MAS is right to resist push for even looser leverage requirements for Singapore Reits

SOME respondents to the recent public consultation on amendments to the leverage requirements for real estate investment trusts (Reits) had a rather audacious request.

They wanted volatility in foreign exchange and interest rates as well as tenant defaults to be considered as events beyond the control of a Reit’s manager.

Reits have to maintain an interest coverage ratio (ICR) of at least 1.5 times, but this requirement would not be considered breached if a Reit’s ICR falls below the minimum threshold due to circumstances beyond the control of its manager.

Among events considered to be beyond the control of a Reit’s manager are pestilence, acts of war, terrorism, insurrections and revolutions.

The idea that Reit managers should be no more capable of navigating interest rate volatility than an insurrection seems bizarre to me. Just as strange is the notion that regulatory flexibility rather than asset quality and prudent management might be key for Reits to cope with their next crisis.

While the recent turmoil in the Reit sector clearly demonstrated that funding costs and real estate valuations can change dramatically in the blink of an eye, failure on the part of Reit managers to anticipate and deal with these uncertainties ought to be met with severe consequences rather than regulatory forbearance.

The Monetary Authority of Singapore (MAS) said on Nov 28 that it will not include foreign-exchange and interest-rate volatility or tenant defaults among the circumstances under which the minimum ICR would be considered not to have been breached.

“MAS expects Reit managers to take these factors into account when managing (a) Reit’s aggregate leverage and ICR levels,” it said, in response to feedback from the public consultation.

Still, I found it disturbing that the idea was put forward at all – and, apparently, by more than one respondent. There were also several voices pushing for a generally more liberal regulatory stance towards Reits.

Is the Singapore Reit sector on a path to looser rules? Should investors be worried or excited?

Parsing the feedback

MAS proposed in July to subject all Reits to a minimum ICR of 1.5 times, and an aggregate leverage cap of 50 per cent.

Reits were previously subject to a leverage cap of 45 per cent, but they were allowed to go up to 50 per cent if they had an ICR of at least 2.5 times.

MAS also proposed that the trusts provide sensitivity analyses of the impact of changes in their earnings before interest, tax, depreciation and amortisation (Ebitda) and interest rates on their ICRs.

MAS said last week that the proposed amendments to leverage requirements would be implemented after receiving broad support. In fact, a few respondents to the consultation suggested setting the leverage ceiling at 60 per cent, instead of 50 per cent.

These respondents, MAS added, had noted that the leverage requirements in Singapore are still among the strictest in the world, and that adopting an even higher leverage limit would make Singapore Reits more competitive.

MAS said that three respondents had disagreed with the proposal, arguing that an ICR threshold of 1.5 times might worsen the risk profile of Singapore Reits.

There were 20 respondents to the MAS consultation. Of these, seven asked not to be identified, while a further seven asked to not be identified and that their submissions be kept confidential.

MAS was not swayed by the calls to be more liberal, though. Besides rejecting the suggestion that interest rate volatility and tenant defaults be considered events beyond the control of a Reit manager, it also said that it saw no case to increase the leverage limit beyond 50 per cent.

Moreover, MAS said it will require Reit managers to disclose plans to improve their ICRs when this financial metric falls below 1.8 times.

The majority of respondents to the consultation also agreed with the proposal for Reits to provide sensitivity analyses on the impact of changes in their Ebitda and interest rates on their ICRs.

However, several of them baulked at the requirement that the sensitivity analyses include a scenario that assumes a 10 per cent decrease in Ebitda and a 100-basis point increase in interest rates.

The objection, MAS said, was that the assumption was unrealistic, and that it might alarm investors.

This seems odd to me. The purpose of the sensitivity analyses is precisely for investors to understand what it would take for a Reit’s ICR to drop to an alarming level.

In any case, MAS refined its proposal after receiving the feedback. It will now require Reits to provide two separate sensitivity analyses on their ICRs – one based on a 10 per cent decrease in Ebitda, and another based on a 100-basis point rise in interest rates.

This wasn’t much of an accommodation by MAS, though. Investors can easily use the ICR based on the 100-basis point interest rate rise to derive an ICR that reflects a concurrent 10 per cent decline in Ebitda.

Manager internalisation next?

The way I see it, MAS is right to resist the push for even looser leverage requirements.

Many sponsor groups have set up Reits in Singapore because the external manager model is generally accepted by local investors, despite the widely held view that internal managers are more likely to act in the interests of unitholders.

This broad acceptance of the external manager model is, in my view, the result of what leading local sponsor groups have brought to the table over the past two decades: high-quality assets, capital whenever required, and good management.

Loosening the leverage requirements for all Reits in Singapore – including the ones that are here just for the external manager model – may be a recipe for trouble.

As it is, some of the weaker Reits in Singapore are now facing pressure from disgruntled unitholders to internalise their managers.

Notably, Sabana Industrial Reit is on the brink of replacing its external manager with a newly set up internal manager, following a long and fierce fight led by activist investor Quarz Capital.

Singapore Exchange Regulation chief executive Tan Boon Gin noted in a speech on Nov 20 that the growing interest in manager internalisation comes in the wake of a sharper focus on unitholder value, pressure from higher interest rates, and the increasing heft of many Reits.

He added that the push for manager internalisation is a form of market discipline that could drive performance in the Reit sector.

However, this is still a new phenomenon, and there isn’t yet a clear pathway for an existing Reit to internalise its management function. “We will need to work with our fellow regulators to improve the process,” Tan added.

MAS should perhaps now turn its attention to this matter. Having a pool of thriving internally managed Reits might do far more to spearhead the next phase of growth for the whole sector than any further loosening of leverage requirements.