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EHT's default not just caused by Covid-19 and hurricanes but by a valuation deficit

Goola Warden
Goola Warden  • 8 min read
EHT's default not just caused by Covid-19 and hurricanes but by a valuation deficit
On its first day of trading on May 24, 2019, Bank of America, which was one of the under­writing banks, sold more than four million units of EHT at 71 cents.
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SINGAPORE (March 30): In our manifold coverage of Eagle Hospitality Trust (EHT) in print and online — see cover story “Saving Queen Mary” (Issue 906, Nov 4, 2019) — we had flagged issues with the REIT, including its inauspicious debut, portend by its under-subscribed retail tranche of its IPO.

On its first day of trading on May 24, 2019, Bank of America, which was one of the under­writing banks, sold more than four million units of EHT at 71 cents. Since then, EHT units have not seen light of day and things reached a nadir with its March 23 trading suspension. This is probably a necessary step as the REIT restruc­tures its loans, says a boutique fund manager who has no holdings in EHT.

On March 19, EHT’s manager announced it was undertaking a strategic review. Yet, in a statement to the Singapore Exchange (SGX) on Nov 6, 2019, EHT’s manager said: “The REIT manager also wishes to dispel a rumour report­ed in The Edge article: There is no strategic re­view underway nor has any consideration of a strategic review been discussed with the board.”

In its trading suspension announcement on March 23, EHT’s manager announced that dis­tributions were not going to be paid to unithold­ers as scheduled on March 30 and that it had received a notice of default and acceleration for a US$341 million ($493 million) loan from Bank of America on March 20. The loan needs to be repaid immediately. The reason for the default was because of the non-payment of rent by the master lessee under the master lease agreements in respect of certain properties in EHT’s port­folio. The master lessees are affiliates of Urban Commons, EHT’s sponsor.

According to the IPO prospectus, Urban Commons signed master lease agreements for the properties in EHT. Valuations of the prop­erties — and hence the fundamental value of the trust — are based on the master leases. The master lease agreements were for 18 properties and each agreement came with a security de­posit. Altogether, EHT should have security de­posits of US$43.7 million.

On March 19, EHT’s manager revealed it had approximately US$28.7 million of security deposits and planned to draw down US$12.5 million. However, the master lessee is required to replenish the security deposits within seven days of any drawdown, EHT’s manager added.

EHT’s manager also said that the master les­see, which is assumed to be Urban Commons, was meant to provide US$15 million of security deposits by June 8 so that total security depos­its would once again amount to US$43.7 mil­lion as stipulated by the prospectus.

Defaulting on ASAP loans

According to the prospectus, EHT had borrow­ings of US$508 million at IPO. Of the IPO loans, US$341 million was secured against subsidi­aries of US Corp and the three ASAP property borrowers. The latter comprises Hilton Atlanta Northeast, Doubletree Salt Lake City and the Sheraton Denver Tech Center (properties with asterisk in table).

EHT owns six ASAP properties, called the ASAP6 (see table). The ASAP6 properties were from private equity funds managed by the Yuan family who have been major sellers of EHT from August onwards. In a November announcement, EHT’s manager said the Yuan family “were in­troduced by the sponsor (Urban Commons) to the placement agents during the bookbuilding process for the IPO and subscribed for stapled securities in the placement tranche”.

A further US$78 million of mortgage loans was secured against Renaissance Woodbridge, Hilton Houston Galleria Area and Crowne Pla­za Dallas Near Galleria-Addison. These are also ASAP6 properties. EHT also has an US$89 mil­lion unsecured loan.

Problematic valuations

The prospectus stated that the purchase con­sideration paid by the ASAP6 Portfolio did not include the value of the master lease agree­ments by Urban Commons. However, the val­uation of the portfolio by two valuers includ­ed master lease agreements. Ten of the REIT’s properties are on long leases of 20 years plus 20 while the remaining eight of the properties are on long leases of 20 years plus 14, all com­mencing on the date of the IPO.

In the prospectus, HVS, a US valuer, says an estimate of a hotel’s market value under a mas­ter lease is based on estimates of the asset’s 10- year annual rent.

In addition to the 10-year net rent cash flow forecast, the projected cash flow for year 10 is increased by an estimated growth rate to ar­rive at the new cash flow for year 11 and cap­italised for the remaining term of the property tenure. HVS then applies a DCF rate to arrive at the total investment amount under the mas­ter lease arrangement.

Colliers was the second valuer for EHT’s as­sets. It says its valuations were based on the “proposed master lease structure as provided by the client”.

“Each property is subject to a master lease agreement with property taxes, property in­surance and land rent borne by the master les­sor, with the exception of Queen Mary where all costs are borne by lessee,” states the pro­spectus but without giving a valuation exclud­ing master leases.

Yet, in the March 24 announcement, it ap­pears that master lease rents did not happen for at least three of the ASAP6 properties and hence the default notice.

If the master lessee Urban Commons is un­able to meet the master leases, the valuation of the REIT changes. As at Dec 31, 2019, the port­folio was valued at US$1,260.6 million, down 2.6% y-o-y. However, the speed of the collapse in EHT’s unit price to 14 US cents when its NAV per unit as at Dec 31 was 89 US cents, or US$779.1 million, suggests a more serious problem.

Some market watchers are won­dering if the vendors of the ASAP6 portfolio — the Yuan family — are responsible for the master leases for the ASAP6 portfolio. So far, they have been net sellers of EHT units.

In the event of default

What happens when a master lessee fails to pay? In general, the owner of the property needs to find another tenant or master lessee.

“If the building was committed to a tenant on a long-term basis, there is no vacancy and the valuer will value it with 100% occupan­cy. If the tenant has now vacated, the valuer will [use] market rents to value,” suggests Alan Cheong, head of research at Savills. “If the previous rental agreement signed is in line with the market, there is no change in the valuation. But if the previous rental is higher than mar­ket, the valuer will use the current market rent to value and that would lead to a lower valua­tion,” he explains.

Consultants say that a case such as EHT is unlikely to materialise in Singapore. “Typical­ly in Singapore, in a good tenancy agreement, the landlord will need the tenant to give am­ple notice if they need to vacate or if the ten­ant is unable to pay the rent, the landlord will have the power to ask the tenant to vacate and the security deposit forfeited (Since the tenan­cy is 20 years, the security deposit or Banker’s Guarantee should be substantial). Meanwhile, the landlord can still market the property with­in the notice period, minimising any void pe­riods,” explains Christine Li, head of research for Singapore and Southeast Asia, Cushman & Wakefield.

“Technically, [valuation] treatment will be based on these assumptions with slightly more provision for voids/vacancy in the cash flow. There will likely be some adjustment for voids if all things remain constant but, on the other hand, the landlord could also get a better tenant with better rentals. There are many considerations in property valuations and we look at them on a case-by-case ba­sis,” she suggests.

Clearly, the valuers of EHT’s portfolio did not take into account non-payment by the master lessee. In the event of default, the pro­spectus says that EHT, as master lessor, is en­titled to terminate the master lease agreement which includes the non-payment of rent or oth­er amounts, repudiation of lease by the master lessee, failure of the master lessee to comply with obligations imposed by lease and an in­solvency event by the master lessee.

When asked on March 24 about the regula­tory actions SGX could take on EHT, Tan Boon Gin, CEO of SGX RegCo, says: “This is some­thing we are monitoring closely. It is premature for us to comment on that, though I would ob­serve that the entire hospitality sector has been very badly hit by this [Covid-19] situation.”

While EHT is in the SGX coverage scheme, an irate EHT unitholder points out although analysts are required to have two updates, if an unusual situation such as a default occurs, they are obligated to issue a comment. “You have a moral obligation, if something like this happens to at least give an update to highlight the problem,” the unitholder says. “You can’t just pretend that nothing happened and ana­lysts don’t update and give a view especially if they initiated a buy.”

In its strategic review, EHT’s manager did say it is preparing to identify selected assets for sale as part of a portfolio reconstitution plan. The best option would be to divest the entire portfolio, redeem gross loans as at Dec 31, 2019, of US$506.6 million, and return the remaining money to unitholders. But with a credit crunch happening in the US, finding buyers would be near impossible.

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