SINGAPORE (Sept 2): In our article “Attracted by fees, foreign sponsors continue to list, boosting SGX’s position as global REIT hub” (Issue 891, July 22), we wrote that there had been three large real estate investment trust (REIT) IPOs with US assets since the beginning of the year, and that future large IPOs are most likely to be S-REITs with US assets.
S-REITs with US assets differ from -those with local assets in many aspects. Generally, they include the length of the leases, reflected by their weighted average lease expiry (WALE); management fees, comprising base and performance fees; and rental reversions, which is the change in rents upon the expiry of the lease. But, more importantly, the assets in these REITs have exposure to a different geographic location, which may explain the lack of interest and unfamiliarity among local investors.
Clearly, S-REITs with Singapore assets are more popular with investors than -those with US assets. REITs with local assets have higher liquidity, based on their average daily traded volume, and they trade at more compressed yields than those with US assets (see table). In addition, some S-REITs with predominantly local assets, such as CapitaLand Mall Trust, CapitaLand Commercial Trust, Frasers Centrepoint Trust, Mapletree Commercial Trust and Mapletree Industrial Trust, have a large following of institutional investors.
When the US REITs were listed, some of their initial investors were high-net-worth individuals, family offices and retail investors. Since then, Manulife US REIT (MUST) has made efforts to garner some institutional investors.
Another drawback is the perception that some US sponsors are not as committed to their REITs as the likes of CapitaLand, Ascendas-Singbridge, Mapletree Investments and Frasers Property. This is because no single unitholder can own more that 9.8% of a US REIT for withholding tax purposes. Other S-REITs, including those with European and Australian sponsors, can get sponsor support, as sponsors own between 18% and 40% or more of their REITs, and are ready to backstop equity raisings.
Sponsor support is important, particularly if a REIT needs to raise equity to purchase properties. The perception of a lack of sponsor support could be a reason why both MUST’s and Keppel KBS US REIT’s (KORE) rights issues in the past couple of years were not well received, resulting in sharp selldowns. Now, both REITs are likely to make acquisitions, which means that they will be raising equity.
KORE has articulated that it plans to acquire US$100 million ($138.8 million) of assets this year. Its manager may need to either lean on unitholders to help fund the acquisitions or obtain new investors through a placement.
MUST’s manager has stated that one of its objectives is to become a constituent of the FTSE EPRA NAREIT Developed Asia Index. To achieve this, it needs a free float market cap of around US$1.3 billion.
“We look forward to entering the FTSE EPRA NAREIT Index in due course,” said Jill Smith, CEO of MUST’s manager, in a recent results briefing. “We are a little short,” she added, referring to the free float market cap required. To get there, MUST needs an additional US$140 million, which it could achieve through an acquisition funded by debt and equity.
Sound assets, sustainable yields
REITs with US assets, a sound capital management and leasing strategy, and whose managers’ interests are aligned with those of unitholders are a good way to diversify the portfolio. Yields are attractive in a yield-hungry environment and properties are usually freehold.
Listed in November 2017, KORE is a play on US office REITs. Its strategy is to focus on key growth markets driven by innovation, particularly the tech sector. KORE has assets under management of US$1.09 billion. Its portfolio consists of 13 freehold office buildings and business campuses across seven cities with a lettable area (NLA) of 4.2 million sq ft. As at June 30, the company’s portfolio had a committed occupancy rate of 94%. The key growth markets of KORE have outperformed gateway cities such as San Francisco and Los Angeles on the macroeconomic fundamentals front for the past five years (see Chart 1), and are expected to continue doing so, which bodes well for KORE’s strategy of geographic market focus.
KORE’s portfolio is mainly concentrated on the West Coast, particularly Seattle. The three properties in Seattle are located in one of the most active leasing submarkets within the city. This submarket is one of the best-performing office markets in Seattle, mainly driven by the technology and aerospace manufacturing industries. Projected rental growth over the next 12 months for these three properties is expected to be the highest within the portfolio, at a steady rate of 4.3% to 7.8%. Accordingly, the WALEs for these properties are much lower than that of the portfolio, to capitalise on the higher potential cash rental income. Overall, the prospects for KORE‘s portfolio appear good and stable, denoting that yields are more likely to be sustainable.
Market intelligence reports have indicated positive overall net absorption, stronger rental growth and lower vacancies for 2019 to 2023 for key cities in the US. Furthermore, real GDP and the employment rate for the submarkets are projected to grow at a rate of 3.0% and 1.9% a year respectively from 2018 to 2022, compared with the gateway cities’ 2.1% and 1.0% growth a year respectively.
Distributable income in 1HFY2019 also outperformed the company’s forecast by 23.1%, which resulted in an adjusted DPU of three US cents compared with the forecast 2.44 US cents. KORE’s WALE as at June 30 was 3.8 years by cash rental income and 3.9 years by NLA; this rather short WALE is to capitalise on potential positive rental reversion, which grew 8.6% y-o-y in 1HFY2019.
On the credit quality front, KORE has hedged 76.8% of its term loans, which limits its interest rate exposure. With the dropping interest rate climate, KORE may lose out on potentially lower interest expenses. Regardless, Ebitda (earnings before interest, taxes, depreciation and amortisation) interest coverage is healthy at 4.6 times. Leverage is also at 37.7%, moderately below the stipulated 45% limit on S-REITs. The average cost of debt (weighted average interest rate on debt) and average term to debt maturity are rather decent at 3.78% per annum and 3.32 years respectively as at June 30. No major red flags on the credit front affecting KORE’s sustainability of yields are visible.
Some concerns as US economy cools
A concern local investors may have regarding S-REITS with US assets is the taxation policy. KORE in particular has a tax-efficient structure, whereby it is not subject to the 21% US corporate tax and 30% US withholding tax. However, the tax structure may be subject to changes, as the US Department of Treasury has delayed finalising these tax regulations. KORE indicates that this will not cause any material changes to its consolidated net tangible assets (NTA) and distribution per unit. In addition, the company is not subject to the 17% Singapore corporate tax or 10% Singapore withholding tax. As it stands, KORE is only subject to a limited tax not expected to exceed 2% of distributable income. As long as the DPU figures are not subject to material changes, yields for KORE should be sustainable.
KORE’s focus on riding the tech sector growth, however, could be a double-edged sword. With close to one-third of its tenant base from the technology sector, and with finance and insurance being the third-largest sector of tenant exposure (see Chart 2), KORE would be in a rather precarious position if an economic slowdown occurs, as the tech sector in particular is one of the more elastic sectors during economic recessions. Furthermore, of the top 10 tenants by cash rental income, six are from the tech sector, contributing 13.2% to KORE’s cash rental income. Two of the other tenants are from the finance and insurance sector, which contribute 3.8% of CRI.
The capital expenditure of US companies is expected to take a hit, owing to the trade war and the likelihood of a recession. Specifically, technology companies appear to be most affected by the pressures of a slowing growth outlook and the trade tariffs with China. Though most sectors are expected to increase spending moderately, tech firms will most likely cut capex by 8.7%, much higher than the expected 3.1% forecast three months ago, according to Citigroup analysts. Case in point: Cisco Systems, a networking hardware company, issued a weak forecast, owing to a significant drop in IT equipment orders by companies fearing slower growth and the trade war. Cisco happens to be one of the tech occupiers in Seattle, where KORE has a strong presence.
However, although it looks like the capex outlook for the tech sector is downbeat, this does not mean all tech companies will be affected. KORE’s top tenant, Ball Corp, which contributes 3.5% of the portfolio’s CRI, has a solid financial profile. The company has been resilient throughout the past few financial recessions, right from its listing 40 years ago on the New York Stock Exchange.
Overall, at an annualised distribution yield of 7.9%, the prospects for exposure to the US tech property market through KORE are rather compelling compared with the lower yields of S-REITs with local assets. Investors will need to make their own investment decisions, based on their risk profile.
