Manulife US REIT (MUST) is the first S-REIT with US assets that is testing the generally held view that sponsors are meant to support their REITs.

 

On July 18, MUST&rsquo s manager announced that the valuation of the entire portfolio had declined by 14.6% from the valuation as at Dec 31, 2022. This caused MUST to breach the 50% aggregate leverage ceiling. The valuation decline was blamed on higher discount rates to compute net present value (NPV), higher capitalisation rates and weakening occupancies.

 

According to the July 18 announcement, the bulk of the US$280 million ($371 million) decline came from properties Figueroa, Michelson, Exchange, Penn in Washington DC and Phipps Tower in Atlanta.

 

Potential financial covenant breach

 

MUST&rsquo s loans contain a financial covenant where its loan-to-value (LTV) of the total unencumbered debt to unencumbered assets is 60%. With its latest voluntary half-year valuation, MUST&rsquo s financial covenant is at 60.2%. The problem with covenant breaches is the potential for cross-defaults.

 

Robert Wong, chief financial officer of MUST&rsquo s manager, explains: &ldquo We&rsquo re proposing to prepare the token amount of debt [to be paid] to get the LTV down to below 60%. Then we won&rsquo t be in a technical breach. From there, negotiations and discussions will be more conducive, because the respective lenders will then be able to say we are not in default.&rdquo

 

&ldquo We&rsquo ve got to work through a solution whereby the lenders will either waive the covenants or relax them to give us a bit more runway to execute our divestment plan to release more capital into the REIT and to pay down the debt,&rdquo he adds.

 

The covenant breach would result in a cross-default of MUST&rsquo s interest rate swaps, which have fixed the interest rate. If this materialises, MUST would be subjected to higher interest rates for its loans which would impact the interest coverage ratio (ICR).

 

The existing loans contain a financial covenant which states that MUST&rsquo s ICR shall not be less than 2x. If the banks do not agree to waive the breach of the financial covenant, the ICR would fall below 2x.

 

During its IPO back in 2016, MUST was listed with three assets sold to it by the sponsor Manulife. These were Michelson, Figueroa and Peachtree. MUST swiftly acquired two more properties, Plaza in Secaucus and The Exchange in Jersey City, which was from the sponsor. In 2018, MUST acquired a further two properties from the sponsor: Penn and Phipps. Centerpointe I and II in Fairfax, Virginia and Capitol in Sacramento were also acquired in 2019.

 

MUST raised equity in 2017, 2018, 2019 and 2021 when it acquired three more smallish properties in the so-called &ldquo Sun Belt&rdquo of the US. Of these, Tanasbourne was divested to Manulife in April this year. MUST&rsquo s manager announced that Manulife would acquire Phipps following a valuation exercise to infuse the REIT with cash.

 

The problem for MUST unitholders could be the absence of distributions for DPU. &ldquo We can&rsquo t make any distributions because all the loans are considered due right now,&rdquo Wong points out. &ldquo The lenders have listened to our near-term, mid-term and long-term plan. Between now and the results, we can&rsquo t get a ton of resolutions on whether they can waive the current breach in covenants. The possibility of distribution in the 1HFY2023 is limited but it doesn&rsquo t mean that it&rsquo s going to be permanent. Once we can work out something with the lenders, things will be back to normal,&rdquo he says.

 

William (Tripp) Gantt, chief executive officer of MUST&rsquo s manager, says: &ldquo Over the mid-term, we&rsquo re going to continue to look at ways of raising proceeds in order to continue to pay down debt.&rdquo

 

As Gantt tells it, MUST has three ways to raise proceeds to pare debt, excluding the rather unpopular avenue of preferred placements to new investors. These are raising equity via a dilutive rights issue, divesting assets either to the sponsor or a third party or getting a shareholder loan from the sponsor.

 

&ldquo The property sales are the most obvious another alternative is some kind of lending [agreement] and [for the sponsor] to become a lender to pay down near-term debt. That&rsquo s something we&rsquo ll continue exploring with the lenders,&rdquo Gantt says.

 

Separately, the regulatory guidelines on aggregate leverage have an ICR component. S-REITs are required to keep their aggregate leverage ratios no higher than 50%, subject to a minimum ICR of 2.5x. If the ICR is below 2.5x, aggregate leverage ratios need to be no higher than 45%.

 

S-REITs used to be more conservative with aggregate leverage ratios. However, the quest for higher assets under management (AUM) has led even large, previously well-managed REITs like CapitaLand Integrated Commercial Trust to move their aggregate leverage above 40%.

 

Sponsors that used to be supportive of their REITs have restructured as real estate investment managers (REIM) or alternative real asset managers focused on AUM growth and fee income. Whether these restructurings disadvantage their REITs and property and business trusts remain to be seen.

 

A sponsor&rsquo s role

 

In the first couple of decades of S-REITs, the external manager model worked well as sponsors supported their REITs with a pipeline and the financial support to acquire that pipeline. Sponsors also supported their REITs financially during stressful occasions, such as the global financial crisis.

 

Increasingly though, REITs are being pushed to acquire more assets &mdash not just from the sponsor but from third parties &mdash and some of these acquisitions have been questionable. In particular, CapitaLand Ascendas REIT&rsquo s (CLAR) acquisition of The Shugart, Seagate&rsquo s R& D facility in Southeast Asia, is an acquisition from a troubled company, which signed on as a master lessee of the property. The second issue is the property&rsquo s limited land lease of 20 years.

 

As CLAR is large and diversified, it can weather declines in valuation. For its part, CLAR&rsquo s US portfolio continues to perform a lot better than either Keppel Pacific Oak US REIT (KORE) or Prime US REIT.

 

RHB Group Research believes MUST&rsquo s sponsor should step up.

 

&ldquo The sponsor, Manulife, with its strong financial position, could help offer support in the form of i) the completion of the proposed acquisition of The Phipps from the REIT, preferably at an average of year-end (December 2022) and latest valuation as well as potentially buying back few more assets from the REIT and ii) working with the lenders in resolving and offering continued financial support to the REIT, and, if needed, provide a shareholder loan or act as a lender of the last resort,&rdquo RHB says.

 

Alternatively, despite articulating a wish to exit office property, Manulife could lead the formation of an office property fund to acquire distressed assets. This would infuse MUST with cash without breaching the 9.8% ownership rule.

 

In the meantime, Gantt has an unenviable task ahead of him. The excuse cited for Manulife&rsquo s inability to render more support to the REIT is because of a widely held rule where no single investor can hold more than 9.8% of the REIT in order for MUST unitholders to enjoy a waiver of the US&rsquo s 30% withholding tax on distributions.

 

&ldquo Our sponsor is limited to a 9.8% holding in the REIT, which somewhat limits their ability to put equity directly into the REIT. We&rsquo re continuing to work with the sponsor on the Phipps transaction. We have been engaged with brokers, looking at disposition options in the US. We&rsquo ve remained engaged, trying to gauge the market for opportunities to sell assets. We are working with a broker right now to identify which assets we think that we would be able to sell,&rdquo Gantt explains.

 

&ldquo Going forward, we need to have the sponsor in the room to express directly what the appetite is and what their objectives are. What I can tell you is they&rsquo re in the trenches with us, involved in the lender phase, they understand they&rsquo re the critical part of the solution but I can&rsquo t speak on behalf of them in terms of appetite and what they&rsquo re going to do moving forward,&rdquo he adds.

 

Valuation declines

 

According to a briefing by MUST&rsquo s manager on July 18, the key drivers of the valuation declines were widening discount and terminal capitalisation rates. The discount rate used in its valuation exercise increased by 50&ndash 125 basis points (bps) while the terminal cap rate increased by 25&ndash 100 bps. The cap rate in the income capitalisation valuation method expanded by 75 bps to 7%.

 

Patrick Browne, chief investment officer of MUST&rsquo s manager, says: &ldquo I just want to re-emphasise that the main driver of valuations in the US valuation process is the discounted cash flow (DCF) model, which is primarily driven by discount rates and terminal cap rates to arrive at a valuation.&rdquo

 

Other inputs in DCF are operating cash flow, which depends on costs, rents and occupancies, including their outlook. Costs have risen and occupancies have fallen because of the work-from-home trend. In MUST&rsquo s portfolio, a few large tenants downsized.

 

&ldquo We made the voluntary decision to take this [revaluation] action early. And as soon as we got wind of these valuations, we began looking at options right away. We are in the early stages of trying to figure out the solutions for this and the sponsor is engaged with us,&rdquo Gantt says.

 

DBS Group Research has downgraded MUST to &ldquo fully valued&rdquo . &ldquo We are late in this change in call and we take responsibility for that. We have previously, in our past reports, envisioned a roadmap which highlights a more urgent response from their sponsor (through asset sales and/or equity injection) towards MUST in order to prevent an incidence of any breach of the financial covenants, but found the timing to be lacking. With another round of asset write off (25% year-to-date) signalling further stress in the balance sheet and in the face of a spiralling debt crisis and a near-term &lsquo dividend stopper&rsquo , we believe that there is a rising risk that equity shareholders will not be compensated to wait out a recovery,&rdquo the DBS update says.

 

These issues are not peculiar to MUST&rsquo s portfolio. Tech companies are rightsizing their headcount. KORE&rsquo s manager has articulated that its portfolio is tech-heavy from a tenant perspective. Unit prices of KORE and Prime are down by 30% and 51% respectively.

 

Analysts need to relook at KORE and Prime to see if the stresses that materialised for MUST could surface for the other two US-based S-REITs.

 

The manager expects the Reit to report a loss in the first half of 2023. 

 

SHARES of Manulife US Real Estate Investment Trust : BTOU -31.36% (Manulife US Reit) fell as much as 33.1 per cent after resuming trading on Wednesday (Jul 19) morning.

 

The counter reached a low of US$0.113 as at 9.06 am &ndash the lowest since the company&rsquo s listing in May 2016.

 

By 9.22 am, Manulife Us Reit&rsquo s units were trading 31.4 per cent or US$0.053 lower at US$0.116 &ndash about a fifth of its FY2022 net asset value of US$0.57. The counter was also the second most traded by volume, with 17.4 million units changing hands.

 

On Tuesday, the Reit&rsquo s manager said a surprise sharp decline in portfolio valuations caused a breach of loan covenants, potentially affecting distributions.

 

The valuations decline was attributed to factors like higher discount rates and terminal capitalisation rates, along with the continued weakening of occupancy performance across the US office market.

 

The manager expects the Reit to report a loss in the first half of 2023.

 

Manulife US Reit&rsquo s aggregate leverage has also risen to 57 per cent following the new set of valuations, passing the 50 per cent limit set by the Monetary Authority of Singapore.

 

However, the manager noted there was no gearing limit breach, as the circumstances that led to the exceeding of the limit were beyond its control.

 

The manager is in discussions with its lenders to seek their waiver for the breach in financial covenants and is working on potential solutions. It will also look at ways to raise proceeds to pay down debt over the mid-to-long term.

 

THE manager of Manulife US Real Estate Investment Trust (Reit) said it was &ldquo surprised&rdquo by the sharp decline in portfolio valuations that caused a breach of loan covenants, potentially affecting distributions.

 

&ldquo We were surprised at how deeply they had come down,&rdquo said Tripp Gantt, chief executive of the manager at a briefing on Tuesday (Jul 18), after it announced that the Reit&rsquo s real estate portfolio valuation had declined by 14.6 per cent to US$1.6 billion as at June 30, 2023.

 

&ldquo The different indices that we were looking at, the different information sources we were looking at to kind of gauge where we were in terms of valuations were mixed, but none of them pointed to where our valuation declines would be at mid-year,&rdquo he added.

 

The decline in valuations was due to several factors including higher discount rates and terminal capitalisation rates, as well as continued weakening of occupancy performance across the US office market. The Reit is expected to report a loss in the first half of 2023.

 

Manulife US Reit&rsquo s : BTOU 0% aggregate leverage has risen to 57 per cent following the new set of valuations, passing the 50 per cent limit set by the Monetary Authority of Singapore (MAS).

 

The manager noted there is no gearing limit breach as the circumstances that led to the exceeding of the limit were beyond the manager&rsquo s control.

 

The Reit, however, has breached a financial covenant in some of its financing documents relating to the ratio of unencumbered debt to unencumbered assets.

 

Its existing loans contain a financial covenant stating that the Reit must at all times ensure its ratio of consolidated total unencumbered debt to consolidated total unencumbered assets was no more than 60:100. With the updated valuations, this ratio has changed to 60.2:100.

 

&ldquo One of the impacts &hellip is a potential impact to our distributions for the first half of 2023. It&rsquo s unclear to us at the moment whether we&rsquo ll be able to make those distributions,&rdquo Gantt said, adding that the manager is addressing this with its legal and accounting team.

 

If distributions cannot be declared, there may be an impact on the structure of the Reit, which would result in additional taxes being required to be paid. The manager is also seeking advice from a US tax adviser.

 

The breach of the financial covenant would also result in a cross default of the Reit&rsquo s interest rate swaps, potentially resulting in higher interest rates for its loans and affecting the interest coverage ratio.

 

The manager is in discussions with its lenders to seek their waiver for the breach, and is working on potential solutions. Gantt said: &ldquo Since we are close &ndash we&rsquo re at 60.2 per cent &ndash our objective is to try to get that down below 60 per cent in the short term.&rdquo

 

Over the mid-to-long term, Manulife US Reit would continue to look at ways to raise proceeds to pay down debt.

 

&ldquo We&rsquo re continuing to work with the sponsor on some sponsor support &ndash the Phipps transaction &ndash or a potential alternative that would bring in proceeds,&rdquo he said.

 

Manulife US Reit said in May that it entered into a letter of intent to sell Phipps Tower in Atlanta, Georgia, to an affiliate of its sponsor. Discussions for this are still ongoing but the Reit&rsquo s aggregate leverage would still remain above 50 per cent even if all proceeds from the sale are used to repay loans.

 

The manager and sponsor are also &ldquo actively exploring a potential alternative method which may work to address Manulife US Reit&rsquo s mid- and long-term liquidity needs&rdquo . Gantt noted that property sales are one possibility. Another alternative could be some form of lending, in order to pay down debt.

 

Besides sponsor support, Manulife US Reit is also exploring the disposal of assets, and it may seek a &ldquo disposition mandate&rdquo from unitholders. This would allow the Reit the flexibility to dispose of certain assets as long as certain conditions are met. The manager said it is still in the midst of drafting the disposition mandate and would provide more details when ready.

 

Darren Chan, research analyst at Phillip Securities, said the mandate would be helpful to speed up the process, as buyers are less willing to wait for an extraordinary general meeting to proceed with a purchase.

 

He added that equity fund raising at the current price is &ldquo highly unlikely&rdquo for Manulife US Reit.

 

&ldquo The US office market remains challenging with slower leasing volumes and higher vacancies,&rdquo Chan said. &ldquo As a result, the other US office Reits might face valuation declines as well, but we think to a lesser extent due to the location of the properties.&rdquo

 

In terms of why the manager decided to take on a fresh valuation of assets at this point in time, Gantt said that they &ldquo took the initiative&rdquo to do this once they had indications that valuations were going to be down to an extent greater than they thought.

 

&ldquo Obviously we&rsquo re facing the music earlier than we might have had to otherwise,&rdquo he said. &ldquo But I think that both the regulators and the banks appreciate that we are being very open, and the conversations today have been consultative and cooperative, and we are going to continue that and find a solution here together.&rdquo