(Aug 19): With five US real estate investment trusts listed on the Singapore Exchange, Jag -Obhan, chief financial officer of Manulife US REIT’s manager, clearly wants MUST to differentiate itself. How has the REIT done this? “By derisking,” Obhan says. “Derisking the balance sheet, portfolio, tax issues and tenant profile.”
From just three properties at IPO, MUST, through a series of acquisitions, now owns a portfolio of eight properties, of which two are trophy buildings and the remainder, Class A buildings. In May, the REIT bought Centerpointe I and II in Fairfax, Virginia, on the outskirts of Washington, DC, for US$122 million ($169.4 million) at an implied capitalisation rate of 7.55%.
Rental escalations and the acquisition of two properties in 2018 — Phipps in Atlanta and Penn in Washington, DC — helped grow net property income for 1HFY2019 by 30.8% y-o-y to US$52.3 million.
The manager renewed anchor tenant Hyundai Motor Finance’s lease at Michelson, a trophy building in Irvine, Orange County, California. Altogether, two leases that totalled 151,000 sq ft were renewed for 11 years at Michelson, with rental escalations of 3% a year.
For the portfolio as a whole, the top 10 tenants accounted for 38.9% of gross rental income as at June 30, compared with 43.8% in December 2018. No sector accounts for more than 21% of GRI, with legal services, and finance and insurance contributing 20.7% and 20.2% respectively.
“We want to have a good diversification of tenants — either [companies that rent space] for their headquarters or listed companies with very long leases. We will continue to [expand] into these areas and focus on the big themes of healthcare, finance, technology and information,” says Jill Smith, CEO of MUST’s manager.
The renewal of Hyundai’s lease and the acquisition of Centerpointe have helped to extend weighted average lease to expiry to 7½ years as at June 30, compared with a WALE of 5.8 years as at Dec 31.
Long WALEs are stabilising and can affect valuations — higher valuations are ascribed to properties with long WALEs because of more predictable rents. According to Smith, the REIT has only 1.8% of leases by GRI left to renew for this year. “We are pushing lease expiries right out to 2024 and beyond,” she says.
The REIT has also mitigated near-term interest-rate risk, and 96.1% of outstanding loans are on a fixed-rate basis, resulting in a weighted average interest rate of 3.32%.
MUST announced that Figueroa’s (a Class A building in downtown Los Angeles) was refinanced with a bank loan of US$110 million at a fixed rate of 3.25%. In 1HFY2019, MUST secured a total of US$193 million in bank loans at the trust level from a bank club of five banks in Singapore. Of this, US$33 million was to partially fund the Centerpointe acquisition.
Post-refinancing, the weighted average debt maturity has lengthened from 2.3 years as at June 30 to 3.1 years. The debt maturity profile was staggered such that not more than 30.9% of debt matures in any year. The weighted average interest rate after refinancing Figueroa was 3.45%. Of the REIT’s portfolio, 24.1% was unencumbered.
At IPO, funding the portfolio with onshore property mortgages helped boost distributable income because of the tax-shield nature of mortgages. However, Obhan says the advantages of financing debt at the trust level outweigh onshore property mortgages. “When you take a loan at the property level, you normally get to deduct mortgage interest. When you take it at the trust level, the [tax shield] is at the shareholder loan level, which is [more] insecure, and transfer pricing is a bit higher,” he explains.
Interest on a mortgage is tax-deductible, and this is one way the US REITs are able to shield distributable income. Overseas investors have to pay a 30% witholding tax for US dividends. Hence, when the loan is taken at the REIT level in Singapore, this mortgage shield is no longer in force. So, to shield distributions, REITs have to rely on inter-company or shareholder loans, and this is less secure than an onshore mortgage.
But, the main reason for having debt at the trust level is to unencumber properties. If 50.1% of the property portfolio is unencumbered, it is easier for MUST to get a rating and diversify its sources of funding from bank debt and mortgages to include bonds and perpetual securities. “The aim is to get to over 50% of properties unencumbered, which is when rating agencies will take you seriously. We will unencumber our assets in logical order, asset by asset, with acquisitions first, followed by refinancing mortgages with loans at the trust level,” Smith adds.
Last year, MUST implemented a multi-currency medium term note programme. A rating will allow the REIT to obtain lower coupons.
Other disadvantages of a mortgage are its covenants and limited financial flexibility. Among the covenants are lease conditions and loan-to-value ceilings. Furthermore, with a property mortgage, the REIT can get credit only for that particular property. Loans at the trust level provide a lot more financial flexibility, as they are fungible, and covenants at the trust level are less restrictive. The main covenant at the trust level is that the LTV ratio or gearing does not cross 45%.
“When the five banks in the bank club looked at the credit of the REIT, they saw strong WALE, and rates were [lower]. It’s a bit cheaper than what we could get at mortgage level,” Obhan points out. Lower debt implies lower costs and more available distributable income.
For 1HFY2019, MUST announced a distribution per unit of 3.04 cents, up 0.3% y-o-y, giving an annualised yield of 6.8%. (The REIT had a placement and preferential equity offering in June 2018 to fund Phipps and Penn.) Full-year DPU could exceed 6.08 cents, as the REIT has not had a full quarter of contributions from Centerpointe. There is also an average rental escalation on a portfolio basis of 2% a year.
The US is enjoying an unprecedented period of growth. But MUST is ready for murkier economic conditions. “When times get tough, tenants’ headquarters and locations become important, and there is some evidence that people will go for Class A buildings in a good area,” Smith says. “We are convinced that our diversified and high-quality tenant base will enable us to ride out the property cycle.”
