In August, I wrote my review of what I could gather about the REIT Manulife US REIT. You can read it here.
In the article, there were some questions, that I could not figure out on my own.
So the folks at Manulife US REIT reached out and I thought I will try to clarify some of these stuff with them.
The majority of these posts will contain clarifications to the previous article. Thus, it might not make a lot of sense if you do not read the previous article.
Since then, Manulife US REIT share price have moved down from US$0.845 to US$0.77 today.
At a dividend per unit estimated of US$0.06, the dividend yield is 7.80%. At some point, at US$76.5, the dividend yield was 7.84%.
Does Manulife US REIT have the Ability to Raise Dividend per Share without the Growth
One area that we acknowledge about Manulife US REIT was the quality of the portfolio that they have built up.
- As of Mar 2018, 120 tenants
- 7 commercial office properties
- Land Tenure is freehold
- Weighted Average Lease Expiry of Tenants 6.3 years
- Average rental escalation of 2.1%
- Nature of new leases tend to be 3 to 10 years
- Debt to Asset of 37.3%
- 100% Fixed Debt
- Weighted Average Interest Rate 3.27%
- Build in CPI or Fixed Rental Escalation
- USD Denominated
By right, we think that this portfolio should give us a pretty predictable organic dividend per share growth.
And this is the main question I would like to find out. If the management can grow the REIT with the quality of the existing properties, then naturally the shareholders, as well as institution would be favorable to support the REIT, by keeping share price high.
While the management cannot give a definite answer to whether for the next few years dividend per unit can be predictably higher, I think the shareholders (and ourselves in the meeting) have stressed enough that, while distributable income can grow, it is ultimately dividend per share growth that they will be ultimately judge upon.
And the management do heard the shareholders on this.
How the Management Could Navigate the Rising Interest Rate Environment
A factor that will affect whether DPU is accretive or not, will depend on their ability to refinance the debt well.
For Manulife US REIT, about $108 mil worth of debt on Figueroa is coming to maturity in 2H 2019 (July). The impact to Manulife US REIT’s results would not be a full year.
This represents 16% of their overall portfolio.
The fixed interest is 2.39% but the prevailing rates is closer to 2% higher. If they were to refinance today, the rates are closer to 4.39%.
As a reference, the interest rate on the loan to finance Phipps and Penn averages around 4.26%.
This is a major jump in the interest rate.
Management have indicated that they have a few levers how the higher interest income can be mitigated:
- organic rental escalation of leases on Figueroa
- they are evaluating both local (SGD) as well as USA debt to see which one is able to bring down the credit spread
- they can vary between floating and fixed rate debt
- other forms of organic growth
2% more is rather high and looks pretty difficult to mitigate.
While the whole commercial office portfolio of Manulife US REIT on average have 2.1% per year rental escalation, the problem is that the cost of debt rose nearly 80% in such a short time.
Management believes that the escalation of the entire commercial portfolio can mitigate the potential interest increase of the Figueroa loan.
I was thinking how this is possible.
However, on further analysis this may be possible.
Note: this portion is my analysis with some clarifications by the management. By no means should you treat this as actual numbers.
The main reasons are
- The WALE is 6.3 years and the portfolio have an average rental escalation of 2.1%/yr. Suppose cost are mainly fixed, the escalation of the gross rent flows direct to the net property income. This assumes properties have strong operating leverage
- The loans are well spread out that only a portion is matured annually. This will result in rent slowly stepping up.
Now let us assume that the rates do rise for the next 4 years. We know this year rates is close to 4.5%. So suppose from 2019 onward, the prevailing rates are:
- 2019: 5.5%
- 2020: 6.5%
- 2021: 7.5%
- 2022: 8.5%
The table above shows the current debt value of Manulife US REIT, the duration of the debt, as well as their current interest rate on each debt.
On 2018, the average interest rate is 3.27%.
Now, almost every year, one set of debt matures and needs to be refinance. Suppose they are refinanced based on the prevailing interest rate that I described.
You will observe that the average interest rate of Manulife US REIT could hypothetically rise from 3.27% to 6.41% over a 4-5 year period.
Now, in such an environment, the rates are raised because the economy is still strong, and 10 year treasury rates do track the GDP of the country. This means that it is likely that the economy is conducive for greater rental reversion and landlords in attractive areas can rent out well.
Manulife US REIT have indicated that other than Michelson, the rest of the buildings tend to be under-rented by 5-10%. Each renewal could come with a 7% average rental escalation. If on average 1 out of 7 properties is up for renewal annually, this would add 1% growth to the 2.1% average annual escalation.
Suppose we put the interest rate, and the revenue growth of 3.1% into a hypothetical 6% cap rate $10,000 property.
The average annual interest rate on the $3,500 debt rises from 3.27% to 6.41%. The revenue rises 3.10% annually. All other factors such as, asset value, management cost, expenses remain constant.
We can see that the income yield rises from 6.7% to 6.98% to 7.25% to 7.27%. In the forth year the income yield eventually fell to 7.01%. Note that the fourth year income yield is still higher than the year 0 income yield.
This is possible because the growth rate is 3.1%.
Had I use the annual escalation of 2.1% only, the income yield would be 6.7%, 6.82%, 6.94%, 6.76%, 6.34%. The last year income yield would be lower than the current.
Now, we won’t know how the rates will progress, but if we try and simulate a rise then fall in interest rate such as:
- 2019: 5.5%
- 2020: 6.5%
- 2021: 5.5%
- 2022: 4.5%
The rates peak in 2020 before normalizing to 4.5%. In this case, the revenue growth normalizes to 2.1% in 2021 and 2022.
The average interest rate would peak at 5.05%.
The income yield in this case will be accretive annually from 6.70% to 7.57%.
Manulife US REIT’s actually operating leverage might not be so perfect, and cost could rise, but I believe the effect would be the same.
Management might perhaps choose to take on the risky endeavor of re-financing with Singapore dollar debt.
There is a risk to that as well, because with USD, there is a natural hedge. The worst case scenario happens when USD weakens against SGD and the debt is in SGD.
Management updated that, should they take on SGD debt, they will hedge the currency risk using currency swap. As such, they do not expect currency risk in this situation.
It is not assuring that the interest could spike so much in a short time.
Jill Smith, Manulife US REIT’s CEO, mentioned to us that they might also have the option of extending the debt for a short duration (perhaps 1 year) and see if the interest rate situation becomes better.
Who knows the economy overheats fast and the interest rate could peak and moderate downwards.
Plaza and Exchange had Performed Better than Expected
Management updated that overall, they do think that the acquisitions that they made turned out well.
CFO Jagjit clarified that when Plaza and Exchange was acquired, based on the proforma result, the acquisition is accretive by 4-5%.
If we look at the result today, the actual performance was higher than the original projection.
The Average WALE of 1H 2018 New/Renewed Leases
In the first half of the year, Manulife made 3 new/renewed leases.
The rental revision looks good but we have no idea how long is the WALE.
The management clarified that they announced the WALE to range from 2 years to 11.6 years for the 3 new/renewed leases. The average WALE is estimated to be 11.2 years.
The Ability to Tap A Strong Pipeline of Manulife’s Properties
Through the meeting, I got a very good idea about the advantage of having a strong sponsor backing them up.
The first advantage is that in 2004, Manulife bought over John Hancock Life Insurance. John Hancock Life Insurance have a very large office, residential, retail and industrial portfolio in the USA. Manulife have a pretty strong portfolio in Canada as well.
The office portfolio is probably worth US$10 billion.
It is from this existing property base that they could purchase Exchange, Penn and Phipps. Plaza was acquired from a third party.
Interestingly, Manulife US REIT do not have a right of first refusal (ROFR) over their parent’s property.
This is because as a SEC company, the parent has to be fair to all third party. I find that this mitigates the risk of the REIT having to take in a property just because the parent said so.
The tight compliance might mitigate a potential issue that comes with a sponsor that happens a lot in the past in Singapore REITs.
I find that there is also a difference in that by purchase from John Hancock Life Insurance, and not a private equity, or hedge fund.
I think that there is a stronger incentive for a private equity fund to achieve a hurdle internal rate of return. Thus, without that structure, and perhaps another agenda (to spur the company’s growth in Asia), the price is less dear.
The properties also serve as a unique role.
Since Manulife/John Hancock is an insurance company, their liabilities or insurance premiums have to be put in participating funds. These participating funds need to grow their cash value over time.
So in order to achieve predictable growth over time, they have to be secured against assets that are of adequate quality.
Thus, John Hancock Life Insurance are consistently on the look out to develop or to purchase these high quality properties.
From time to time, they rejigged their portfolios, and some of these properties are available to third party and therefore Manulife US REIT.
This somewhat underwrites the quality of the Grade A properties that Manulife US REIT own and are exposed to.
Tapping Upon the Economies of Scope and Scale of the Parent for Property Management and Investment Advisory Capabilities
Jill’s team in Singapore started with only 6 people, but have since expanded to 16 people. The advantage that they have is to tap upon the expertise of 660 real estate professionals that worked with the parent Manulife Real Estate.
The parent team is very strong in various aspect of the real estate business. This allows Manulife US REIT to manage their properties from Singapore, do due diligence and other prospecting work on the group.
And while not mentioned, I believe that with such a strong team, together with a large network of real estate, it allows them to have an advantage in filling up properties when leases are up for renewal.
When they are looking to acquire, they have the ability to discuss and negotiate, in the name of Manulife / John Hancock, instead of using Manulife US REIT, which is a lesser known entity, compare to the parent.
The success and failure of acquiring or disposing commercial properties depend not just on price but also various factors.
If the counter party knows that they are dealing with a big player such as Manulife, who is able to execute well, it gives Manulife US REIT a good advantage.
Not just that the ancillary capabilities are pretty impressive.
Recall the instance when there was a change in the tax act in the USA that affects the deductibility of certain interest expense.
On the day of the announcement, some of the team members was not in Singapore officially, but they were able to tap upon the tax advisers back in Manulife USA and shift the management structure towards a structure that alleviates the impact to the shareholders.
The announcement was pretty swift, and this would not have been possible without their link to such a strong parent.
The cost of this is embedded within the single management fee structure.
You can Review the Commercial Listings of Manulife Real Estate Properties… Including the REIT’s Properties
If you are interested to know what are the potential properties that they can acquire from under Manulife / John Hancock real estate, you can search for all their properties on Manulife Real Estate’s website.
This includes Manulife US REIT’s properties, and other Manulife funds properties.
The value to the investor is that you can see for each building, whether there are available listings, and perhaps the asking prices.
In this way, you could possibly see the occupancy status for the portfolio.
According to the management, this information presented are used for advertising purpose by the property management team. The data might not be up to date.
The Potential to Have Cheaper Cost of Funds and Better Acquisition Execution
One of us asked whether with a parent like Manulife, the REIT enjoys some advantage in financing.
Jagjit, the CFO for Manulife US REIT, replied that cost of funds, through John Hancock Life, could be cheaper by 20 basis points.
Not just that, potential acquisition is done through the name Manulife. As Manulife are in this region for real estate, it makes them a strong party to work with in terms of counterparty risk, ability to execute the purchase or sale.
Thus, they would win a potential future acquisition not based on the price paid, but on execution, credibility.
Why Didn’t the Parent Choose to list a $1 billion portfolio immediately during IPO?
One common question that was asked a lot, even before we asked was that why don’t Manulife list a $1 billion portfolio but instead list one that is 50% smaller.
I think to put in context, that would have avoided a lot of the problems. In order to be recognized by institutional investors, and so that they are able to invest, your portfolio needs to be of a certain size, preferably greater than $1 billion.
A bigger REIT would be included in indexes, command better valuation and this would make a lot of things much easier.
The management indicated that we have to be cognizant that this would only be Manulife’s second listed vehicle in the entire world. So took a cautious posture to how receptive this new market is to this new portfolio.
They tried listing in 2015 once, but that was during a period where demand was low due to the market turmoil in 2015. Prior to this listing, there were no new listing for the past 12 to 18 months, other than a small Chinese retail REIT, which was already covered pre-IPO.
So they decide to be prudent and list with a US$500 mil fund raising.
I think that if they start off with a $1 billion portfolio it would save them a lot of communication trouble. The Singapore investors have some justifiable skepticism of foreign listing and every time you come to them to ask for money, they view it with skepticism.
Had that not been done, and the investors can assess the larger portfolio as a group of diversified assets, the reception might just be as good and less problems now.
However, this is all hindsight speak. The management believe it is quite challenging to do a IPO in that climate and get people to take a $1 billion portfolio off the table.
The Purchase of Penn in Washington
When Manulife US REIT officially listed, they replaced the Washington building with an Atlanta Class A property which boosted the dividend yield well.
However, one of their latest acquisition is again in Washington. During the capital raising, there were no details released of the acquisition cap rate.
However, in the Q2 2018 financial result slides, they did indicate the CAP Rate used for valuation to be closer to 5%.
Caroline, the head of IR lets us know that one common question investors ask is why not just purchase equivalent properties in Atlanta at 6% CAP Rate instead.
Management’s strategy is to build a resilient and high quality portfolio so that in the mid to long term, the credit rating agencies and also investors are able to differentiate then from the rest.
Hence, while investors prefer higher yielding assets (higher cap rate), management thinks there is a fine balance for them and the fund to withstand different cycles and strengthen their REIT.
Revisiting The Tax Structure Risk
If I were to list one major risk for this REIT, it would have been changes to the tax structure.
For a shareholder dealing with a REIT with foreign assets you have to think about:
- withholding taxes levied by the country where the asset is in (in this case USA)
- taxes on foreign income coming into the country you are in (in this case Singapore)
- taxes on the business entity (in this case Manulife US REIT)
- taxes on the entity receiving and owning the business entity (in this case you the individual, or a unit trust, or ETF)
To make things simple, Manulife US REIT structure their properties like how many business entities would structure their entity to rationalize on the tax front. The result of this is that as a non-resident, you do not pay the 30% withholding tax, since majority of the dividend income is repatriated as interest income due to the shareholding loan structure (as explained in my previous article, which I shall not go too deep into)
This takes care of #1, but it’s not always water tight. As I have mentioned, there was some tax act changes and Manulife was swift to handle that. They would try their best to structure the company within legitimate means to rationalize the taxes paid.
However, it is not a guarantee. This affects other foreign listed REITs as well, as attest to the challenges faced by Lippo Malls recently.
I did ask the question whether Manulife US REIT are structuring their REIT differently from the other private property funds.
Management replied that the way that they structure it is not very different from how Keppel KBS, large private equity funds such Blackstone, private unlisted property funds and normal business structure.
Given this, any impact of taxes on the REIT is plausible but the ramifications would be extensive, and so the result might be not so extensive.
For #2, Manulife US REIT have obtained an advanced tax ruling from IRAS during IPO to have their foreign sourced income to be exempted from taxes. After Jan 2018, the REIT will rely on the existing IRAS rules on foreign sourced income to be exempted. This is similar for other REITS with foreign income.
Like other REITs with foreign assets, Manulife US REIT’s foreign source income is tax exempt based on technical tax guidance under Singapore tax rules. This rule is not subject to 5 year sunset clause.
For #3, As long as Manulife US REIT abide to pay out more than 90% of their income as dividends, and qualify for REIT status, they are exempted on tax at this level.
For #4, if you are a local individual, you will not need to pay taxes on your dividend. As an entity, you still need to pay corporate tax. As a non-resident individual, you will not need to pay taxes on your dividends. If you are a non-resident non individual, you would need to.
Ensuring a Feasible CAP Rate and Yield Accretiveness
I tried to find out where are the attractive areas they would be venturing to, and what I got was the areas that they would not go to.
Some of the name drop includes Boston and Manhattan.
The main reason is probably that the CAP Rate would not make it accretive for the investors.
If you we look further than the properties but the business operating environment, the demand for those areas look strong, due to the vibrant business there. While the CAP rate is low, the robust dynamics might make properties in those expensive areas low but predictable.
If you invest in Manulife US REIT, you are placing a bet that the management can find the sweet spot between high quality properties, and areas that are growing and favorable supply and demand dynamics.
On Manulife US REIT’s Lofty Goal to Doubling their AUM
I think one of the direction management has provided is to double their AUM. If you are looking for a REIT that have a growth angle, perhaps you are interested in this.
Jill explained that the doubling of the AUM is a general direction that they wish for because they find that there is a ready pipeline to acquire and grow. With the rise in interest rate, this would probably have to be re-evaluated carefully.
Hence, the intermediate priority is to focus on maintaining the DPU, growing organically.
When she post the question whether we would like a REIT that is growing or one that is stable, majority of us reflected that fundamentally, the REIT should be able to grow their DPU without addition of new properties.
However, I do think the objective for a REIT as with business trust is to grow, with the dividend yield provide the attraction.
The investors will earn more from the capital growth.
Perhaps due to the tax structure in the USA, and the dynamics, the USA REITs have a lower dividend payout versus their free cash flow, and have a development component.
You will get more capital gains from the total return.
I think to a certain extend, the REIT have to be of a certain size to be optimal. You can then take on some debt to carry out AEI without impacting the DPU so much.
You get a better reception from institution for preferential rights issues as well as other forms of equity fundraising.
Explaining the Big Disparity in Michelson’s Asking Rent and Average Rent. Putting Context on the Rental Data provided by CoStar Group
One of my concerns previously was that when I saw the great disparity between Michelson, Irvine’s average passing rent and the gross asking rent.
Caroline, the head of investor relations, explained to us that the $36 passing rent shown in their presentation is from Co-Star, which provides commercial real estate information of the region. This is to add color to us the investor the market supply and demand in the area.
From what I can understand, the class A property data will cover a large area but sometimes there can be disparity within that market space.
So for example, the data provided could cover Greater Los Angeles but if we constrain to a smaller area, such as Downtown Los Angeles, the asking rent and vacancy rate could be different.
Since Figeuroa is located in Downtown Los Angeles, the asking rent can be very different from the data provided by Co-Star.
This also affects the vacancy data. For example, 500 Plaza Drive in Meadowlands show a 11% vacancy on the data, but the vacancy rate in the region is closer to 6%.
In general, the management guided that except for Michelson, which is a trophy asset, which means it is one of the top buildings in the submarket, the rest of their portfolio is under-rented by 5-10%.
Michelson would command a higher rent than average. They believe that Michelson has a strong competitive position and they expect it to be able to attract and retain tenants at trophy market rates.
I did my check on the listing details for the Michelson and while the larger floors were negotiable. You can see the asking price of the smaller units is at $51 to $53.
This is higher than the average asking rent for the Michelson in Q2 2018 result.
The Commercial Properties that are on Triple Net Lease
At some point in my research I realize that Peachtree’s asking rate is US$26. This seems below the US$37.64 that Co-Star provided.
Turns out the US$26 is a guide provided by the leasing team, as it was marketed on a triple net basis.
This means that the clients borne the insurance, property tax, and maintenance cost. So the asking rent is lower, but the margins are near 95%.
It turns out that out of Manulife US REIT’s properties, 3 of them are triple net lease:
The NPI margin for Manulife US REIT’s overall portfolio is between 60% to 65% for all net/gross rent properties.
Management explained that for most REITs, the cost is capitalized on the balance sheet while for Manulife US REIT, the cost is recognized on the income statement.
Thus, we do not detect easily that a few of their properties are on triple net lease.
It turns out the tenants do pay the costs, but is recorded in Manulife’s expenses.
This cost is recovered from the tenant and classified as “Recoveries Income” which is disclosed on a yearly basis in their Annual Report.
Bringing some clarity to the Valuations of the Properties
In my question on the potential drop off in rent for Michelson, I commented that the property valuations did not go up but the CAP Rate was compressed.
Management updated that the CAP Rate compression is due to different assumptions used by the new appraiser.
In the most recent appraisal, the market rent assumed was higher than the previous appraisal.
The Free Cash Flow Situation…. is Pretty Complex for Me to Understand
One of the questions that was left unanswered during the last post was whether the REIT is financing maintenance capital expenditure with debt and not accounting the maintenance capital expenditure in free cash flow.
The reply that I have gotten is that
“the cash flow” includes capital expenditure and leasing cost, which makes up the majority. For capital expenditure it includes the AEI of the lobby renovation in Exchange.
They have adequate funding from the purchase price, credit and debt facilities to fund these capital costs. To-date, they have only drawn US$0.8 mil of debt facility to fund capital facility to fund capital expenditures and leasing costs.
As such, they have been utilizing the funds from purchase price credit to fund these costs rather than only relying on debt.
They further clarify on the capital expenditure:
Maintenance capital expenditure are repairs and maintenance and are funded through our regular distributions. In addition, these costs are also recovered from tenants and are included in recoveries income for certain assets.
Base building capital expenditures include AEI or other capital expenditures that increase life of the property. These costs are financed through debt or purchase price credit received on acquisitions of the buildings. Since, these capital expenditure costs are financed through debt, it is not included in distributable income calculation.
This is a little bit confusing, so what I did was to read up on one white paper.
So there are 2 kinds of expenses:
- Leasing expenses. This constitute to the expense spend as part of the work for an incoming tenant. This is usually not part of maintenance capital expenditure. This can be funded by debt
- Base building expenses. Capital expenditures to
- Physical building substructure, shell, and common areas
- Elevators, escalators, plumbing, HVAC, fire protection
- Site improvement such as driveways, parking lots, walkways, paving, landscaping
The focus here is on #2 base building. In it, there can be repairs and maintenance and capital improvement. Repairs and maintenance, if I understand well, is funded by the rental cash flow. Capital improvement is funded by debt.
A clearer way to differentiate repairs and capital improvement is to consider those that fit the description below to be capital improvement:
- Substantially prolongs the useful life of the property beyond original expectations (for e.g. extensively renovating a property, updating the wiring and plumbing, replacing the roof)
- Materially increases the value of the property
- Adapts a property to a new use
So those that fall out of this is considered under free cash flow. Not sure about you but originally I thought things that prolong the life of the property should be factored into free cash flow computation. However, if you factor in those previous three points, Then they seem to lean closer towards investment capital expenditure.
How Long Does it Typically take for US Commercial Office to Be Listed Out?
There are certain differences in leasing culture in the USA compared to Singapore.
In the past, management have indicated that it is the norm to maintain 10% vacancies. This is to facilitate tenants who wishes to expand their premises.
It also allows them to increase the property income earned during the very good times, to take advantage of historically high asking rents.
One question on my mind was how long typically does it take for commercial spaces to be leased out.
In US, it typically takes about 6 months to 18 months, depending on the size to lease up any floor space vs in Singapore.
Leases signed in US (usually 5 years to 15 years lease) are also longer as compared to Singapore (3 to 5 years lease).
Typically, for long leases, management would start negotiation with existing tenants 1 year prior to expiry.
So in the case of key spaces in Michelson that are expiring next year (30% of it), management have already initiated discussions with the tenants.
Some more Updates After Q3 2018 Results
I met up with the management again after the results, and here are some more insights:
What is covered:
- Of Michelson’s 2019 Lease Renewal Status
- The Impact of the Rise of Co-Working Spaces to Office Landlording
- The Nature of Lease Agreements for Manulife US REIT’s Properties
- The Appeal of the Flow Through of Rental Escalation to Net Rental Income
- Clarification on rental escalation, WALE of new renewals
- The Difference Between CBD and Suburban, Class A, Class B and Trophy Properties
- Is Management able to Switch to a Quarterly Dividend Payout?
- The Impact of Impending Clarifications to the 2017 Tax Cuts and Jobs Act – Some thoughts about it
- Manulife US REIT’s Capital Strategy – Unencumbered Assets, Perpetuals and Convertible Bond Issue
- Manulife US REIT’s Capital Strategy – Trading Liquidity, AUM Size, Rights Issue, Preferential Offering, Placements
I think these details certainly helps investors like myself build a better picture of the kind of REIT we are looking into.
I would like to thank Manulife US REIT’s management for spending time speaking to minority shareholders like myself so that we can validate our conviction in the company.
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