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As First REIT's master leases approach 15-year mark, ill winds seen buffeting rental support

Goola Warden
Goola Warden • 8 min read
As First REIT's master leases approach 15-year mark, ill winds seen buffeting rental support
On June 1, Lippo Karawaci (LPKR) announced it wanted to restructure its rental support agreements with First REIT.
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SINGAPORE (June 5): On June 1, Lippo Karawaci (LPKR) announced it wanted to restructure its rental support agreements with First REIT.

This was the result of the Covid-19 pandemic in Indonesia and its material negative impact on LP- KR’s 55%-owned hospital subsidiary Siloam International Hospital’s business.

LPKR was the sponsor of First REIT and a 27.6% unitholder when it listed in 2006.

First REIT has 16 properties in Indonesia, comprising 12 hospitals, two integrated assets comprising hospital & mall, one integrated hospital & hotel and one hotel & country club.

”All our healthcare assets in Indonesia are operated by Siloam and our master leases for our Indonesia assets are with LPKR, except for three properties that are leased to the third-party PT Metropolis Propertindo Utama (MPU) and/or its subsidiaries. Siloam is co-named as a lessee with LPKR and/or PT MPU for three of these hospitals within the portfolio,” said First REIT’s manager when asked about the impact on the REIT from LPKR’s June 1 announcement and Siloam’s FY2019 results issued on May 20.

At the time of its IPO, the master lease agreement was a 15-year lease term with option for the master lessee, LPKR, to renew for a further term of 15 years. The rent is paid to First REIT in Singapore dollars, although Siloam’s and LPKR’s revenues are in Indonesian rupiah.

The base rent is subject to an increase every year at a rate equal to two times the percentage increase of the Singapore Consumer Price Index for the preceding calendar year (subject to a cap of 2% and a floor of 0%). The variable rent is pegged to the gross revenue growth of the master lessee’s healthcare and hospitality businesses carried out at the properties.

On June 1, LPKR stated in its press release that under the current rental structure, LPKR provides a rental support which guarantees First REIT a certain rental level, such that a decline in Siloam’s revenues would increase the support provided by LPKR.

Furthermore, the rental support agreements, which were entered into over the past 10 years, also have a currency peg component. This puts additional pressure on the arrangement with LPKR due to the recent depreciation of the rupiah. The IPO prospectus stated that the rent will be paid in Singapore dollars at a fixed rate of $1.00 to IDR5,623.50. This formula is fixed for the entire duration of the lease term. Since then, the rupiah has depreciated against the Singapore dollar to IDR10,000.

“Even before accounting for the- decline in revenues as a result of Cov-

id-19, the rental amounts for almost all the hospitals range to 30–100% of the hospital’s gross operating revenue — and with a weighted average of close to 40% — a level that is unrealistic to sustain and support,” adds LPKR.

According to First REIT’s FY2019 annual report, 83% of the REIT’s rentals were from LPKR including Siloam (see table 1).

Breakdown in relationship

At the time of First REIT’s IPO, Siloam was privately held by LPKR so all three parties had their interests aligned. Siloam was listed in 2013 with LPKR holding more than 70%. This was whittled down to 55% through two rights issues. Meanwhile, LPKR’s stake in First REIT fell as well as the latter had a rights issue in 2010 to raise $172 million.

Due to a reorganisation in 2018, LPKR no longer owned First REIT and its manager. As a result, unitholders were concerned whether it would continue to support First REIT as interests between master lessee LPKR, operator Siloam and the owner First REIT were no longer aligned.

In Oct 2018, LPKR divested its stake in First REIT and its manager to OUE and OUE Lippo Healthcare (OUELH), a subsidiary of OUE. As at May 20, OUE’s and the unlisted Lippo Group’s deemed stake is around 19.2%. First REIT’s manager spun this reorganisation as the REIT having two sources of growth through right of first refusal offers for assets from both LPKR and OUELH which owns 12 nursing homes in Japan.

When Siloam announced its FY2019 results for the year ending Dec 31, 2019, on May 20, the hospital operator made a net loss of IDR333 billion ($32.8 million). This included an impairment charge of IDR426 billion that comprised IDR208 billion for accounts receivable; IDR143 billion for discontinued projects as well as IDR75 billion for fixed assets, inventories, intangibles and accruals.

“Management took this opportunity to also review the carrying value of its assets to be more conservative and ensure it fairly reflects the revised business strategy,” Siloam said in an announcement. And there could be further impairments at Siloam. “The possibility of new impairments is an overhang. In addition, Covid-19 may temporarily hinder progress at loss-making hospital,” Credit Suisse says in an update.

Credit Suisse points out that revenue remained weak while costs rose in FY2019, and the trend is unclear, especially with the added challenge of Covid-19. In its June 1 announcement, LPKR pointed out that Covid-19 has significantly impacted Siloam’s revenues and led to a drastic decline inpatient volumes across Indonesia.

Master lease conundrum

Unfortunately for unitholders, four IPO properties in Indonesia are up for lease renewal next year (see table 2), comprising three hospitals: Siloam Hospitals Lippo Village, Siloam Hospitals Kebon Jeruk and Siloam Hospitals Surabaya, and one integrated hotel and country club: Imperial Aryaduta Hotel & Country Club.

“The master leases for all these four properties are with LPKR and we are currently in discussion with all our stakeholders and we are evaluating all options to arrive at mutually beneficial terms to ensure a steady stream of income from these properties for our unitholders. It is too early to comment on the impact to the valuations at this stage,” First REIT’s manager said in an email reply to The Edge Singapore.

Although the relationship between LPKR, Siloam and First REIT is quite tenuous, they remain tied at the hip because of the master lease arrangements. “The hospital assets owned by First REIT are integral to the day-to-day operations of Siloam (and by definition, integral to LPKR too as LPKR is Siloam’s parent company), rather than third parties,” notes OCBC Credit Research in a recent update.

Also, First REIT would have issues divesting the parts of the portfolio. “The Indonesia property market is not that transparent, the healthcare market in Indonesia is also not liquid, where hospital assets are mostly owner-occupied and owner-operated. Divestments are as complex as acquisitions. The criteria to consider when looking at divestments include the quality of assets considered maturity of operations and stability of rental income. Ultimately, pricing is also an important factor,” First REIT’s manager said in replies to unitholders.

With a lower stake in Siloam, and after selling out of First REIT, it should come as no surprise that LPKR may want to change the terms of the master lease. Through the years, both LPKR and First REIT’s unitholders have benefited from the arrangement.

According to one irate unitholder however, LPKR sold assets into the REIT based on master lease rentals which would have priced the assets at a relatively rich valuation, and now, he says LPKR wants to change the terms of the master lease because of a change in the macro environment.

“While LPKR in its announcement on June 1 positioned its pay- ments to First REIT as a rental sup- port, in our view, similar to other property owners monetising prop- erty assets via REITs, LPKR was a key beneficiary of the IPO proceeds when it injected hospital assets into the First REIT structure,” OCBC Credit Research points out in its update.

Interestingly, LPKR had already budgeted for the master leases (see chart 1) in its FY2019 results. However, master lease rentals fall off noticeably after 2021. LPKR says this is due to assets maturing, but could it also be due to a significant change in master lease terms?

“Given the declaration of the current Covid-19 situation as a national disaster by the Indonesia government, the manager will consider any reasonable and commercially viable proposal from LPKR carefully, with any agreement to be mutu- ally agreeable and beneficial in the long term interest of First REIT and having regard to applicable legal and regulatory requirements. The manager will monitor the situation closely and provide an update as and when there are any material developments,” First REIT’s manager replied via email when asked by The Edge Singapore, repeating largely its statement to SGX.

On May 6, First REIT announced a DPU of 1. 86 cents in 1QFY2020 ended March, down 13.5% y-o-y, as the REIT’s unit base has grown bigger, and because it held back $1 million out of the first quarter’s income available for distribution of $15.92 million, down 6.5% y-o-y.

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