in large part because they were too small and inefficient as we’ve grown. If you think about where next that [divestment] might make sense, that would take you to Sacramento, where we have another smaller and less efficient asset and is certainly one we will consider over time. And we’ve also mentioned in the past that we might consider selling 1800 West Loop at some point in time,” Snyder continues.
In FY2022 ended December 2022, KORE’s portfolio had a stable performance in the face of increasing challenges. Even then, DPU for 2HFY2022 was 2.78 US cents, 12.6% lower than 2HFY2021’s DPU of 3.18 US cents. This brought FY2022 DPU to 5.80 US cents, 8.5% lower than FY2021’s DPU of 6.34 US cents. As at Feb 8, KORE’s DPU yield is at 11.7%.
KORE’s manager is changing the way its management fee is being paid. The manager will be increasingly receiving cash for its base fee instead of units. In FY2022, the manager received 100% of fees in units in 1QFY2022, and 100% in cash from the next three quarters. This caused a larger decline in distributable income and DPU than if the comparison had been like-for-like.
Additionally, paying fees in cash — and should rental income for its properties deteriorate — would cause the interest coverage ratio (ICR) to fall. Once again, KORE’s ICR at four times leaves a decent margin even when fees will be paid in cash. Since KORE is trading at a discount to NAV, receiving the fees in units would continue to dilute the REIT.
Interestingly, Prime US REIT’s DPU for 2HFY2022 ended December 2022 declined 12.2% to 3.03 US cents and it appears that Prime REIT’s manager is distributing all of its income available for distribution. However, Prime US REIT’s 6.7% decline in property valuation was cushioned by relatively lower aggregate leverage of 42% as at Dec 31, 2022 as it had not been as aggressive on the acquisition front. Its ICR of 4.1 times is also in the comfortable region for REITs.
On the other hand, Prime US REIT will be subject to the same disadvantages in terms of tenant incentives and capex requirements as other US office REITs, which may result in Prime US REIT undertaking similar steps to MUST, such as retaining 10% of distributable income. Prime US REIT has already implemented a distribution reinvestment programme (DRP).
MUST’s options
Asked about its plans and various options under the strategic review, Stephen Blewitt, Manulife’s global head of private markets and interim chairperson of Manulife US Real Estate Management (MUSREM), replies: “As a sponsor, we are committed to working towards an outcome in the best interests of unitholders within regulatory parameters and evolving economic circumstances. We too are a significant unitholder with approximately a 9% stake in MUST.”
In November 2022, MUST’s manager appointed Citigroup as the financial adviser for its strategic review. “Together, we are exploring various options for the future. With work and analysis ongoing, it is premature to speculate on or discuss any particular actions at this stage,” Blewitt says.
Within the strategic review, nothing is off the table. That includes the sale of a property, properties or stakes in properties to third parties to raise cash; the sale of the entire portfolio; equity fund raising (EFR); sale of the manager and the manager’s stake; or the sale of a stake in a property or an entire property to the sponsor. Any such sale to the sponsor or even a third party would need to be within 10% of the latest valuations as stipulated in the Code on Collective Investment Schemes (CIS).
Dilutive EFRs have been undertaken by REITs — the most recent being First REIT in 2021 — to offset the impact of a valuation decline where loan-to-value covenants had been breached. On Feb 10, Link REIT announced a one-for-five rights issue at HK$44.2 ($7.55) per rights unit. Approximately 40% to 50% of the net proceeds will be used to repay HK$7 billion to HK$8 billion of existing debt while HK$1 billion to HK$2 billion will be used to rest revolving credit facilities, Link REIT’s management said.
On Feb 16, E-LOG announced plans to raise $300 million via a private placement cum preferential offering. The private placement, which raised $150 million, was three times subscribed, with two-thirds of the placement allocated to quality long-only institutional investors.
The $150 million preferential offering is to all existing investors. Sponsor ESR Group will “backstop” the preferential offering. Whether these EFRs, which the REITs say can reduce aggregate leverage initially and provide dry powder for either redevelopment, AEIs or acquisitions, will spur MUST to announce an EFR remains to be seen.
While Link and E-LOG have the potential to make acquisitions with their EFRs, MUST’s EFR if it undertakes one, would be primarily to reduce its aggregate leverage.
So far, MUST’s manager has stated that all its LTV (loan-to-value) covenants have not been breached. “The financial covenants in respect of the existing loans of Manulife US REIT are not expected to be breached despite the decline in valuation,” the manager said on Dec 30, 2022. On the other hand, MUST’s aggregate leverage is higher than either Link REITs (27%) or E-LOG (41.8%) as at Dec 31, 2022.
Among the options, MUST’s sponsor is believed to be examining M&A proposals where a partner or institution either takes a stake in the manager or acquires the manager completely, and provides the REIT with a pipeline in the US or Europe. While the options including the manager may dilute unitholders in the immediate term, it would ensure MUST’s longer-term survival, market watchers reckon.
One way of divesting an asset and lowering gearing would be to divest 50% or 51% of a building or many buildings to a third party while retaining 49% and continuing to manage those buildings. MUST could do this with Centerpointe I and II, two buildings in Fairfax, Northern Virginia. Fairfax is around 23km west of Washington DC and is not served by the Arlington, Virginia, metro.
DBS Group Research estimates that US$170 million in asset divestments would be required to bring gearing to slightly below 45%. Centerpointe I and II were valued at US$101 million in December 2022, down 10% y-o-y.
Of course, MUST could divest an entire building, more than one building or its entire portfolio. If it does the latter, proceeds could be returned to investors after the debt repayment. MUST’s manager is reluctant to divest at distressed levels. For MUST to remain as a listed REIT, divesting a property (or properties) that has limited upside would be the best option because at some point, MUST would be able to recycle the monies into a higher-yielding property.
Organic solutions insufficient
For 2HFY2022, MUST is paying out 91% of its distributable income while retaining the rest for general corporate purposes. “Since IPO, we have been paying out 100% of our distributions to maximise DPU payout to investors. To improve financial flexibility, we have the option in our toolkit to retain up to 10% of distributable income for general corporate and working capital purposes, including for tenant incentives,” Gantt says.
Some REITs already retain distributable income. For instance, CapitaLand Integrated Commercial Trust often retains DPU from CapitaLand China Trust and Sentral REIT. In FY2022, $10.6 million received from those two REITs were retained for general corporate purposes and working capital.
On Feb 8, in a report ahead of MUST’s FY2022 results, DBS Group Research also suggested implementing a DRP, which in itself is not without costs.
“While these measures may be able to buy MUST sometime, it may not be sufficient to bring gearing down to the more sustainable level of the 45% limit should its ICR ratio breach the 2.5x level,” DBS says of the “organic” approach of retaining cash.
Gearing vs ICR
CFOs of real estate investment managers and analysts have articulated that for REITs, ICR is more important than gearing as REITs provide returns to investors from their cash flow. And often, consultants and valuers alike have said that valuations are sometimes more of an art than a science.
During an earlier briefing on Suntec REIT’s results, Chong Kee Hiong, CEO of Suntec REIT’s manager, had indicated that the ICR is the metric that his REIT is focused on, and he is looking to divest a property to bring it above 2.5 times. This is despite Suntec REIT’s gearing being at 42.4%.
Elite Commercial REIT, with commercial assets in the UK, announced a relatively high aggregate leverage of 45.8% although its ICR is 4.6 times and with no small print.
A few REITs have announced ICRs of below 2.5 times as a result of distributions to their perpetual securityholders. In a handful of cases, REITs with ICRs below 2.5 times have aggregate levels of below 45% as perpetual securities are treated as equity.
According to Appendix 6 of the Code on Collective Investment Schemes (CIS): “The aggregate leverage limit is not considered to be breached if due to circumstances beyond the control of the manager, the following occurs: a) depreciation in the asset value of the property fund; or b) any redemption of units or payments made from the property fund. If the aggregate leverage limit is exceeded as a result of (a) or (b) above, the manager should not incur additional borrowings or enter into further deferred payment arrangements.”
This means that a decline in the value of MUST’s portfolio is not considered a breach of the aggregate leverage of 50%.
Similarly, the CIS code indicates that the minimum adjusted-ICR requirement is not considered to be breached if it is due to circumstances beyond the control of the manager. “The manager should not incur additional borrowings or enter into further deferred payment arrangements if the property fund’s aggregate leverage exceeds 45% of its deposited property and its adjusted-ICR is below the minimum adjusted-ICR requirement,” the CIS code states.
“If any of these figures are compromised, it’s not a breach according to MAS,” confirms Robert Wong, CFO of MUST’s manager.
“Both ICR and gearing are important. We are focused on getting leverage down as much as possible and maintaining operational liquidity. ICR is quite dynamic. Two-thirds of our leases (in 4Q2022) were new leases and that momentum will carry through. If we can get new leases coming in, we can get the top line up and provide support for ICR,” Wong adds.
Despite the non-breach for MUST, investors may not be comfortable with REITs, which have aggregate leverage near the regulatory ceiling, and hence the need to find a solution. Investors are rarely happy with REIT’s EFRs but that may have to be the price to pay for these structures.
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