SINGAPORE (Aug 20): Manulife US Real Estate Investment Trust’s (Manulife) headline distribution per unit growth for 1HFY2018 ended June 30 is not really representative of its future yield and DPU growth from its current portfolio of five Class A and two trophy buildings in the US, all on freehold land. Class A and trophy buildings are those with large floor plates, high ceilings, large windows (preferably floor to ceiling), natural lighting and other high-end specifications.

For 1HFY2018, Manulife’s DPU fell 14.2% y-o-y to 2.53 US cents because of an enlarged unit base from a preferential offering that was completed in June and only nine days of income contribution from the acquisitions of 1750 Pennsylvania Avenue (Penn) in Washington DC and Phipps Tower (Phipps) in Atlanta. As at June 30, 2018, Manulife had 1,269.9 million units in issue compared with 1,036.1 million as at March 31.

According to Manulife’s original estimates, on a pro forma basis, distributable income rises to US$47.5 million ($65.5 million) from US$46.7 million recorded for FY2017, but this sounds very modest. For 1HFY2018, Manulife reported distributable income of US$32.14 million, up 57.6% y-o-y, on the back of a 60.2% increase in revenue to US$63.67 million and a 56.6% rise in net property income to US$40.03 million.

Much of that growth has come from an increase in assets under management. The US pure-play office REIT has more than doubled its AUM size since its IPO in 2016, from US$777 million to US$1.7 billion as at June 30, by acquiring four properties. Its portfolio of Class A and trophy buildings is differentiated from that of the other US office S-REIT, Keppel KBS REIT, which has a mixture of Class A and B buildings, including campuses.

To fund AUM growth, Manulife raised US$208 million from unitholders last year, through an issue of 299.29 million new units based on a 41- for-100 rights issue at 69.5 US cents per new unit to fund the acquisition of 10 Exchange Place for US$313 million. Earlier this year, Manulife raised a further US$197.16 million through a preferential equity fundraising exercise to fund the US$387 million acquisition of Penn and Phipps.

Organic growth a priority

With rising interest rates, Manulife is likely to focus on leasing and organic growth. “We are going to drive organic growth via rental escalations,” says Jagjit Obhan, chief financial officer of Manulife’s manager. “Our focus is to take as much organic growth as possible and, opportunistically, if some inorganic opportunity (acquisition) comes up, we will look at that.”

According to the REIT’s results announcement, 93.9% of leases by gross rental income (GRI) have rental escalation clauses. Of this, 55.4% have annual rental escalations that average 2.7%, 38.5% have mid-term or periodic rental increases, and the remaining 6.1% of the portfolio has no rental increases.

As much as 86.9% of this subset are leased to government-related entities based in Penn.

The overall Weighted Average Lease Expiry (WALE) by net lettable area increased from 5.7 years in 1QFY2018 to 6.3 years as at June 30, with 60.4% of the leases by NLA expiring in 2023 and beyond.

During 2QFY2018, Manulife renewed three leases — at Figueroa in Downtown Los Angeles and Exchange Place in Jersey City — with average rental reversion of 7.2%. For the remainder of this year, only 1.2% of the portfolio by GRI and 1.6% by NLA are left to be renewed.

On the other hand, a tenant has left Michelson, the REIT’s trophy building in Irvine, California. Michelson’s occupancy has dropped from 96.5% in 1QFY2018 and 4QFY2017 to 94.4% as at end-June (see Table 1).

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Michelson’s rents are somewhat higher than market rents (see Table 2). “This is a trophy building and has a market rent that is higher than normal, so when we do renew leases, there could be some price sensitivity. This is the one building in our portfolio that is over [rented] versus the rest of [the buildings near it],” explains Jennifer Schillaci, chief investment officer of Manulife’s manager. However, she adds that there are no “systemic issues” with the property and she is confident of filling the vacated space.

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Rising interest rates a double-edged sword

Rising interest rates in the US are mainly a result of higher inflation and faster growth. In 2Q2018, US GDP grew 4.1% y-o-y, the highest since 2014. Inflation is viewed as positive for rents, which are likely to rise. Hence, positive rental reversions should continue for the rest of this year, and most probably into next year. Next year, 7.9% of Manulife’s portfolio by GRI expires, and in 2020, 8.6%.

However, rising interest rates pressure riskfree rates such as the yield on 10-year US Treasuries. REIT prices trade at a yield spread above risk-free rates. As the latter rise, REIT yields also rise, leading to a dip in unit prices. No surprise then that Manulife’s unit price underperformed the Straits Times Index (see chart).

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During a results briefing on Aug 6, questions swirled around capitalisation rates. Cap rates are a ratio of a property’s net operating income to market value. Future NOI is usually an estimate, based on operational assumptions such as occupancy and rental outlook and, indirectly, interest rates.

For instance, Michelson’s cap rate fell from 5.7% to 5.1%, but its valuation remained unchanged at US$342 million. Although gross rent as at June 30 was US$50.59 psf compared with US$49.27 psf as at end-December, occupancy was lower than the 96.5% as at end-December. On the other hand, the cap rate stayed unchanged at 5.9% for Peachtree in Atlanta, but the building’s valuation rose 4.5% in six months to US$203 million as at end-June. Schillaci attributes these differences to a change in appraisers, and rental and occupancy outlook.

Supply of over one million sq ft is likely to come on stream in midtown Atlanta and in Washington DC. “In Atlanta, large buildings are being built close to ours. The largest one is approximately 60% leased to Georgia Institute of Technology. We won’t compete with that because not a lot of professional firms or law firms would want to be [in the same building],” Schillaci says. The other significant new supply in midtown Atlanta is a build-to-suit for NCR, which will be 100% occupied.

There is also supply coming up in Irvine, but Schillaci believes none of it is likely to provide strong competition for Michelson.

Manulife’s gearing of 37.3% is well below the regulatory limit of 45%. The weighted average debt maturity is 3.2 years, and debt expiry is well spread across the REIT’s seven properties from 2019 to 2023. As at June 30, 100% of the REIT’s debt was fixed-rate loans.

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In April this year, Manulife set up a US$1 billion multi-currency medium-term note programme to diversify its sources of funding. An ideal capital structure, according to an earlier interview with the REIT’s manager, comprises mainly equity, 35% to 40% debt, and a small portion — perhaps as much as 10% — of perpetual securities.

Figueroa’s US$108.5 million mortgage matures in 2019. “We had secured Figueroa’s loan at 2.5% and since then, the market has moved up by 200 basis points [bps],” Obhan says. “We’re looking at different ways to mitigate some of that increase, and one of the ways is to reduce the credit spread. We have a couple of options we’re looking at.”

The portfolio’s vacancy rate is relatively miniscule compared with the national office vacancy rate of 14.9%. Jillian Smith, CEO of Manulife’s manager, points out that the larger portfolio (compared with that at IPO) has diversified its tenant base, with no single tenant contributing more than 7.5% of GRI.

At IPO, the legal sector accounted for more than 40% of tenant exposure, but it has since fallen to 21.7% as at end-June. A fragmented tenant base should prevent a drop in occupancy, as there are no large anchor tenants that would vacate. Schillaci prefers occupancy rates to be in the mid-90s, as buildings can retain tenants during growth phases. “A 100% occupancy is not sustainable and it can only go one way. If a tenant can’t grow in your building, it will leave, so we are more comfortable with the mid-90s,” she explains.

The consensus DPU forecast for this year is 5.7 US cents, and 5.9 US cents for next year, giving forward yields of 6.7% and 6.94% respectively. UOB Kay Hian has maintained its “buy” recommendation, but with a lower target of US$1.06 versus US$1.12 previously, to reflect a 25bp rise in its risk-free rate assumption to 3.25%.

US Congressional Budget Office cautious on GDP outlook

The US Congressional Budget Office (CBO) report is probably uncomfortable reading for US office real estate investment trusts, which depend on a positive business outlook and economic growth for tenants to fill up their buildings.

CBO is expecting lower GDP growth of 2.4% in 2019 compared with its estimate of 3.1% for this year. In its August report, it said when it had completed its forecast in July, the US tariffs and foreign retaliatory tariffs that had been implemented were modest. However, since then, US President Donald Trump has raised his trade war rhetoric.

Higher tariffs on more imported products could add to inflationary pressure, which in turn would reduce the purchasing power of domestic income and increase the costs of domestic production, making the prices of US exports less competitive in international markets, CBO says. In addition, retaliatory tariffs on US exports are likely to reduce the profitability of US businesses whose products are targeted by those tariffs.

“Furthermore, heightened uncertainty about trade policy could discourage businesses from making capital investments that they might otherwise have made, because changes to trade policy affect price competitiveness in foreign markets as well as the costs associated with global supply chains,” CBO states. Recent volatility in equity markets might be an indication that such uncertainty is already taking a toll on the value of US businesses, CBO adds.

Manulife US REIT to focus on organic growth following spate of acquisitions

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