When Black Lives Matter protests broke out in Washington DC earlier this year, one of Manulife US REIT’s (MUST) properties located a few blocks away from The White House, was badly hit.
“We had graffiti on the walls of the Penn and we had to board up the windows at Penn. Penn’s occupancy fell below 10% because people didn’t feel safe,” says Jill Smith, CEO of Manulife US REIT’s manager, using the nickname for the building located at 1750 Pennsylvania Avenue.
Fortunately, the damage to Penn was covered by insurance, and its tenants, which are largely government agencies, continued to pay rent.
“For Penn, close to half the building is occupied by government agencies,” Smith says. “This is when you find out the creditworthiness of your tenants. We’ve had 96% of our tenants paying their rents in 2QFY2020 end-ed June. Some people have been slow so we may have to wait till next month,” she adds.
Smith says Penn is “like the Tardus”, alluding to the British phone booth that is the time travel machine used by Dr Who of the sci-fi TV series of the same name. “Everything’s been changed inside although it was built in 1964,” she says of the building.
Better news yet, it appears that the worst of a double whammy — the Covid-19 pandemic and the protests, otherwise known as the 2Ps — has receded. “We had Covid-19 and the pro-tests. We went from pandemic to pandemonium, a P2P,” Smith tells The Edge Singapore in an interview, making light of the crisis in the understated British way.
As it stands, MUST’s books closed on Aug 12 and unitholders will receive all of their 3.05 US cents DPU for 1HFY2020 ended June on Sept 25. MUST is one of a handful of REITs that did not cut DPU in 1HFY2020. In fact, it is up marginally y-o-y, helped by 18.8% y-o-y higher Net Property Income (NPI) of US$62.2 million from two acquisitions.
MUST completed the acquisition of Center-pointe in Fairfax Virginia and Capitol in Sacramento last year. Centerpointe and Capitol added US$5.7 million and US$7.6 million respectively to 1HFY2020’s NPI, offsetting de-clines by Exchange in Jersey City, Michelson in Orange County and Figueroa in Los Angeles.
Relatively insulated
According to Smith, more than a third of MUST’s tenants used its properties as headquarter locations. These are usually the last offices to be downsized should the US economy continue its downward spiral. Fortunately, the stimulus programme — the Heroes Act — has staunched the losses suffered by businesses and prevent-ed their closure. One of the facets was the Pay-check Protection Programme (PPP) that provided small business loans to SMEs.
“We have very few SMEs, and they can apply for loans under the PPP,” Smith clarifies. SMEs are viewed as the most vulnerable business segment during Covid-19.
Unlike in Singapore, office leases in the US are usually long, with no break clauses. If ten-ants are in trouble, the landlord is likely to negotiate with the tenant, help in doing a financial assessment, or sublet the premises. As at June 30, MUST’s weighted average lease expiry (WALE), is 5.7 years, one of the longest among office REITs.
A long WALE with no break clause insulates MUST’s portfolio from Covid-19 uncertainties. Moreover, lease expiries for this year are just 3.5% by gross rental income. However, certain costs have risen because of Covid-19. For instance, the air filters of its properties have been upgraded, the frequency of cleaning has increased, and MUST has issued a guidebook for tenants on what to do when they return to the office.
But there have been cost reductions elsewhere too.“Unnecessary cost has been reduced,” Smith says. In particular, with Quantitative Easing to infinity, and no raising of policy interest rates by central banks, in particular the US Federal Reserve, till at least 2022, the cost of debt is falling.As at July 31, MUST’s average cost of debt stood at 3.21%, down from 3.26% as at the end of 2QFY2020, which in turn is lower than the 3.37% as at end December 2019 and the 3.32% in 2QFY2019.
“Next year, our cost of debt will fall further for Penn and Michelson [3161 Michelson Drive, Irvine, California]. Penn’s cost of debt was above 4% and Michelson was 2.5% and we should be able to bring these costs down by mid-2021,” Smith says.
In May, MUST received a US$100 million ($136.6 million) green loan from Oversea-Chinese Banking Corp to refinance 1100 Peachtree Street, Atlanta, Georgia. “A green loan is not more expensive. It means the building is good enough for a green building and a green mark. Investors who look at your ESG score would look at you more favourably. Eventually, you could have a lower cost of capital as more investors are beginning to focus on sustainability,” says Smith, referring to MUST’s ESG (environmental, social and governance) initiatives.
Lower valuations at half time
Despite the stability of MUST’s portfolio, half-year valuation fell by 2.9% because CBRE, MUST’s appraiser, had assumed lower rental growth projections. For example, if rents are growing at 3% a year and zero rent growth is assumed, that would cause cash flows to fall, and hence the property’s net present value, even if discount rates remain stable.
Jennifer Schillaci, chief investment officer at MUST’s manager, says there were no changes in capitalisation rates because there are very few transactions this year. One notable deal was US Bank Tower in Los Angeles, which was owned by OUE and sold to a unit of Silver-stein Properties for US$430 million, or a 34% discount to its book value of US$630 million.
“US Bank Tower’s headline valuation was below what it was worth and that was on the market for more than a year. The building traded more than where it should have been with less than 80% occupancy and the required capital to get the leasing up to stabilised rates of 85% [was hefty],” Schillaci says. This is different from MUST’s property at 865 South Figueroa Street, which is also in downtown LA. “Figueroa is not affected [by that transaction] because we have long-term leases, strong tenants and higher occupancy rates,” explains Schillaci.
WFH trends
Although all of MUST’s nine buildings remain open, in terms of actual occupancy, only 10-20% is occupied despite the official occupancy rate with paid tenants being 96.2%. This is because Covid-19 has accelerated the digi-talisation and work from home (WFH) trend. In a recent report, property consultancy JLL points out that there will be “an inevitable correction in the short term for office space as the economic impact flows through to corporate activity”. Covid-19 is leading to a “de-densification” trend which could offset the decline in demand for office space from WFH trends.
”The successful implementation of large-scale homeworking and widespread adoption of technologies for remote working are now causing corporates to re-evaluate their future space requirements,” JLL says in its report. “As yet, few appear to be taking this opportunity to reduce footprints, although this may increase as occupiers reach lease expiry dates,” the report adds.
Glassdoor Economic Research which provides data and research on the labour market says that 54% of workers work from home in the US as at March. That represents a substantial increase from only 28% of workers in 2011.
“In the US, the top few sectors — legal, finance, media and tech — were the early adopters of WFH and 60–75% of their workforce are eligible to WFH,” notes Carol Fong, head of investor relations at MUST’s manager.
According to the Gensler US Work From Home Survey 2020, 10% of the population work from home full time, and only an incremental 2% want to WFH full-time. “People may really want to go back to the office. Incrementally, the proportion of people wanting to work from home is tiny, just 2%,” Fong points out.
JLL says the correlation between economic growth and office demand has always been strong. “A significant recession is forecast in 2020 with a full recovery taking time, but risks exist around this scenario. The OECD has released a double-hit scenario where there is a second wave of infections before the end of 2020 substantially prolonging the impact and recovery time. In either scenario, unemployment will rise sharply and employment growth will be negative. This implies a slowdown in office demand over the recovery period similar to other downturns, but a bounceback is forecast over the longer term,” JLL suggests.
Since its IPO in May 2016, Smith has focused on fortifying MUST’s portfolio by adding properties, and diversifying geographically and tenant base. “We are in a fortunate position and we do have a buffer. There’s been talk of pent up demand. If you’re 5–10% below market rents if you get 5% increase, you’ve still got positive rental reversions,” she says.
While a couple of MUST’s properties command above-average market rents, overall, the passing rent is US$40.93 versus average market rent of US$41.3.
As Smith sees it, MUST remains in a resilient place. Firstly, there is limited supply in the cities where its buildings are situated. Secondly, Class A and trophy properties will be in higher demand. “You want a building where the air filters are the newest and we changed all ours to the newest around,” Smith says. “Employers want their employees to be safe. If I want to bring my employees back, Class A is man-aged better and would be cleaner.”
Third, de-densification should offset WFH trends. Fourth, there should not be a big jump from WFH trends.
And finally, “urban suburban” spaces — referring to offices not in gate-way cities — are likely to outperform those in the CBD of gateway cities, Smith reckons. At any rate, secondary cities such as Fairfax County, Secaucus and Jersey City are less likely to be places where protests start.
With a resurgence of protests following the shooting in the back of an African-American man in Kenosha, Wisconsin, Smith must be relieved that most of MUST’s buildings are in urban suburban locations. “Better to be urban suburban than the CBD,” she says.
