Manulife US REIT’s (MUST) pure-play US office portfolio has been hit by problems big and small. The biggest issue is the US workforce’s reluctance to return to the office.
Occupancy across MUST’s 12 properties stood at 90.0% at the end of 1HFY2022, above the US Class-A building average of 80.7%.
However, that figure represents leased floor area, independent of the staff filling them. “To date, tenants have been slow to return to office at MUST’s portfolio, with the latest physical occupancy at 28% in July,” says the REIT’s manager.
This is symptomatic of a nationwide problem — a “once-in-a-generation upheaval”, says MUST, with physical occupancy in the US languishing at 44.7% as of July 25.
The hybrid-work model is changing company culture and office needs, adds MUST’s management. This has led to downsizing by large tenants — even those with significant history in their buildings.
TCW Group, a finance and insurance tenant who has been in MUST’s Figueroa property for 31 years, has decided to vacate its space upon lease expiry in December 2023. TCW’s expiring rents are about 9% below current market rents. It decided to relocate to avoid major renovation downtime, says MUST.
Law firm Quinn Emanuel Trial Lawyers, a 28-year tenant of Figueroa, has decided to downsize by 71,000 sq ft effective Aug 31, although it has also renewed its remaining 64,000 sq ft for another 5.4 years at a positive 2.5% rent reversion starting September 2023.
In a media briefing on Aug 4, MUST’s management acknowledged that it is a tenants’ market.
Patrick Browne, chief investment officer (CIO) of MUST, says: “What’s happening is that big tenants are saying: ‘I need to be in the buildings that have the best amenities in the best locations that my employees want to come into. If I need a six-month project, I want to be able to lease some special floor on a short-term basis within the building, to flex into or contract out of as needed.”
But perhaps the one metric investors are most concerned about is MUST’s distribution per unit (DPU), which has been on a steady decline. For 1HFY2022 ended June, MUST declared a DPU of 2.61 US cents (3.6 cents), down 3.3% y-o-y.
This follows DPU of 5.33 US cents for FY2021 — down 5.5% from the FY2020 DPU of 5.64 US cents, which, in turn, was a 5.4% drop from 5.96 US cents in FY2019.
At the release of its FY2021 results in February, MUST blamed higher rental abatements, lower car park income and lower rental income from higher vacancies during the period. This was partly mitigated by the net reversal of provision for expected credit losses.
Six months later, MUST pointed to falling occupancy rates and the absence of credit provision reversals, which were partially offset by acquisition contributions, lower rebates and higher carpark income.
While distributable income was up 6.9% y-o-y to US$46 million in 1HFY2022, MUST attributes falling DPU to a larger unit base following a private placement last year.
The crux of the problems is falling occupancy, which gets reflected in net property income, distributable income “and so forth”, says MUST’s chief financial officer Robert Wong. “We are operating in a very challenging environment; we’re doing what we can. The only way to address it is through active management and getting income up.
Management is certainly active — three months in, MUST’s new chief executive officer is raring to go.
When asked if the management’s priority lies in increasing occupancy, pursuing active rebalancing or making new acquisitions, CEO Tripp Gantt says he is eager to do all of them.
“There are things we can’t control and there are things we can control. The things we can’t control, we have to monitor and make sure we’re positioning ourselves as well as we can afford. With the things we can control, we have to be proactive and decisive, and go out and take these actions and do them,” says Gantt.
Tenants want flexibility and MUST wants to offer those concessions. Gantt’s solution, unveiled at the 1HFY2022 results, is “hotelisation”.
MUST’s hypothesis is that offices with premium amenities in great locations are most likely to attract top tenants. These top tenants want more flexibility in their space requirements, with fewer dedicated workstations, more versatile spaces and experiential offerings, says management.
“Formulating the optimal mix of traditional, flex and turnkey space will enable us to stay ahead of the curve amidst the uncertain leasing environment,” says Gantt.
To “reassert” the trophy status of MUST’s Michelson property, for instance, MUST could introduce F&B tenants, lounges, outdoor “chill-out zones”, fitness centres and gyms. Located within a mile of John Wayne International Airport, Michelson is a 19-storey trophy-quality office building in Orange County, California.
“We do have some competitors that have done hotelisation of their assets, but they aren’t assets like Michelson,” says Gantt. “Some of them are smaller buildings, where they’ve done it on the common places around the outside; they simply don’t have a floor area or the kind of buildings to hotelise themselves.”
The upgrades, such as an “enhanced lobby and concierge type offering”, will come with “some level of AEI [asset enhancement initiative] spending”, says CIO Browne. They will likely begin contributing revenue from FY2023, he adds.
As at the end of 1HFY2022, the portfolio’s weighted average lease expiry (WALE) remains at five years, with 4.8% and 10.2% of leases by net lettable area (NLA) expiring in 2022 and 2023 respectively, while 59.6% of leases will expire in 2026 and beyond.
In 1HFY2022, MUST executed some 192,000 sq ft of leases at an average rental reversion of +1.0%, “mainly from the legal, finance and insurance and real estate sectors”. Of the leases signed, two-thirds were renewals, while 28.7% were new leases and 4.6% accounted for lease expansions.
According to Gantt, MUST is in talks with a co-working operator for one of its assets. “That is something that we could deliver in the coming months.”
While MUST notes that tenants prefer flexibility, the REIT signed longer but fewer leases in 1HFY2022. Could tenants demand shorter leases in the future and how would this trend affect WALE?
Browne says the average lease in the US is about seven years, down from eight years pre-pandemic. “They’re not terribly off pre-Covid-19 levels, but I do think that the trend is likely that leases will be shorter… It’s not unforeseen to think that these terms will be lower than what they were pre-Covid-19.”
But long leases will not disappear altogether, he adds. “I don’t think we’ll ever be in a state where we have a one-year WALE, or a lease that’s just one year in perpetuity, because the truth is it doesn’t work for landlords or tenants. As much as tenants might want shorter leases, they still need to have a financial plan for their organisation.”
The tenants who may choose shorter leases typically opt for smaller spaces, says Caroline Fong, MUST’s chief investor relations and capital markets officer. “If you have 2,000 or 3,000 sq ft, maybe the flex space will work for you. But most of our tenants lease headquarters; they’re still quite big and average about 5,000 to 10,000 sq ft. They won’t sign short leases because they want negotiating power.”
In March, The Edge Singapore noted that MUST's gearing was at a historical high of 42.8%. This has since moderated to 42.4% as at July 11.
Some 85.7% of gross borrowings are secured on a fixed rate basis. In July, MUST obtained a new US$225 million unsecured sustainability-linked loan, mainly to refinance the mortgage loan facilities for Plaza and Exchange properties and the revolving credit facilities.
No refinancing is required for FY2022, while weighted average debt maturity has improved to 3.3 years from 2.6 years in 1QFY2022.
MUST would likely favour asset recycling over sizeable acquisitions in the near term. Acquisitions are also unlikely given the US$100 million private placement for the Tanasbourne, Park Place and Diablo properties bought in December.
Asset recycling could help the REIT rotate into more accretive assets, but Gantt is coy. “If we have assets and locations that are vulnerable, we need to look at those as recycling opportunities into either assets that are going to be more stable over the long term and provide better income growth, or locations where we feel we can drive demand.”
MUST has stopped valuing its properties twice annually, and will update its property values at the end of the year instead. This is to keep in line with the business practice of other Singapore REITs, says MUST.
Excluding the three acquisitions in December, the value of MUST’s other nine properties rose 0.4% to US$1.98 billion over the six months to Dec 31 last year. Among the nine, however, a third saw their valuation shrink during the period.
Among the trio of properties in the REIT’s IPO portfolio, Michelson is the only property whose valuation has fallen overall. From a value of US$317.8 million at the REIT’s debut on May 20, 2016, Michelson’s value stood at US$317 million as at Dec 31, 2021. There are no lease expiries in Michelson in 2022.
Save for a red herring, the mention of Michelson in the management’s hotelisation plans could be a sign that it is off the chopping block, if there is one.