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US office REITs continue to face challenges

Jovi Ho and Goola Warden
Jovi Ho and Goola Warden  • 12 min read
US office REITs continue to face challenges
Manulife US REIT's Centerpointe I&II in Virginia, US. Photo: Bloomberg
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Richard Kimble, lead portfolio manager and an executive officer for the Nuveen Global Cities REIT indicated in an interview late last year with The Edge Singapore that he has been negative towards the office sector in the US since 2017. When he started the Nuveen Global Cities REIT in 2017, he made a conscious effort to underweight the office sector.

According to Kimble, offices are the most expensive to run in the US. He says investors, be they funds or REITs, are only getting 65% to 70% of a building’s net operating income (NOI) because the remaining 30% is going to capital expenditures and/or tenant inducements, unless they are brand new buildings.

On the other hand, corporates are assessing their space needs as the work-from-home/work-from-office hybrid model becomes entrenched even after Covid-19. As a result, traditional offices built in the 1980s or 1990s will need to rethink the use of space, Kimble says.

Manulife US REIT (MUST) BTOU -

listed on the Singapore Exchange in May 2016, followed by the IPO of Keppel Pacific Oak US REIT (KORE) CMOU - in November 2017 and Prime US REIT OXMU - in 2019, during periods when US funds and private REITs, such as Nuveen’s, were sidestepping office assets. For instance, KORE was seeded with assets divested by private REITs managed by US commercial real estate investor KBS.

Fast forward to Dec 30, 2022. On the morning of the last working day of 2022, MUST alerted analysts and media to a 10.9% decline in its portfolio valuation, driven in large part by a building in downtown Los Angeles that was part of its IPO portfolio — Figueroa. While the valuations of all the properties fell, none were as dramatic as Figueroa’s 33.1% decline. “To maintain a sustainable capital structure, the Manager is exploring options to reduce the aggregate leverage of Manulife US REIT,” MUST’s Dec 30, 2022 announcement states. This would include divesting of a property, stakes in properties or entire properties.

In the meantime, Manulife, the sponsor of MUST, has pivoted towards forestry assets and is reported to be the largest investment manager of forestry assets. In December 2022, Manulife Investment Management announced the launch of Manulife Forest Climate Fund.

See also: Manulife US REIT reports 18.6% lower 2HFY2022 DPU of 2.14 US cents after capital retention

Because of MUST’s need to lower its gearing in relatively short order, Tripp Gantt, CEO of MUST’s manager, has indicated that its sponsor could help in MUST’s “disposition” of property. For this to materialise, an EGM is required if the “disposition” is greater than 5% of NAV.

“We are more engaged with our sponsor. We are somewhat limited on the size of the transaction and there aren’t any assets at a price low enough to stay under that EGM threshold. And we can’t sell to the sponsor at a price lower than book value so any transaction has to be based on book value,” Gantt says.

Recycling capital

See also: Manulife US REIT taking the 'right measures' after 10% fall in valuation: analysts

Divesting properties to recycle into higher yielding, possibly DPU accretive acquisitions is not a bad way to manage a portfolio during periods of rising interest rates, and a path followed by a number of REITs. The Mapletree- and CapitaLand Investment-sponsored REITs have undertaken divestments with monies earmarked for higher yielding acquisitions. Elsewhere, ESR-LOGOS REIT J91U -

has announced $450 million of divestments to be recycled into properties with higher yields and longer land leases.

Among the US REITs, both KORE and United Hampshire US REIT have divested properties. KORE’s IPO portfolio was valued at US$829.4 million, growing to US$1.42 billion as at Dec 31, 2022, or 1.7x its IPO portfolio. During that period, KORE’s manager had only two equity offerings, in 2019 and 2021. In 2021, KORE acquired two properties, Bridge Crossing and 105 Edgeview, which were completed in August 2021, and divested two assets, Northridge Centre I & II and Powers Ferry in FY2022.

Under MUST’s previous manager, MUST’s AUM tripled from US$777 million at its IPO in May 2016 to US$2.2 billion as at June 30, 2022. As at Dec 31, 2022, MUST’s property portfolio had receded to US$1.95 billion. The expansion was financed by a combination of equity and debt. In fact, MUST had raised equity four times with the latest placement in December 2021.

KORE’s expansion was a lot more measured than MUST’s following its IPO in 2017. As at Dec 31, 2022. KORE’s all-in average cost of debt was 3.2%. Aggregate leverage as at Dec 31, 2022 and ICR for the 12 months to Dec 31, 2022 were 38.2% and 4x respectively, giving KORE a lot more wiggle room than MUST.

On the other hand, KORE probably faces similar challenges in that capex and tenant initiatives could take a toll should it acquire tenants with long leases. Still, David Snyder, CEO of KORE’s manager is a lot more circumspect than MUST’s previous management when asked about growth.

“In terms of the acquisition front, there's not much out there. And if you consider prices, issuing units at that significant discount is probably not ideal. So on the acquisition front, I don't think for both reasons, that is something we're going to see a lot of this year,” Snyder said during a recent results briefing.

“We sold the two Atlanta assets and actually had a small gain versus the valuations that we had in place. We made the decision in large part because they were too small and inefficient as we've grown. If you think about where next that [divestment] might make sense, that would take you to Sacramento, which is another, smaller side, less efficient for us [asset], so that is certainly one that we will consider over time. And, we've also mentioned in the past that 1800, West Loop, at some point is something we might consider selling,” Snyder continues.

See also: Prime REIT’s 2HFY2022 DPU falls 12.5% y-o-y within challenging sector, messaging is cautiously optimistic

In FY2022, KORE’s portfolio had a stable performance in the face of increasing challenges. Even then DPU for 2H2022 was 2.78 US cents, 12.6% lower than 2H2021’s DPU of 3.18 US cents. This brought FY 2022 DPU to 5.80 US cents, 8.5% lower than FY 2021’s DPU of 6.34 US cents. As at Feb 8, KORE’s DPU yield is at 11.7%.

KORE’s manager is changing the way its management fee is being paid. The manager will be increasingly receiving cash for its base fee instead of units. In FY2022, the manager received 100% of fees in units in 1Q2022, and 100% in cash from the next three quarters. This caused a larger decline in distributable income and DPU than if the comparison had been like-for-like.

Additionally, paying fees in cash — and should rental income for its properties deteriorate – would cause interest coverage ratio (ICR) to fall. Once again, KORE’s ICR at 4x leaves a decent margin even when fees will be paid in cash. Since KORE is trading at a discount to NAV, receiving the fees in units would have continued to dilute the REIT.

MUST’s options

When asked what plans are afoot and what could be the various options under the strategic review, Stephen Blewitt, Manulife Global Head of Private Markets and Interim Chairperson of Manulife US Real Estate Management (MUSREM), replies: “As Sponsor, we are committed to working towards an outcome in the best interests of unitholders within regulatory parameters and evolving economic circumstances. We, too, are a significant unitholder with approximately a 9% stake in MUST.”

In November 2022, MUST’s manager appointed Citigroup as financial adviser for its strategic review. “Together we are exploring various options for the future. With work and analysis ongoing, it is premature to speculate on or discuss any particular actions at this stage,” Blewitt says.

Within the strategic review, nothing is off the table. That includes sale of a property, properties or stakes in properties to third parties to raise cash; the sale of the entire portfolio; equity fund raising (EFR); sale of the manager and the manager’s stake; or the sale of a stake in a property or an entire property to the sponsor. Any such sale to the sponsor or even a third party would need to be within 10% of the latest valuations as stipulated in the Code on Collective Investment Schemes (CIS).

Dilutive EFRs have been undertaken by REITs — the most recent being First REIT AW9U -

in 2021 — to offset the impact of a valuation decline where loan-to-value covenants had been breached. Note though, that MUST’s manager has stated that all its LTV covenants have not been breached. “The financial covenants in respect of the existing loans of Manulife US REIT are not expected to be breached despite the decline in valuation,” the manager said on Dec 30, 2022.

Among the options the sponsor is believed to be examining are M&A proposals where a partner or institution either takes a stake in the manager or acquires the manager, and provides the REIT with a pipeline in the US or Europe. While this may dilute unitholders in the immediate term, it would ensure MUST’s longer term survival, market watchers reckon.

On the divestment front, one way of divesting an asset and lowering gearing would be to divest 50% or 51% of a building or many buildings to a third party while retaining 49%, and to continue to manage those buildings. MUST could do this with Centerpointe I and II, which are two buildings in Fairfax, Northern Virginia. Fairfax is around 23km west of Washington DC, and is not served by the metro that serves Arlington, Virginia.

DBS Group Research estimates that US$170 million in asset divestments would be required to bring gearing to slightly below 45%. Centerpointe I and II were valued at US$101 million in December 2022, down 10% y-o-y.

Of course, MUST could divest an entire building, more than one building or its entire portfolio. If it does the latter, proceeds could be returned to investors after repayment of debt. For MUST to remain as a listed REIT, divesting a property (or properties) that have limited upside would be the best option because at some point, MUST would be able to recycle the monies into a higher yielding property.

Organic solutions insufficient

In 2HFY2022, MUST is paying out 91% of its distributable income, retaining the rest for general corporate purposes. “Since IPO, we have been paying out 100% of our distributions to maximise DPU payout to investors. To improve financial flexibility, we have the option in our toolkit to retain up to 10% of distributable income for general corporate and working capital purposes, including for tenant incentives,” Gantt says.

Some REITs already retain distributable income. For instance, CapitaLand Integrated Commercial Trust C38U -

often retains DPU from CapitaLand China Trust AU8U - and Sentral REIT. In FY2022, $10.6 million received from those two REITs were retained for general corporate purposes and working capital.

On Feb 8, in a report ahead of MUST’s FY2022 results, DBS Group Research has also suggested implementing a distribution reinvestment programme (DRP) — which in itself is not without costs.

“While these measures may be able to buy MUST some time, it may not be sufficient to bring gearing down to the more sustainable level of the 45% limit should its ICR ratio breach the 2.5x level,” DBS says of the ‘organic’ approach of retaining cash.

Gearing vs ICR

During an earlier briefing on Suntec REIT’s results, Chong Kee Hiong, CEO of Suntec REIT’s T82U -

manager had indicated that the ICR is the metric that his REIT is focused on, and he is looking to divest a property to bring it above 2.5x.

Elsewhere, other REITs have announced ICRs below 2.5x, but their aggregate levels remain below 45% with the use of perpetual securities.According to the Code on Collective Investment Schemes (CIS): “The aggregate leverage limit is not considered to be breached if due to circumstances beyond the control of the manager the following occurs: a) a depreciation in the asset value of the property fund; or b) any redemption of units or payments made from the property fund. If the aggregate leverage limit is exceeded as a result of (a) or (b) above, the manager should not incur additional borrowings or enter into further deferred payment arrangements.”

This means that a decline in the value of MUST’s portfolio is not considered a breach of the aggregate leverage of 50%.

Similarly, the CIS code indicates that the minimum adjusted-ICR requirement is not considered to be breached if it is due to circumstances beyond the control of the manager. “The manager should not incur additional borrowings or enter into further deferred payment arrangements if the property fund’s aggregate leverage exceeds 45% of its deposited property and its Adjusted-ICR is below the minimum Adjusted-ICR requirement,” the CIS code states.

“If any of these figures are compromised it's not a breach according to MAS,” confirms Robert Wong, CFO of MUST’s manager.

“Both ICR and gearing are important. We are focused on getting leverage down as much as possible and maintaining operational liquidity. ICR is quite dynamic. Two-thirds of our leases (in 4Q2022) were new leases and that momentum will carry through. If we can get new leases coming in, we can get topline up and provide support for ICR,” Wong adds.

Despite the non-breach for MUST, investors may not be comfortable with REITs which have aggregate leverage near the regulatory ceiling, and hence the need to find a solution.

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