If there was one standout from the REITs that announced results in the week of April 18-22, it was their focus on capital management. REIT managers are moving to limit the impact of interest rate hikes on their distributable incomes and distributions per unit (DPU). Interest expense is often locally listed REITs’ highest cost, higher than their management fees. Increasingly, as oil and gas prices rise, analysts and investors are also enquiring about the impact of higher electricity prices on DPU.
The REIT managers of Keppel Pacific Oak US REIT (KORE), Keppel DC REIT (KDC), Keppel REIT, Mapletree Commercial Trust (MCT) and Sabana Industrial REIT announced higher fixed-rate debt for the three months to March 31, compared to the October–December quarter in 2021. MCT has a March year-end, while KORE, KDC, Keppel REIT and Sabana REIT have December year-ends.
First, the backdrop. At the start of the year, before the Russia-Ukraine war, the US Federal Reserve had communicated the need to raise the Federal Funds Rate (FFR) around six to seven times, to get the FFR to higher levels of as much as 2% from the 0%-0.25% as at end-2021, to fight inflation. Inflationary pressures have become worse following the war because of various sanctions on Russian oil and gas, and food inflation could also be a serious problem as Ukraine is viewed as the breadbasket of Europe.
Back to the REITs. Higher interest rates affect REITs in three main ways. First of all, REITs’ unit prices take their pricing off riskfree rates. Hence higher risk-free rates imply expanding yields, which may lead to a price drop. REIT managers have little control on market pricing, except to manage their portfolios well. Interest rates indirectly affect capital values through their impact on discount rates, which are inputs required for capital values of properties.
Interest rates also affect the way REIT managers manage their portfolios. Managers can mitigate interest rate impact by prudent capital management. Among the factors in prudent capital management are staggered debt expiries, higher fixed-rate debt, different sources of debt, and the ability to keep funding costs as low as possible. All the REITs that announced results on April 18-21 have staggered debt expiries. Notably, S-REITs with Chinese assets (except for CapitaLand China Trust) do not have clear, staggered debt expiries.
Interest rate impact on DPU
See also: CICT's manager proposes to acquire ION Orchard at $1.85 billion, subject to EGM
Among the REITs that have reported results or business updates, Keppel REIT has shown the most dramatic improvement in its portion of fixed-rate debt, rising from 63% as at end-December to 71% as at end-March (see table). In addition, Keppel REIT’s manager has said that every 50bps rise in rates will shave 0.14 cents or 2.4% off its FY2021 DPU. While the Fed has indicated that the FFR is likely to rise by 100bps this year, the so-called pass-through between US and local SOR and SORA may not be 100%. In fact, if there is additional US dollar liquidity in Singapore, local rates may remain flat, or rise by a lower quantum.
KORE’s DPU is likely to be more directly impacted by US FFR as it is priced in US dollars. Its fixed-rate debt rose to 84.2% in 1QFY2022 ended March 31, compared to 83.4% for the quarter ended Dec 31 (see table). KORE’s manager says every 50bps would impact DPU by 0.062 US cents. Among the REITs that have reported results, only Mapletree North Asia Commercial Trust’s (MNACT) portion of fixed-rate debt had fallen. The portion of MCT’s fixed rate debt increased notably, from 75% as at Dec 31, 2021, to 80% at March 31. MNACT’s average cost of debt was 1.81% and MCT’s average cost of debt was 2.4% as at March 31.
See also: CICT's manager proposes to acquire ION Orchard at $1.85 billion, subject to EGM
Higher utility costs
Increasingly, analysts are focusing on utility costs. This is because Keppel DC REIT’s manager surprised the market by announcing that “a further 10% increase in our portfolio electricity costs would have an approximately 3% impact on FY2021 DPU on a pro forma basis”.
A spokesman for KDC REIT’s manager explains: “Electricity costs for our co-location assets are still largely on a pass-through basis. For our master leased assets, power is contracted by our clients directly with the power supplier. For the electricity costs that are not passed through, a further 10% increase in our portfolio electricity costs, which includes tariffs as a potential factor, would have an approximately 3% impact to FY2021 DPU on a pro forma basis.”
According to the spokesman, co-location contracts are generally shorter than the master leased assets. “We will also try to secure positive reversions at renewals and see how we can pass on increases in energy costs to our clients when we sign the new contracts,” the spokesman says, referring to co-location contracts.
“On a portfolio basis, the built-in income and rental escalations based on Consumer Price Index or similar indexation, or fixed rate mechanisms, will serve to mitigate the inflationary impact,” he adds.
Data centres are heavy users of power. KDC REIT’s manager is taking steps to mitigate the use of oil and gas as sources of power. The REIT is a signatory of the Climate Neutral Data Centre Pact in Europe. Its Dublin assets are all using renewable energy sources. “Our assets have either/or a combination of sustainability awards, accreditations and certifications,” the manager says.
KDC REIT’s manager has targeted to introduce renewable energy (including the use of solar-powered equipment) to at least 50% of the REIT’s co-location assets by 2030, as well as encourage renewable energy use at all other portfolio assets. The manager is also planning to achieve at least a 10% reduction in effective Power Usage Effectiveness for co-location assets that undergo major asset enhancement works, by 2025 from a 2019 baseline.
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Analysts question impact of costs on NPI
Sharon Lim, CEO of MCT’s manager, reveals that MCT’s portfolio has a utility contract at “the low 10 cents” level, that is, electricity is contracted at just above 10 cents per unit. For the 12 months to March 31, 2022, MCT’s electricity cost was $7 million, compared to its property expenses of $110.8 million, and its net property income (NPI) was $377 million.
“Utilities cost less than 7% of operating expenditure. Our fixed-rate contract ends in end-October so we have five months till we enter into a new contract,” Lim says. She acknowledges that electricity prices could be on an upward trend. “If we talk about doubling, we are talking about [3.7%] of NPI. So if the price goes up to 30 cents, it will be more than that,” she adds.
Elsewhere, Donald Han, CEO of Sabana REIT’s manager, has been proactive in articulating the impact of both rising interest rates and higher utility costs. In 1Q2022, Sabana REIT’s portion of fixed debt rose to 72.3% from 66% as at Dec 31, 2021. “As a small REIT navigating through the current inflationary environment, we are keeping a close watch on rising costs. For this reason, we are proactively taking measures to reduce overall utility consumption across our portfolio,” he says.
