Perps, interest coverage and gearing in focus during results season

Goola Warden
Goola Warden2/2/2023 01:06 PM GMT+08  • 9 min read
Perps, interest coverage and gearing in focus during results season
When China reopens, the retail sector in Singapore could benefit from REITs such as Suntec REIT, Starhill Global REIT and Paragon REIT, profiting from their tourist belt malls
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REIT managers are guiding for higher interest expense and higher cost of debt for the 12 months to Dec 31. Although the interest rate cycle is closing in on its peak, and rates may reach a plateau in 1Q2023, REITs will continue to battle with higher interest costs as they refinance their debt because rates are higher now than they have been for the past five years.

As it is, interest coverage ratios (ICR) have deteriorated for most REITs that have announced their results for the October to December 2022 quarter. It is no surprise that REIT managers are trying to keep interest expenses in check. And this includes keeping a lid on perpetual securities (perps) issuance despite their equity treatment on the balance sheet of REITs.

On Dec 30, 2022, ESR-LOGOS REIT (E-LOG) announced it would redeem $100 million of perpetual securities it inherited from ARA LOGOS Logistics Trust (ALOG) when it acquired ALOG. The merger was completed on April 28, 2022.

“The perp market is not open. It’s a viable funding source but won’t make up more than 10% of our capital,” says Adrian Chui, CEO of ESR-LOGOS REIT’s manager. “We redeem $100 million instead of resetting it to 7.2%. We can use internal funds for this tranche, and the cost would be 4.2%.”

In 2022, a $150 million tranche of perpetual securities for E-LOG was reset at more than 6%. “There is only so much [perp] you can use. Although perps get equity treatment, they carry a higher cost. Our $150 million of perps reset to 6.3%. People need to remember perps are good because of equity treatment, but it cannot be too much of a capital stack,” Chui adds.

For example, AIMS APAC REIT (AAREIT) announced a 10.2% y-o-y rise in DPU to 2.59 cents for the 3QFY2023 ended Dec 31, 2022. However, its ICR has fallen below 2.5 times. While its ICR is reported at 4.1 times, its adjusted ICR, which includes the amount reserved for distribution to perpetual security holders, is 2.3 times.

See also: Myer seeks to terminate lease with Starhill Global REIT's Myer Centre Adelaide

AAREIT’s gearing as at Dec 31, 2022, was 36.4%, but that is because two properties, 7 Bulim Street and Woolworth HQ, were financed by perpetual securities of $125 million and $250 million, respectively. If these perpetual securities had been debt, AAREIT’s gearing based on total debt to total assets could have been as high as 50%.

Read the small print

While valuations may remain an art, the ICR is arithmetic. Under the Monetary Authority of Singapore’s (MAS) guidelines, REITs can gear up to 50% if their ICR stays above 2.5 times. Perpetual securities can be classified as equity in a REIT’s capital structure, but REITs have to announce their ICR after including distributions to their perpetual security holders.

See also: Foreign REITs continue to face challenges

Some REITs are upfront about their adjusted ICR (post perpetual security distributions), but some have their adjusted ICRs in the small print.

Elsewhere, for its 1QFY2023 announcement, for the three months to Sept 30, Lendlease Global Commercial REIT’s (LREIT) ICR stood at 6.9 times. But its adjusted ICR, after accounting for perpetual security holders’ distributions, is lower at 2.3 times. Analysts suggest that LREIT’s gearing could be approaching 50% if its $400 million of perpetual securities are included.

Lippo Mall Indonesia Retail Trust (LMIRT) is perhaps the most stressed REIT with perpetual securities in its capital structure. Its ICR is below 2.5 times, excluding the impact of perpetual securities distributions. Yet, LMIRT’s gearing would be above 50% (compared to 43.7% as at Sept 30, 2022) if debt is used instead of perpetual securities.

Mapletree Logistics Trust’s (MLT) ICR as at Dec 31, 2022, was 4.3 times; including distributions to perpetual security holders, ICR is 3.6 times. MLT has a 3.65% $180 million perpetual securities tranche with a call date in March this year.

“MLT may either opt to refinance its upcoming perp into debt at 4.3%, but this would lead to gearing increasing by 1.4 percentage points (current aggregate leverage of 37.4%), or to reset the perp to around 5%, with the option of calling every six months. MLT is likely to reset. We have assumed a reset at 5.3% in our numbers,” JP Morgan says, adding that “guidance is for 2.9% to 3.0% borrowing costs for FY2024.”

CapitaLand Ascott Trust’s ICR for the 12 months to Dec 31, 2022, is 4.4 times, but its adjusted ICR is 3.6 times. CLAS has some $400 million of perpetual securities, but its gearing would still be below 45% if perps were debt.

Similarly, E-LOG’s gearing would be below 45% if the debt had been raised instead of perpetual securities. Its MAS-adjusted ICR in 2022 was 2.8 times. Of course, ICRs can rise if REITs’ cash flows improve and outpace the cost of debt and interest expense rise. CLAS has a good chance of improved gross profit metrics as about half of its portfolio is a proxy to the reopening of economies and resumption of travel.

For more stories about where money flows, click here for Capital Section

ICR or gearing?

Suntec REIT does not have any perpetual securities in its capital structure. Its gearing stood at 42.3% as at Dec 31, 2022. But its valuations were a concern pre-results announcement on Jan 20 this year because of its UK exposure.

As it turned out, Suntec REIT’s UK properties did not decline as much as expected, noted RHB Research. However, Suntec REIT is likely to conserve cash. Its DPU from operations for the 12 months to Dec 31, 2022, fell 6.7% y-o-y to 8.084 cents, but DPU from the capital of 0.8 cents took full-year DPU to 8.884 cents, up 2.5% y-o-y.

In FY2023, however, Suntec REIT is unlikely to distribute from capital given its 42.3% gearing, the continued risk of downward revaluations, and its ICR of 2.4 times for the 12 months to Dec 31, 2022, below the 2.6 times for the same period a year ago, and below the minimum of 2.5 times stipulated by MAS.

When asked what gearing level he would be comfortable with, Chong Kee Hiong, CEO of Suntec REIT’s manager, replies: “Our focus will be ICR. The main issue is interest cover and the expectation of interest rates. Under normal stable conditions, we are happy with 40% to 42% with a comfortable ICR.”

Chong reckons Suntec REIT could stay below 2.5 times in the near term. He is looking to divest property in Australia when interest rates are “more stable”.

Recall that Suntec REIT acquired 177 Pacific Highway as a property still under development, paying the equivalent of $457 million. The property was valued at A$712 million ($663 million) as at Dec 31, 2022. Chong is also looking to divest individual offices at Suntec office towers should there be interest.

Hybrid debt and equity

Perpetual securities are classified as hybrid equity. Other forms of hybrid debt and equity are convertibles, or bonds or preference shares that can be converted into equity.

When OUE Commercial REIT acquired a 67.95% stake in One Raffles Place (ORP) in 2015 for $1.1 billion, it was funded by a nine-for-20 rights issue raising $218.3 million and the issuance of $550 million worth of convertible perpetual preferred units (CPPU). Based on the funding, ORP’s acquisition was dilutive to DPU by double digits.

Since then, 75 million CPPUs were redeemed in 2017, 100 million in 2018 and 155 million in 2022, leaving 220 million CPPUs outstanding as at November. The most recent $155 million redemption was funded from the divestment proceeds from the partial divestment of OUE Bayfront to a fund managed by Allianz Real Estate in 2021 at a premium of 26.1% over the purchase consideration of $1.005 billion. The net proceeds from the divestment were $262.6 million.

In December 2022, before the announcement of its acquisition of Jurong Point, Swing By @ Thomson Plaza, and the management contract for AMK Hub, Hong Kong-listed Link REIT issued HK$3.3 billion ($548 million) of five-year convertible bonds at 4.5%. The strike price of the bonds is HK$61.92 versus Link REIT’s current price of around HK$63 to HK$64.

In November, when the bonds were first announced, China had yet to give any indication of lifting its zero-Covid policy, and Link REIT was trading at around HK$53. If prices continue to rally with China’s re-opening — particularly after peak-Covid-19 — a total conversion of the bonds will dilute Link REIT’s unitholder base by around 2.5%.

A chance for ICRs to rebound

When China reopens, the retail sector in Singapore could benefit from REITs such as Suntec REIT, LREIT, Starhill Global REIT and Paragon REIT, profiting from their tourist belt malls, and this could alleviate stressed ICRs.

“China’s opening up. There will be more flights to the rest of the world. That certainly will be helpful for the retail business, especially downtown [malls]. We hope to see that trajectory coming through in 2023, which would also improve the hospitality side,” notes Tony Tan, CEO of the manager of CapitaLand Integrated Commercial Trust (CICT).

CICT owns Plaza Singapura, Bugis Junction, Bugis+ and Raffles City, which comprises a mall, Swissotel The Stamford and Hotel Fairmont Singapore.

CICT’s ICR fell to 3.7 times for January to December 2022 from 3.9 times a quarter ago. Tan says gross turnover rent (GTO) rose to 7% in FY2022. GTO is usually a beneficiary of higher shopper traffic and tenant sales.

Suntec REIT is also likely to benefit from more Mice (meetings, incentives, conventions and exhibitions) events coming to Singapore. As for capital management, Chong says he prefers to sell a building or withhold capital distributions to equity fund raising (EFR) as a P/NAV discount would make an EFR dilutive.

Meanwhile, MLT is targeting $300 million to $400 million worth of divestments of noncore assets and recycling the proceeds into higher-yielding assets with an acquisition target of $200 million to $400 million. MLT’s recent divestments were sold at a 3% to 4% exit yield. “MLT does not have any immediate plan to raise equity to acquire properties,” says the JP Morgan update.

On a positive note, DBS Group Research points out that 50% of MLT’s China leases are up for renewal and could experience positive reversions. “With China re-opening a near-term focus, we have seen increased interest in MLT as investors look for proxies,” DBS says.

Chui at E-LOG says his REIT has lined up to divest $450 million of assets to recycle into higher-yielding properties with either freehold or longer land tenures. “We want to divest the shorter land lease assets and redeploy them into longer leasehold or freehold assets. We have access to scalable markets and value accretive assets where [sponsor] ESR Group has a footprint in Australia, Singapore and Japan. In between, there will be markets which have a negative spread.”

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