by: Tam Ging Wien
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Lippo Karawaci, the anchor tenant and master lease of First REIT’s hospitals made a surprised announcement on Monday, 01-Jun-2020 with the press release entitled Covid-19 Renders Rental Subsidies Unsustainable; LPKR To Initiate Restructuring Discussions On Leases With First REIT.
The relevant part of Lippo Karawaci’s announcement is reproduced below for the convenience of readers:
Immediately upon the announcement, Units of First REIT tumbled 11.3% to 78.5c with 6.6mil units just before 12pm when it called for a trading halt. After the announcement and the lifting of the trading halt, the units ended the day down 18c closing at 70.0c cents. First REIT closed the week at 71c or 20.2% down from its prior trading peak from previous week at 89.0c.
The announcement made by First REIT was somewhat surprising as it clarified that it has not been approached by LPKR regarding these matters. The link to the announcement can be found below:
The relevant part of First REIT’s announcement is reproduced below for the convenience of readers:
First REIT has 5 master leases which are due to expire in 2021. In this article, we use available data till date to estimate the potential impact of the lease renewals. We will present what we think is a possible base case and another optimistic and pessimistic case. As this is an estimate and negotiations are on-going, we remind readers that these estimates could change as more information and data is made available to public. Assumptions will be made where practical and will be made known to readers. Readers relying on this article should therefore update their own estimates when new information becomes available.
This rental renewal risk is not new and ProButterfly.com has previously written about First REIT in the following blog articles:
First REIT was listed on the SGX on 11-Dec-2006 and is Singapore's first healthcare REIT. Its investment strategy encompasses a diverse portfolio of yield-accretive healthcare and healthcare-related real-estate assets in Asia.
At the point of listing, the exchange rate between the Singapore Dollar (SGD) and the Indonesian Rupiah (IDR) was approximately SGD1 to IDR5,850. Today, the exchange rate is about SGD1 to IDR10,100. This means that the SGD must decline in value against the IDR by 42.1% to revert back to the exchange rate back when it was listed.
First REIT received its rental income in SGD from Lippo Karawaci and therefore transfers the exchange rate risk to its tenant. It would be reasonable to assume that at the time of listing, none of the people involved in structuring the IPO could have imagined that the IDR could decline so drastically. Therefore, in the present day, we could take a base case that leases renewals need to be renegotiated down approximately 40% to bring the leases back to the levels during the IPO period.
At this stage, we are assuming that the lease renewals will be renewed upon the contracted expiry date and not terminated early and renegotiated. We also assume that significant clauses in the rental agreements will continue to prevail and the structure will remain intact as it is with only the rental figures changed. For example, the rentals will continue to be paid in SGD and not changed to IDR.
In Lippo Karawaci’s announcement, it mentioned that the rentals paid to First REIT are in the range of 30% to 100% of the hospital’s Gross Operating Revenue with a weighted average of close to 40%. In the base case, if all rentals are brought down by 40%, it would bring down the ratio of rental expense to between 18% to 60% with a weighted average of approximately 16%. This seems like a reasonable figure for the rental expenses for the Base Case.
Further to Lippo Karawaci’s announcement, revenues in some hospitals have fallen between 40% to 50% year-on-year due to the impact of COVID-19. Assuming that this structural impact is persist, then we would need to bring down the rentals down another 50% on top of the 40% fall in the base case which would entail a renegotiation of up to 60% reduction in the rentals between Lippo Karawaci and First REIT. This would form the pessimistic case where the double impact of COVID-19 and the IDR depreciation is considered in the negotiation.
Using the range of the Base and Pessimistic Case, we set the optimistic case for 20% reduction in the rentals. Perhaps both parties may not want to rock the boat too hard and arrive at a lease amount that is mutually beneficial in the interest of unitholders and the tenant.
Quoting Lippo Karawaci’s announcement “unrealistic to sustain and support”, we read this as strongly worded and it is unlikely that the conclusion of the negotiation will end up with no change to the lease structure or amount. Therefore, we do not consider an optimistic case to be have zero impact.
According to First REIT’s latest results presentation slides for FY2019, the following asset leases are due to expire on 2021:
In total, all the assets due to expire in 2021 account for 24.8% of First REIT’s portfolio valuation. Referencing another source of responses to substantial and relevant questions from unitholders, First REIT had responded that “The 5 master leases which are due to expire in 2021 take up approximately a quarter of the rental income received by the Trust”. Therefore, we can assume that the renewals account for approximately 25.0% of First REIT’s rental income and we can adjust this component down by the Base, Optimistic and Pessimistic Case.
Based on First REIT’s annual report, the manager of First REIT receives its management fee in the following components:
For FY2019, the management fee components are $5.756mil and $5.645mil respectively. With the reduction of the rental components, we expect at the asset valuation and NPI will also adjust correspondingly resulting in lower management fees.
Based on First REIT’s latest Quarterly Business Update dated 06-May-2020, the manager had reduced the management fee taken in units from $2.5mil in FY2019 to $1.4mil in Q1-FY2020. While there is no information if this is a one of or a permanent change, we will make an assumption that this is permanent and going forward, the management fee taken in units are likely to decline by $4.4mil over a full year.
We are also going to budget for a 1% quarterly compounded increase in the units and therefore over one year’s time, the number of units in FY2019 are estimated to increase from 797.675mil to 830.064mil. This could be due to a variety of factors for example management fee taken in units and scrip dividends. While we do not discount the possibility of an equity fund raising, we are not able to take this consideration into account in the absents of a reasonable estimated figure.
We will assume the following in our estimates to err on the conservative side:
A 2.9% other adjustments downwards for the Amount Available for Distribution
After making all the adjustments mentioned above together with the various assumptions, we found that on a pro forma basis, our base case of 40% decline in the 25% component of the rental income could result in approximately 19.5% decline in DPU.
In the optimistic and pessimistic scenario, DPU could decline between 13.9% to 25.2%.
Interestingly, the decline in stock price to close this week at 71c from the previous week’s close of 89c is a 20.2% decline – fairly assigned with our base case of a potential 40% drop in the upcoming rental renewals of assets due in 2021.
If we assume that the impact of the stock price is roughly aligned to the impact of the DPU, a decline of between 13.9% to 25.2% from 89c would give a range of 66.5c to 76.5c.
This is an interesting exercise for us this line of thinking allows us to estimate the impact of a potential decline in DPU and hence provide us with a guidance on the potential impact on the stock price.
Given that that First REIT’s unit price has stabilised this week at 71c, it is likely that the market has priced in a 40% decline in the upcoming rental renewals. Since markets tend be forward looking, perhaps we do not have to wait for final decision on the renewals to be made to take a position.
This is, however not a one-off scenario. The next rental renewal is due on Dec-2025 for the assets Mochtar Riady Comprehensive Cancer Centre and Siloam Hospitals Lippo Cikarang which collectively account for about 23.9% of the portfolio valuation. Investors in First REIT may have to live with this nagging renewal risk over the long term.
The estimates in this article also contain many assumptions, some which may not hold true as more information becomes available. These may break out derivations of our Base, Optimistic and Pessimistic case. For example, one key assumption is that the new re-negotiated rental rates will only take effect upon expiry of the existing contracts and significant structure such as the leases to be paid in SGD will continue. Should these assumptions not hold true, the impact on First REIT could be much worse than our pessimistic case.
Should we decide to invest in First REIT for the yield, we will take cautious and portfolio risk managed approach to account for many uncertainties that may not be apparent at this stage.
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