Survey: Some REITs may breach leverage limits, Real Estate Use Evolving (PART 2)

REIT AsiaPac conducted a mini survey in June of this year in which we asked Asia-Pacific REIT fund managers and market participants for their views on the sector’s recovery amid the on-going impact of the pandemic.

This is part 2 of the survey. For Part 1, click here.

6. Some REITs could breach leverage limits

Question: Do you see the potential for REITs to breach leverage limits or even potentially run into insolvency as a result of Covid-19 pandemic?

As business conditions deteriorate, the negative impact on REITs will likely continue to worsen until the economy can be reopened to resume normal operations. 

In Singapore, REITs’ leverage limit was raised from 45% to 50% to allow S-REITs greater flexibility to manage their cash flows and raise funds amid a challenging operating environment. S-REITs were also given an extension of the deadline for the distribution of least 90% of their taxable income from 3 months to 12 months after the end of Financial Year 2020 to qualify for tax transparency. While the measures will help to mitigate cash flow impact, S&P Global has nevertheless downgraded its ratings on Frasers Centrepoint Trust due to the REIT’s heightened leverage and deteriorating cashflow amid the pandemic. 

In Japan, S&P Global said most of the J-REITs and real estate companies it rates“have some financial buffer and adequate liquidity to weather the storm.” After the global financial crisis, J-REITs took steps to moderately improve leverage levels, accumulate reserves, increase committed credit lines, and diversify debt maturity profiles. Nonetheless, caution is warranted because of the possible decline in real estate prices, it said.

We asked investors if they see the potential for REITs to breach leverage limits or even become insolvent as a result of the financial and business impact from the Covid-19 pandemic. The responses were mixed.

Some investors commented that this is unlikely to occur in Asia, with one fund manager saying “REITs can simply tap the market for more capital unless there is an underlying issue with the REIT.” One investor in Australia said, “Not in the countries we focus on over the next one year.”

Other respondents were less positive. According to an investor from Hong Kong, “Nothing is impossible. You already have it in SG (Singapore) with Eagle Hospitality.”  Eagle Hospitality Trust has about 18 hospitality assets in the U.S., and the trust has come under regulator’s scrutiny after its non-executive chairman Howard Wu and deputy chairman Taylor Woods were found to be engaged in “prejudicial” deals that are “not on usual commercial terms”.

Junnosuke Shinkawa, a senior fund manager with Sumitomo Mitsui DS Asset Management Singapore, said that: “A few from the hotel sector may potentially breach LTV (loan to value) or covenants.” One Singapore-based respondent said retail REITs are at risk because “we can’t see the end of the pandemic.”

James Maydew, head of global listed real estate at AMP Capital, believes that while this could occur, banks would likely cooperate. “Yes, in some sectors, but banks will work with them to not force deeply discounted equity. This is not 2008/09,” he said.

The current expectation is that we are likely to see most of the down draft to earnings and capital values come through in the second half of this year with concerns around a second wave. While the trough will probably happen this year or early in 2021 in terms of capital value and dividend yields, there will be upside from there, especially once a vaccine is found,” Shern-Ling Koh, CFA – Portfolio Manager, Principal Real Estate Investors said.

7. Secondary offerings may be necessary but should be avoided

Question: Should REITs be conducting secondary offerings to improve their balance sheets?

With interest rates at record lows, REITs encountering cash flow problems may turn to the debt market to raise funds. However, banks are also becoming more cautious with regards to their credit lines.

Alternatively, they could raise capital via secondary stock offerings. However, this would be dilutive and could depress already weak stock prices. 

Based on our survey among REIT investors, many believe REITs secondary offerings may be necessary given the current challenging market conditions.

Shinkawa with Sumitomo Mitsui DS Asset Management Singapore said, “Yes, especially for retail REITS with downside risk for valuation.” 

This is supported by two more respondents from Singapore, with one saying that “If they are at risk of breaching covenants then yes. As an investor, I will attempt to avoid those types of REITs.”

An investor from Hong Kong commented, “They have done so in Australia, at the cost of large dilution effects. Not favourable.”

A separate respondent from Australia said, “this should only be done where necessary,” adding that he was disappointed by some companies that had opted for an “opportunistic repair of [their] balance sheets that aren’t under pressure.”

While some are required to do so, “those deferring while markets improve should be commended,” he said. 

Another Australian investor said, “Only if it helps enhance shareholder value and not if they can help it. That said, a number of REITs have been doing this and because the REITs are trading at significant discounts to NAV (net asset value), the take up rate has been strong.”

8. Balance of power between landlords and tenants is dynamic

Question: How do you see the balance of power between landlords and tenants?

The unprecedented lockdowns implemented across many Asia Pacific economies came with a particular point of friction, namely, lease contracts that lock tenants into long term commercial agreements regardless of whether they use the premises. This was especially true for office, retail and hospitality properties, for which usage fell by half or more during the lockdowns.

The economic pain was acute as many businesses saw revenues and cashflows plunge to near zero overnight. This led to calls for renegotiation of rental contracts and rental boycotts. Should the burden of economic pain fall on tenants as is contracted or should landlords demonstrate solidarity by bearing some of the fallout? 

Respondents had mixed views on the balance of power between landlords and tenants depending on the lens taken.

While landlords have more power on paper because tenants are contractually locked into long term leases; yet paper leverage means nothing if tenants were to default, and there is no occupant for the property. Moreover, governments looking to save jobs and salvage their economies sided with tenants for most part.

 “It’s pretty dynamic and the relationship is symbiotic. Rental terms are subject to competitive market forces and landlords know they can’t drive tenants out of business or they’d have a massive issue on their hands in the longer term,” said one fund manager.

While some sectors suffered badly amid the pandemic, others flourished. It is “sector specific – retail has lost most power, industrial the least,” one fund manager commented.

With Japan having started its rental relief measures only in May, one comment was “compare SG with JP – seems like two different worlds.”

9. REITs should work with tenants to achieve the best outcome.  Good tenants should be retained

Question: Should REITs be offering their tenants rental rebates? How do you see rental renegotiations playing out and what is the role of government in this?

Responding to the crisis, the governments of many countries have come to the rescue to assist tenants, particularly in the retail and hospitality sectors. In the Asia Pacific region, Singapore, Japan, Australia, and Hong Kong have implemented varying measures to help businesses with their rents.

For now, the days of landlords having the ability to employ several measures against a defaulting tenant to maintain a stable stream of income are temporarily gone.

A number of participants in our survey agrees that rental rebates must be provided by landlords to tenants.

According to Shinkawa, “Yes, landlords should help to provide rental rebates to tenants. At the same time, the government should also support landlords.”

“An empty building is worth less than one with tenants on lower rent contracts. Everyone has to bear some pain including landlords,” another Singapore-based investor commented. 

“The government should firstly support labour-intensive sectors to control unemployment, then it can focus on secondary needs like those of landlords. The measures taken in Singapore are quite well-structured,” he added.

“Given the unprecedented nature and the wide economic impact, some government regulation to manage near term leases are necessary,” said another respondent from Singapore.

However, government assistance isn’t free, one investor said. “It often involves utilising tax payer monies,” but he added that “it is far less helpful for governments to arbitrarily change contractual terms without providing support.”

Maydew said, “Yes, you need to work with your tenants to ensure long term success.”

While it is a good practice for REITs to offer rental rebates and be open to rental re-negotiations for the welfare of tenants, some respondents commented that it is also important for them not to disregard the business aspect of maintaining long-term returns. Ensuring a successful partnership can be delicate balance. 

“It should be a partnership. While REITs can provide support for the short term, there are also operational costs that REITs have to shoulder,” said one Singapore-based investor.  It’s a delicate balance and hence tenants and landlord must take this time to have a hard look at the relationship and forge a partnership going forward,” he said. 

“Landlords know that if their tenants fail, it would be difficult to source replacement tenants during this period,” said a separate investor.

Landlords should have had a choice of who they wanted to support, rather than be obliged to do so,” said one investor. Therefore, rebates should be provided “where relevant, if it means a good tenant is retained.”

Another respondent from Hong Kong agreed, “Go for quality and sustainability with keeping ESG in mind.” 

10. Real estate use will evolve, and the sector could shrink 

Question: Following Covid-19, what is your view of the future of real estate? Do we really need physical office space or mall?

The commercial property sector has never faced such a level of uncertainty.  While the global pandemic is not expected to erase the use of commercial real estate, the volume of space required for office, retail, and hospitality will likely decrease.  

Many economic activities all over the world were forced to move online as businesses learned how to cope with the restrictions brought about by the coronavirus disease. Office work has largely turned to telemarketing, with video conference programs like Zoom and Skype allowing for meetings and collaborations in real time. The retail sector has also turned to “online malls” and e-commerce platforms so patrons can shop from the comfort of their own homes. 

Business travel has taken a big plunge, and is unlikely to recover to the hey-days of pre-Covid-19 even if a vaccine is found as business executives learn to conduct deals virtually.

Respondents to the survey said the ‘physical nature’ of offices and retail spaces cater to humans’ basic social engagement need, deeming them essential even after major advances were already made in making everything digitised.  

“All those of you who have been locked down for weeks or months, how eager are you to re-socialise with people? And where exactly do you do that?  — In the office, in the mall, leisure facilities and public places,” one fund manager said.  

However, “how we use office and retail has likely changed forever,” said Maydew.

“People will still need a place to work and to shop. Although the amount of space needed may decrease,” a fund manager said. “Retail was already facing structural challenges pre-Covid. Covid may have accelerated digitisation and will change how retailers provide omni channels. Retail won’t be dead but evolve,” said another. “Same for office. We will always need physical offices, but the makeup of space may change.”

One Asia-Pacific fund manager said digitisation was already in the radar of firms all over the world, and Covid only expedited this evolution.  “People would prefer high maintenance and high-quality buildings,” said Shinkawa.

While landlords and tenants are still working out rent abatement and deferrals, tenants in various market sectors are seeing less value in physical space today than in the past prior to the pandemic.

Indeed, an analysis updated in June by the National Bureau of Economic Research showed 37% of jobs in the U.S. can be performed entirely at home.

With rent typically making up a third of operational costs, tenants are likely to carefully consider what they need over the longer-term.

*** For Part 1 of the survey, click here.. ***

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