REITs can't fully camouflage gearing with perpetual securities

The Edge Singapore
The Edge Singapore 10/6/2021 09:45 AM GMT+08  • 9 min read
REITs can't fully camouflage gearing with perpetual securities
Perpetual securities have been used to camouflage gearing but will be unable to do so with ICR to be implement in 2022.
Font Resizer
Share to WhatsappShare to FacebookShare to LinkedInMore Share
Scroll to top
Follow us on Facebook and join our Telegram channel for the latest updates.

Despite the recent curbs on socialising implemented on Sept 27, Jem, which is adjacent to Jurong MRT interchange, continues to be a crowded mall at weekends. As one of the more successful suburban malls, Jem is likely to be a desirable addition to the portfolio of Lendlease Global Commercial REIT (LREIT).

As it stands, LREIT’s manager says through various announcements that LREIT now holds 28.05% of Jem for $337.3 millioin which it acquired through equity stakes in Lendlease Jem Partners Fund (LLJP) and Lendlease Asian Retail Investment Fund 3 (ARIF3) for $153.1 million and $178.2 million respectively.

“The manager intends to finance approximately 40% of the total acquisition cost (excluding the acquisition fee units) through debt facilities and the remaining funding through its existing cash balance, including the proceeds from issuance of perpetual securities and/or such other methods of financing as the manager may determine,” a circular in July, ahead of an EGM, stated.

In May, LREIT issued $200 million of perpetual securities or perps priced at 4.2%. Along with the debt, the stake in Jem is accretive to DPU to the tune of 3.6%. The net property income (NPI) yield of Jem based on the agreed price of $2,077 million is 3.9%. The reason why LREIT paid $337.3 million for a 28.05% stake in a $2,077 million property was because it had acquired Jem based on its net asset value.

According to a recent report by OCBC Credit Research, its effective stake is therefore 18.5%. A 31.8% stake in Jem would be valued at $660.486 million. With a stake in Jem under its belt, LREIT now owns 100% of [email protected], 100% of Sky Complex in Milan and the redevelopment of a 48,200 sq ft car park adjacent to [email protected] into a new multifunctional event space.

In a Sept 17 report, OCBC Credit Research points out that a 31.8% stake in Jem would reduce the portfolio concentration in [email protected] by asset to 55% from 67.6%. “Assuming LREIT’s interest in Jem increases to 31.8%, headline aggregate leverage is expected to remain healthy at around 34% (from 32.0% at end June). However, if LREIT’s portion of debt on Jem were to be consolidated, we estimate that LREIT’s aggregate leverage would be 40%,” OCBC Credit Research notes. The 40% gearing would not include the perps which now account for 17% of its capital. (See table)

“We think LREIT may remain acquisitive and look to further increase its stake in Jem if the opportunity arises. LREIT may also look to acquire other assets from its sponsor [or held by funds managed by the sponsor], which has A$69 billion in total funds and assets under management [AUM],” the report adds.

Separately, on Sept 30, AIMS APAC REIT (AA REIT) announced the potential acquisition of Woolworths Headquarters for the equivalent of $454 million or $484 million including expenses. This raises the AUM of AA REIT to $2.18 billion.

Based on DPU recorded in FY2021 for the year to end March, the Woolworths acquisition is DPU accretive by 4.7%, taking pro forma DPU to 9.37 cents.

“This is a Woolworths anchored asset and the cash flows are very secure. Ultimately, when we look at the combination of debt funding, which is just under 2% [in cost], it is a very attractive yield spread that we are achieving,” notes Russell Ng, incoming CEO of AA REIT’s manager.

Net property income yield is around 5.2%, or 4.8% on a total cost basis. “When you include the escalations over the next 10 years we are easily getting a property with an average tenure NPI yield of 5.86%, or about 5.5% on total cost. So, it [is] really providing us with strong income stability over the next 10 years,” Ng reiterates.

Along with $125 million of perps issued in 2020 and $250 million of perps issued in August, perps now comprise some 25% of AA REIT’s capital.

No regulatory caps on perps issuance for REITs

The perps of LREIT and AA REIT are the highest among the locally listed REITs. Interestingly, there are no regulatory caps on the maximum amount of perps that can be issued by a REIT.

As can be seen from the table, to date, REITs have been cautious about the amount of perps they have issued with the exception of Lippo Mall Indonesia Retail Trust (LMIRT) and more recently, AA REIT and LREIT.

Of note though is that from Jan 1, 2022, the aggregate leverage for REITs will be capped at 45% if the adjusted interest coverage ratio (ICR) is less than 2.5 times, or capped at 50% if the adjusted ICR is equal to or above 2.5 times.

While the REITs’ perps are not treated as debt for the computation of REIT’s aggregate leverage, the computation of adjusted ICR does take into account the interest payable on perps. As long as the perps can meet these criteria, it will not count towards the aggregate leverage cap.

“With respect to aggregate leverage, we believe there is no limit. However, there will be considerations that may prevent a REIT from issuing too many perpetuals such as indigestion by the market and change in perceived risk profile. Note that there will be a limit with respect to ICR from Jan 1, 2022,” says Wong Hong Wei, a credit analyst at OCBC Credit Research.

Some market observers believe that the Monetary Authority of Singapore (MAS) may defer or make adjustments to the ICR should the pandemic take a turn for the worse. However, only two REITs and one business trust have ICRs below 2.5 times. The ICR was meant to be implemented earlier but the REIT managers’ feedback indicated that the pandemic impacted their ICR.

Among the REITs with the lowest ICR, LMIRT’s ICR as at end June was 1.7 times and Frasers Hospitality Trust’s ICR was 1.5 times as at end March. ARA US Hospitality Trust, a business trust, which did not report distributable income in 1HFY2021 ended June, announced NPI of US$9 million ($12.2 million) in 1HFY2021, interest expense of US$6.1 million and gearing of 49%.

Too many perps could impact perception

While MAS has not stipulated a cap on the amount of perps that a REIT can issue, too many perps are likely to impact perception.

“With respect to the credit profile, an issuer with a higher proportion of perps (versus equity) is deemed riskier than a similar issuer that funds this portion of capital solely by equity. This is because issuers may choose to call the perpetual securities. Equity is usually more permanent than perps as part of the capital structure,” Wong says.

Indeed, many investors view equity and retained earnings as the best form of capital. REITs do not retain their earnings because of tax transparency, hence they usually fall back on equity when they need to fund acquisitions.

But with tight capitalisation rates for retail, office, warehouses and data centres, REITs fund acquisitions with a mix of debt and equity. Only ParkwayLife REIT (PLife REIT) which has a DPU yield of around 2.98% has a sufficiently low cost of capital to fund an acquisition with equity alone. Up till 2020, PLife REIT did not have a general mandate. Interestingly, PLife REIT has the highest ICR among S-REITs of 21 times.

There are a few key differences for perps to be classified as equity by REITs. For one, perps cannot have a step-up, only a reset if they fail to call at the appropriate year. Perps are “called” at the option of the issuer. Usually, deferred distributions are non-cumulative. However, most distributions have “dividend stoppers”.

“To be classified as equity in REITs, perps cannot have a step-up, only a reset and in many cases there is a dividend stopper,” Wong notes.

Perps carry risk for investors

While distributions to perps are not mandatory, issuers are likely to make good on the distributions as failure to do so would have negative connotations. But since REITs’ perps are structured with resets, their distributions could be variable over time, differentiating them from a bond.

“There is potential for wrong-way risk here. For example, if interest rates shoot up, distribution rates will shoot up upon reset if the perps are not called. Cap rates of properties may likely follow interest rates trajectory. We understand also that rating agencies may see perps as half equity, half debt. As such, the credit ratings may come under pressure if a substantial portion of the capital is perps, which in turn may impact funding cost,” Wong notes.

OCBC Credit Research points out that four issuers did not call their perps since the pandemic. They are Ascott Residence Trust, Wing Tai Properties, LMIRT and First REIT. More issuers can be expected to miss their calls, OCBC Credit Research says.

Distribution deferrals, whether wholly or partially, are at the issuer’s discretion. (So far, among the REITs, only LMIRT has missed a distribution).

The absence of many covenants that are typical in a vanilla bond implies that perp holders take higher risks, Wong notes. These include stoppages of distributions and the risk that the perps may not be called as has been experienced.

As an example, investors in LREIT’s perps included fund managers, hedge funds, insurance companies and banks and private bank customers at 36% and 64% respectively. The investors were mainly in Singapore (98%). The minimum investment is $250,000, hence only private banking clients or accredited investors are likely to be among the non-institutional investors. Selected fund managers and hedge funds have the wherewithal to take on higher risk.

While REITs can issue perps with financial covenants including having an event of default, such perps will unlikely be treated as equity by MAS, Wong indicates.

Hence, perps issued by REITs could be almost as risky as equities, given that they are deeply subordinated, their distributions can vary, are non-cumulative and are entirely at the discretion of the REIT manager.

And, as its moniker implies, they can be as perpetual as equity.

Loading next article...
The Edge Singapore
Download The Edge Singapore App
Google playApple store play
Keep updated
Follow our social media
Subscribe to The Edge Singapore
Get credible investing ideas from our in-depth stock analysis, interviews with key executives, corporate movements coverage and their impact on the market.
© 2022 The Edge Publishing Pte Ltd. All rights reserved.