Perpetual securities, or perps as they are often called, are in the news again, but in a positive way. Lendlease Global Commercial REIT (LREIT) announced that it plans to increase its interest in Jem to as much as 31.8%, for up to $337 million. This will enlarge its portfolio to around $1.8 billion. The agreed property value for Jem would be $2.08 billion and the acquisition is subject to an EGM. With the acquisition, LREIT’s DPU could rise by 3.8% while its gearing ratio would fall to 33.8% from 35.1% as at end December 2020.
How can LREIT acquire a property on a DPU accretive basis and yet anticipate that its gearing ratio could fall? That’s because perps issued by REITs are viewed as equity for the purpose of a REIT’s capital structure. Therefore, in Table 1, we have perps as a percentage of total equity that includes perps and minority interests.
On May 27, LREIT announced it would issue $200 million in perpetual securities on June 4 at a coupon of 4.2%. Perps are the closest thing to a panacea for REITs looking to keep gearing under control. Some REIT managers view perps as expensive debt. This is because perps are subordinate to bonds and hence cost more. On the other hand, perps cost less than equity.
At a coupon of 4.2% of its perps and DPU yield likely to be around 5.9%, LREIT would still have to use a portion of the debt to make the transaction yield accretive. Jem’s net property income yield is just 3.9% based on the agreed property value.
Shortly after LREIT’s announcement, Suntec REIT announced on June 7 it plans to issue $150 million of perpetual securities. Earlier this year, Mapletree Industrial Trust announced the issuance of $300 million of perps and sister REIT, Mapletree North Asia Commercial Trust announced on June 1, it is issuing $250 million of perps on June 8.
When perpetual securities are offered mainly to accredited investors and institutions, the announcement accompanying them states that distributions are non-cumulative and that the REIT trustee is not under any obligation to pay distributions. And given perps are perpetual, they may be redeemed or they need not be redeemed. If not redeemed, the distributions are reset. Unlike corporate perpetual securities, the perps of REITs have no step-up feature.
Helps to keep gearing at bay
Because REITs have a cap on their gearing — currently at 50% in terms of debt to assets — some REITs are tempted to issue perps. For instance, Suntec REIT’s gearing stood at 44.4% as of March 31, 2020.
OCBC Credit Research says it tends to look at perpetual securities as a percentage of the sum of an issuer’s equity, perpetual securities and its debt. This is in order to gauge the portion of perpetual securities vis-a-vis the issuer’s total capital.
For instance, Lippo Mall Indonesia Retail Trust’s (LMIRT) perpetual securities comprised 34% of its total equity as of end December but have improved to 18.5% following a rights issue that raised $281 million in January.
Similarly, LREIT’s perpetual securities are likely to comprise some 12.6% of its total equity based on its balance sheet as of Dec 31, 2020. LREIT is a relative small REIT with assets of just $1.5 billion.
“We think perps are good funding alternatives for S-REITs on top of traditional bank loans, bonds, or equity — as long as they are not utilised as “financial engineering” to make deals look accretive on acquisitions. However, important metrics to look at are perps as a percentage of equity — anything above 10% can be perceived as “high” by the market and look through gearing — preferably remains below the statutory limit of 50%,” notes Soochow CSSD Capital Markets in a comment on Suntec REIT.
OCBC Credit Research says in a note dated June 7 that Suntec REIT’s aggregate leverage at March 31, 2020, was 44.4% and would be higher at 45.3% after adjusting 50% of its perpetual securities as debt. In December 2020, Suntec REIT completed the acquisition of a 50% interest in two Grade A office buildings with ancillary retail components in London, for $766.5 million.
Why REITs’ perps are equity-like
The distributions to the REIT perps are entirely at the REIT issuer’s discretion. The issuer may, at its sole discretion, elect not to pay a distribution (or pay only a part distribution) which is scheduled to be paid on the payment date for the perpetual security. The non-payment of any distribution on the perpetual security in whole or in part does not constitute a default, much like for ordinary equity. In addition, any distribution which is deferred is non-cumulative and will not accrue interest. The issuer is not under any obligation to pay that or any other distribution that has not been paid.
However, as a safeguard to protect the interest of the perp investors, there is a “dividend stopper” feature on these REIT perpetual securities. A dividend stopper or “blocker” is a term which states that the issuer will not, within a specified period of time (usually known as the “stopper period”), pay a coupon on another security or class of securities if it does not pay a dividend on the security in question. This feature means that if on any distribution payment date, payment of all distribution scheduled to be made on the perpetual security on such date is not made in full, the issuer would not be able to declare or pay any dividends on any of the securities which rank junior to the perps, including the REIT’s common units.
As an example, On Dec 14, 2020, LMIRT announced that distribution due to be paid on Dec 19, 2020, for its 6.6% perpetual security would not be paid. This triggered its dividend stopper clause. This prevents any distribution for other perpetual securities, including its 7% perpetual securities.
Subsequently, LMIRT announced an optional distribution and fulfilled this in February. The optional distribution is one of the conditions for lifting the dividend stopper. Moreover, by February, LMIRT had monies in from its rights issue and was able to fulfil its bond obligations which also had a dividend stopper.
REITs loathe skipping distributions on their perpetual securities. This is because REITs are valued based on their DPU yields and payment of distributions on common units is fundamental to the construct of REIT investing. As a result, issuers will endeavour to pay the full distributions on their perps to avoid stopped distributions on their common units. In other words, an issuer can elect not to pay (or pay partial) distributions on the perps, but then it will have to forgo paying distributions on the common units which rank junior to the perps. Only very stressed REITs such as LMIRT would opt not to pay perpetual security distributions.
Issuer’s option to call, reset instead of step up
Perpetual securities are redeemed at the option of the issuer, usually on their distribution dates. However, there is no obligation to “call” the securities. It is usually made clear to investors, that the issuer may or may not redeem the perps. Among the S-REITs, Ascott Residence Trust chose not to redeem its perps on June 30, 2020, and its next call date is in December.
First REIT — another stressed REIT in the Lippo Group that had to undertake a dilutive rights issue raising $158.2 million in February this year mainly to repay debt — has a call date coming up in July. But it is under no obligation to redeem this tranche of perps. And it can also miss a payment without having to default.
Similarly, LMIRT has a call date in September. But as has been the experience of its investors, it can lower distributions, reset or simply not pay distributions without having to default. And the issuer may or may not redeem the perps. Suntec REIT’s coupon is 4.25% from June 15, 2021, to June 14, 2026. From June 15, 2026, the coupon is likely to be the prevailing reference rate plus a spread of 3.29% if it fails to call.
While it is tempting to view REITs’ perpetual securities as expensive debt, their subordination, their perpetual nature (by sidestepping call dates) and their ability to skip distributions — which have been experienced by investors this past year — make them equity-like
