With the latest move to semi-annual reporting, Prime US REIT will not be announced it’s official financial results.

However, as with many REITs, they are providing business development updates.

The results looked good on paper. Distributable income rose 12.9% from IPO projection. Net property income rose by 6.7%. One of the main reasons the results looked better was because it factors in about 40 days contribution from new acquisition at Park Tower.

Management was kind enough to update us in a media brief. Here are some short points that I could gather.

1. One of the key criteria for Prime US REIT’s acquisitions is to focus on less dense areas, more affordable areas where there can be population growth and employment growth. Park Tower fits the selection.
2. Prime US REIT do not have much debt refinance obligations to do until 2024. I did not ask what about the debt obligations maturing in 2022 and 2023.
3. Just yesterday evening, Prime US REIT announced that they have proactively restructured their existing interest rate swaps by entering a new agreement with Bank of America that locks in the lower interest rate on its borrowings through 2026. This lowers their interest rate from 3.3% to 2.8%. CEO Barbara Cambon guided savings in excess of US$1 mil through 2023. I would think that the savings are actually more, not sure why it is only $1 mil. In this climate, I think it gives investors confidence that such improvements can be done and show evidence of the long term banking relationship built up by KBS with the banks.
4. Part of the reason the actual numbers looked better than IPO projections was that they can find improvement in interest expenses and trust expenses.
5. The breakdown in the 12.9% variance in distributable income
   1. 3.2% organic growth
   2. 6.6% park tower
   3. 3.1% savings in trust and interest expenses
6. Despite MAS relaxing the leverage to 50%, their strategic leverage level has all the while been less than 40% leverage.
7. Management of Prime US REIT have an aim to see if they could stagger the debt maturity more and diversify their lender base.
8. Kyith: Interest coverage of 5.8 times and unencumbered assets of 84.8% is very healthy buffer levels.
9. Their debt covenant on their debt is 45% loan to value
10. Atlanta, Texas, and Georgia have started plans to re-open for work. Utah was not affected at all during this period.
11. Companies are starting to strongly consider renewing spaces as opposed to moving out of spaces primarily due to the uncertainty of the economy. There is also a cost for them to move as well.
12. Out of the 6% lease expiry in 2020, a large percentage belongs to Wells Fargo bank. Pre-IPO, Prime did a very large renewal with Wells Fargo and as part of the renewal, they have the right to give back two floors of space. So there might be more spaces to lease out. Out of all the tenants that management feels are more unknown, they managed to re-leased 45% of them. The tenant retention for these unknown tenants would be closer to 88%.
13. One of the tenants has sub-leased spaces to sub-tenants. They believe that the sub-tenant will lease the space directly from them.
14. 9% of the portfolio will expire in 2021 and management is actively negotiating with tenants on 50% of those spaces. They feel that going into 2021, they will have a strong year. They were negotiating for new leases but that died down because prospective new tenants could not go and view the properties. COVID-19 has not slowed down the negotiations.
15. Across the markets, there have been strong absorption except for Philadelphia
16. Sodexo’s office is their headquarters
17. Apache has paid their rent and their lease expires in 2024.
18. All top 25 tenants paid their rent in April except for WeWork who did not pay 100% of their rent. Aside from WeWork, Prime has 3 more co-working spaces owned by Regus, who is a more traditional co-working player with private offices.
19. Co-Working spaces represent 3.8% of their cash rental income
20. The WeWork space is in the San Francisco area and a significant portion of the WeWork tenants are enterprise companies. There is an opportunity to establish a direct relationship with these enterprise companies.
21. They have provided deferral of rent to about 12 retail tenants. These form a very small percentage to Prime’s rental revenue
22. Social distancing may become a requirement over time. While leasing may soften, these requirements may mean companies still need quite a fair bit of space.
23. Management believes this is the first test for remote work. Some companies might find a way to make it work while others may find that they still need an office. IBM and Yahoo tried to do the same 10 years ago but eventually reversed that. There are technologies out there that track their employees when they work at home, mainly because productivity is a suspect. California is considering mandating the spaces per square foot per employee. Prime has fielded inquiries from 4 existing tenants (in banking and technology) with an existing very dense seated environment. If the mandate is to have 250 sqft separation between employees and a company that has 20% of their workforce working from home, the company in question will have to double their spaces based on square foot.
24. Some sub-leasing colors (In United States, tenants cannot easily break leases. They can, however, sublease to sub-tenants. There is a sub-lease market):
    1. Village Center I: About 25,000 sqft of space sub-leased out. When that expires, Chartered Communications is obligated to take that space
    2. Sodexo: About 18,000 sqft of space
    3. Rovi Corp at Crosspoint: About 36,000 sqft of space
    4. 222 Main: About 12,000 sqft of space
    5. All added up to about 2% of the portfolio

I think it was a good update for me. There is a lot of uncertainty about how real estate will be like after this Coronavirus situation. Everyone is guessing what will happen, and someone is bound to get it right and some will get things wrong.

The situation on the ground probably reflects the real situation: Everyone is trying to figure this out. We hear that prospects are enquiring. Even before this episode, there are companies that have rationalized and have sub-leased out spaces. Existing tenants are enquiring about how to increase their spaces.

Update: This morning, I came across this post talking about how Coronavirus may prompt Americans to move out of cities.

I think a lot of these things are abit of hyperbole. If the best jobs are still going to be in cities, then you got to stay near there. However, it might make sense to stay close by. This could be like the situation for both Manulife and Prime in their Sacramento purchase. It is to tap into the proximity to the more expensive San Francisco area.

Anyway here is what the experts think:

Hopefully this update can give you a better idea about this US Office REIT. Prime US REIT has run up in price a bit. Still provides a prevailing dividend yield of 9.4% based on a unit price of $0.74.

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There are probably 7 REITs that up to this point have announced their results or put out notes on their latest quarter of business development.

3 of the REITs have cut their latest quarter of dividend per unit that is distributed to shareholders.

If you look at the dividend per unit cut, they are very drastic. What it shows is that based on the net cash flow that the REIT earned in the last quarter, they decide to pay out 50% to 80% less.

The REITs that have announced but did not cut their dividends to this drastic extend are Keppel REIT, Keppel Pacific OAK, Parkway Life, Sabana, Keppel DC.

The reason this is done is to conserve cash flow.

The Singapore Government and Australian Government have announced that landlords cannot evict their tenants. They have provided landlords with property tax rebates and expect that these rebates are passed on to the tenants.

Contractually, the tenant are supposed to pay rent. But tenants are pushing back that if I am not operating my business, if I am not earning any revenue, why should you still continue to charge me rent?

So a few REITs have passed these rebates provided by the Government to their tenants, and some have extended their own cash to support their tenants.

Cash flow needs to be conserved because, for the next quarter, the properties are not going to get much revenue due to forced locked down. If this drags on, the next quarter is going to get effect.

Even with no revenue, you can minimize management fees paid to the manager through paying in units, but there are some ancillary costs of landlording that you cannot stop paying.

Most important, the landlords still have to pay the interest on loans.

If you look at the REITs who have cut their dividend per unit, they are mainly the retail-centric REITs. Together with the hospitality REITs, they are the most hard-hit because they are forced to close.

So almost zero revenue for the month, yet still have to pay costs. Of course, the natural thing to do is to conserve cash, even if it means losing certain tax transparency.

In order for Singapore REITs to enjoy certain tax transparency, they would have to pay out 90% of their distributable income to their shareholders.

When a REIT conserves it’s distributable income and not paid out, they do not enjoy that. What Monetary Authority of Singapore did was to give some flexbility there to allow the REITs to delay their dividend payout to no later than Dec 2021.

In this way, the Singapore REITs can still enjoy that tax transparency.

What This Means for You the REIT Investor

When distributable income is cut, this means that if you depend on the income for your upcoming needs, you do not have it.

This is more impactful if the majority of your portfolio are in specific sector of REITs.

Or majority in REITs for the matter.

If your REIT survives COVID-19 and go back to some semblance of normacy, then in 2021, your REIT would backpay the distributable income that they conserve.

So this means that you are not going to stop seeing this money.

Is This a Black Eye On the REIT Model?

I think there are enough people having an eye on the REIT ran up the last few years and say this is a bubble.

And you have REIT investors looking at these people and think they are laughing at them.

However, I do think it is not really a broken model. It is just that it is misunderstood.

What we have today is pretty unprecedented:

1. Almost all your tenants, no matter how diversified, don’t have revenues or cannot work
2. It is an uncertainty which of your tenant is going to survive, despite how “blue chip” their status is
3. You still have expenses
4. You still need to pay interest

I want you all to touch your heart, and think if you are corporate planning this, how would you risk managed a situation where you have zero revenue from a diversified tenant base, across geogrpahical regions, when all of them stop paying you.

I think you can put it out there, but to really execute on it is rather tough.

In a severe downturn, at least some of the businesses are still bringing in revenue for you. This time it is not.

The Single Property Experience is Not Perfect Either

If this is a poor model, then I wonder about the alternative, which is to purchase a single private property and rent it out.

One of the reasons people would gravitate to a portfolio of stocks and bonds is that they witness first hand that they go through periods of tenant vacancy and the maintenance cost of repairing your place for the next tenants.

If you own a single private residential property, you would face the same problem as the REITs, but you are better off because the government allows you to defer your mortgage payments. But you still need to cut the rent of your tenants as they negotiate with you.

The Ineffciency of “Lao Kok Kok” Property Companies

The biggest gripe, of a lot of people, is paying out almost all their cash flow.

They say it will be better if it is not a REIT model like Hotel Grand Central or those “Lao Kok Kok” (old) property companies.

To me, these Lao Kok Kok property companies are doing the same thing.

If you observe whether they can cover their dividends with their cash flow, a lot of them tries to cover their dividend payment almost equal if not pay out more than their recurring rental cash flow from their investment properties and operating business.

This is no different from what a REIT does.

Their payout ratio is lower… because not all their business is in buying and renting out properties. It is mixed with property development or other things.

There is also a reflexive effect.

The REITs are rated by the market better because they are cleaner. People see them as a portfolio of buy to let properties. There is a clear dividend payout policy. The management job is to grow AUM and get properties to rent.

They are build-to-suit for certain investment purpose.

If you contrast it to others, the narrative is not so clear cut. It is up to the discretion of the management who tends to hold their cards closed to their chest.

When you package everything clearer, the market gives them a better price. And we see them trading close to their price to book.

In contrast, many mixed-property companies, they tend to trade below their book value.

You make money from these mixed-property companies when development profits shows up, and during price dislocations where the price trades closer to book value.

Whichever way, you can go ask the owners of non-REIT properties whether they have or do not have the same problems as the REIT landlords.

The Frustrating Thing About Looking at Investors

If we go back to finance 101, we know that dividend payout is not mandatory. Interest payment on debts is an obligation.

Dividends are paid out only when times are comfortable.

REITs are essentially still stocks. So dividend payment is not mandatory.

It is just that, due to the specific nature of this property sector, the probability of a company not having comfortable cash flow is low.

Well, we have a period now.

I get frustrated when investors or prospective investors say “Cannot cut dividends. This shows poor management. They should have anticipated this”

Sometimes, I wonder if they talked to people in real business or been in business themselves.

It is not always plain-sailing.

These businesses are listed probably because they have stabilized in a certain way. But for those SME, we been like fighting tooth and nail over different business decisions and capital decisions.

I think these shareholders prefer the situation where the stock they own

1. lays off 100,000 workers
2. they can commit to paying out dividends

This is what is happening at Disney now.

I used to be someone who just looks at the black and white. The numbers just tell the management decisions.

The managers can get you in a meeting or seminar and talk all the flowery stuff but at the end of the day the numbers support it.

I would say this is still right at this point but I tend to think knowing certain qualitative aspect is important.

But if you look at the context of this COVID-19 situation, the shareholder perhaps are the more unreasonable ones. This is not a black swan but a real tail event.

Some of these employees or certain services got your dividends in the past, and now when the going gets tough you just want to cut them off.

I dunno. I think it just sounds plain selfish.

Think I still have something to say but going into a daily standup meeting soon. Perhaps that will be for tomorrow.

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I break down my resources according to these topics:

1. Building Your Wealth Foundation – If you know and apply these simple financial concepts, your long term wealth should be pretty well managed. Find out what they are
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3. Learning about REITs – My Free “Course” on REIT Investing for Beginners and Seasoned Investors
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5. Free Stock Portfolio Tracking Google Sheets that many love
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7. Providend – Where I work doing research. Fee-Only Advisory. No Commissions. Financial Independence Advisers and Retirement Specialists. No charge for the first meeting to understand how it works

Somewhere in September 2018, the share prices of two Office REITs with properties in the United States went down a lot.

In Keppel Pacific Oak’s rights issue document, they stated, in a certain formal way that, that should there be changes in certain tax rules, there might be material impact on their dividend per unit.

This has got to do with whether their United States sub corporation can use interest expense as a tax shield.

We know that with interest expense, you can bring down your taxable income, thus you pay less tax expense. This increases the cash flow to pay dividends.

If a company cannot do that anymore there will be a material impact.

The worry is that REITs like Keppel Pacific OAK, Manulife US REIT’s dividend per unit will be impacted by 30%.

Thus their share prices plunged.

When the United States amended their taxes in 2017 with the Tax Cuts and Jobs Act (TCJA), a specific section 267A states that hybrid transactions made to and from hybrid entities no longer are qualified for tax deductions.

This section 267A was a bit vague whose structure is considered as hybrid entity. Usually a year after the announcement, the United States tax office will put out a clarficiation so that firms can have a better idea what to do.

The clarification put out shows that the structure of both REITs would not be considered as a hybrid entity. The short answer is that this section 267A does not affect them.

Thus, there is no material impact due to this.

However, things have not been official yet. Until now.

The final regulations under Section 267A was issued on 7th April 2020.

Due to this, both REITs would be reverting to a group structure without their Barbados entities.

Both REITs setup Barbados entities just to risk managed the possibility that in the event they were considered hybrid entities, there would be material impact. Barbados have very low corporate taxes and would have resulted in lower material impact to shareholder’s dividends.

With the final regulations, there is less of a need for Barbados entities. Thus, both are reverting.

From what I understand, there will be cost savings and this should be material to unit holders. But likely to be small.

Do Like Me on Facebook. I share some tidbits that is not on the blog post there often. You can also choose to subscribe to my content via email below.

I break down my resources according to these topics:

1. Building Your Wealth Foundation – If you know and apply these simple financial concepts, your long term wealth should be pretty well managed. Find out what they are
2. Active Investing – For the active stock investors. My deeper thoughts from my stock investing experience
3. Learning about REITs – My Free “Course” on REIT Investing for Beginners and Seasoned Investors
4. Dividend Stock Tracker – Track all the common 4-10% yielding dividend stocks in SG
5. Free Stock Portfolio Tracking Google Sheets that many love
6. Retirement Planning, Financial Independence and Spending down money – My deep dive into how much you need to achieve these, and the different ways you can be financially free
7. Providend – Where I work doing research. Fee-Only Advisory. No Commissions. Financial Independence Advisers and Retirement Specialists. No charge for the first meeting to understand how it works

Most of the REIT investors endure some extreme volatility in this March Madness. Their holdings have quite a good run in 2019.

Coming into 2020, investors believe that the low rate environment is here to stay. Even when the threat of Corvid-19 reaching the United States and Europe, investors rationalize that when the interest rate plunge, this must be a more conducive environment for the REITs.

What comes next is that in a span of 2 weeks, many REITs saw their stock prices plunge 50%.

Manulife US REIT and Prime US REIT both endure the same fate as their peers.

In the past 2 days, both REITs provided some updates to analysts, so as to address the potential uncertainties of investors.

Since then both REITs saw their share price go up 20-25%. Manulife’s share price held up better, probably because they are in the Index and are much more liquid.

Their transparency may have worked wonders for their share price. However, overall, a lot of the REITs managed to bounce off their lows.

Here are some updates that I have gathered.

Possible Reasons for the Sharp Price Falls

Management updated that possible reasons why the drawdown was so swift was due to

1. Manulife’s entry into the index. When index funds, exchange-traded funds systematically sell down, there isn’t many fundamentals per se
2. There was a lot of margin calls from the Private Banks (my friend KK from RisknReturns mentioned a few days ago that the three US Office REITs may have been removed from the list of marginable stocks on private banks)
3. Funds redeeming and switching around. They are switching from smaller stocks to more liquid stocks
4. Ultra-rich Chinese are facing heavy margin calls (we can guess who they are). Manulife US REIT does not have them on their register

Are Manulife US REIT’s Properties Affected?

The city of New Jersey and California have shut down. Only gas, pharmacy and grocery stores were available.

You cannot take public transport in Virginia, Washington. It is a matter of time before Atlanta shut down.

MUST’s properties are currently 20% occupied. The F&B shops were closed.

Rental Rebate Requests and Business Continuity Insurance

Rental rebates were not offered to tenants. This is even during GFC.

However, they may provide rental rebates to F&B tenants on a case by case basis. F&B tenants only make up ~1% of MUST’s portfolio by GRI.

Management highlighted that a pandemic does not qualify for business interruption insurance.

Adequate Amount of Security Deposits

The security deposits collected by MUST amounts to 0 to 4 months. This is based on the credit profile and length of relationship with the REIT.

A tenant can be considered as default if rent payments are 60 days in arrears.

The Properties’ Experience During the Great Financial Crisis (GFC)

Occupancy during GFC drop to between 80% to 90%.

Figueroa and Peachtree fell to 90% and 80% during the GFC.

One of the fears is that property value will be valued downwards, which will increase the debt to asset ratio, violating loan covenants or MAS guidelines for a maximum 45% leverage ratio.

Management update that valuers will assess value based on the intersection of a couple of different valuation method:

1. Discounted cash flow of projected forward leases
2. Comparable transactions

During periods like this, buyers and sellers are likely to halt their transactions. When there are fewer transactions, there are no comparables to use to value the property at a lower value.

New real estate dues will be put off until there is clarity. Nobody wants this price discovery in the short term.

Thus, valuation should be more stable.

Risk of Top 10 Tenants Right-Sizing

While there were comments of structural shifts for tenants to right-size their office space, their top 10 clients may have already the right size recently or unlikely to change as many of the corporates in the US would already have flexible work arrangements.

Still Struggling to Fill Michelson’s Space

Management update that since Covid-19 happen, a lot of the activity grind to a halt. Management was negotiating with a prospective tenant but since then, most prospects would rather adopt a wait and see attitude.

Less Liquidity and Re-financing Concerns

Manulife US REIT’s property valuations need to go down $351 million or 16% of the portfolio (24 Mar) to reach the MAS Cap of 35%.

They have $90 million in liquidity for working capital purposes and $200 million in credit facility from DBS to tap upon, should they need to make acquisitions.

They do not anticipate that there are risks. Manulife has one debt that needs refinancing this year. The current loan has a 2.46% interest. They are quietly confident that the re-finance loan could be cheaper than this. They have the option to extend the current loan for 1 year as well.

MUST’s unencumbered debt position should improve from 34% to 41%.

Low Key Tenant Risk

The top 10 tenants in their portfolios, which comprise 35% of rental income, are mostly MNCs and government agencies.

They mostly have their headquarters or key operations based out of their assets. Tenant sectors are diversified with no one sector being greater than 23% of the portfolio.

DBS also released some updates with regards to their conference call with Prime US REIT.

Here are some of the key takeaways.

Portfolio have Less Near Term Concerns

Prime’s management believes that there will be market disruptions in the next few months, however, its base case is for the economy to rebound on a very quick V-shaped recovery with the stimulus package.

The key attributes of Prime’s portfolio

1. Long WALE of 5.1 years
2. Low lease expiries (<10% in the next 2 years)
3. High committed occupancy of 96%
4. No debt refinancing in FY2020/21- augurs well as it navigates near-term disruptions.
5. Management expects more tenants to renew their leases in times of uncertainty which bodes well for Prime.

Prime has limited lease expiries in the near term with only less than 7% and less than 10% (estimated after Park Tower’s acquisition) of cash rental income (CRI) expiring in FY2020 and FY2021 respectively.

While there are termination rights on some leases expiring in FY2021, management does not expect to exercise this especially for a lease to a government entity.

On Tenant Defaults and Rent Rebates

There are currently no tenant defaults and rental rebates are given to F&B tenants which contribute less than 1% of total income.

Nature of Security Deposits and Guarantees

While there are concerns about the WeWork operations, WeWork as a tenant will drop off the top 10 tenants list and is estimated to contribute less than 2% of CRI post the acquisition of Park Tower.

In addition, WeWork’s lease provides corporate guarantees / LCs which covers 2 years of income. Sodexo, one of the top 10 tenants which contributes c.5% of CRI (estimated after Part Tower acquisition), provides corporate guarantees for all remaining obligations.

The lease is expiring in 2023.

Oil & Gas Tenants Lease Expires 2 Years Later

While mining and O&G tenants contribute some 6.6% of CRI, the major O&G tenants’ leases are only expiring from 2022 onwards with a larger lease only expiring in 2024.

Sponsor KBS Experience during GFC

Management believed that in times of crisis, occupancies could fall to 80% which is still decent, and rental rates and valuation may fall by 20%.

During GFC, KBS’ (Prime’s sponsor) portfolio continues to generate good returns (c.11% in 3 years) a testament of a strong team and good quality assets.

Conclusion

I do not think that one of the contributing factors for the price fall is due to these two REITs being based in the United States, which is the epicenter of where the number of new detections are ramping up.

The price fall was across the board.

There are adequate uncertainties for properties based in the United States. billionaire investor Carl Icahn biggest position by far is a short on the US commercial mortgage-backed securities. His take is that banks, instead of securitizing residential loans are now securitizing commercial loans on office and shopping malls and selling them away.

Tom Barrack, another billionaire real estate investor, believes that commercial mortgages are on the brink of collapse.

At this point, I would not dismiss this risk yet. I would only comment that I do not know if the commercial loans they are referring to is similar to the same pool of commercial loans Prime and Manulife use.

While both management paints a picture that everything is OK, it really depends on how much the mainstream economy suffers. If it is a long-suffering, I cannot imagine a scenario where commercial real estate will not be affected.

Carl and Tom’s scenarios will work out if this situation prolongs and there are more rental revenue arrears. Like what the management updated, most tenants would have put a few months of security deposits.

However, if this situation persists everyone does not have enough cash flow, sooner or later the landlords will run into issue. The billionaire’s opinion will prove to be correct in some ways.

Prime US REIT does not have any debt renewal risk. Manulife US REIT does. But I believe at this point, Manulife US REIT should not have a problem refinancing their debt. The unique thing is both REITs should have access to USD denominated loans in the United States and Singapore.

Both REITs have 14-15% of their leases expiring in 2020 and 2021. Prime US REIT may have more risks with their exposure to Apache Corporation. However, even then, at this share price, it bakes in the risk if Apache does not renew their lease in 2 years time. There is enough time for oil prices to normalize (if it ever does). The bigger threat is when companies other than the usual suspects start not renewing or right sizing.

What I am more concerned about is more of the risk of property revaluations. This affects potential forced, dilutive, and non-income generating rights issues. Manulife provided some sensitivity analysis on how much property valuation have to fall to reach 45%. While Prime did not provide a sensitivity analysis, they are 4% lower in terms of their net debt to asset.

I leave you with my own sensitivity analysis. It lists the potential interest savings. It also lists potential non-renewal of 50% or 100% of their 2020 & 2021 expiring leases.