Credit Update: Suntec REIT – Aggregate leverage ratio getting close to the edge

Suntec Real Estate Investment Trust (“Suntec REIT”) holds a mixed portfolio of properties primarily used for office and/or retail purposes, with the flagship property being Suntec City itself. The majority of its portfolio is located in Singapore (74%), with others situated in Australia (15%) and the UK (10%) (Chart 1). Suntec REIT has a total of SGD 11.8b assets under management.

Chart 1: Property Valuations in SGD m

Financial Highlights

Chart 2: Suntec REIT’s performances in 1H23 and 3Q23 (in SGD m)

For the quarter that ended 30 September 2023 (“3Q23”), the growth in gross revenue and net property income (“NPI”) was at 15.0% YoY and 9.7% YoY respectively – largely due to higher contributions coming from various properties.

However, Suntec REIT saw a drop in Joint Venture (“JV”) income, falling by 20.4%. Despite stronger operating performance for its properties held under JV, higher interest expenses have resulted in an overall lower income. The poorer performance had also been partially contributed by a weakened AUD against SGD across the period.

The performance across 1H23 was mostly similar. Gross revenue (by 10.2% YoY) and NPI (by 0.3% YoY) rose, largely due to increased contribution from office and retail units in Suntec City and Suntec Convention. JV income was down (by 24.6% YoY), primarily due to higher interest expenses and a one-off impairment arising due to a change in accounting policy for Nova Properties.

Nonetheless, the overall performance of Suntec REIT remains resilient. As of 3Q23, occupancy in both office and retail portfolios remains relatively high at 97.4% and 97.9% respectively – notably a 99.5% committed occupancy in Singapore office properties. This figure comes in well above the average 95.3% occupancy rate observed in Singapore’s Core Central Business District.

The portfolio weight average lease expiry stands at 4.3 years for the office portfolio and 2.2 years for the retail portfolio, sufficiently short to allow Suntec REIT negotiate better rents upon the lease renewal.

Meanwhile, rental reversion also looks good for Suntec REIT, particularly in its Singapore and Australia portfolios. Singapore retail portfolio saw rental reversion at 25.3% in 3Q23, while the Singapore office portfolio and Australia portfolio saw 14.4% and 12.0% in 3Q23 respectively.

Despite the higher interest expense, we think Suntec REIT has potential to offset the increasing interest costs with rent growth, especially with the management guiding for further positive rental reversion in the Singapore portfolio. We believe its performance will remain stable in the meantime.

Thin buffer for the aggregate leverage ratio

Suntec REIT’s aggregate leverage ratio stands at 42.7% as of 30 September 2023, one of the higher ones across the Singapore REITs space. At its current level, we understand that investors might be worried about the thin buffer to a regulatory requirement of 45% (For the limit to be 50%, MAS requires an interest coverage ratio (“ICR”) of 2.5x which Suntec REIT did not fulfill. The REIT has an ICR of 2.1x). We will be examining the aggregate leverage ratio and the available buffer in greater detail.

We look back at Suntec REIT’s Annual General Meeting held on 20 April 2023, which answered a couple of questions raised pertaining to its aggregate leverage ratio.

1. Management indicated that Suntec REIT will not be able to borrow more if it breaches the 45% limit. However, there is no penalty.
   
   
2. The target aggregate leverage ratio is around 40% to 42% during a normal interest rate environment. In a high interest rate environment, for prudence, the target is to be below 40%.
   
   
3. A divestment of mature assets is being considered to reduce the REIT’s aggregate leverage ratio. This would primarily come from the Australia portfolio.
   
   
4. Management highlighted that the valuation of its properties tends to be on the conservative side with a discounted cash flow method. For example, Suntec City offices have a carrying book value of around SGD 2,500 per square feet, but transactions by subsidiary proprietors have reached SGD 3,850 per square feet.

Why we think Suntec REIT might not breach the regulatory limit

With the current aggregate leverage ratio at 42.7% and total borrowings of SGD 4,300m, we estimate that valuations (of the deposited properties) need to fall by SGD 514m before breaching the 45% limit. While the aggregate leverage ratio is relatively high for Suntec REIT, we do not expect Suntec REIT to breach the 45% limit.

Property valuations generally have improved since the recovery from the COVID-19 pandemic (Table 1). This is especially so for its Singapore portfolio which had been seeing rising valuations despite higher interest rates. Generally, some REITs have debt covenants that requires them to repay specific loans upon breaching the 45% regulatory limit. We believe this does not apply to Suntec REIT as the management has indicated that there are no consequences (in breaching the limit).  This means that the REIT will unlikely fall to distressed levels, especially with positive net income and little need for additional borrowings.

For investors who are worried about a major devaluation with a rise in capitalization rates following higher interest rates, we see little concern. Valuations for Suntec REIT are based on a combination of the discounted cash flow method, capitalization approach and direct comparison method, depending on the location and category of the properties being valued. Most REITs in Singapore generally uses a combination of methods as well, rather than limited to a particular approach. This allows for a fairer valuation of the properties, as compared to drastic devaluations that might occur with just using the capitalization approach.

Table 1: Valuations of the properties under Suntec REIT

Credit profile has deteriorated

The REIT’s credit profile has suffered from higher interest expenses over the past quarter. All-in financing costs increased from 3.64% p.a. year-to-date (as of 30 June) to 3.78% year-to-date (as of 30 September). Concurrently, all-in financing costs for 3Q23 also reached 4.07%. Considering the increase in financing costs, the adjusted interest coverage ratio fell from 2.1x (as of 30 June) to 2.0x (as of 30 September). Lastly, the proportion of floating rate borrowings had risen, further increasing Suntec REIT’s exposure to changes in interest rates.  

Even though we expect net income to remain stable, we believe improvements to its credit profile will be limited as better performance of its properties will likely be offset by the higher finance costs, given the higher proportion of floating-rate borrowings.

While credit profile has indeed deteriorated, we believe there is no immediate concern. We do not expect Suntec REIT to face difficulties in refinancing at the moment – given several factors: (1) successful refinancing of loans thus far (with a high aggregate leverage ratio), (2) being able to tap into sustainability-linked green financing, and (3) having the ability to pledge its assets for secured borrowings if necessary.

Suntec REIT notes and perpetuals

Table 2: Fixed rate issuances by similar REITs

Table 3: SUNSP Perpetual Securities

In our opinion, SUNSP fixed rate issuances pale in comparison as compared to other similar Singapore REITs, such as OUE Commercial REIT (“OUECT”). OUECT offers a significantly better credit profile, boasting an investment grade credit rating of ‘BBB-’ by S&P – with yields similar to that offered by SUNSP.

Non-call risk remains a concern for perpetual securities amidst the current high interest rates environment, with interest rates expected to remain higher for longer. Currently, we believe there is no incentive for Suntec REIT to refinance its perpetual securities, especially with fixed rate issuances, as the aggregate leverage ratio is already close to the MAS regulatory limit. Furthermore, there are no step-ups embedded within the reset rates which may serve as further incentivize to call.

At the same time, given the current credit profile and potential credit deterioration, we also see little incentive for the REIT to refinance its perpetual securities, with another perpetual of a lower initial spread. As of 6 December, Z-spreads on the SUNSP 3.8% and SUNSP 4.25% perpetuals are about 315 basis points (“bps”) and 330 bps respectively – both similar to their respective initial spreads of 329.5 bps and 329.0 bps.

Currently, we do not see a need to sell the perpetuals. Although a call seems unlikely, allowing the perpetuals to reset enables existing bondholders to benefit from a higher coupon rate. Based on the 5Y SORA at 2.765% as of 6 December 2023, and an average spread of 23.3 bps (to compensate for using 5Y SORA instead of 5Y SOR as the latter has been discontinued), we expect SUNSP 3.8% and SUNSP 4.25% to reset at approximately 6.3% coupon rate. Investors are likely to benefit from a higher current yield with the reset in coupon rates.

We understand that there are clauses pertaining non-cumulative deferral of distributions and dividend stopper for Suntec REIT's perpetuals. With the REIT still profitable, and our expectation of a continued positive net income, we do not expect Suntec REIT to invoke these clauses. Furthermore, the REIT remains more than capable of covering the interest payments inclusive of perpetual distributions, and we believe it will continue making distributions on its perpetuals. 

For investors worried about Suntec REIT’s credit profile, a good alternative will be the paper by ESR Group, the parent company of Suntec REIT’s manager – ESRCAY 5.100% 26Feb2025 Corp (SGD) – with a yield to maturity of 5.01% at the ask price of 100.10, with 1.23 years left to maturity.

Declaration: For specific disclosure, at the time of publication of this report, IFPL (via its connected and associated entities) holds a position in SUNSP 3.800% Perpetual Corp (SGD), ESRCAY 5.100% 26Feb2025 Corp (SGD), and the analyst who produced this report holds a NIL position in the abovementioned securities.