It is tough being the manager of a REIT with US properties listed in Singapore, with the exception Digital Core REIT. For some reason, investors just do not value US S-REITs with commercial properties at more compressed yields. This is despite a rally of sorts in Singapore-based office S-REITs — even in the face of higher interest rates.
The US office REITs, which include Keppel Pacific Oak US REIT (KORE), Manulife US REIT (MUST) and Prime US REIT, are trading at DPU yields of between 8% and 9% and discounts to net asset value (NAV). United Hampshire US REIT, which owns retail properties, is trading at 10%.
One of the reasons that Soilbuild Business Space REIT gave for its privatisation announced in 2020 is that the manager found it challenging to grow the REIT given the high yields and lack of investor support.
S-REITs are required to pay out at least 90% of their distributable income. As a result, S-REITs do not have retained earnings in their capital structure. For acquisitions and growth, S-REITs have to lean on their unitholders and other investors. In addition, the Singapore external manager model comprises a sponsor that holds a major stake in the REIT, and the manager. The sponsor supports the REIT financially and it also provides the REIT with a pipeline of assets. Often, REITs lean on their sponsors for financial support in the event of capital-raising.
In order to have full tax transparency, no single unitholder can own more than 9.9% of a US S-REIT. This has limited the sponsor’s role in US S-REITs. That could be one of the reasons that US S-REITs trade at higher yields than S-REITs. “The higher yields of US S-REITs are possibly because of the lack of anchor investors, coupled with a large mix of retail investors,” notes Vijay Natarajan, an analyst at RHB Bank.
In the event of any preferential equity fundraising or rights issue, sponsors often act as a backstop, underwriting the issue should it not be fully subscribed. The US S-REITs do not have such an advantage.
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Still, to date, since its IPO in November 2017, KORE has managed to raise equity and grow its net lettable area and asset size by 27% and 43% respectively. During the same period, its DPU is up 15%. That is a pretty good track record compared to its peers even though DPU growth is a lot less than AUM growth.
“Over the last few years, the yield on our REIT has been significantly higher than we believe is warranted given the strength of the US office market, in particular the markets we are in and the performance of our portfolio. We have expected our yield to fall as our portfolio and results proved themselves over time. However, while our portfolio’s performance and financial results have been strong, our stock price and therefore yield, have not performed in accordance with our underlying performance,” acknowledges David Snyder, CEO of KORE’s manager.
To be sure, KORE’s occupancy has held up better than its peers. Since IPO, occupancy remained stable as the portfolio expanded. This, coupled with under-rented properties, has helped to underpin DPU.
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Defensive campus properties
When KORE first listed, its properties were seen as less premium than those in MUST’s portfolio. However, as evidenced by the performance of KORE’s portfolio and also Ascendas REIT’s US campus properties, the sector appears to have more or less withstood the underminings from the pandemic.
“Our focus, since listing in 2017, has been to invest in business campus and office buildings in key growth markets driven by tech and innovation, including several Sun Belt markets, which has been an important differentiator for KORE. The majority of KORE’s properties are in fast-growing markets and that have significantly higher technology/TAMI (technology, advertising, media and information) and healthcare tenancy,” Snyder says.
Interestingly, MUST acquired three campus properties in the Sun Belt last December, diversifying away from Class A and trophy buildings. “While gateway cities and gateway adjacent markets remain popular investment choices for many, KORE has differentiated itself since its inception with a strategy to invest in desirable buildings in first choice submarkets in key growth markets in the US, rather than investing in gateway and gateway adjacent markets like our competitors. That has proven to be an astute decision as the majority of our chosen markets have consistently outperformed in many metrics, including GDP growth, employment growth and rental growth, even during the pandemic,” Snyder points out.
The pandemic changed the way many of us work. For white-collar workers, work-from-home (WFH) became a way of life. According to a report in The New York Times, in the last two years, some 50 million Americans left their offices. “Before the pandemic, in 2019, about 4% of employed people in the US worked exclusively from home; by May 2020, that figure rose to 43%, according to Gallup,” the report says. Although this means that a majority of the workforce continued working in person throughout the last two years, for white-collar workers, 6% worked from home before the pandemic. By May 2020, this figure rose to 65%.
KORE’s essentially campus properties are relatively low rise, spread out, and located in second-tier cities such as Seattle, Denver, Nashville and Houston. These campus-style properties are generally focused on TAMI, medtech and healthcare companies.
The other point is that there is little speculative construction in the cities and sub-markets where KORE’s properties are located. “New development has been very limited during the pandemic as office developers, and especially the banks that generally finance them, have been quite cautious. The resulting slowdown in new supply, especially from speculative office construction, should help the office market stabilise and support higher occupancy and lease rates even as work-from-home trends may cause some businesses to shrink their office footprints,” Snyder says.
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Before the pandemic, long leases came with rental escalations. However, landlords also provided tenants with something called tenant incentives which are the equivalent of rent-free periods. For ultra-long leases of, say, 10 years, tenant incentives could include 10 months of rent-free periods.
Since the pandemic, leases are a lot more flexible. This may mean lower tenant incentives, as leases are shorter, and tenancies could come with break clauses.
Offsetting impact of rate hikes
“Focusing on the right tenant base should also help to insulate the REIT from rising interest rates and inflationary pressures. Having a tenant base that consists significantly of fast-growing sectors including technology/TAMI and healthcare companies can potentially facilitate rental growth that will keep up with, or potentially beat rising costs,” Snyder says.
Another way to combat rising interest rates is to utilise a reasonable amount of fixed rate debt. Snyder puts this at 50% to 90%. As at end 2021, KORE’s fixed-rate debt accounts for 83.4% of total debt. The high fixedrate debt portion provides stability and defence against rising interest rates. The US Federal Reserve announced a 25bps rise in the Federal Funds Rate on March 16. The rate hike is likely to be the first of four hikes in a rate hike cycle.
Rate hikes are being used to curb inflation, too much of which has a negative impact on the economy. The rental escalations built into long lease structures also partially offset higher costs from inflationary pressures.
“KORE has quite a high level of built-in growth, largely due to the choice of markets we invest in and our strong TAMI, medical and healthcare tenancy profile,” Snyder says. “Despite the ongoing pandemic, our technology markets, in particular, have fared better than most other markets, resulting in an overall positive rental reversion of 6% as at end 2021,” he indicates, adding that KORE’s in-place rents remain at 4.9% below our asking rents, providing further room for growth.
Interest rates affect risk-free rates such as the yield on 10-year US Treasuries. REITs take their pricing off riskfree rates through the yield spread. “We are hopeful that our yields will not be significantly impacted by a rise in the 10-year treasury as our spread is far higher than what we believe is warranted, based on our strong portfolio and its performance as well as the significant spread between the risk-free rate and cap rates in our markets,” Snyder says.
On the flip side, generally, in a rising interest rate environment, at some point, rates rise enough to cause some amount of increase in capitalisation (cap) rates. Income capitalisation is a common valuation methodology. Interest rates would eventually lower capital values. The spread between risk-free rates and cap rates is tighter in gateway cities than in the markets KORE invests in.
“There seems to still be a fairly wide margin, or cushion, between the risk-free rate and cap rates in our markets. Even in gateway cities, there is still a reasonable gap by historical standards, especially compared to fixed income spreads in other asset classes,” Snyder says.
Hence even if KORE’s yields expand, cap rates are likely to rise as well, and that would imply that net property income (NPI) yields would rise. Since these yields are likely to offset each other, rising rates would most probably not affect KORE’s ability to make an acquisition. At any rate, the cap rates of campus properties in KORE’s markets are likely to be higher than Class A properties in gateway cities.
“If our yields were to increase, it could impact our ability to raise equity, but given the current wide spreads, it seems likely that the effect on cap rates should be more significant than the effect on our yield/price/value. Hopefully, our performance before and during the pandemic will lead to investors’ having increasing confidence in KORE that would also help to realign our current yield,” Snyder hopes.
