Monday 16 October 2023

What Threatens REITs is not Leverage Ratio but the Interest Coverage Ratio

Many of us investors would be aware of the rule where REITs have to maintain a leverage ratio of 50%. However,REITs are in fact able to exceed its leverage ratio to above 50% in cases where it is due to its properties being valued lower or circumstances it can't control with the condition they are not to take on more debts. This means even if a REIT exceeds 50% leverage, it is not in breach of any regulatory requirments.

The key regulatory requirement that investors have to be wary of is the "Interest Coverage Ratio" (ICR).

What is the "Interest Coverage Ratio"

MAS's defines the ICR as "Earnings before interest, depreciation, tax and amoritisation" divided by "the interest expense plus borrowing related fees".

For Singapore listed REITs, the ICR should not be below 2.5 times. 

The equation is simple, either a fall in revenue (which affects the earnings) or a rise in interest expense will adversely affect the ICR ratio. The lower the ICR, the more worried investors will be. In a way, ICR tells us how much of the REITs income is used to service the interest of its debt. An ICR of 5.0 means 80% of the REITs earnings is given to shareholders and 20% of it is channeled towards servicing its debt; on the other hand, an ICR of 2.5 means 60% of the earnings are left for shareholders while 40% is for servicing the REIT’s debt.

How Will REITs improve its ICR?

Revenue is an item that REITs have no control of. Businesses can cease to exist, terminate, or downsize its tenanted spaces. The only variable within the REITs sphere of control is how much it pays its interest. The most efficient method is to reduce its debt which will reduce interest expense.

In the current climate of reduced demand of property spaces and of high interest rates, shareholders are worried. A bear scenario is that REITs do a cash call on existing shareholders in order to reduce its debts and maintain an ICR of 2.5. In my view, US REITs realistically are facing this bear scenario of breaching the ICR of 2.5. US interest rates are stubbornly high, in addition, as these commercial properties are now viewed of a much riskier profile, the spread from the SOFR rate when their loans are refinanced will be at a larger spread. All these will increase interest expense.

As an investor of US REITs, I am cognizant of this risk and have set aside money in the event that I am forced to participate in a rights issue.

Ranking by which REIT will need to do a cash call, my bet is Manulife US REIT, followed by Prime, then Elite Commercial, Utd Hampshire and lastly Keppel Pacific Oak. Manulife US REIT is in a damned position because its sponsor (Manulife) holds a 9.8% stake and will not be able to subscribe to excess rights. This means support for the REIT rights (if it happens) is extremely low.

What I think MAS will do

I foresee in a few months’ time; MAS will announce a temporary reduction of ICR from 2.5, likely the ICR will be reduced to 2.0 to protect REITs. Without any amendment by MAS, a few REITs will face a downward spiral of fortunes. In the worst case, REITs like Manulife US REIT will be forced down the path of a fire sale which will destroy the wealth of Singapore investors but benefit US buyers of distressed assets. Therefore, my bet is MAS will relax the ICR ratio.

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