Unitholders of First REIT have two options on Jan 19: To vote in favour of the restructuring of the REIT’s Indonesian master leases and a whitewash waiver, or against them. But these are not really options. As The Edge Singapore has said before, this is Hobson’s choice. Not voting in favour of any of the two resolutions would result in default. So, to preserve what little value there is left in First REIT, unitholders should — in their own interest — vote in favour.
How unitholders should vote to save the REIT should in no way excuse the manner in which the former sponsor and current master lessee Lippo Karawaci has behaved. Although Lippo Karawaci has experienced negative operating cash flow since 2015, Lippo Karawaci’s management has put a positive spin on its performance, causing confusion among unitholders. Now is the time for Lippo Karawaci’s management to tell its shareholders that its prospects hinge on First REIT’s recapitalisation.
First REIT’s Indonesian properties are master leased to Lippo Karawaci and operated by Siloam International Hospitals. Its sponsors are OUE and OUE Lippo Healthcare (OUELH). All four entities are controlled by the Lippo Group and the Riady family.
In June 2020, Lippo Karawaci unilaterally announced that it intended to restructure the master leases for as many as 13 properties. Under the current rental structure, Lippo Karawaci provides a rental support which guarantees First REIT a certain rental level, such that a decline in Siloam’s revenues would increase the support provided by Lippo Karawaci.
In a press release on June 1, 2020, Lippo Karawaci says, “Revenues in some hospitals are down as much as 40–50% y-o-y and we anticipate the impact to be significant and structural over the medium term. Additionally, the rental support agreements, which were entered into over the past 10 years, also have a currency peg component, which puts further pressure on the arrangement in light of the Rupiah’s depreciation.” Rental amounts for almost all the hospitals are at only 40% their gross operating revenue, which Lippo Karawaci said was not feasible to sustain.
As Victor Tan, CEO of First REIT’s manager tells it, he was already in discussions with Lippo Karawaci for three IPO hospitals and a country club as far back as 2019. However, in June 2020, Lippo Karawaci announced it intended to restructure all the Indonesian hospitals leased to either itself or certain subsidiaries of Siloam. Of the 13 properties, 11 are hospitals, one is a mall while another is a country club. Three master leases expire at the end of this year, two master leases in 2025, three in 2027, two in 2028, one in 2031 and two in 2032.
“We were talking with them about the three hospitals and the country club [in 2019] and we were not aware they wanted to restructure everything in the middle of last year. Two years ago, the credit agencies downgraded them. We thought after the rights issue [in 2019 for Lippo Karawaci] things should be better and we could resolve the initial four IPO leases,” Tan says. “We were only aware in June last year they wanted to renegotiate the entire portfolio.”
Litigation, arbitration not feasible
Adrian Chan, senior partner at Lee & Lee and an independent director of First REIT’s manager, says, “We looked carefully at how feasible it would be to conduct arbitration procedures in Indonesia. It would be lengthy, costly, and during that period we won’t get rental income. if you want to sue your lessee, it would keep you in litigation for a long time and it would push them into insolvency.”
Based on data from Bloomberg, Lippo Karawaci’s operating cash flow and free cash flow have been negative since 2015. For the nine months ended Sept 30, 2020, Lippo Karawaci’s operating cash flow was negative IDR2,077 billion ($195,397), compared to negative IDR4,283 billion in FY2019 and IDR3,000 billion in FY2018. This was despite having raised some US$787 million ($1.04 billion) in 2019 through a rights issue and a further $340 million by selling Lippo Mall Puri to Lippo Mall Indonesia Retail Trust (LMIRT).
Preventing a double default
Restructuring the master leases and recapitalisation of First REIT would prevent a double default — that of Lippo Karawaci and First REIT.
Hospitals accounted for around 72.1% of First REIT’s rental and other income in FY2019, or $83.1 million, compared to total rental and other income of $115.3 million. Should Lippo Karawaci default on its rent given its stresses, First REIT would also default. For starters, the REIT would lose 72% of its own income, despite being offset by security defaults in the initial year.
Lippo Karawaci’s default would trigger a string of defaults notably on its US dollar bonds which could set off systemic problems within the entire group.
For First REIT, the rent defaults would breach its debt covenants and compound its inability to repay a $196.6 million debt due on March 1. What follows would inevitably be liquidation.
Tan says he and the board had studied other ways and means to raise cash, including the sale of assets and perpetual securities. But by the time the manager and its board had completed negotiations, it was already too late.
The problem with master leases
It is increasingly evident that master lease agreements (MLA) are a double-edged sword. (See sidebar) For First REIT, the experience is extremely negative. In 2020, First REIT was the worst-performing REIT (excluding Eagle Hospitality Trust which is suspended), followed by LMIRT. For all of Lippo Karawaci’s current problems, it appeared all too eager to sell its properties into First REIT at relatively overvalued levels 15 years ago.
During its IPO in 2006, First REIT’s prospectus clearly stated almost as a warning, that the valuation of the initial properties was based on the rent/Ebitda ratio (also known as Ebitdar) of approximately 99% for FY2005. This was almost twice as high as valuations in other REITs. Rent/Ebitda in Australian healthcare REITs ranged from 50% to 60%, according to First REIT’s prospectus, and healthcare REITs in the US ranged from 48% to 53%. This means the valuation of the IPO properties was based on inflated values.
The prospectus added that “the ratio of rental over Ebitda [Ebitdar] becomes lower over time from the listing date of a REIT and the cumulative average yearly rent/Ebitda ratio for the properties over the next five years from FY2006 appears to be in line with that of international case studies. Taking that, as well as the tenure of the Master Lease Agreements into consideration, Knight Frank [the then valuer] concluded that the rental payments for the properties are sustainable.” Unfortunately, this did not materialise.
“The IPO prospectus states that at IPO, the percentage of Ebitdar was higher than the 40-45% of Ebitdar [for the sector] but meant to come down to 40-45% in time,” Tan points out. “The IPO assets started with almost 100% of Ebitdar. But they didn’t manage to achieve that [decline to 45%] and Covid impacted [the portfolio] as well and made the whole scenario from [Lippo Karawaci’s] basis become unsustainable,” Tan explains, adding, “Lippo Karawaci bore the foreign exchange risk and this contributed to the problem.”
Now, the new rental formula translates into an Ebitdar of 40–45%. The rent is in rupiah and the base rent is 8% of the preceding gross operating revenue. This is a lot simpler than the old MLA which had one formula for four hospitals, and a slightly different formula for the seven other hospitals. The step-up mechanism for the fixed rent is 4.5% per annum as compared to the current step-up mechanism which is two times the Singapore consumer price index subject to a cap of 2.0%. For the buffer against depreciation, there is a 2.45% increase in 2022 and up to 40.35% in 2035 when compared against the growth in the base rent of First REIT under the existing base rent formula.
First REIT’s announcement says that the commencement base rent translates into an Ebitdar range which is similar for other healthcare REITs such as ParkwayLife REIT, Northwest Healthcare Properties, Medical Properties Trust and RHT Health Trust of 40–45% of Ebitdar.
“On restructured leases, rents are 40–45% of Ebitdar, and that is supported by the valuers and in line with REITs in Singapore. In Australia, there was a transaction where Brookdale Senior Living sold assets at 45% of Ebitdar,” Tan points out.
Revaluation loss
However, all these ratios including the rental escalation is cold comfort for unitholders who will have to grapple with revaluation loss by funding it. Renegotiating and restructuring First REIT’s portfolio based on the new MLA would result in a revaluation decline, and hence funding shortfall in the capital structure. As evident, First REIT’s hospitals and other assets are valued based on their rents and cash flow.
The new rent causes a decline of 32.7% in rental income to $77.6 million, and 32.9% decline in net property income to $75.1 million when compared to FY2019 levels. This translates into DPU of 4.44 cents (pro forma, pre-rights) compared to FY2019’s DPU of 8.6 cents. NAV falls from 99.6 cents in FY2019 to 51.8 cents on a pro forma basis (before the rights issue).
OCBC Bank and CIMB Bank announced they are willing to refinance $260 million out of a previous $400 million loan package, resulting in a funding shortfall of $140 million. Hence the need to recapitalise the REIT through a dilutive rights issue of 791.06 million new units at 20 cents per unit, in the ratio of 98-for-100 units.
“We announced we have a $260 million refinancing package and there is a shortfall of $140 million, and we need to recapitalise the REIT by raising $158.2 million,” Tan continues. “Out of this $140 million will be used to pare down the loan and we can refinance the whole $400 million package.” Tan says that OCBC and CIMB have supported First REIT since IPO. “They are willing to continue to support us. Given the situation we’re in and potentially looking at lower cash flow from the master leases that would impact valuation, they will continue to support us. But they need to see that all unitholders, in particular our parents, can support us,” he adds.
OUE and OUELH, which together owns 19.7% of First REIT, and its manager have given an undertaking to acquire all the units that are not subscribed for, in effect underwriting the rights issue.
What can First REIT acquire?
When it was formerly International Healthway Corp or IHC, OUELH had been tidying up its balance sheet by divesting its Australian assets and finishing up the litigation with the previous shareholders. OUELH has kept its Japanese nursing homes which were valued at around $299 million as at end FY2019 and valued at $314 million as at June 30, 2020, due to a stronger Japanese yen.
After the rights issue is completed, and based on a theoretical ex-rights price of 31 cents, the post-rights DPU of 2.59 cents translates into a yield of 8.35%, but with a gearing ratio of around 34% to 35%.
“It’s going to be very challenging for us to acquire anything, but it can still be yield-accretive if we were to acquire Japanese nursing homes,” Tan acknowledges. First REIT could borrow at 1% for an NPI yield of 4% from the nursing homes and still get some accretion.
“Our gearing ratio is 35% and we have debt headroom. We could borrow at a higher loanto-value on local Japanese assets on low Japanese rates and have a high yield-on-equity. Then it would be accretive,” Tan elaborates.
On top of that, First REIT would be able to diversify away from its Indonesian assets that have been something of a millstone around the REIT’s neck. “The goal is to have a more diversified asset base,” Tan says.
