US office S-REITs in shambles

·       Back in July 2023, Manulife US REIT exceeded the MAS’ regulatory leverage due to a large decline in its portfolio valuation. The pure-play US commercial real estate REIT had to abandon its distribution policy and receive help from its sponsor.

·       As the structural shift in how people work post-pandemic dampens demand for US commercial real estate, especially those located in central business districts, other S-REITs with substantial exposure to these assets may face greater challenges moving forward.

·       Higher capitalisation rates due to falling occupancy rates and higher interest rate environment are affecting property valuations and pushing leverage closer to regulatory limits.

·       Moreover, S-REITs that secured low-cost debt in the past now face higher refinancing risks and increased interest expenses. This could subject them to a lower leverage threshold, leading to financial implications like distressed property sales, equity fundraising, and abandonment of distribution policy.

·       As uncertainties in the US commercial real estate persist, we caution investors of the risks involved in US office S-REITs.

Previously, we ran stress tests on the top ten S-REITs by market capitalisation to assess their resilience. Besides elevated interest rates, tenant defaults, refinancing risks and declining property values have heightened concerns.

Manulife US REIT (SGX:BTOU) (MUST), a pure-play US commercial real estate REIT, is a textbook example to illustrate the financial implications of exceeding the regulatory leverage threshold.

Related Article: Be selective in S-REITs as rates stay higher for longer

In this article, we seek to present our findings from our stress tests on similar S-REITs namely, Prime US REIT (SGX:OXMU) (PRIME) and Keppel Pacific Oak US REIT (SGX:CMOU) (KORE) and to caution investors about the risks involved.

Challenges in the US commercial real estate landscape

After the pandemic, most companies transitioned towards hybrid working arrangements for greater cost synergies, reducing the need for large office space. Furthermore, the option to work remotely has become a trait in attracting as well as retaining employees. This structural change in how people work post-pandemic has resulted in a fall in demand for commercial real estate, particularly in the US.

With falling occupancy rates challenging their ability to pay debt obligations, owners of US office towers were forced to lower rental charges or sell the property. This was also further exacerbated by the Fed’s rate hike cycle last year.

High-profile defaults last year include Brookfield which incurred about USD 750 million default on two office towers in downtown LA and PIMCO-managed Columbia Property Trust which defaulted on USD 1.7 billion of debt backed by a portfolio of US office assets. Meanwhile, Clarion Partners sold an office building in New York which was bought for USD 230 million about a decade ago for USD 127 million, a steep discount of 45%.

Meanwhile, a pure-play US office S-REIT, MUST, saw one of its key tenants, The Children’s Place, prematurely ending its lease, shortening its tenure from May 2029 to May 2024. It was also heavily impacted with a 14.6% decline in its property valuation, resulting in a spike in its leverage ratio to 57% in 1H23. Additionally, the prevailing higher interest rates have exerted further downward pressure on its interest coverage ratio (ICR). It fell from 2.6X in 2Q23 to 2.4X in 3Q23, which renders a downgrade in the leverage limit from 50% to 45%.

Since then, the REIT has abandoned its distribution policy while its sponsor stepped in with a recapitalisation plan to provide it with a loan which will extend its weighted average debt maturity from 2.3 years to 3.7 years in 3Q23. The plan also grants the REIT to divest underperforming assets without the need for an extraordinary general meeting (EGM). As of 31 December 2023, its leverage stood at 58.3%, with an ICR at 2.4x and a lower weighted average debt maturity of 3.3 years.

This event could serve as a warning to investors with exposure to US commercial real estate. Recent property appraisals according to Capital Economics in its 2024 Outlook, have signalled US CRE property values to fall further by another 10% this year. Moreover, as of December 2023, offices made up 41% of the distressed US CRE, suggesting that more office loans are at risk of default.

Looking at other S-REITs with exposure to US commercial real estate, PRIME faced a year-on-year (YoY) drop of 8.7% in its property valuations while KORE experienced a decline in property valuations of 6.8% YoY as of 31 December 2023.

Based on latest quarterly data, the occupancy rates of both PRIME and KORE remain below their pre-pandemic levels of about 94%. We note that PRIME’s occupancy rates have remained below 90% while KORE’s are still above 90%. This disparity may be due to the asset locations. PRIME’s portfolio has a larger exposure to assets located within central business districts (CBD), while KORE has a greater focus on assets located in suburban markets. According to MSCI Research, property valuation declines are more pronounced for those in CBD than those in suburban markets. This is likely due to larger declines in demand for offices in CBD.

Overall, as occupancy rates in US CRE continue their declines, further drops in the REITs’ net property income (NPI) could be expected. This could in turn, result in an increase in capitalisation rates as well as further reductions in their distribution per unit (DPU).

Figure 1: Occupancy rate between 1Q2020 to 4Q2023

Higher capitalisation rates to dilute property values and increase leverage

We illustrate the potential consequences of falling occupancy rates and higher interest rate environment on the respective REIT’s property valuations. We found that a 100 bps or 1% expansion in cap rates will result in property valuations of PRIME and KORE both falling by around 13%.

Figure 2: Adjusted property valuation after cap rate expansion

A lower value of assets will automatically increase a REIT’s leverage. Thus, we computed the adjusted property values and then calculated the amount of buffer available for these REITs before exceeding the regulatory gearing limit of 50%.

Both PRIME and KORE have zero buffers after cap rate expansion. This is largely attributed to PRIME and KORE having a high leverage of 48.4% and 43.2% as of 31 December 2023 respectively. PRIME’s adjusted leverage ratio would increase from 48.4% to 55.5% while KORE’s would increase from 43.2% to 50.9%, thereby, exceeding the MAS’ regulatory leverage limit of 50%.

This may sound like bad news for investors. We caution that this is only the tip of the iceberg as we look to capture the near-term refinancing risks in the next layer of our stress test.

Figure 3: No buffers available after cap rate expansion

Refinancing risks persist, dragging down interest coverage ratios

In this layer of stress test, we estimate PRIME and KORE’s new cost of debt in accordance with the prevailing high interest rate environment.

Since we anticipate no Fed rate cuts this year, near-term refinancing risks would remain prevalent. With the resilient US economy and the uncertainties surrounding the Red Sea that could potentially drive up shipping and freight costs, these factors may contribute to sustained inflationary pressures.

Related Article: The Fed will not cut rates this year. Here’s why.

We compute the cost of debt after refinancing in 2026, with interest rates based on a credit spread over the Secured Overnight Financing Rate (SOFR). Our estimates also took into consideration that MUST had obtained a loan from its sponsor at an interest rate of 7.25% per annum back in December 2023.

Through our analysis, we find that they locked in a low cost of debt a few years ago and have a larger proportion of their debt maturing in the next two years. PRIME has an all-in weighted average cost of debt of 4.00% while KORE has an all-in weighted average cost of debt of 4.12% as of 31 December 2023. Also, PRIME has a lower weighted average term to maturity of 1.3 to 1.6 years relative to KORE’s 2.7 years as of 31 December 2023, reflecting PRIME’s larger proportion of near-term debt (PRIME: 64%, KORE: 48%).

This is a consequence of its decision made last year to extend its loan maturity on debts expiring July last year to July this year. We believe the deferred payment terms is only a temporary relief. The potential for refinancing risks persists especially as we expect the Fed to hold rates this year.

Hence, after adjusting for refinancing risks, PRIME would experience a greater increase in its cost of debt from 4.00% to 5.92% (+48.00%) as compared to KORE with a smaller increase of 4.12% to 5.41% (+31.32%).

Figure 4: Cost of debt after refinancing

Higher interest expenses due to an increase in borrowing cost would lower the ICR. It is crucial to look into the ICR as it determines which leverage threshold a REIT would be subjected to. On 16 April 2020, MAS announced that it would raise with immediate effect the leverage limit for S-REITs from 45% to 50%, to provide S-REITs greater flexibility to manage their capital structure amid the challenging environment created by the COVID-19 pandemic. MAS also proposed to require S-REITs to have a minimum ICR of 2.5 times before they are allowed to increase their leverage beyond the prevailing 45% limit (up to 50%).

Our findings suggest that PRIME and KORE would eventually see a lower ICR of 2.3X and 2.7X respectively, because of higher interest expenses. Particularly for PRIME, the potential decline in ICR would render a downgrade in MAS’ regulatory leverage limit of 50% to 45%.

Figure 5: Interest coverage ratio after refinancing

Even though KORE would not see a downgrade, we believe that the challenging outlook for US commercial real estate may further exacerbate the credit crunch. During KORE’s release of its full-year results, the REIT manager shared that lenders are less willing to lend REITs with significant exposure to US CRE beyond the leverage of 45%. Hence, even if the REIT is theoretically subjected to a leverage limit of 50%, it may only realistically have a debt headroom of 45%.

Coupled with having zero buffers after cap rate expansion, the downside risks appear even larger after taking into consideration refinancing risks.

Financial implications upon exceeding the threshold

Upon exceeding the regulatory gearing limit, the potential financial implications could include distressed sales of properties, equity fundraising, and abandonment of distribution policy.

In the event of distressed sales of properties, it could potentially cause a ripple effect in the market and widespread falling property valuations. Meanwhile, NPI will be reduced.

Moreover, to further lower its leverage, a REIT may seek equity fundraising, which may not be desirable at the current low share price. This move could also dilute the equity value of its existing shareholders.

Lastly, S-REITs are also at risk of eventually breaching other debt covenants, forcing them to abandon their distribution policy. An example is MUST, which breached its debt covenants, leading to the abandonment of its distribution policy.

In the case of KORE, it has recently suspended its distribution policy till 2026 during its full-year results update, even though it did not breach any covenants. The REIT manager has taken a proactive stance as such to manage its balance sheet health to adhere to MAS’ regulatory leverage limit. However, there is always the possibility that changes in asset valuations could lead KORE to exceed the MAS regulatory gearing limit or breach its debt covenants.

As for PRIME, our stress test has revealed its vulnerabilities in the face of cap rate expansion and refinancing risks. During its latest results release, its leverage rose to 48.4%, prompting efforts to deleverage to assure creditors and adhere to the regulatory leverage limit. To do so, the REIT has reduced distribution payout, which resulted in a 90% YoY decline in DPU for 2H23.

Conclusion

After running stress tests involving cap rate expansion and refinancing risks on PRIME and KORE, we see that PRIME may be at a greater risk than KORE due to its higher adjusted leverage and the potential for a greater increase in interest expense. Furthermore, PRIME’s quarterly occupancy rates have been on a sharp downward trend.

Overall, the US CRE is not plagued solely by the problem of elevated interest rates after an era of cheap money, but also a structural shift in how people work after the pandemic. Hence, with the various uncertainties within this property sector, it may be prudent to consider S-REITs in other property sectors such as logistics and data centres.

Declaration:

For specific disclosure, at the time of publication of this report, IFPL (via its connected and associated entities) and the analyst who produced this report hold a NIL position in the abovementioned securities.