SINGAPORE (May 21): Since the beginning of the year, real estate investment trusts (REITs) have appeared to be in a rush to raise cash from private placements, perpetual securities and preferential equity fundraisings (EFRs). This came to a head on May 8, when DBS Group Holdings held a lunch event at the JW Marriott to promote Manulife US REIT, Mapletree Greater China Commercial Trust (MGCCT) — soon to be renamed Mapletree North Asia Commercial Trust — and CapitaLand Commercial Trust (CCT).

One of the attendees was put off by the tone of the Manulife US REIT presentation. It was just too bullish, the attendee said.

It has not gone unnoticed that REITs are planning to shore up their future distributions per unit (DPUs) with acquisitions. In some cases, declines in DPUs have been caused by property cycles cresting. For REITs that announced rights issues last year, their DPUs could have fallen because of the dilution. The 1QFY2018 DPUs of CCT and Manulife US REIT fell because of dilution, although the latter also blamed downward pressure on occupancies and net effective rents and a small tax charge.

Most importantly, the interest rate cycle is normalising. Rising interest rates are set to impact DPUs as interest expense rises. According to economists, the three-month Singapore Interbank Offered Rate (Sibor) and Swap Offer Rate (SOR) are already rising. “The three-month SOR/Libor [London Interbank Offered Rate] spread bottomed at -99bps around mid-April and has since narrowed to 63bps,” says DBS Economics Research. “Singapore dollar rates are biased higher, with the Fed poised to hike another two to three times this year.”

A handful of investors and analysts remain somewhat sanguine about the impact of these higher rates on S-REITs’ operational performance. The S-REITs themselves, such as Keppel REIT, Ascendas REIT and CCT, know investors are concerned about the impact of rising rates and the impact of rising rates on their DPUs can be seen in their recent quarterly results announcements.

The European Central Bank maintains its accomodative interest rate policy, providing CCT, which changed its investment mandate to include foreign assets earlier this year, with an opportunity. On May 17, CCT announced that it was acquiring a 94.9% stake in a Grade-A office building in Frankfurt called Gallileo that has Commerzbank as the anchor tenant. The building and associated fees will cost the equivalent of $548 million. A private placement to investors will raise $212 million (see table) to partially fund the acquisition.

Gallileo’s net property income (NPI) yield is 4%, and CCT says the acquisition is 2.6% accretive to DPU, based on pro forma FY2017 financials and 1.4% accretive to DPU based on 1QFY2018’s DPU. However, CCT’s gearing ratio is likely to rise from 37.9% to an alarming 39%. Last September, S&P Global Ratings downgraded CCT to BBB+ from A- after it took on more debt to acquire Asia Square Tower 2.

It is no longer a Goldilocks economy for the US. This year, the pace of tightening is accelerating, with three hikes plus the first full year of balance sheet run-off, notes Morgan Stanley in a recent strategy report. “Following the third hike in September, real rates will be a touch into positive territory. With rates generally in line with current r* (the equilibrium real rate of interest), the Fed pauses in December, but continues to tighten passively via balance sheet run-off. However, stronger growth and higher inflation prompt the FOMC [Federal Open Market Committee] to deliver three additional hikes beginning in March 2019 — one more than we expected previously,” the Morgan Stanley report says. (r* is the short-term interest rate when the economy is at equilibrium, unemployment is at its natural rate and inflation is at 2%.) “We place a 15% probability on a recession commencing in the US within the next 12 months,” it adds.

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Manulife US REIT’s DPU falls 8.5%

Morgan Stanley’s prognosis of the economy and the interest rate cycle does not augur well for Manulife US REIT. During a results briefing on Feb 6, the manager of Manulife US REIT surprised the market by announcing that it planned to double the REIT’s assets under management (AUM) to US$2.6 billion ($3.5 billion) within two years. As at March 31, Manulife US REIT had properties valued at US$1.31 billion. The target appears aggressive in view of the normalisation of interest rates, some unsettled unitholders say. DPU for 1QFY2018 fell 8.5% y-o-y to 1.51 US cents.

Subsequently, the manager also announced a US$1 billion multi-currency medium-term note issuance programme and a distribution reinvestment programme in which unitholders can opt to choose units in lieu of DPU.

Also somewhat surprising was the REIT’s own assessment of the office market in the US. “Office absorption during the first quarter of 2018 has slowed,” it said in its 1QFY2018 results announcement. JLL reported absorption of 3.7 million sq ft in the first quarter, as a result of reduced tech activity, skilled talent shortages and softness in the energy sector, Manulife US REIT said in the announcement.

According to JLL, annual US rent growth continues to climb; however, concession packages are also increasing, putting pressure on net effective rents. Rent growth varies across the different US markets. Los Angeles and Orange County in California, and Atlanta have all achieved above-average growth in the past 12 months, owing to limited new supply and steady or growing demand, while rent growth in Northern New Jersey has lagged the national average, Manulife US REIT says.

In its financial statement announcement, the REIT also stated that 1QFY2018 DPU was lower by 8.5% y-o-y “largely due to lower income from Figueroa and Michelson resulting from lower occupancies in these properties and higher income taxes in 1Q2018 compared to 1Q2017”. Figueroa is a Class-A office building in Downtown Los Angeles and Michelson is an office building in Irvine, Orange County.

New acquisitions mildly DPU-dilutive

Manulife US REIT’s acquisition of two buildings — 1720 Pennsylvania Avenue in Washington DC for US$182 million and Phipps Tower Atlanta for US$205 million — approved by unitholders on May 15, was meant to boost DPU. However, that may not be the case and the acquisitions are not immediately DPU-accretive.

After several days of roadshows and market talk of a perpetual securities issuance priced at 6%, Manulife US REIT opted for a preferential EFR exercise. The underwritten EFR will raise US$197.16 million from 228 million new units offered to unitholders in the ratio of 22-for-100 units at 86.5 US cents apiece. Some US$6.1 million (which is equivalent to 3.1% of the gross proceeds of the preferential offering) will be used to pay estimated fees and expenses.

“After consulting the joint lead managers and underwriters and taking into account the prevailing market conditions and interest rate environment, the impact on Manulife US ­REIT’s capital structure and DPU, the manager believes that the preferential offering is an overall beneficial method of raising funds to finance the proposed acquisitions,” the circular to unitholders states.

Based on pro forma financials, pro forma DPU is likely to fall from 5.77 US cents in FY2017 to 5.71 US cents. Although pro forma distributable income rises 28% to US$59.8 million from US$46.7 million in FY2017, pro forma DPU yield barely inches higher to 6.19% from 6.17% in FY2017.

Rental support for Keppel DC REIT’s new property

Keppel DC REIT’s 1QFY2018 DPU fell 4.8% y-o-y to 1.8 cents. This is because 1QFY2017 DPU included a one-off capital distribution of 0.15 cent per unit. On May 7, Keppel DC REIT announced that it had entered into a conditional sale and purchase agreement for the acquisition of a 99% interest in Kingsland Data Centre for $295.1 million. To fund the acquisition, KDC REIT raised $303.1 million through a private placement of 224 million units at $1.353 each. The fundraising and its larger asset size helped to lower its gearing to 32.1% from 37.4%, KDC REIT’s manager said in the announcement.

The vendors of Kingsland Data Centre — to be renamed Keppel DC Singapore 5 (KDC SGP 5) — are providing rental support should the adjusted NPI received by KDC REIT for the first 12 months after completion be less than $25 million. The total rental support is likely to be up to $8 million for the year.

The $25 million level was derived based on the independent valuer’s opinion that such an amount would give KDC SGP 5 an initial NPI yield that is at a reasonable market rate. KDC REIT’s NPI yield for FY2017 was around 7.3%. The current occupancy rate of KDC SGP 5 is 67.7% and the committed occupancy rate will rise to 84.2%, with the remaining vacancy being office space. The rental support provided by the vendor will bring the adjusted NPI up partially. Despite income support, NPI is likely to be below the level it is likely to be when the property’s occupancy reaches 84.2%.

KDC REIT says the acquisition will lift distributable income by 25.5% to $101.2 million if tax transparency is granted, and by 21% to $97.81 million if tax transparency is not granted. With tax transparency, the acquisition (with income support) would be 4.3% accretive to DPU, based on the new placement shares. Without tax transparency, but including income support, the acquisition would be only 0.6% accretive. Without income support and tax transparency, the acquisition is probably not immediately DPU-accretive.

Plethora of placements and preferential EFRs

MGCCT is acquiring a 98.4% interest in six freehold office properties in the Greater Tokyo area. Three properties are in Tokyo: Koto-ku, Chuo-ku and Toshima-ku; one property is in Yokohama and two are in Chiba, a satellite town of Tokyo. The acquisition costs ¥60,926 million ($742.6 million), including fees, and is being partially funded by a private placement of 311.6 million units at $1.06 each to raise $330.3 million.

In April, Mapletree Logistics Trust said it planned to acquire a 50% stake in 11 modern logistics properties in China developed and owned by sponsor Mapletree Investments, for RMB985.3 million ($207.5 million). The funding structure has yet to be officially announced, but for illustrative purposes, MLT has indicated that it could comprise $200 million in equity. The extraordinary general meeting for unitholder approval, since this is an interested party transaction, will be held on May 24.

ESR-REIT raised $141 million through a preferential EFR exercise in March. It had earlier acquired 7000 Ang Mo Kio Avenue 5.

Frasers Commercial Trust raised around $100 million through a private placement in January to partially fund the acquisition of a 50% stake in Farnborough Business Park in the UK. FCOT and sponsor Frasers Property jointly acquired the business park for £174.6 million ($316 million).

Last October, Cache Logistics Trust raised $102.7 million through a rights issue to lower gearing. As at March 31, gearing had dropped to 38.3%, but this was after completing the acquisition of a portfolio of nine properties in Australia for A$177.6 million ($178.7 million). In February this year, Cache raised $100 million by issuing 400 perpetual securities at $250,000 each.

The acquisition is part of Cache’s portfolio rebalancing and growth strategy. It has divested properties in Singapore and recycled capital into income-producing freehold assets in Australia. This latest acquisition takes its Australian assets to around 28% of the portfolio value.

Perpetual securities — a double-edged sword

During a recent briefing by Chua Tiow Chye, deputy CEO of Mapletree Investments and outgoing president of the REIT Association of Singapore, and Andrew Lim, chief financial officer of CapitaLand and incoming president of REITAS, Chua indicated that real estate investment trusts are at a disadvantage compared with private-equity property funds.

“There is lot of competition between the private [property funds] market and REITs. Private banking clients and institutional funds are prepared to invest in private-equity property funds, which have an inbuilt gearing level of 60% to 65% to ensure the managers [don’t get too aggressive],” Chua says. “If you want to keep REITs competitive, you need to benchmark [them] to the private-equity market.”

To get around this, some of the REITs have utilised  “hybrids” such as perpetual securities to raise funds, Chua continues. For loan-to-value purposes, the Monetary Authority of Singapore considers perpetual securities as equities. Rating agencies recognise only 50% of the perpetual securities as equities, with the remainder seen as debt.

“There is a cost to perpetuals, which is higher than medium-term notes and bank loans. In the overall situation, it’s better to manage the capital structure with a higher gearing level,” Chua says.

Lim agrees. “If you think about why the hybrid market has blossomed, it is because most REIT managers feel constrained, as they can’t raise the required gearing to compete with the private market. If you are up against a number of private-equity funds looking at an asset, the PE funds have an advantage because they can gear up higher,” he says. “If I’m a REIT manager and my mandate is to grow and I want to bid for this asset, [I need the funds to fund the acquisition]. If the gearing limit is raised, it will allow REIT managers to compete on a more level playing field and it will remove the requirement for products such as hybrids.”

At any rate, there is a tacit level of perpetual securities that bankers and investors will let the REIT managers raise, beyond which the perpetual securities will pull down the overall rating of the whole REIT, Chua points out.

In his view, overnight placements are the most efficient means of raising equity. “Some retail investors don’t understand that there is no dilution when you do a placement, because every asset you buy must be accretive. First, the REIT manager has to pay the existing investors their DPU [distribution per unit] before it pays the new investors,” Chua says.

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