SINGAPORE (June 11): Jill Smith, the vivacious CEO of Manulife US REIT’s manager, appears eager to explain that the REIT is very important to its sponsor Manulife, and also why she announced aggressive growth plans in February this year.
“We’ve been described as [the jewel in Manulife’s crown]. We are pretty important,” she says at a recent breakfast meeting.
In April, Manulife US REIT announced plans to acquire two office buildings from Manulife. These are 1750 Pennsylvania Avenue NW, Washington, DC (Penn) for US$182 million ($242.8 million); and Phipps Tower (Phipps), an office building at 3438 Peachtree Road, Atlanta, for US$205 million. These acquisitions come hot on the heels of two acquisitions last year — 500 Plaza Drive in Secaucus (Plaza) for US$115 million from a third party, and 10 Exchange Place, Jersey City (Exchange) for US$313.2 million from Manulife.
Manulife US REIT’s assets under management (AUM) had already doubled last year from US$777 million at its IPO in 2016 when it listed with three properties from Manulife — Figueroa in Los Angeles, Michelson in Orange County and Peachtree (on Peachtree Street) in Atlanta.
“[The properties] have not been groomed specifically for the REIT but they’ve gone through this very stringent process that Manulife puts properties through,” Smith says. They used to be part of Manulife’s general account. For instance, Figueroa was developed by Manulife for a life policy portfolio. “Manulife has made every effort to think of the REIT first, particularly with the Exchange, Penn and Phipps,” Smith says.
The REIT is part-funding the two latest acquisitions with a preferential equity fund raising (EFR) to raise US$197.2 million through an issue of 227.93 million units at a ratio of 22-for-100 to unitholders at 86.5 cents apiece. It is planning to obtain three- and five-year mortgages on the properties at a blended cost of debt of no more than 4.3%.
Last November, Manulife US REIT raised US$208 million from a 41-for-100 rights issue at 69.5 cents apiece to part-fund the acquisition of Exchange.
DPU growth paramount
The general principle is to grow to expand the REIT’s distribution per unit, Smith says, adding that the objective was to “fortify the portfolio against [whatever] headwinds there might be in the economy in the US and in markets in general”.
To be sure, seven buildings in a portfolio makes for a stronger REIT instead of just three. The REIT is geographically diversified, and has a presence in four very different states. Hence, if the economy in one state turns down, the REIT still has properties in other areas that can stabilise its DPU.
The tenant base has also diversified. After the acquisition of Penn and Phipps, Manulife US REITs will get two new tenants, the US Department of Treasury with 4.2% of the enlarged portfolio, and United Nations Foundation with 3.7%. Both these organisations are tenants of Penn along with the US Chemical Safety Board and the United States Postal Service.
“We started with quite a concentrated portfolio, and it [is] common sense to want to diversify your tenants and location. We bought two properties in Atlanta and two in New Jersey [since IPO],” Smith says.
On the other hand, she reveals a fund manager asked her why she would want the REIT to “sprawl all over the US and not concentrate efforts in a couple of areas”.
Manulife is able to do so as its property management is cast right across the country, she explains. “They have the skills to manage across America. We’ve got 600 people. It’s pretty compelling to keep growing.”
In February this year, Smith announced that the REIT planned to double its AUM to US$2.6 billion (from US$1.31 billion) in the next two years.
“Of course, there is an argument on the speed of the growth and how we can get there. We felt that we should make a statement in February to give people an idea of how fast we want to grow. We’ve always ‘caveated’ that there isn’t a perfect size. We can only grow towards that target in a logical and sensible way, or it would damage all that we’ve built up,” Smith explains.
Navigating interest rates
When Manulife US REIT’s manager was formulating its growth strategy, interest rates were relatively tame despite rising from their lows. “We were fortunate in the first [year after listing] to have the glacial rate rise,” Smith acknowledges.
Now though, the US Federal Reserve is believed to be considering a rate rise this month, and two more later in the year, making for four rate rises in 2018 instead of two or three. Unemployment in the US is at 3.8%, a 60-year low. In addition, its trade war with allies in the European Union, Canada and Mexico, as well as with China could raise producer prices. Inputs to US manufacturing are likely to rise because of the tariffs. This would raise the inflation rate in the US, prompting action from the Fed.
“You’ve got very tumultuous markets caused by this political uncertainty. You’ve got the 10-year Treasury surging above 3% and then slumping back below. It’s a trader’s paradise right now,” Smith observes.
But that is not necessarily good for REITs in general, and particularly for REITs with a growth objective. Since the acquisition of Penn and Phipps is being part-funded by EFR, it is not immediately DPU-accretive.
Ideally, Manulife US REIT’s manager had planned for the acquisition to be part-funded with perpetual securities, which the Monetary Authority of Singapore recognises as equity for the purposes of a REIT’s debt-to-asset ratio. However, market volatility during the roadshow meant that core equity through an EFR was the safer option.
“What worries me is, of course, interest rates going up but we don’t really know the pace at which they are going up,” Smith cautions. REITs have to “look through” this noise and work out the best capital structure for themselves.
“We would like to use alternative ways of funding. We would like to [avail ourselves] of the credit market. We would like to give our investors something of a rest. They’ve been extremely loyal,” Smith says. “We can’t always do what we want to do, so we must take our opportunities when we can. If we’re closing a deal, we have to take notice of where the rates are.”
The best capital structure for Manulife US REIT, according to its head of investor relations Caroline Fong, is to have 50% to 60% of core equity. If bond markets allow, 35% to 40% should be debt, including bonds, and perpetual securities should be no more than 5% to 10%.
Perpetual securities are increasingly seen as a last resort. In a recent briefing by the REIT Association of Singapore, both its outgoing and incoming presidents acknowledged that there is a cost to perpetuals, which is higher than medium-term notes and bank loans. In the overall situation, it is better to manage the capital structure with a higher gearing level than resorting to perpetual securities, they said. The reason perpetual securities are in demand by some REITs is because most REIT managers are constrained by the regulatory debt ceiling of 45% and are unable to compete with the private market for assets.
Size has its advantages
Large REITs with strong sponsors have obvious advantages over their smaller peers. Liquidity and REITs with market capitalisations of over US$1 billion are considered for inclusion into indices. In turn, passive funds that track these indices would need to invest in these larger REITs.
Acquisitions are also easier for large REITs. A bigger Manulife US REIT would perhaps have been able to fund Penn and Phipps with an overnight placement, which would have made the acquisitions DPU accretive. Under the general mandate, REITs can issue up to 20% of their units outstanding. Overnight placements are rarely dilutive, and they are done with smaller discounts to their volume weighted average price than preferential EFR and rights issues.
Bigger REITs also have the ability to undertake asset enhancement initiatives without affecting the stability of their DPU.
REITs also want to have as many unencumbered properties in their portfolios as possible. These are properties that do not have a mortgage at the property level. The REIT takes on debt at its level usually through a bond issuance. To do this, REITs must implement multicurrency medium term note programmes (MTNs).
Manulife announced its US$1 billion MTN in February. The REIT has not yet issued any bonds or perpetual securities because the bond markets have been volatile. The MTN is also in preparation for 2019, when the mortgage for Figueroa comes due. Smith plans to replace the mortgage with a bond if possible, and unencumber Figueroa.
A REIT with a “good” credit rating can access the debt markets at a lower cost of debt, and the highest ratings are given to REITs with unencumbered assets.
A larger REIT also has access to a wider tenant pool, as they are on the radar screens of consultants looking for properties for their clients.
Above all, Smith appears to have bought property well. All seven buildings are either Class A or trophy buildings. Although Plaza is in suburban Secaucus, it is also a Class A building. Class A buildings are defined as those with higher floor-to-ceiling height, and big windows. They are column-free and have relatively large floor plates.
“We’re aiming for Class A and trophy buildings because that is how we are going to sustain the income we get through cycles, by choosing the better-quality buildings,” she states.
Manulife US REIT’s latest acquisitions
1750 Pennsylvania Avenue, Washington DC
Penn is in the CBD of the US capital, in an area that is fully built up, and hence has no new supply. The 10-year average vacancy rate is 10.7%, the lowest in the city. Over 90% of leases by net lettable area expire in 2022 and beyond. These leases have built-in rental escalations. The weighted average lease to expiry (WALE) is 6.8 years. The building’s passing gross rent is US$48.90 psf versus market gross rent of US$500 psf.
Phipps Tower, Buckhead Atlanta
Phipps is a 19-storey trophy building built by Manulife. Trophy buildings are usually landmark buildings built with the very best construction materials and finishes. According to the description in the Manulife US REIT announcement, Phipps has a distinctive penthouse top noticeable across the Atlanta skyline and offers floor-to-ceiling window walls.
The property has a WALE of 10 years. Most of the leases have built-in rental escalations. Its passing net rent is US$22.20 psf versus market net rent of US$30 psf.
Of note is that Phipps is subject to a so-called “bonds for title” arrangement under which the fee simple title to Phipps is owned by the Development Authority of Fulton County, Georgia, which leases Phipps to a unit of Manulife US REIT. Under this arrangement, no money changes hands for the lease. After this arrangement expires in December 2020, the REIT will acquire the fee simple title to Phipps from the Development Authority for US$100 and will commence paying the full amount of real estate taxes on Phipps, which means Phipps will be assessed in a manner and amount consistent with similar commercial office buildings in the taxing area. Given the expense reimbursement structure of the leases at Phipps, the difference in real estate taxes payable following the expiration of this arrangement will largely be borne by the tenants.
