Sunday 8 October 2023

Will US Office Commercial REITs Run Into Trouble with Its Bankers?

Was talking about investing in the US Office Commercial REITs. The risk highlighted was how US office REITs could breach their financial convenant and become a Manulife US REIT. The reply I was given is as follows:

"The big issue / unknown are the banks financing. They will have financial covenants in place. In particular, the "loan to value" covenant could be triggered as office space is being marked down across the US. That could trigger a default. Under such a scenario, the banks are likely to insist that dividends be stopped and cash diverted to repay loans."

This could be what is deterring investors from investing in US Office REITs. To me, the worries faced by investors is valid and can be classified as two types of worries:

1. Banks Loan Recall as Loan to Value Ratio Falls

As described in the above quote, the value of office spaces could get marked down due to an increasing risk free/interest rate globally or due to a fall in demand for ''ready to be leased" office space, the loan-to-value ratio rises till it breaches the contractual agreed value between the REITs and its bankers. This results in the dividend being stopped.

Investors are now holding a 0% yielder. Do we have a real world example? Yes, it is Manulife US REIT. Its downward revaluation of its property assets caused it to breach above the agreed 60% ratio it had with its bankers which caused a stop in dividends.

2, Banks Loan Recall as Loan to Interest Ratio Falls Dangerously

With the rising vacancy in office spaces (not just in USA but across the world as well), the other worry is that the property revenue earned from these REITs ends up below the agreed ratio between the REIT and its bankers. The banks may force dividends to be stopped (which they have the legal right to do so) and the REIT no longer gives dividends. 

Personally I am starting to be worried about this second scenario. Interest rates are still rising on the global scene. While many REITs have hedged their floating interest rates, there would be a time when their hedge ends and they have to pay a higher effective interest rate. To add to that, they are now facing a declining property revenue because tenants realise they don't need that much office space due to hybrid working arrangements. 

For those who are not well tuned to words, I have done a mathematical example:

A 30% drop in property revenue mixed with a 50% rise in interest expense can result in dividends falling by multiple of times.

As the situation worsens, it can deteriorate to a situation where all of the REIT's income is used to service the loan. What was once a high dividend yielding REIT becomes a no dividend yielding REIT. The second type of worry is definitely the more damaging of the 2.

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