Our Sept 18 symposium on REITs titled Cresting Interest Rate Hikes turned into a lively session with interaction between the panel and the audience.
Nupur Joshi, CEO of the REIT Association of Singapore (REITAS), gave the keynote speech. The panellists were Kelvin Chow, CEO of Lendlease Global Commercial Trust Management; Han Khim Siew, CEO of OUE Commercial REIT Management; and Victor Tan, executive director & CEO of First REIT Management.
The title and topics addressed the impact of interest rates on the performance of S-REITs, focusing on capital management and keeping portfolios and cash flows stable in the form of net property income (NPI) and distributable income.
Questions from the audience were on issues such as aggregate leverage, interest coverage ratios (ICR) and hedging. Several other questions centred around Lendlease Global Commercial REIT (LREIT), the US office sector and the strong Singapore dollar.
In her speech, Joshi addressed the challenges the S-REITs are facing. She says: “The unexpectedly large and rapid increase in interest rates by the US Federal Reserve hit the sector hard. The Fed has raised its Fed Funds Rate 11 times since March 2022 by a total of 500 basis points, which is quite unprecedented.”
As REITs need capital to fund their business and do not keep much cash in their balance sheets due to regulatory and tax reasons, the rapid increase in rates impacted them negatively.
S-REITs primarily attract investors seeking yield. Interest costs are a REIT’s highest cost, so higher interest rates may lower distributions per unit (DPU). Rising interest rates also lead to a narrowing of the yield spread between S-REITs and benchmark government bond yields. This affects S-REITs’ price performance.
Interest rates also impact property valuations primarily because they prompt valuers to employ a higher discount rate. This elevated discount rate typically translates to a reduced property valuation unless the property’s income potential rises proportionately to offset the impact of the higher discount rate, Joshi explains.
“Looking ahead, the decisions made by the US Fed will remain important in influencing the performance of S-REITs,” says Joshi.
Pro-active capital management
The S-REITs themselves have been proactive with their capital management. Han points out that OUE Commercial REIT (OUE C-REIT) completed early refinancing of close to $1 billion of secured debt in August 2022 with an unsecured $978 million sustainability-linked loan. In May 2022, OUE C-REIT issued a $150 million 4.2% note. In June, OUE C-REIT refinanced a loan for OUB Centre which owns One Raffles Place with an unsecured sustainability-linked loan of $430 million.
OUE C-REIT owns 50% of OUE Bayfront, One Raffles Place, OUE Downtown, Hilton Singapore Orchard, Mandarin Gallery, Crown Plaza Changi Airport and Lippo Plaza in Shanghai. The Shanghai property comprises just 9% of OUE C-REIT’s AUM.
Han says: “We do not have any more refinancing until the second half of 2025. So we’re fairly comfortable for the next two to three years.”
REITs also need to ensure that their cost of debt is relatively insulated from short-term fluctuations in interest rates. At present, short-term debt is more expensive than long-term debt as evidenced by high yields on short-term T-bills compared to the yield on 10-year government bonds.
“We are also focused on our hedging level. We’re currently 68% hedged. That’s a fairly comfortable number. The question obviously is: Are we near peak rates? We do think we [US Fed Funds Rate] will go up with one or two more hikes potentially,” adds Han.
Whether to put on more hedges or let some roll off depends on whether the Fed’s rate cycle is at an inflexion point.
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With rates at current levels, hedges could cost more. “You’re paying a premium whether it is one year, two years, three years out,” Han says.
Chow, CEO of Lendlease Global Commercial REIT’s (LREIT) manager, says capital management and portfolio management are connected. All loans that need to be repriced this year are likely to be repriced at a higher rate.
“We are future-proofing ourselves. The two areas we are focusing on are capital management and driving cash flows,” Chow explains. “In the longer term, the REIT will continue to drive cash flow. More importantly, we need to observe the portfolio’s ability to grow its cash flow. That is the way to offset the rises in interest rates.”
Around 88% of LREIT’s assets are in Singapore. “You can touch and feel these assets, visit them and make your own judgement. I believe the assets that we have can grow and improve on their performance,” he adds.
LREIT owns 313@Somerset on Orchard Road and the adjacent multifunctional event space, Jem in Jurong Gateway and Sky Complex in Milan, Italy. On June 6, LREIT announced the acquisition of a 10% stake in Parkway Parade Partnership which indirectly holds 77.09% of the share value in Parkway Parade. The purchase price takes into account the agreed market value of Parkway Parade at $1.38 billion.
LREIT’s options to raise capital
Following LREIT’s FY2023 ended June results announcement on Aug 7, its unit price eased. On Sept 18, questions from the audience centred around LREIT’s gearing of 40.6% as at June 30, up from 39.3% as at end March.
“We have no sentiments concerning our portfolio. If we need to do something drastic to address the gearing, we can do that. A recent DBS report mentioned that we might potentially sell Jem Office Tower,” Chow says. Jem comprises a popular suburban mall and an office tower which has a long lease to a government agency.
“Jem Office Tower gives a really good cash flow, which probably is ideal for investors who may want to acquire it. If we do sell that asset, that will probably be able to help us to resolve all the gearing issues that investors have in mind,” Chow adds.
“We don’t have any balance sheet issues. Singapore’s office sector is supported by the demands from different sectors and new sectors. Investing in a decentralised office is one of the strategies that investors may adopt, given a more decentralised workforce around different areas,” he says.
“That’s why the office is still relevant. This doesn’t mean we will take action but it’s a concern among investors. And we are happy to address gearing issues. We need to make sensible decisions, instead of just holding on to an asset that doesn’t help us the REIT to grow,” Chow adds.
When LREIT acquired Jem in 2022, Jem Office Tower was estimated at around $451.5 million. Additionally, Sky Complex in Milan could also be divested. As at June 30, it was valued at the equivalent of $428 million, down some 9% y-o-y but still above the IPO acquisition price of $420 million.
“The Milan asset has the potential to improve on the valuations. The current valuations are based on the discounted cash flow of the existing lease of EUR200 psm per annum ($292 psm pa). The other two buildings adjacent to our building are leased at around EUR350 psm pa,” Chow says.
LREIT’s tenant has been in the building for around 13 years. Although rental escalations are pegged to the Consumer Price Index, the rate is still below market. “We believe we can maximise the value of the asset before selling it,” Chow points out.
If LREIT can divest both office buildings, that would give it ample capital to acquire Parkway Parade without equity raising. Interestingly, Parkway Parade also has an office tower.
The DBS report that Chow alludes to suggests that gearing could fall to around 32% with the sale of Jem Office Tower.
First REIT’s limited impact from rate hikes
First REIT has a largely non-Singapore-based portfolio, with only three nursing homes comprising 2.8% of its portfolio in Singapore. Its Indonesian assets comprise 11 hospitals, two integrated hospitals with malls, one integrated hospital with a hotel, and one hotel integrated with a country club, the Imperial Aryuduta Hotel & Country Club. Tan has articulated that he is looking to divest non-core assets such as the hotel and country club.
During the symposium, Tan recalls the rather challenging time he had explaining to investors the necessary steps to recapitalise First REIT in late 2021 and early 2022. The recapitalisation was necessary because its former sponsor Lippo Karawaci could no longer pay the master lease rent as stipulated in its IPO prospectus in Singapore dollars.
“About three years ago, we had to restructure our leases so that, going forward, we have a very sustainable rental income,” Tan says. The master lease rent for the Indonesian properties is the higher of base rent escalation of 4.5% or performance-based rent escalation of 8% of the hospital’s gross operating revenue in the preceding financial year.
“Our operator Siloam Hospital has been able to achieve very good results every quarter. They are experiencing double-digit increases in terms of their revenue and net profit,” Tan says.
In 1HFY2023 ended June, Siloam’s revenue, which is priced in Indonesian rupiah, rose by 17% y-o-y while net profit more than doubled.
On the capital management front, First REIT has not faced the same challenges that Singapore-focused REITs have faced. The Bank of Japan has not moved on interest rates while Bank Negara Indonesia has kept its rates stable as the rupiah hasn’t weakened much. First REIT’s gearing ratio as at end June was 38.7%.
“We will continue to manage our capital structure. Last year, we diversified our funding requirements. We were able to tap into a social bond with a credit guarantee from the Credit Guarantee and Investment Facility (CGIF), a trust fund of the Asian Development Bank,” Tan says. The $100 million five-year guaranteed bonds were priced at 3.25%.
“We also need to pay around 1% fees to CGI, but the total costs are below 5%. I would say, in hindsight, this is a very attractive price. We also completed some early refinancing. Hence, we do not have any refinancing needs until May 2026. At the same time, we also tried to manage our interest rates by entering into some hedges and our interest rates are capped at 86% of our debt on a fixed basis. So high and rising interest rates may have a very limited impact on us,” Tan points out.
Sustainable buildings attract tenants and investors
Joshi says sustainability is about future-proofing the properties owned by REITs. “Sustainability practices, though involving costs, can lead to operational savings over time. Examples include energy-efficient lighting, heating, ventilation and air conditioning, and advanced automation for energy control. There are also opportunities for green finance. seeing as more capital is allocated to green, or projects transitioning to green,” says Joshi.
Banks with net-zero targets are more willing to lend to REITs that have credible sustainability strategies and transition plans. Equity investors are also seeking out REITs with credible sustainability roadmaps, aligning investments with their own sustainability goals.
“Tenants, especially multinational corporations, look for sustainable buildings to lease space, benefiting REITs that invest in such improvements. As a result, the opportunity cost of neglecting sustainability is higher than greening a portfolio by adopting a long-term view and considering cost savings. By seizing sustainability opportunities REITs can enhance their financial and operational resilience,” Joshi concludes.