Should First Reit Be Given a Second Chance?

First Reit had been a good investment for me over the years. It had provided good distributions regularly and also some capital gains. The reason I sold it away was because its Debt-to-Equity ratio had exceeded my comfort zone of 50% or less. For investments that I do not have time to monitor regularly, it is best that their debts are low in the first place.

Last year, First Reit's share price had been dropping since the COVID-19 outbreak and the announcement by its sponsor, Lippo Karawaci (LPKR), to restructure the master leases of the hospitals that it lease from First Reit. The low share price attracted my attention, but when First Reit announced that the rents would be paid in Indonesian Rupiah (IDR) instead of Singapore Dollars (SGD) in future, I was no longer interested. Having the rents paid in IDR instead of SGD would subject it to foreign exchange risks. Not only that, the assets would be devalued in line with the depreciation of IDR while the liabilities would continue to be in SGD. This would lead to a sharp drop in Net Asset Value (NAV). This was exactly what happened to another REIT with Indonesian assets, Lippo Malls Indonesia Retail Trust, when IDR depreciated sharply against SGD in 2013. First Reit, however, was not affected then as its rent revenue was pegged to SGD instead of IDR. See A Tale of 2 Indonesian REITs for more details.

Arising from the lease restructuring, First Reit's revenue in FY2019 will drop from SGD115.3 mil to SGD77.6 mil. 73% of this revenue (SGD56.7 mil) will be paid in IDR. NAV will also drop from $1.00 to $0.52. Leverage will correspondingly rise from 34.5% to 47.9%. In addition, lenders are uncomfortable with the sustainability of First Reit's capital structure and decided to only refinance SGD260 mil out of the SGD400 mil loan, of which the first tranche of SGD196.6 mil will mature on 1 Mar 2021. First Reit has proposed a 98-for-100 rights issue at a heavily discounted price of $0.20 to bridge the funding gap of SGD140 mil. Post rights issue, NAV will drop to $0.36 while leverage will drop to 33.9%.

While I do not own First Reit, my family has it. Thus, a key question we have been discussing is whether to subscribe for the rights and give First Reit another chance. Will it be throwing good money after bad, or will it be a rare opportunity to invest more money in a REIT that had provided good, regular distributions for the past 13 years?

As part of the lease restructuring, the Base Rent for hospitals leased to LPKR and Metropolis Propertindo Utama (MPU), a related company to LPKR, will be reset from SGD92.2 mil in FY2019 to IDR613.1 bil (equivalent to SGD56.7 mil at an exchange rate of SGD1:IDR10,830) in FY2021. The Base Rent will increase annually at a rate of 4.5%. In addition, there will be a Performance Based Rent pegged at 8% of the hospitals' Gross Operating Revenue. The rent payable will be the higher of the Base Rent and the Performance Based Rent, on an asset-by-asset basis.

Opportunities

Although the rents for the Indonesian hospitals will be paid in IDR instead of SGD in future, the Performance Based Rents are likely to provide some upside. Fig. 1 below shows that the revenue of Siloam International Hospitals, which leases the hospitals from LPKR, MPU and First Reit as the end user, has been increasing since 2011.

Fig. 1: Revenue of Siloam Hospitals International

Siloam also reports the revenue of its major hospitals in its annual reports. Fig. 2 below shows the total revenue and rent paid by LPKR to First Reit for hospitals which revenue data is available from FY2014 to FY2019.

Fig. 2: Revenue and Rent Paid to First Reit for 6 Hospitals

The figure shows that the revenue in IDR has increased at an annual rate of 12.2% from FY2014 to FY2019. When converted to SGD, the revenue has increased at an annual rate of 10.4%. Over the same period, IDR has depreciated against SGD by an average of 1.6% annually. In contrast, the rent paid to First Reit has stayed constant.

Assuming revenue in IDR in FY2021 recovers to the same level as FY2019 after COVID-19 and continues to grow at an annual rate of 10% from FY2021 to FY2035, the Base Rent and Performance Based Rent in IDR will be as shown in Fig. 3 below.

Fig. 3: Projected Base & Performance Rent in IDR

From Dec 2006 when First Reit was first listed till now, IDR has depreciated against SGD at an average rate of 4.3%. Assuming this historical depreciation rate continues, when converted to SGD, the Base Rent and Performance Based Rent in SGD will be as shown in Fig. 4 below.

Fig. 4: Projected Base & Performance Rent in SGD

Based on Fig. 4, the projected Base Rent in SGD will largely stay flat as the annual rent increase of 4.5% barely outstrips the historical IDR depreciation rate of 4.3%. Performance Based Rent in SGD is projected to exceed the Base Rent in 2031. It is projected to reach SGD73.3 mil in FY2035 when the leases expire, 20% short of the existing Base Rent of SGD92.2 mil in FY2019. If this revenue growth materialises, it will provide some upside to the Distribution Per Unit (DPU) in the last 5 years of the 15-year leases. 

Without the revenue growth, DPU will be around 2.59 cents immediately after the lease restructuring and rights issue. Maintaining the DPU at this level requires other risks not materialising in future.

Risks

There are plenty of risks with this investment. The first and foremost is whether LPKR and MPU will continue to face financial difficulties and default on the rents payable to First Reit. If that is the case, all bets are off. Its Indonesian assets which are leased to LPKR, MPU and Siloam, including those not subject to the current lease restructuring, comprise 95% of its assets post-restructuring. These assets will be significantly impaired. First Reit will likely default on its loans.

The second risk is the currency mismatch between its assets of which 81% are valued in IDR and loan liabilities which are in SGD. This is the same problem encountered by Lippo Malls when IDR depreciated sharply against SGD in 2013. It is important to monitor whether First Reit will take steps to minimise the currency mismatch by converting the SGD loans to IDR loans. Entering into forward contracts to hedge the IDR receivables into SGD is another option, but there is a limit to the no. of years you can hedge. Hopefully, there is no sharp depreciation around the time loans mature and First Reit enters into discussions with banks for refinancing.

The third risk is that after the current SGD400 mil loan has been refinanced with the rights issue, there remains another SGD100 mil loan due in May 2022. The concern is whether First Reit is able to refinance this loan in full. If it is unable to, there is risk of another rights issue. 

However, I am not too concerned with this loan. The existing SGD400 mil loan was a syndicated loan from OCBC while the SGD100 mil loan was from OCBC and CIMB jointly. The new SGD260 mil loan to partially refinance the SGD400 mil loan is also from OCBC and CIMB jointly. That means that the 2 banks have considered First Reit's ability to repay the SGD100 mil loan when they decided to offer the new SGD260 mil loan to First Reit. My guess is when it is time to refinance the SGD100 mil loan, both OCBC and CIMB will come together again.

Having said the above, the ability to refinance the SGD100 mil loan depends greatly on whether there are any other adverse developments affecting First Reit's ability to collect rent from its assets, such as whether LPKR's and MPU's financials continue to deteriorate further, or whether there is a sharp depreciation in IDR that is unhedged.

The fourth risk is there is a SGD60 mil perpetual securities that is due to reset its distribution rate on 8 Jul 2021. Usually, companies will choose to redeem the perpetual securities and issue new ones to replace them. However, given First Reit's financial conditions, it will likely not redeem the perpetual securities when the distribution reset date comes. Non-redemption does not constitute default. Furthermore, given the low interest rate environment, the distribution rate will likely be lower after reset. The current distribution rate is 5.68%. The distribution rate will reset to 5-year SGD Swap Offer Rate (SOR) + 3.925%.

Distribution on the perpetual securities is also discretionary. Non-payment of distribution does not constitute a default. However, distributions on the Reit units will need to be stopped. The annual distribution on the perpetual securities is SGD3.41 mil.

The fifth risk is besides the 14 Indonesian hospitals that are subject to lease restructuring, there are other assets whose leases are due to expire. The lease on Sarang Hospital will expire on 4 Aug 2021. The current annual rental is USD0.7 mil. Although there is an option to renew for another 10 years, likely it will be renewed at a lower rental rate. The hospital was purchased for USD13.0 mil in 2011. The latest appraised value is only USD4.6 mil in 2020, which suggests lower rental rate going forward. First Reit has also flagged that there will be upcoming capital expenditure, and further marked down the value to USD3.1 mil.

As mentioned in last week's blog post on What Siloam's Financial Reports Can Tell Us About First Reit's Lease Restructuring, there is another Indonesian hospital which is leased directly to Siloam which could be subject to lease restructuring or lower rental when the lease expires in Dec 2025. The annual rent for this hospital is SGD4.2 mil.

The sixth risk is that after the lease restructuring, the leases of the 14 Indonesian hospitals will be extended to Dec 2035. Fig. 5 below shows the new lease expiry profile.

Fig. 5: Revised Lease Expiry Profile

An unintended consequence of this lease extension is that there is now a concentration of lease expiry.  66% of all leases by GFA will now expire in Dec 2035 instead of being fairly distributed. If First Reit is not able to buy new properties to diversify the geographical, tenant and lease expiry concentrations, there will be another round of concern when Dec 2035 comes near.

Conclusion

The lease restructuring is a painful exercise for existing shareholders. However, there are silver linings in the form of higher rents through Performance Based Rent towards the end of the 15-year leases. Nevertheless, even if the restructuring and rights issue go through smoothly, there are still road bumps and risks down the road for First Reit.

Should First Reit be given a second chance? I cannot advise you what you should do, but for us, we are inclined to give it a small second chance. We will monitor how First Reit manages the risks identified above, and if it does well, increase the chance given to it.

See related blog posts:

• What Siloam's Financial Reports Can Tell Us About First Reit's Lease Restructuring
• A Tale of 2 Indonesian REITs
• The Hidden Risks of Buy-and-Leasebacks for Industrial REITs
  

What Siloam's Financial Reports Can Tell Us About First Reit's Lease Restructuring

On 28 Dec 2020, First Reit dropped a bombshell by announcing a major rights issue at a heavily discounted price. This caused the share price to dropped significantly. The main reason is the proposed restructuring of master leases that First Reit have with Lippo Karawaci (LPKR) and Metropolis Propertindo Utama (MPU). First Reit leases hospitals to LPKR and MPU which in turn lease them to Siloam International Hospitals. The proposed lease restructuring would reduce the Base Rent of LPKR-leased hospitals from SGD80.9 mil to SGD50.9 mil and that of MPU-leased hospitals from SGD11.3 mil to SGD5.8 mil. These represent a reduction of 37% and 49% respectively.  Not only that, the rents will be paid in Indonesian Rupiah (IDR) instead of Singapore Dollar (SGD) in future. As a result of the reduced revenue, First Reit's lenders have decided to only refinance SGD260 mil out of the SGD400 mil term loan, of which the first tranche of SGD196.6 mil will mature on 1 Mar 2021.

To sweeten the deal, the restructured master leases would include a fixed rental escalation of 4.5% per year, instead of 2 times Singapore's Consumer Price Index (CPI), but capped at 2% per year. In addition, there will a Performance Based Rent pegged at 8% of the hospitals' Gross Operating Revenue. The actual rent will be the higher of the Base Rent and Performance Based Rent. 

Siloam is listed on the Indonesia Stock Exchange, hence its financial reports are publicly available. As the Indonesian hospitals are all leased to Siloam as the end user, and we can cross check the information from Siloam's financial reports to understand better the proposed lease restructuring.

Siloam's Annual Report for Financial Year 2019 documents the rent that Siloam pays to LPKR and MPU for the hospital leases. See Fig. 1 below. For the 14 hospitals that are subject to lease restructuring, Siloam paid a total of IDR156.8 mil to LPKR and MPU in FY2019. In contrast, the total existing and proposed commencement Base Rent paid by LPKR and MPU to First Reit is IDR997.6 mil and IDR613.1 mil respectively. The rent paid by Siloam is only 15.7% of the existing Base Rent and 25.6% of the proposed commencement Base Rent. This shows that post-restructuring, LPKR and MPU are still subsidising Siloam's rent and/or topping up First Reit's revenue. Since the hospital leases are not revenue neutral to LPKR and MPU even after lease restructuring, there is a risk that LPKR and MPU could seek another lease restructuring in future.

Fig. 1: Siloam's Rent to LPKR and MPU as % of Existing & Restructured Base Rents 

Siloam's annual report also documents the Gross Operating Revenue (GOR) generated at some of its major hospitals. See Fig. 2 below. Pre-restructuring, the GOR as a percentage of existing Base Rent ranges from 7.5% to 40.7%. Post-restructuring, the GOR as a percentage of proposed commencement Base Rent ranges from 6.7% to 14.8%. For hospitals which data is available, the weighted GOR is 18.7% of existing Base Rent and 11.6% of the proposed commencement Base Rent.

This information also tallies with the information provided by First Reit during the investor dialogue on 7 Jan 2021. To a shareholder question, First Reit replied that the proposed Base Rent in aggregate is in the range of 10% to 15% of the GOR for LPKR-leased hospitals in FY2019.

Fig. 2: Existing & Restructured Base Rents as % of Hospital Revenue

Under the proposed lease restructuring, the actual rent will be the higher of the Base Rent or Performance Based Rent, which is pegged to 8% of the GOR, on an asset by asset basis. Based on the financial performance of the hospitals in FY2019, a slightly higher rent could be expected from a few hospitals, namely Kebon Jeruk, Surabaya, Purwakarta and Sriwijaya. However, take note that this is based on the financial results in FY2019, which does not include the impact of COVID-19. COVID-19 has affected the hospital revenue significantly as patients defer their visits to hospitals to avoid exposure to COVID-19.

Amid the uproar regarding the proposed lease restructuring for 14 Indonesian hospitals, one other Indonesian hospital is actually not subject to lease restructuring. The hospital is Lippo Cikarang. This hospital is leased directly from First Reit to Siloam. Siloam's annual report also shows that it is paying much higher rent on this hospital compared to those on the other 14 hospitals, i.e. there is no rent subsidy and/or top-up by LPKR and MPU. 

A check on the history of the lease of this hospital shows that the hospital was acquired by First Reit in Dec 2010. At the time of purchase, the hospital was purchased from and leased back to a subsidiary of LPKR. Some time from then till now, Siloam acquired the subsidiary. Hence, Siloam is paying rent on Lippo Cikarang directly to First Reit, unlike the other 14 hospitals.

The key question to the lease restructuring is what are the true market rents for the Indonesian hospitals? Is it close to the rent paid on Lippo Cikarang which is comparable to the existing Base Rent of the other 14 hospitals, or close to the proposed commencement Base Rent of the 14 hospitals? If it is the former, the proposed lease restructuring is disadvantaged to First Reit as it will now receive below-market rent. If it is the latter, LPKR and MPU have been topping up the rent for First Reit's benefit and the restructuring might be more equitable to all parties, although painful for First Reit. It also suggests that Lippo Cikarang might have to undergo a lease restructuring at some time in future.

Siloam's annual report also shows the net profit at its major hospitals. See Figs. 3 and 4 below. Take note that the net profits are based on the rents Siloam paid to LPKR and MPU and not the top-up rents paid by LPKR and MPU to First Reit.

Fig. 3: Revenue and Profit at each Hospital (Part 1)

Fig. 4: Revenue and Profit at each Hospital (Part 2)

The figures show that the net profit at Lippo Cikarang is the lowest among all the major hospitals. Its net profit margin is only 1% of revenue. This is likely due to the high rent that Siloam pays to First Reit. The operating expense is 96% of the gross profit. In contrast, the same ratio for the other hospitals ranges from 38% to 81%, with a weighted average of 50%. A hospital that has similar revenue and gross profit as Lippo Cikarang is Purwakarta. The operating expense is 55% of gross profit and net profit margin is 10%. The information does suggest that the existing Base Rent might be unsustainable for LPKR, MPU and Siloam, and some lease restructuring might be necessary.

By right, the hospitals are very secure assets to ensure Siloam fulfils its rent obligations. Termination of the leases would lead to Siloam not being able to continue its business, which is a very serious implication. However, this does not apply to LPKR and MPU, as they have other businesses besides Siloam's business. Also, using Lippo Cikarang as an example, Siloam is not making much profit from the hospital. If First Reit insists on LPKR and MPU fulfilling their rent obligations, there is some probability of them breaching the lease agreements, as there is not much profit to be made anyway. At some point in time, LPKR, MPU and Siloam will seek a restructuring of the leases to be more sustainable. This includes Lippo Cikarang, which, while not subject to lease restructuring currently, is due for lease renewal in Nov 2025.

Another key question of this lease restructuring is whether LPKR and/or MPU will seek another restructuring if they continue to encounter financial difficulties in future, since they have already sought one now. It is very difficult to answer this question as very few persons can tell how LPKR's and MPU's businesses will perform in future. However, using Lippo Cikarang as an example, by reducing the Base Rent to a more sustainable level, there is more money left on the table to keep LPKR, MPU and Siloam from walking away.

The proposed lease restructuring is a very painful exercise for First Reit's shareholders who have been accustomed to it paying good distributions regularly. However, based on the information gleaned from Siloam's financial reports, it suggests that the rents that First Reit collect from LPKR, MPU and Siloam might not be sustainable. Reducing them to a more sustainable level might be a more equitable outcome for all parties in the long run.

This episode shows that investing in REITs is not a buy-and-forget activity. It also shows the importance of knowing your customers well. 

See related blog posts:

• Should First Reit Be Given a Second Chance?
• A Tale of 2 Indonesian REITs
  
• Know Your Customers Well!

Will Suntec Reit Carry Out a Rights Issue?

It is the new year already, and in another 3 weeks' time, REITs will start to report their financial performance. For REITs with December as their Financial Year-end, they will also have to update their property valuations. With COVID-19 having caused significant changes to the way people live, work and shop, one of the key risks to REITs during this period is whether property values will decline significantly. This could lead to breaches in Aggregate Leverage limits, leading to rights issues at unfavourable prices.

One of the REITs that caught my attention is Suntec Reit. It owns offices, retail spaces and part of the convention centre in Suntec City. It also owns part of One Raffles Quay, Marina Bay Financial Centre and 9 Penang Road (formerly known as Park Mall). In recent years, it has diversified into Australian properties. 2 weeks ago, it bought a 50% stake in 2 office buldings (Nova) in London. The acquisition was fully funded by debts and perpetual securities. Post-acquisition, the Aggregate Leverage limit would rise from 41.3% as at 30 Jun 2020 to 43.5%. An Extraordinary General Meeting was held on 4 Dec 2020 to seek shareholders' approval for the acqusition. One of the questions that shareholders asked was "what is the level of Aggregate Leverage Ratio (ALR) the board would be comfortable with?". Suntec Reit's reply was "the target ALR is between 40% to 45% with the appropriate interest coverage multiples". Thus, although REITs are allowed to raise their ALR to 50%, Suntec Reit would not be comforable if the ALR were to rise above 45%.

In the latest business update for 3Q2020, Suntec Reit reported that the committed occupancy for its Singapore offices dropped from 99.1% in 4Q2019 (pre-COVID) to 98.1% in 3Q2020, while that for the Singapore retail spaces dropped from 99.5% in 4Q2019 to 93.4% in 3Q2020. Footfall in Suntec City Mall is down by 53% in 3Q2020, although tenant sales are down by only 21% over the same period. The occupancy for retail spaces is more greatly affected as people work from home and as travel restrictions and safe distancing measures limit the number of exhibitions held at the convention centre. If you have not been to Suntec City for a while, you should visit the row of shops where "llao llao" is (at Level 1, near the entrance of Esplanade MRT station), to witness the impact on retail occupancy.

Over at its Australian properties, the committed occupancy for offices dropped from 97.8% in 4Q2019 to 94.0% in 3Q2020. The occupancy figure was dragged down by a new office buiding (21 Harris St) acquired in Apr 2020, although there is rent guarantee on vacant spaces for its Australian office buildings. For retail spaces, the committed occupancy dropped from 92.8% in 4Q2019 to 91.7% in 3Q2020.

As at Dec 2019, the total value of its properties was $10,204 mil. By Jun 2020, the total value is estimated to have increased to $10,446 mil, contributed by the AUD$295 mil acquisition of 21 Harris St, but offset by a fair value loss of $66.6 mil on Suntec Singapore (convention centre). Aggregate Leverage as at end Jun before and after acquition of Nova was 41.3% and 43.5% respectively.

For 3Q2020, the URA Property Price Indices for Office and Retail Spaces show there is a Year-on-Year decline of 8.4% and 0.7% respectively. Applying these drops in value to the Singapore offices and retail spaces, the total value of the properties would have dropped by 4.1%, leading to Aggregate Leverage increasing from 43.5% to 45.4%, which is just above the target range for Suntec Reit.

Given that the Aggregate Leverage is above the target range of 40% to 45%, it is possible that Suntec Reit could carry out a rights issue to bring down the Aggregate Leverage to 40% or below. Lowering the Aggregate Leverage to 40% would mean raising approximately $580 mil in cash, equivalent to $0.21 per existing share (e.g. 1-for-7 rights issue at $1.44 per share).

Alternatively, since the Aggregate Leverage is only slightly above the target range, the REIT manager could opt to receive its fees in units of Suntec Reit instead of being paid in cash. It could also allow shareholders to opt for scrip dividends instead of cash dividends. This would reduce the Aggregate Leverage over time.

In conclusion, Suntec Reit's Aggregate Leverage has been increasing prior to COVID-19. With the acquisition of Nova that is fully funded by debt, it has increased further. Any revaluation loss during the annual revaluation exercise would likely tip the Aggregate Leverage over the target range that Suntec Reit is comfortable with. To lower the Aggregate Leverage, Suntec Reit could carry out a rights issue, or allow its REIT manager and shareholders to be paid in units instead of cash for their fees/ dividends.

See related blog posts:

• Things Don't Look Good for Retail Landlords
• Will ARA US HT Carry Out a Rights Issue?
  
• Should First Reit Be Given a Second Chance?