The first perpetual security (perp) issued this year was by Lendlease Global Commercial REIT (LREIT). It was met with strong demand and upsized from the original $150 million priced at 5.5% to $200 million priced at 5.25%. In the end, the tranche was 5.3 times subscribed, an indication of demand for yield products.
Last year, LREIT issued $200 million of perps, taking its total to $400 million. Last month, LREIT raised another $400 million through an equity placement. The first call or reset date of the perps, issued on April 11, will be April 11, 2025. Including the perps and an additional $648.8 million of equity, LREIT’s pro forma total equity would be around $2.15 billion. Its total perp issuance translates to more than 18% of total capital (see table 2).
Originally, on Feb 14, when the acquisition of 100% of Jem was announced, LREIT’s manager had indicated in a presentation that the acquisition would be more than 10% accretive subject to an equity fundraising of 1,025 million units at 82 cents. Since then, LREIT’s equity fundraising has comprised 551.73 million units at 72.5 cents and 345.58 million units at 72 cents. LREIT will also be issuing $200 million of perps at 5.25%. The cost of debt has not been announced but the cost of perps is SORA plus a spread of 3.04%. Against this background, the accretion from the Jem transaction is likely to be closer to 2% than the 10.5% that was indicated in a Feb 14 presentation although that financing structure could keep aggregate leverage at or just below the 40% mark.
The 20% rule
Market watchers have indicated that there is no formal regulatory cap on the amount of perps a REIT can have in its capital structure. Ideally, perps should comprise no more than 20% of a REIT’s total equity. On the other hand, the coupon paid on perps is used in the calculation of 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.
“There is market expectation that perps in the capital structure should not be more than 20%. We usually cap the amount of perps because they rank ahead of equity and behind debt,” observes Eng-Kwok Seat Moey, managing director and head, capital markets group, DBS Bank, in a recent interview. Hence if aggregate leverage (gearing) is at 40% and perps at 20%, equity would be 40%. “A loan-to-value of 60% is the market norm,” Eng-Kwok says.
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So, while there is no regulatory limit, there is industry expectation among bankers, REITs, ratings agencies and investors of a ceiling. “If you don’t have an internal industry expected limit, [capital structures] could go haywire, although perps rank behind equity. If anything goes wrong or if price and valuations fall, [the REIT] could be in a default situation,” EngKwok cautions.
From the start of this year, REITs can have an aggregate leverage (gearing) of 50% subject to a minimum ICR of 2.5 times. Only one REIT has an ICR of 1.9 times with perps above internal guidance of 20% of total equity, Lippo Mall Indonesia Retail Trust (LMIRT).
Viewed as a stressed REIT, LMIRT has a high proportion of perps relative to total equity (see table 2), low ICR and elevated gearing (see table 1), LMIRT trades at 0.56x net asset value and owns 29 retail properties in Indonesia.
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AIMS APAC REIT’s perps are also above the 20% guidance at 27% of total equity, the highest among REITs here. At the time of issuing the perps, Russell Ng, CEO of AA REIT’s manager, had indicated that the perps partly financed AA REIT’s acquisition of the Woolworths Headquarters in Australia for the equivalent of $454 million. The property had a weighted average lease expiry (WALE) of 10 years. Ng felt that the building offered a net property income (NPI) yield of 5.86% compared to the coupon of 5.38% on $250 million of perps raised last September (see table 2).
When perps are considered equity As local investors have experienced, perps are not necessarily “called”. There are a few key differences for perps to be classified as equity by REITs. Perps are “called” at the option of the issuer. The “call” year is usually set when the perps are issued. Issuers do not have to “call” their perps. There are examples of issuers who have opted to reset the coupon rather than call the perp. These include Ascott Residence Trust (ART), LMIRT and First REIT.
At the reset, if the issuer does not plan to “call “or redeem their perps at the appropriate year, they can reset the coupon to a new rate which is stated in the original document. This is often SOR or SORA plus a spread. To date, ART, LMIRT and First REIT have been able to reset their perps at lower coupons.
But this may not necessarily be the case in the next two years as the US Federal Reserve has embarked on a rate hike cycle, which is likely to take the Federal Funds Rate to 2% by the end of the rate hike cycle. Furthermore, the war in Ukraine, stagflation and the inverted yield curve add to an uncertain external environment.
The dividend stopper
A REIT can decide not to distribute to its perp holders. These deferred distributions are non-cumulative. However, most perp distributions have a “dividend stoppers” option. This means that if the issuer fails to pay a distribution to perpetual security holders, unitholders are unlikely to receive distributions.
LMIRT had a dividend stopper which came into effect in 2020. As at Sept 30, 2020, LMIRT’s distributable income less any distribution made to the holders of its perps and unitholders was zero. According to the terms of the US$250 million ($339 million) 7.25% senior notes guaranteed by LMIRT, if the amount is zero, LMIRT is only permitted to distribute up to US$5 million for the remaining life of the US$ notes due in 2024. LMIRT had distributed $4.9 million in September 2020 to perp holders and $2 million in 3QFY2020 distributions to unitholders. It had thus reached the US$5 million limit. As a result, LMIRT elected not to pay the distribution on December 19, 2020. Distributions resumed following the REIT’s rights issue which was completed in 1QFY2021 ended March 2021.
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While distributions to perp holders are not mandatory, issuers are likely to make good on the distributions as failure to do so would have negative connotations. But, since the perps of REITs are structured with resets, their distributions could be variable over time, differentiating them from a bond.
Impact of rising rate cycle
The problem with resets materialises during a rising interest rate cycle. Interest rates affect capitalisation rates, albeit indirectly. Interest rates also affect discount rates used in discounted cash flow (DCF) analysis. Both the income capitalisation and DCF methods are used to value investment properties.
Hence, rising capitalisation and discount rates can cause capital values to fall if cash flows are not able to rise and outrun the expansion in capitalisation and discount rates. If a perp reset occurs during falling capital values, distributions, in particular, DPU for unitholders are likely to be negatively impacted.
Capital management is an important facet of managing a REIT. “Most REITs have their interest cost hedged (see table 1). Most REITs have termed out their average term to maturity. The proportion of floating debt, fixed debt and maturities are staggered, some up to five years to mitigate refinancing risk,” Eng-Kwok points out.
Perps are part of capital management. To date, perps have helped to lower gearing levels. On the other hand, unitholders may not be happy if there are too many perps in the capital structure. “You cannot tap on perps forever because your unitholders will ask you to explain why there are so many tranches of perps because they eat into distributions and DPU. There is also an expectation the REIT will call the perp so you should not look at them as permanent capital,” Eng-Kwok says
