As REITs started reporting their 1H2024 results, a couple of factors stood out. One was that the average cost of debt remains stable instead of rising. The other is the reopening of the perpetual securities or perps market. These factors became evident before the New York Federal Reserve on July 29 released its multivariate core trend (MCT) model, which fell to 2.06%. The MCT model is essential for inflation watchers like Fed governors as it measures the persistence of inflation in the 17 core sectors of the personal consumption expenditures (PCE) price index. It was released on the Monday following the release of PCE price index data, which was July 26 for the month of June.
When the MCT figure was announced, Nobel laureate Paul Krugman tweeted on X: “The eagle has soft landed. The New York Fed’s measure of underlying inflation is just 2.06%. The Fed should cut rates now, now, now.” The Fed’s target inflation rate is 2% a year. As expected, the Federal Open Market Committee did not announce any cuts on July 31 but is widely expected to announce a cut in the Federal Funds Rate (FFR) in September.
The anticipated September cut has led to a decline in risk-free rates. The 10-year US Treasury bond yield and the 10-year Singapore Government Securities yield are already in a developing downtrend. Those who regularly subscribe to the six-month and one-year Singapore T-bills will have noticed that yields are falling, albeit above 3%. The 10-year SGS yield is at 2.968%.
Perps market reopens
The easier rate environment appears to have opened up the perps issuance market. On July 29, CapitaLand Ascott Trust HMN ’s (CLAS) manager called its 2019 $150 million 3.88% perps issued in September 2019. It is issuing $150 million at 4.6% perps, callable in 5.5 years.
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“We see encouraging signs from CLAS perpetual issuance. This is an early signal that investors are reallocating capital back to this instrument, potentially removing the risk that the managers will need to raise debt or sell assets to repay upcoming perpetual securities due for their next reset dates in the coming quarters,” says DBS Group Research.
“In addition, CLAS’s ability to compress the reset margin spread to 197 bps (basis points) from 230–250bps for its expiring perpetual securities is a positive sign that investors are looking to refinance or deploy into quality names within the real estate sector. We expect more S-REITs to diversify their funding sources and selectively tap the perpetual security market to either refinance or part fund any potential acquisitions,” DBS observes.
The local bank adds that REIT perps have seen an increase in prices to the tune of 13% in 2023 and 7% from the start of the year to date, “implying that demand for perpetual securities is returning and more issuers will likely look to tap this market going forward”.
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CLAS is not the only issuer tapping the perps market. Keppel Infrastructure Trust A7RU ’s (KIT) trustee-manager announced the issuance of a $200 million 4.9% perps tranche, callable in 2034 or 10 years later. KIT has a $300 million 4.75% tranche of perps issued on June 12, 2019, callable in 2029 and a $100 million tranche issued in June 2019. The $200 million and $100 million issuances were amalgamated, and the $300 million tranche will be callable in 2029.
On June 9, 2021, KIT issued $300 million perps at a rate of 4.3%, callable in 2031. Altogether, KIT has issued $800 million of perps callable in 10 years.
Perps were popular tools for REITs to disguise their aggregate leverage. The Monetary Authority of Singapore’s (MAS) regulations enable perps to be classified as equity so long as there is only a reset on the call date and no step-up.
While there is no formal regulatory cap on the amount of perps a REIT can have in its capital structure although perps ideally should comprise no more than 20% of a REIT’s total equity. On the other hand, the coupon paid on perps is used to calculate the interest coverage ratio (ICR). In addition, when rating agencies look at debt levels, they generally classify 100% of debt as debt and 50% of perps as debt.
Serena Teo, CEO of CLAS’s manager, views perps as equity. On the other hand, some REIT managers view perps as expensive debt. Hyflux 600 , the former listed water company that went bust, is a cautionary tale of the danger of viewing perps as equity.
Since the Fed’s rate hike cycle, S-REITs and business trusts have held back from calling their perps and issuing new ones. The S-REITs that have reset their perps instead of calling them include CLAS, Mapletree Logistics Trust M44U (MLT) and Lippo Mall Indonesia Retail Trust (LMIRT). These perps were reset as the market for new perp issuance was closed.
“A key data point to watch is the refinancing of upcoming $2 billion worth of perpetual securities that will approach their reset dates in 2024–2025. The ability to tap the market back will be one of the more optimal scenarios, enabling the REITs to keep their current capital structure,” DBS says.
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A repeat of Hyflux?
While DBS and Teo view the use of perps as a positive outcome, too many perps as a percentage of equity in a capital structure raises risk.
CLAS and MLT have conservative levels of perps while LMIRT and AIMS APAC REIT have higher levels of perps within their capital structure.
Ordinary equity and retained earnings are the best forms of shareholders’ and unitholders’ funds. When hybrids start comprising a large portion of the capital structure, the making of another Hyflux or “Hyfluxation” could materialise. Hyflux was a local water company with an inordinate amount of hybrids, some $900 million in perps, and preference shares. Market watchers will remember how it collapsed spectacularly.
KIT’s perps will likely increase to $800 million once the most recent tranche of $200 million is issued. As of June 30, KIT had gross debt of $3.3 billion and net debt of around $2.8 billion versus shareholders’ funds of $825 million excluding perps and minority interests. Including perps and minority interests, net debt to equity would be around 1.65 times. If the perps (excluding the $200 million issued recently) are classified as debt, then net debt to equity is three times.
Since KIT is a business trust, it does not have to adhere to an aggregate leverage ceiling or minimum ICR floor. According to KIT’s 1HFY2024 presentation slides, aggregate leverage based on net debt works out at 44.7%, while Net debt/Ebitda is 6.5 times and ICR 14.1 times. Undoubtedly, KIT’s ratios do not suggest the trust is anywhere near Hyfluxation levels. Nonetheless, the $800 million perps match the trust’s core shareholders’ funds of paidup capital and retained earnings.
Capital management stays sound
Unlike DBS, JP Morgan reckons REITs are not out of the woods yet. For example, JP Morgan points out that Keppel REIT’s aggregate leverage rose 1.9 percentage points to 41.3% due to the acquisition of a 50% stake in 255 George Street.
“With media reports suggesting the suspension of T Tower disposal in Korea, we remain concerned that Keppel REIT will enter a period of higher gearing pending asset sales. Despite expectations of Fed rate cuts, we anticipate interest rate headwinds as 1H2024 borrowing cost of 3.3% is still below our stabilised borrowing cost assumption of 4.1% for Keppel REIT,” JP Morgan says.
According to OCBC Investment Research, CLCT’s aggregate leverage “remained stable” at 40.8% as of June 30. The average cost of debt nudged up 2bps to 3.49% in 1HFY2024 compared to 1QFY2024. Despite a q-o-q rise in the average cost of debt, this parameter is lower h-o-h and y-o-y. The ICR also remained unchanged at 3.2 times. CLCT has refinanced all loans due FY2024 and its manager has announced plans to increase the proportion of renminbi (RMB)-denominated debt to 30% by the end of 2024. This increase enables CLCT to take advantage of favourable onshore interest rates to lower the overall cost of debt. In the second quarter, CLCT increased its portion of onshore RMB debt to 27%.
The manager of CDL Hospitality Trusts J85 (CDLHT) is looking forward to cost savings in 2025 from rate cuts. However, CDLHT’s lowcost debt that matures at the end of 2024 will need to be refinanced with more expensive debt, JP Morgan points out.
Elsewhere, Xavier Lee, equity analyst at Morningstar, says the highlight of MLT’s results briefing was the participation of former CEO of MLT’s manager and current Mapletree group deputy CEO Chua Tiow Chye.
In his report, Lee writes: “Chua reiterated the group’s commitment to prioritise unitholders’ interests in real estate investment trusts sponsored by Mapletree. He also shed some light on the group’s latest five-year plan and goal to achieve assets under management of $100 billion–$120 billion by March 31, 2029, from $77.5 billion as of March 31, 2024.”
He adds: “MLT is expected to contribute to the group’s goal by increasing its AUM by $5 billion during the same period. In our view, the target is somewhat ambitious and would require the trust to be able to raise equity due to the high absolute size and gearing. Given the current market environment and weak unit price performance year-to-date, we think large-scale acquisitions will likely happen in the medium term rather than the near term.”
One of the more stressed REITs is LMIRT. Its 2Q2024 operating metrics remained lukewarm, OCBC Credit Research says. “Though there are little liquidity risks until 2028, we believe LMRT will not resume distribution to perpetual holders in the foreseeable future given that the current cash flow is still insufficient to support the payout. Besides, most valuable assets are likely to be pledged for the IDR secured loan facilities and near to aggregate leverage limit of 45%, and we don’t think LMIRT will be able to refinance the existing two perpetuals with more secured IDR loans,” OCBC Credit Research cautions.
In 2QFY2024 ended June, LMIRT’s NPI fell by 9.2% y-o-y in Singapore dollars (SGD) and 2.7% y-o-y in Indonesian rupiah (IDR). The lower NPI was due to weaker IDR against SGD and lower net reversal for impairment loss on trade receivables y-o-y.
With proceeds from IDR8.5 trillion ($701 million) of IDR loan facilities, LMIRT fully repaid its SGD bank loans and fully redeemed a bond in June, and significantly reduced another outstanding bond due February 2026 to US$22.6 million ($30.38 million). Due to Its proactive capital management, LMIRT’s pro forma weighted average maturity of debt increased to 6.94 years as of July 29 compared to 2.75 years in December 2023, OCBC Credit Research says.
A major development that could help S-REITs with aggressive capital structures is the MAS’s proposal to have one-tier aggregate leverage and ICR, with a leverage ratio limit of 50% and an ICR of 1.5 times. Most rated REITs will likely stay within these limits as they defend their ratings.
“Our A3 rating is important to us as it provides financial flexibility and strong access to capital,” says a spokesperson for CLAR’s manager. CLAR and its sister REIT CapitaLand Integrated Commercial Trust C38U are rated A3.
Despite their continued challenges, S-REITs have made it through the apex of the interest rate hike cycle. They will continue to experience a higher average cost of debt as cheap Covid debt rolls off, to be refinanced with a higher cost of debt.
Conscious of the risk but looking on the bright side, DBS points out that CLAS’s tightened pricing and margins for its perps implies the sector could enter into a virtuous cycle of cheaper funding, and the signal to investors is that the “worst is over”.
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