Yong Yean Chau, the unassuming and soft-spoken CEO of ParkwayLife REIT’s (PLife REIT) manager, describes the relationship between a healthcare REIT, its operators and master lessees as a collaboration. PLife REIT owns three hospitals in Singapore, where IHH Healthcare is the master lessee and an IHH unit is the operator. PLife REIT also owns 49 nursing homes in Japan, operated and tenanted by 27 operators and master lessees.
PLife REIT’s most important relationship is, of course, with IHH. On July 14, PLife REIT and IHH jointly announced they had renewed the master leases for the three hospitals for another 20 years, starting in August 2022.
“I stressed it is not about how much rental I can get. Our objective is far more than that. It is about how to support our operator to be even more successful. Healthcare expenditure will grow in the region and the stronger players will be in a position to capitalise. The end objective is to help the operator compete. When the operator faces difficulty and loses market share it will affect the landlord,” Yong says in a recent interview with The Edge Singapore.
The new master lease agreement provides the REIT with very modest uplifts in rental in the first three years. This is because PLife REIT is committed to spending $150 million to upgrade its hospitals. However, the manager has clinched a right of first refusal (ROFR) for Mount Elizabeth Novena Hospital from IHH.
Rent cap at 15% of revenue
The new master lease agreement assumes that rental revenue from the three hospitals — Mount Elizabeth Hospital, Gleneagles Hospital and Parkway East Hospital, paid by IHH — is no more than 15% of the revenue IHH receives as operator and master lessee of the hospitals, as stipulated in PLife REIT’s 2007 prospectus.
PLife REIT will inject a one time renewal capex of $150 million to renovate and upgrade the Singapore Hospitals, most of which will be spent on Mount Elizabeth Hospital between 2023 to 2025. During this period, the master lessee (IHH) will get a total rent rebate of $60.9 million. Hence, the rent increase during 2023 to 2025 — assuming the new lease starts in August 2022, with 2023 being the full year of the new lease — is likely to be modest.
If the expiring rent for this year is $71 million, a 2% increase is likely in 2022, which will take rental revenue to 72.4 million. Rental growth for year one or 2023 is likely to be 3% to $74.6 million, year two or 2024’s rental revenue is likely to be $76.9 million, for a further y-o-y growth of 3%, and year three or 2025’s rental revenue is likely to be $79.2 million, for an additional y-o-y growth of 3%.
Once the asset enhancement initiative (AEI) on Mount Elizabeth completes, rental revenue is likely to surge by 25% y-o-y to $99.2 million in 2026, or year four, when the impact of the renewal capex kicks in, and rental rebates fall away.
“There is a 3% uplift in rents per year over the downtime period [2023 to 2025]. By year four [2026] when the tiered rent rebate drops off, there will be 25.3% increase in rent to $99.2 million at end of year four which signifies 39.6% growth over year 15 (of the old master lease) rent of $71 million,” Yong confirms.
The renewal capex is likely to be funded by cash and debt. Hence, the new master lease agreement is DPU and NAV accretive, and gearing is set to stay below 38%. DPU rises from an annualised 13.9 cents in 2021 to a projected 14.3 cents in FY2023. By year four of the new master lease in 2026, DPU rises to 18.26 cents — assuming there are no changes in units or portfolio and not taking into account acquisitions.
The importance of occupancy cost
“Rental affordability is a big issue. Can the tenant pay me this rental for 20 years? The collaboration comes in the form of the landlord providing the tenant and operator with a platform to improve profitability. The end motivation is to look at further synergies we can derive from each other. That is our key priority,” Yong continues.
For healthcare REITs, occupancy cost is usually measured by the ratio of rent to Ebitda. The guide for PLife REIT is its rental revenue ceiling of 15% versus the revenue the hospitals provide for IHH. As such, and based on the Ebitda of the hospitals in IHH’s annual report, PLife REIT’s rent/Ebitda ratio for the three hospitals is low, at around 20%.
The three hospitals contributed around 60% of PLife REIT’s NPI in 1H2021, with 39% of NPI contributed by 47 out of 49 Japanese nursing homes. Two were acquired on June 30. While PLife REIT does not publish its rent/Ebitda ratio, the occupancy cost of Japanese nursing homes is around the average for healthcare assets, at 45% or so. PLife REIT’s Japanese portfolio is believed to be within the average in terms of occupancy cost.
Tenant default risk is a real issue that local investors grappled with last year. In January, following an EGM, First REIT’s master leases were restructured, and it raised equity through a dilutive rights issue to stave off a double default, that of Lippo Karawaci (LPKR), First REIT’s master lessee, and First REIT itself. The master lease was restructured such that the valuation of the hospitals fell sharply, hence the equity raising of $158.2 million.
When First REIT listed in 2006, the rent/Ebitda ratio for LPKR was 99%, almost twice as high as ratios for healthcare REITs in developed markets at the time. First REIT’s assets are mainly in Indonesia.
Separately in July, First REIT announced it planned to sell Sarang Hospital in South Korea, for US$4.52 million ($6.1 million). It was acquired for US$13 million in 2011.
Nursing homes offer stability
In January, PLife REIT announced the divestment of a non-core asset in Japan — a pharmaceutical facility — for the equivalent of $37.1 million, at a yield of 4.3%. The sale price is 12% higher than the original purchase price of $33.2 million. In June, PLife REIT acquired two nursing homes in Japan for the equivalent of $49.4 million, 7.7% below valuation with a net property yield of 5.7%.
Japan will continue to be on the radar, as PLife REIT is one of the largest owners of Japanese nursing homes.
Yong says the Japanese nursing homes provide stable income as the average length of stay is years rather than months or weeks. PLife REIT’s nursing homes have an average length of stay ranging from three years to five years. On the other hand, hospital stays are short, around three days to five days. The Singapore hospitals’ cash flow is more volatile. “In the hospital, a lot of people check in and out. In nursing homes, you see the same residents,” Yong says.
Yet, the margins of the Singapore hospitals are much higher than the Japanese nursing homes. PLife REIT investors are aware that the rent/Ebitda ratio of the Singapore hospitals is a lot lower than those of other REITs.
“There is market precedence where landlords can charge high rentals but this is not sustainable because the tenants’ cash flow does not allow it to be sustainable,” Yong explains. “It’s something we’re very mindful of in calibrating a good rental. The tenant’s ability to service the rental was part of the evaluation we’ve given due consideration to,” he says, adding that the new master lease rental agreement was based on the hospitals’ cash flow.
The new master lease agreements are likely to tilt PLife REIT’s portfolio in favour of Singapore. By year four, Singapore could account for as much as 70% of NPI and assets if there are no further acquisitions. “The ideal mix is likely to be predominantly in Singapore, that is no less than 50%. When we talk about moving into other countries it is about enhancing return and diversifying risk,” Yong says.
What’s next?
Geographically, for a third country, Yong prefers a developed market, with political stability and a developed healthcare system. During PLife REIT’s AGM last year, it finally received approval from unit holders for a general mandate. Since its IPO to last year, PLife REIT did not have a general mandate, and is one of a very few REITs not to have issued units in any form of equity fund raising.
Mount Elizabeth Novena is valued at some RM3.9 billion ($1.2 billion) in IHH’s FY2020 annual report. IHH has also stated that its capitalisation rates for its hospitals range from 4.8% to 6.7%, similar to those reported by PLife REIT’s annual report.
Assuming Mount Elizabeth Novena is sold at a more compressed cap rate of say 3.5%, it would still be accretive. If PLife REIT’s DPU yield of 3% (it is actually lower) is assumed to be its cost of equity, and its cost of debt is say, 0.6%, its cost of capital would be closer to 2.1%. PLife REIT’s gearing ratio is around 37% in 1H2021, its NPI yield is 5.6% based on 1H2021 results and cost of debt is 0.56%.
While PLife REIT’s AUM is $1.99 billion, its market cap is $2.88 billion. Hence, if Mount Elizabeth Novena is sold into the REIT for $1.5 billion, PLife REIT would be able to fund the acquisition with 50% debt and 50% equity, using a combination of a placement and/or preferential equity fund raising. IHH holds 35.6% of PLife REIT. IHH in turn is held by Mitsui & Co (32.9%) and Malaysia’s Khazanah Nasional (26.02%).
Yong declines to elaborate on the ROFR to Mount Elizabeth Novena, except to point out that with the renewal capex, the hospitals are able to drive profitability. With a low occupancy cost there is a greater chance the revenue sharing can kick in. From 2026 onwards, the rental formula is similar to the existing one: IHH pays the higher of either the preceeding year’s rent plus [1+(CPI+1%)] or base rent plus variable rent (3.8% of average hospital revenue).
“The last thing is to have a very high rental jump and tenants can’t afford to pay and they renegotiate. This is the reason why the relationship can be renewed,” Yong says.
All that remains is for unit holders to vote for the new master lease agreement in an EGM where IHH cannot vote.
