THE Monetary Authority of Singapore earlier this month reassured Real Estate Investment Trust (Reit) managers that it will not consider a rise in aggregate leverage that is due to a decline in property valuations as a breach of regulatory limits. This may give some breathing space to Singapore Reits in the current tough environment.

In reality, however, ratings agencies and Reits’ lenders will still be concerned about declines in property values since these would raise loan-to-valuation ratios as far as lenders are concerned and possibly trigger a breach of covenants set by lenders.

Another thing ratings agencies and banks will be nervous about is falling interest coverage ratios (ICR) for Reits, arising from a mix of declining rents and rising interest expense as debt is refinanced. ICR is measured as earnings before interest, tax, depreciation and amortisation divided by interest expense. A decline in ICR could also potentially trigger a breach in covenants set by lenders and raise alarm bells of rating agencies.

Three options

Logically, Reits can try to fix these maladies in one or more of at least three ways: sell some of their properties and use the proceeds to reduce debt and hence interest expense; raise equity (and achieve a similar effect, although with the risk of earnings dilution and pressure on the unit price of the Reit); and reduce their distribution payout to unitholders or ask unitholders to accept their distribution in the form of new units instead of cash to conserve cash and trim borrowings.

From unitholders’ point of view, the most appealing solution would be for Reits to sell some of their assets and repay some loans. So far, market watchers note that no Singapore Reit has sold property assets. It may be time for S-Reit managers to consider broadening their capital management policy to include both buying and selling of assets, instead of the traditional buy, hold and rent model.

The counter point from Reit managers would be that the property investment sales market is quiet. And that buyers are scarce and typically will have difficulty raising debt to fund any property purchase in the current environment, and that potential buyers are eyeing deals only at firesale prices so the Reit would not get a good price for its assets.

Also, because of the way Reit managers are incentivised – their management fees are based on a percentage of the value of the Reit’s deposited property – they would not be inclined to sell assets as that would also reduce their fees.

For industrial Reits, yet another obstacle in divesting assets is a prohibition by JTC Corp against selling industrial properties within three years of their purchase where JTC is the sites’ master lessor. The idea is to deter speculators from flipping industrial properties. However, JTC is known to make exceptions, for instance, if the lessee is in financial distress, according to property consultants.

Equity raising could also lower Reits’ borrowings but the possible flip-side could be earnings dilution and downward pressure on unit price. The impact would depend on investors’ perception of the recapitalisation exercise. If the equity raised is sufficient to repay maturing debt, and with no further debt refinancing coming up in the next one to two years, the market may view the equity raising positively and not punish the Reit’s unit price.

However, if the equity raising fulfils only a fraction of the Reit’s debt refinancing needs for the next 12 months and the market perception is that the Reit manager may attempt another such exercise in the near future, the unit price may receive a drubbing.

Some Reits will also try to reduce their payout to unitholders, reasoning that they need to conserve cash to service debt or even try to trim debt. That may be marginal strategy as distributions may be small relative to the Reit’s debt size.

Also, under current Property Fund Guidelines, Reits would not enjoy tax transparency (that is, exemption from having to pay corporate tax on their income) if they pay unitholders less than 90 per cent of distributable income.

Payouts

Institutional investors in Reits may also not be happy if Reits reduce their payouts as that would negate a key attraction of Reits – the certainty of a regulated minimum distribution.

Another way for Reits to conserve cash could be to request unitholders to take their distributions in the form of new units instead of cash. But that could also potentially lead to some earnings dilution.

There seem to be no easy fixes for Reits in the current environment. Of course, there’s always the option for smaller Reits that are struggling to refinance debt or being choked by high gearing to consider being taken over by a bigger Reit which has easier access to capital. That may also be a good exit route for minority investors stuck in the smaller Reits.

Source : Business Times – 22 Jan 2009