REITs' mark-to-market impact

Goola Warden
Goola Warden1/4/2023 05:49 PM GMT+08  • 6 min read
REITs' mark-to-market impact
Higher discount rates, sales of commercial buildings in overseas markets could cause valuation declines in selected S-REITs
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S-REITs have had a rough ride in 2022 – not surprising given the sharp acceleration in the rate hike cycle in the second half of last year. Some REITs and property trusts faced challenges before the accelerated uptrend in rates – namely EC World REIT, Dasin Retail Trust and Lippo Mall Indonesia Retail Trust.

Among the worst performers in 2022 were the US office REITs, with Manulife US REIT (MUST) down 58% over the past year, Prime US REIT down 53% in the same time frame and Keppel Pacific Oak US REIT (KORE) down 45%.

On Dec 30, the last working day of 2022, MUST’s manager announced that declines in valuation of – in particular – a building named Figueroa in downtown Los Angeles, coupled with The Exchange in Jersey City, caused total portfolio valuation to fall such that its aggregate leverage is likely to reach 49%. The main problem with the mark-to-market high leverage and low interest coverage ratios (ICR) is market perception, and regulatory breaches, although the regulator is known to allow REITs a reasonable time frame to remedy the breach.

“There are a lot of factors that go into a US fair market value process. Some of it is sales comparisons. In the case of Figueroa, The Exchange and Penn in DC there were recently, relatively low sale prices in the case of our Exchange building in New Jersey, and in the case of Penn. there were recent sales comparisons in those three markets that were relatively low sales prices,” explained Patrick Browne, chief investment officer at MUST’s manager. (US East Coast residents often refer to Washington DC as DC.)

One of the properties that Browne cited is US Bank Tower which was divested by OUE in 2020 for US$430 million, at 34% below its book value.

While all REITs are likely to be impacted by the steep rise in policy and risk-free rates, the US office REITs are the worst affected. Inevitably, both the valuations and the distributions per unit for KORE and Prime US REIT could well be similarly affected. KORE’s campus properties cater to the tech sector which has been one of the worst performing sectors from an equity market perspective, while anecdotal evidence exists of tech companies shedding jobs.

Prime US REIT’s aggregate leverage is at 38.7%. Some of the occupancies of its buildings are startlingly low. As at Sept 30, the occupancy of Reston Square in DC (Virginia) was 47.1%, Village Centre Station I (Denver) was 69.9% and Tower 1 at Emeryville near San Francisco was 77.1%; all three are below their sub-market average.

MUST’s manager has perhaps been the most transparent, but its challenges are likely to be faced by the other two US REITs, and some S-REITs in general.

As an example, Suntec REIT’s ICR as at June 30 was 2.7x while its aggregate leverage stood at 43.1%. UK assets have been marked down more aggressively than US assets in recent weeks. Some 6.7% of its assets are in London, and around 17% in Australia. Whether the steady Singapore market can offset declines in these other markets remains to be seen. Unlike most S-REITs, Suntec REIT doesn’t have a sponsor that can support it.

Mark-to-market

“In 2H2022, we expect the challenge from the higher rate interest rate environment to be acutely felt by Singapore listed REITs going into 1H2023. From a credit perspective, reported aggregate leverage are likely to increase from possible revaluation losses, though in our view it is more likely to be a “mark-to-market” loss as we expect REITs under our coverage to be more inclined to hold onto assets rather than be forced sellers. REITs are likely to see their interest coverage ratio thin as debt comes due in 2023,” notes OCBC Credit Research in a Jan 4 update.

Interestingly, on Nov 25, 2022, as part of a strategic review, MUST’s manager announced it had appointed Citigroup Global Markets Singapore as its financial advisor. During the Dec 30 briefing, analysts asked MUST’s manager the possible options the strategic review would consider. It appears that nothing is off the table.

US REITs listed on SGX are at a disadvantage versus their Singapore peers as their sponsors are not able to offer the kind of support including most importantly, financial support offered by non-US REIT sponsors. EC World REIT is a case in point (in another story).

Should MUST survive in its current form? Does the manager aim to narrow the P/NAV discount? Are unitholders’ interests paramount?

These three questions require different answers. For one thing, to survive, all MUST has to do is to weather the interest rate hike cycle by waiting it out, swallowing the bitter pill of low unit prices and high yields, and falling valuations. Its DPU is already falling. Further falls in DPU would lower the yield at any rate. It may not even have to divest US$170 million of assets to bring its gearing down to 45% if interest rates reach a plateau and discount rates used in the discounted cash flow formula ease.

To narrow the P/NAV, MUST’s manager would need to sell a building nearer its book value; then sell a second building near its book value; and so on.

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

Alternatively, some market watchers are wondering if an equity fund raising (EFR) is on the horizon. Recall that First REIT had a dilutive rights issue to cover the shortfall between its valuation decline and loan-to-value covenants when its former sponsor changed its master lease agreement. MUST’s P/NAV is close to 0.5x and any EFR would be hugely dilutive.

Would unitholders be best served by the REIT divesting all its assets and returning cash to unitholders? Saizen REIT – which owned Japanese rental housing – did this in 2015 at a small premium to book value. Unfortunately, Saizen was a REIT ahead of its time, before local players such as City Developments decided Japanese rental housing is a great asset to own.

Is internalisation an answer?

Alternatively, Manulife could just bite the bullet and allow MUST to be internalised without cost to its unitholders. This could even enable MUST to trade closer to the valuations of US listed US office REITs, and it may be a role model for the other two underperforming US REITs in terms of unit price, Prime US REIT and KORE as their sponsors can't provide much support.

Based on the Dec 30 announcement, MUST’s potential revaluation is likely to shave US$0.13 off its NAV per unit which would translate to US$0.55 cents. Would an internalised, leaner MUST trade at US$0.55?

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