CFA Society Singapore
SINGAPORE (Mar 4): The two local real estate investment trusts (REITs) with US properties have moved up handsomely since the start of the year for two main reasons: clarity on tax and a dovish-sounding US Federal Reserve.
Clarity from the US Department of the Treasury on Dec 20, 2018 on proposed regulations under the US Tax Cuts and Jobs Act for REITs led to a price rally at the beginning of the year. Manulife US Real Estate Investment Trust (MUST) and Keppel-KBS US REIT (KORE) announced on Dec 27 that their current trust structures do not need to be changed to maximise distributable income (DI).
“For the time being, interest rates seem to have flattened and the Fed has also moderated its stance on rates,” notes David Snyder, CEO of KORE’s manager. This is seen to have a net positive impact on REITs.
REITs benefit from stable and declining interest rates in three ways. They are valued based on the spread between the risk-free rate and their unit prices. Yields on 10- year US government bonds stand at around 2.65%, the lowest level in a year. Lower risk-free rates imply higher valuations for unit prices. In addition, cost of debt impacts a REIT’s distribution per unit. The lower the cost of debt, the higher the DI and DPU. Capital values are indirectly affected by interest rates, and capitalisation rates tend to expand in a rate hike cycle, although this relationship comprises many other inputs.
Valuations are also affected by the outlook for rents, and transaction values of nearby properties. Sometimes, during rising rates, cap rates can compress. For instance, during the rate hike cycle in 2018, the cap rates of a couple of properties owned by MUST fell. Michelson, a state-of-the-art 19-storey, high-rise trophy office building in Irvine, Orange County, Southern California, compressed 90 basis points to 4.8%, and Peachtree, a 27-storey, high-rise Class A office building in Atlanta, Georgia, inched lower by 10bps to 5.8%. Elsewhere, the cap rate for The Exchange, a 30-storey Class A office building in Jersey City, New Jersey, compressed 3bps to 4.9%.
MUST’s net asset value per unit stayed stable at 80 US cents as at Dec 31, unchanged y-o-y. This is despite a placement and preferential equity offering to finance the acquisition of Penn, a 13-storey Class A office building in Washington DC, and Phipps, a 19-storey trophy office tower in Atlanta. MUST’s total weighted average cap rate for FY2018 is 5.1% compared with 5.5% in FY2017.
Growth through acquisitions to moderate
During a recent results briefing, Jill Smith, CEO of MUST’s manager, said: “Obviously, we’re still committed to growth through acquisition. It has to be the right building, the right time and, most importantly, it has to be accretive.”
In February 2018, Smith announced that the REIT planned to double its assets under management (AUM) to US$2.6 billion (from US$1.31 billion in FY2017) in the next two years. MUST is closing in on that figure. As at Dec 31, 2018, MUST’s portfolio valuation stood at US$1.738 billion.
Annualised DPU for MUST, based on 4QFY2018’s DPU, is 6.12 cents, giving a yield of 7.28%. The REIT’s debt headroom is around US$80 million ($108 million) before it reaches the psychological 40% gearing level. Several cities could offer accretive suburban Class A acquisition opportunities, but there are likely to be fewer opportunities for CBD properties. MUST could, with a combination of debt and equity, make an accretive acquisition in cities such as Chicago and Atlanta, where sponsor Manulife owns properties.
Similarly, Snyder will focus on organic performance. “Following the strategic additions of the Westpark portfolio on Nov 30, 2018 and Maitland Promenade I on Jan 16, this year will see us adopt a sharper focus towards optimising our enlarged portfolio of assets and strengthening our income to drive unitholder returns,” he says.
KORE’s gearing as at Dec 31 stood at 35.1% and any acquisition would probably require debt and equity. KORE is trading at an annualised DPU yield of around 8.5%, based on the pro forma DPU after contribution from the Westpark portfolio in Seattle, which was acquired at a cap rate of between 6% and 6.25%. “Any potential investments will be carefully evaluated to make sure that they are in the REIT’s and unitholders’ best interests,” Snyder says.
‘Class A properties are more resilient’
MUST plans to focus on trophy and Class A assets, according to Smith. “We continue to distinguish ourselves through our high-quality portfolio of trophy and Class A assets, which will provide strong income in upcycles and remain resilient during down cycles compared with Class B and lower-class business park properties,” she says.
Property yields and cap rates are likely to be a reflection of the risk profile of the building. Class A properties will usually have lower cap rates and REITs with just trophy and Class A buildings are likely to trade at tighter yields. While Class B properties are less resilient during down cycles, this is compensated for by higher yields and will suit investors looking for more yield.
For FY2018, MUST announced 16 leases signed with rental reversions of 8.9%. This excludes a recently completed lease to Hyundai Capital America of 20% of Michelson for 11 years. Committed occupancy for MUST’s portfolio as at end-2018 was 96.7%. Excluding the new Hyundai lease, MUST’s weighted average lease to expiry (WALE) was 5.8% as at end-2018.
Snyder says KORE's rental reversions last year were in the high single digits. Its WALE at 3.9 years is shorter than MUST’s, and its committed occupancy rate as at end-2018 stood at 91.6%. Among its properties, 1800 West Loop South and West Loop I & II in Houston have vacancy rates of 24.4% and 9.6% respectively.
“As part of our proactive efforts to boost leasing and occupancy, we have embarked on asset improvement initiatives across these properties,” Snyder says. “This involved building out and fitting out spaces to be move-in ready, redesigning lobbies and common areas, adding new conference rooms as well as refurbishing eating and lounge areas. We are also adding fitness centres. These are amenities that are not commonly found in neighbouring properties and will enhance the appeal of these properties to potential tenants.”
In addition, KORE still has 42.2% of leases to renew by 2021, based on rental income — twice as much as MUST’s 21% for the same period.
Sound capital management, organic growth support DPU
MUST has a weighted average cost of debt of 3.27%, and its debt is almost fully hedged at 98.6% on fixed rates. Its weighted average debt to maturity is 2.7 years. Although KORE has a longer weighted average debt to maturity of 3.7 years, its cost of debt is higher at 3.53%, and 80.4% of its debt is hedged on fixed rates. In addition, 77% of KORE’s bank borrowings mature in 2021 and 2022. MUST has a more evenly spread debt maturity profile.
Both REITs have guided for organic growth in their portfolios. Leases of 94% of MUST’s portfolio by rental income have rental escalations. Similarly, KORE has built in average rental escalations of 2% to 3% of its portfolio by rental income.
KORE’s strategy is to stay with “first-choice submarkets in key growth cities”. “These are markets where economic, population and employment growth outpace the national average, among other factors. A big factor driving that growth is that these are desirable cities in which individuals want to live and work. Important drivers such as these support a strong office market and will drive organic growth, which will help us provide sustainable distributions for unitholders,” Snyder explains. Seattle is an example of a first-choice submarket — it is the home of Amazon, Microsoft and Google.
“At the same time, having our ears close to the ground and to our tenants is important. As the CEO and CIO [chief investment officer], I am based in the US, and this allows me to be closer to the market, tenants and our asset managers,” Snyder says.
Although US economic growth is likely to moderate in the coming years, momentum in the office real-estate sector is projected to continue, Snyder says. “Leasing momentum has been robust, driven by a strong jobs market, coupled with a constrained office supply cycle, especially in first-choice submarkets… given that growth fundamentals in these markets outpace the national average,” he notes.
This story appears in The Edge Singapore (Issue 871, week of March 4) which is on sale now. Subscribe here