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Tenant improvements sink US office S-REITs but the trough is nigh

Goola Warden and Jovi Ho
Goola Warden and Jovi Ho • 13 min read
Tenant improvements sink US office S-REITs but the trough is nigh
Bridge Crossing, a three-storey office building in KORE’s portfolio. US office owners have been pummelled as higher borrowing costs weighed on valuations. Photo: KORE
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Late in March, Bloomberg reported US office property transactions in Downtown Los Angeles are at rock-bottom prices, including the office building at 777 South Figueroa. This is near a property owned by Manulife US REIT (MUST) BTOU -

since its IPO.

Also in Downtown LA, the Gas Company Tower on 555 West 5th St, a property owned by “an affiliate of Brookfield Asset Management” is facing foreclosure. According to Bloomberg, this property was appraised in 2020 at US$632 million based on a note by Barclays and the current valuation could be as low as US$141 psf ($191 psf), valuing the building at US$200 million.

William “Tripp” Gantt, the CEO of MUST’s manager, said at the REIT’s FY2023 ended December 2023 results briefing on Feb 8 that “the distress in Downtown LA has been pretty well-publicised”. “A lot of owners have handed keys back to the banks; some of the properties in Downtown LA are actually bankowned right now.”

Gantt’s comments predated the reported Brookfield transaction by more than a month. He noted then that some “all-cash, high-net-worth buyers” were stepping in and making “pretty aggressive plays” for buildings in Downtown LA.

Bloomberg reports that office owners have been pummelled as higher borrowing costs weighed on valuations, with prices falling about 14% in the 12 months up to the end of February, according to real estate data provider Green Street. Landlords have also struggled with tenant demand given the rise in remote work since the start of the pandemic.

Too good to be true

See also: Asset disposals ‘worth the wait’, even with penalty fee: MUST chairman

In 2016, when MUST was listed, its portfolio was promoted as office buildings with freehold tenures and long weighted average lease expiries.

In addition, because of the way it was structured, distributions per unit (DPU) were mainly absent from the 30% US withholding tax so long as certain forms were filled ahead of DPU distributions.

If this sounded too good to be true, it was. However, that did not stop other REITs with pure US assets from being listed on the Singapore Exchange S68 -

: Keppel Pacific Oak US REIT (KORE) CMOU - in 2017, Prime US REIT OXMU - in 2019 and United Hampshire US REIT ODBU - (UHREIT) in 2020.

See also: European S-REITs: Odyssey with different challenges and opportunities

What was not highlighted or made known to investors at the time was the major difference between US office landlords and Singapore office landlords. In Singapore, tenants usually pay for renovations of their office property. In the US, the landlord pays.

“US office requires a substantial amount of capital to build out and lease office space because the landlords, rather than the tenants, are responsible for funding the tenant improvements in addition to funding new or improved tenant amenities, leasing commissions and other costs,” KORE’s manager stated in a media release on Feb 15.

“This is very different from the Singapore office market. Therefore, office REITs that invest in the US require more capital investment than office REITs that invest in Singapore. Without the necessary capital investments, US landlords’ ability to retain tenants and attract new ones would be greatly compromised, thus leading to a decline in occupancies and net property income (NPI), resulting in valuations declining even more significantly,” they added.

Ideally, MUST’s manager should have stated this back in 2016. Unfortunately, Singapore retail investors were not made aware of the accounting treatment of these tenant improvements.

These are funded by debt but the improved rentals are fed into the NPI — an item on the P&L (profit & loss) statement — and eventually distributable income, which includes expenses such as interest expense and fees.

Hence, although tenant improvements are balance sheet items adding to the value of a property, the depreciation on the capex is paid out.

Ideally, the accounting treatment should be to withhold the depreciation. This anomaly has now been flagged in KORE’s FY2023 ended December 2023 results announcement. Its manager highlighted the amount of tenant improvements required to attract tenants as well as the higher rents tenants have to pay. These were US$46.7 million in FY2023, US$43.6 million in FY2022, US$27.5 million in FY2021 and US$23.6 million in FY2020.

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On Feb 15, David Snyder, CEO of KORE’s manager, explained that KORE’s portfolio occupancy and NPI remained stable despite the difficult US office market, which started to drift downwards in 2020. This is evidenced by KORE’s FY2023 NPI rising 2.2% y-o-y and committed occupancy of 90.3%.

“The occupancy and operating performance have largely been a result of the capital investment into the portfolio. Hence, continued investments are necessary to maintain performance, occupancy and valuation. It is not sustainable for KORE to continue funding capital via debt given its leverage level and the constraints outlined above,” Snyder had said in prepared remarks.

According to Snyder, KORE spent more as a percentage of AUM (assets under management) than either MUST or Prime US REIT. This was indeed the case. In FY2023, KORE’s distributable income was US$52.2 million, down 13.8% y-o-y due to higher interest costs.

During the results briefing back in February, Snyder said KORE is likely to spend about US$60 million on tenant improvements in 2024 and a further US$40 million in 2025.

“Withholding distributions from the fourth quarter for 2023 and the first and second quarter for 2024 should provide us with US$60 million. Suspending distributions through 2025 should provide US$40-plus million. Additionally, we also have availability [of funds] under committed RCF (revolving credit facility). That should cover all of our capital needs for 2024 and 2025,” Snyder estimated.

When asked why KORE needed US$100 million for capex for a US$1.28 billion portfolio, Snyder replied that the monies are primarily for “tenant improvements for new leasing, speculative suite buildouts [something like a showflat] and various asset enhancement initiatives [AEIs] to provide amenities and make the buildings more attractive for tenants”.

“One of the issues we’ve been running into over the last couple of years is just the increase in cost to build space; building quality space is costing us 20% more. That really does represent what we think needs to be spent if we want to try to have a chance at being 90% [occupancy],” Snyder explained. “It’s not that we’re throwing tenant incentives at folks to try to bring them in.”

MUST barely survives spending spree

History has shown that profligate spenders cause problems. MUST was no different. In the second change since the team that aggressively acquired properties departed, MUST’s manager announced last month that John Casasante, DWS’s regional director, will replace its current CEO and CIO while new CFO Mushtaque Ali will replace the current CFO. The three outgoing leaders, along with MUST's current deputy CEO, will depart the manager on June 30.

MUST’s buying spree inflated the number of properties it owned from just three at IPO to 12 in 2022. By then, problems were around the corner and these were highlighted in the article Can Manulife US REIT avoid buyer’s remorse? in March 7, 2022, Issue 1025 of The Edge Singapore.

Yet, it appears remarkable to us now that as recently as late in 2021, when the US was on the cusp of an interest rate hike cycle, MUST acquired a further three properties.

This had a devastating impact on its balance sheet and capital management efforts. Of the three properties that were acquired in December 2021, two have been divested to sponsor Manulife and a third is part of MUST’s tranche 1 properties, which is classified as “not worth keeping”, to put it bluntly.

Among the tranche 1 properties, Figueroa was an IPO property. The other three were part of the previous management’s buying spree — Centerpointe, Penn and Diablo. These tranche 1 assets suffer occupancy risk, high capex requirements and offer low return potential.

Interestingly, Phipps — the property that some in the manager’s C-suite were keen to divest in 2023 — is a tranche 3 property, which means it is worth keeping. Tranche 3 properties are those where occupancy risk is low, capex is “low to medium” and total return potential is medium to high.

Allowances and free rent

According to JLL Research, MUST’s submarkets saw tenant improvement allowance ticking up in 4QFY2023 ended Dec 31, 2023, to slightly below US$60 psf, after three quarters of declines. These allowances grew nearly 20% between mid-2021 and mid-2022, tracking a surge in the amount of free rent offered.

Meanwhile, the amount of free rent offered grew for the second consecutive quarter to slightly above four months in 4QFY2023, returning to a level last seen in 1QFY2023. Then, these submarkets had recorded 10 consecutive quarters of increases in the amount of free rent offered to tenants.

MUST’s property-related non-cash items, which include “straight-line rent adjustments and amortisation of tenant improvement allowance, leasing commissions and free rent incentives”, doubled y-o-y to US$8.35 million in FY2023.

MUST has been transparent about the struggles faced by US commercial real estate. According to its financial statements for FY2023, the continued weakening of occupancy performance across the US office market is leading to higher vacancy levels.

As a result, “higher concession package assumptions” are needed to attract new tenants or retain tenants, giving rise to higher leasing costs.

There were also some aberrations. In June 2023, MUST announced that its then-fifth-largest tenant by gross rental income exercised an early termination of its lease at 500 Plaza Drive, also known as Plaza, in New Jersey. Then, the tenant contributed 3.3% to MUST’s overall gross rental income.

The tenant, The Children’s Place, exercised its early termination rights for its lease expiring May 31, 2029, and said it would vacate its 197,949 sq ft of space on May 31, 2024. By opting to terminate the lease early, the tenant had to pay a US$4 million termination fee.

However, at the release of MUST’s FY2023 results on Feb 8, the manager announced that The Children’s Place had signed another lease at the same building — downsizing to 120,000 sq ft in a 13-year lease expiring 2037. The new lease will begin in May.

“They said that they were leaving the building, and then re-approached us as if they were a new tenant,” said MUST CEO Gantt in February. “I can’t recall a time where I’ve ever seen that approach to a lease negotiation, or renewal negotiation.”

As a new tenant, however, The Children’s Place received about $60 psf in tenant incentives (TIs). MUST’s chief investment officer Patrick Browne said this is a “very strong outcome” for a 13-year lease. “We’ve certainly seen very high TI packages around the country. This feels like a relatively modest outlay for us on this tenant.”

Rental reversion of –2% was also “modest”, added Browne, who is based in the US. “So, it begs the question; we’re unsure why the $4 million termination thing came [about] because I don’t think we’re any worse off in terms of what we may have had to negotiate.”

Either way, MUST is “glad to have them back in the building”, said Gantt. “I’ve never seen anybody take the approach that The Children’s Place did, so I wouldn’t expect that to be a norm moving forward either. I’d be surprised if we see that again.”

He quipped: “I would welcome it because we can certainly use the cash up front and that would be great. But I don’t think we’ll see that again.”

Outlook for US office

Fitch Ratings points out, citing Green Street Advisors US Commercial Property Price Index (CPPI), that US office values have fallen approximately 35% from their peak in 2020, a lesser decline compared to the 47% drop in the Global Financial Crisis (GFC).

However, office values in this cycle are hovering close to their lowest point in nearly four years and have yet to bottom out, Fitch adds. Fitch projects the US CMBS (commercial mortgage-backed securities) office delinquency rate is likely to more than double from 3.6% as of February to 8.1% as at the end of 2024, rising to 9.9% in 2025, surpassing the post-GFC peak.

This means that valuations will fall. In conjunction with elevated rates and lower cash flows, the delinquency rate suggests that the workout of some CMBS office loans may settle at values close to this cycle’s lows. Because of likely further declines in appraisal values, Fitch expects its current CMBS ratings to incorporate at least a 40% decline to values implied by issuer loan-to-value at issuance.

Brookfield is less negative than Fitch. In a February report, Brookfield points out that 90% of all US office vacancies are contained in the bottom 30% of buildings. These are mainly older offices with limited amenities and reduced functionality (obviously in the portfolios of US REITs listed locally).

The top 25% of office buildings, on the other hand, are experiencing record rents including above pre-Covid-19 levels and stable occupancy rates.

“We believe this growing divide will only widen as legacy leases expire and tenants look for new space that reflects evolving business culture to engage employees and meet sustainability goals,” Brookfield says.

“To resolve the vacancy issues plaguing office real estate, we believe a large portion of these older office buildings will need to be repositioned, repurposed or demolished,” adds Brookfield.

“Prior to rising interest rates and the outbreak of the pandemic, there was already a clear trend of companies gravitating to higher-quality office buildings with modern amenities. This shift saw rents in newer or renovated buildings begin to climb along with their profitability.”

Against this backdrop, it is likely that KORE, with the most renovated buildings among the US office S-REITs, is likely to come out of the current backdraft in the best shape.

Among US non-office S-REITs, UHREIT has been relatively unscathed because the valuations of its 20 necessity grocery-anchored properties and two self-storage facilities have not fallen despite rising capitalisation and discount rates. Its valuation rose by 4.7% y-o-y on a like-for-like basis.

Nonetheless, it has not gone unnoticed that UHREIT’s tenant improvements amounted to US$18.69 million in FY2023. Yet, out of the distributable income of US$33.1 million, the REIT manager retained just US$2.8 million as capital reserves for AEIs and management fees. Its depreciation charge in FY2023 was US$1.37 million compared to US$3.40 million in FY2022.

Struggle to survive

Prime US REIT, which owns 14 office properties valued at US$1.4 billion, has as its main challenge a US$600 million loan that matures in July. But, unlike MUST and KORE, which have suspended distributions from 2H2023 till end-2025, Prime declared a DPU of 0.25 US cents and a 1-for-10 bonus valued at 1.03 US cents.

This, coupled with 1HFY2023 DPU of 2.46 cents, works out at 3.74 US cents for FY2023 compared to DPU of 6.55 US cents in FY2022.

Prime’s manager attributed its problems to tenant incentives being funded by debt. Hence, it has reduced its cash distributions drastically to preserve cash to meet Prime’s capex needs and to “provide creditors with the assurance that the REIT will reinvest cash flows in the business alongside its lenders”.

The refinancing of US$600 million of credit facilities maturing in three months is weighing on Prime’s unit price despite analysts hinting that this is under control.

Interestingly, market observers are reporting that a rescue package, including a significantly subordinated structure, is being put together for Prime. It is not known whether the package refers to the US$600 million credit facilities. It remains to be seen if this rescue package has sufficient legs to allay refinancing concerns.

(Editor's note: A previous version of this story attributed data about MUST's submarkets to MUST's portfolio. We are sorry for the error.)

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