Raising leverage ratios may throw some Reits a lifeline, but being selective is still key

REAL estate investment trusts (Reits) with high leverage have been among the worst performers in the sector over the past year.

The dismal showing comes amid challenges both from higher rates and less favourable business conditions.

For example, amid changing post-pandemic work-from-home trends, the three US office Reits – Manulife US Reit, Prime US Reit and Keppel Pacific Oak US Reit – are among the four worst performing S-Reits over the past year.

Reits that are struggling more in the tougher environment may find an easing of regulatory leverage limits in certain circumstances to potentially be a lifeline.

In other cases, having higher debt headroom may also allow Reits to be more competitive, as they can raise more funding to search for yield-accretive investments.

But with an uncertain economic environment where some expect rates to stay higher for longer, taking on additional leverage would introduce fresh risks for investors that few may be keen on.

Prudent investors may find it more rewarding to look for Reits that have stronger balance sheets or attentive managers who proactively sell assets and raise capital before things go south.

Shifting financials

Reits in Singapore are subject to a leverage limit of 45 per cent of the funds’ deposited property. This threshold can be raised to 50 per cent, if a Reit has an interest coverage ratio (ICR) of at least 2.5 times.

When Reits exceed the aggregate leverage limits set out in the Code of Collective Investment Schemes (CIS Code), they are unable to take on additional borrowings. This could restrict the Reit’s ability to carry out asset enhancements, or acquisitions that may be beneficial in the longer term. Managers would thus need to work on improving the balance sheet.

Reits could either raise additional equity or sell existing assets to de-lever and improve their balance sheets. But this is easier said than done.

Selling assets may be difficult if the assets are in sectors facing a slowdown. Potential buyers who are aware of the Reit’s difficulties would also likely demand discounts, adding to the challenge.

Reits with higher gearing have also faced the problem of weak valuations, as investors anticipate future equity fundraising which could be dilutive.

In a recent example, units of Lendlease Global Commercial Reit have seen strong selling after its H2 results, where it announced that aggregate leverage had risen from 39.2 per cent in December 2022 to 40.6 per cent in June 2023.

The counter has fallen over 15 per cent since Aug 7. Citi also downgraded its call on the Reit from “buy” to “neutral”, in view of rising capital management concerns and valuations pricing in a potential equity fundraising.

The broader pool of S-Reits has seen aggregate leverage levels increase in recent months.

Between December 2022 and June 2023, around two-thirds of S-Reits reported higher aggregate leverage ratios. Gearing, on average, rose from 37.6 per cent to 38.1 per cent. Nearly all S-Reits also reported worse ICRs in June, compared with six months earlier.

As at June, 14 S-Reits had leverage ratios above 40 per cent, compared with 10 S-Reits in December 2022.

Manulife US Reit (MUST) reported aggregate leverage of 56.7 per cent as at June 2023, ranking its gearing the highest among S-Reits.

Dasin Retail Trust (DRT) was not far behind, with aggregate leverage of 46.5 per cent as at December 2022, according to the latest financials available for the trust. Ebitda (earnings before interest, taxes, depreciation and amortisation) for the last fiscal year was 1.1 times its interest expense.

Both DRT and MUST have announced this year that they are unable to make distributions as they have breached loan covenants. This occurred due to a decline in valuations of investment properties.

Gaining flexibility

For some Reits that are stuck in a tough situation, where valuations are likely to decline further, being able to take on additional leverage may prove to be a lifeline.

Instead of facing a downward spiral – where investors and creditors lose confidence in the stock, causing its eventual liquidation – being able to tap funding to invest in asset enhancement initiatives (AEIs) could provide a different outcome.

Managers may also appreciate the flexibility of having higher debt headroom for acquisitions, especially if opportunities emerge in a market downcycle. This could provide investors with better returns in the long term.

But retail investors should question whether such a step would be in line with their own investment thesis for investing in a Reit, as higher gearing also brings risks.

Even if regulatory limits were eased or removed, Reits would still have their own financial covenants to adhere to as lenders seek to protect themselves from default. Lenders that are concerned with the stability of a Reit may not be willing to accept further borrowings.

AEIs also come with execution risks, and it is not a certainty that additional investments would result in the desired outcomes. Higher debt, however, would certainly result in equity investors being worse off, if the Reit is unable to turn things around.

It may be better for investors to identify managers that are proactively managing their Reits to do well within the regulatory limits.

Being proactive

The market valuation of assets in a property fund is subject to various factors that are not always within the control of a manager. But we should acknowledge that managers are not entirely powerless.

Attentive managers should be able to forecast some of the challenges and risks to a Reit that could occur in the near future. This could see pre-emptive capital-raising or asset sales to beef up the balance sheet before investors start punishing the unit price.

Last month, Frasers Centrepoint Trust said it would divest Changi City Point for S$338 million, with net proceeds to be utilised to repay loans with higher interest rates. This would reduce pro-forma aggregate leverage to 37.1 per cent from 40.2 per cent.

Earlier this year, ESR-Logos Reit also launched an equity fundraising to raise around S$300 million. It noted that this would lower aggregate leverage and increase debt headroom, giving it flexibility to fund potential future growth including AEIs and acquisitions.

While such moves are not always popular with unitholders, proactively raising capital or selling assets – even at a slight discount – could help avoid situations where a Reit is pinned in a corner with no good options remaining.