Thursday 26 October 2023

Prime US REIT: Going Through the Office Oversupply and High Interest Rates

Investors have been worried about the business of Prime US REIT. Due to the oversupply of office space which has seen tenants vacating and the high gearing, the share price has taken a beating and is down 80% in a year.

Leverage of PRIME US Reit

While the latest published leverage ratio is 42.8%, I expect came year end when there is a revaluation, PRIME's leverage will exceed 45%. Here's why: Firstly, since the last valuation, the Fed has went on to raise rates 4 times (1%). This means risk free rate has increased and hence a cap rate expansion. This decreases PRIME REIT's property value. Secondly, with tenants leaving, I expect the REIT's valuation to fall as well. 

I expect the same magnitude in valuation decrease as that experienced by Manulife US REIT (15% decline). This means Prime REIT's leverage will hit 50.3%. There is no way in my view when year end valuations are revealed for Prime to stay below the leverage ratio of 45%. Prime needs to maintain the interest coverage ratio (ICR) of above 2.5 times or else it is hell.

Interest Coverage Ratio (ICR)

Latest ICR is 3.4 times. However, with a major tenant vacating (5.4% hit to income) and possibly lower passing rent, one can expect Prime's net property income to be 9% lower next year. To add to that, the effective all in interest rate is expected to rise. 

An all in effective i/r of 3.9%, I expect it to rise to about 4.5% next year. With these effects, interest will rise by about 19%. 

Using simple maths, it is expected by year end 2024; based on trailing 12 months, Prime's ICR will be 2.6 times. I expect the refinancing will add some cost and this will lower the ICR. However, Prime will be a borderline in knowing if it will pass MAS's ICR limits.

What can Prime do?

My view is Prime has only 1 option and that is to sell 1 or 2 buildings. With such a sale, the debt will be reduced by about 10% and along with it a lower interest expense which pushes its ICR up to approx 2.8 times.

I prefer Prime REIT does the sale now to secure its safety and prevent any sudden announcement like what happened to Manulife US reit. It is painful but this is needed to protect itself. A $70 million sale off its assets is sufficient. A sale is good news and secures the REIT's survival even beyond 2025; something Manulife US Reit is setting as a target with a great degree of difficulty to achieve. Sticking my neck out, but a sale of an office building should see an upside of 50% of share price due to the rapid decrease in leverage and improvement in ICR; this means safety.

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