What First REIT Unitholders Must Know Before the EGM

by: Tam Ging Wien

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First REIT unitholders got the unexpected news just days before the new year that the management intends to raise funds via a dilutive rights issue at 20c per unit to recapitalise the REIT – a steep 50.0% discount to the closing price of 40.5c just the day before the announcement.

The action is expected to issue on a pro rata basis of 98 rights for every 100 units or a 98% increase in the number of issued units. According to the circular, this would amount to 791mil rights units based on the current 807.2mil as at the date of this announcement.

This follows from the earlier announcement in Nov-2020 that the management proposes to restructure the master lease agreements for all the hospitals which First REIT had leased to its sponsor PT. Lippo Karawaci Tbk (LPKR) and its subsidiaries such as PT. Metropolis Propertindo Utama (MPU). Among the most significant change is the replacement of the SGD (Singapore Dollar) with IDR (Indonesian Rupiah) as the currency of payment. The foundational investing thesis that investors had behind First REIT was the transfer of the currency risk from the REIT unitholders to the REIT’s tenants will now be removed in the proposal.

The extra-ordinary general meeting (EGM) for unitholders to vote on the above two resolutions is scheduled on 2:30pm Singapore time on Tuesday, 19 January 2021 which will be convened and held thought a live audio-visual webcast. Investors interested to attend the EGM need to pre-register by 2:30pm Saturday, 16 January 2021.

Understanding the EGM Resolution Options

There are two key resolutions that the management is seeking to pass the upcoming EGM:

1. Restructuring of the LPKR Master Lease Agreements
2. Waiver to trigger a general offer by OUE Ltd so that it may proceed with a S$158.2mil Rights Issue at 20c per unit

There are several scenarios that could occur:

1. Resolution 1 and Resolution 2 are both passed at the EGM
   • In this scenario the restructuring of the master leases will commence; and
   • First REIT would launch a rights issue
2. Resolution 1 passed but Resolution 2 failed
   • In this scenario the restructuring of the master leases will commence; and
   • First REIT proceed to seek an underwriter for its rights issue, only if the underwriter is found then a rights issue will proceed otherwise it will not launch the rights issue as it does not intend to privatise First REIT through an accidental mandatory takeover offer
3. Resolution 1 failed and Resolution 2 becomes irrelevant
   • In this scenario, neither the restructuring nor the rights issue will take place

In the sections below we will discuss the details behind these resolutions and the implications of the various scenarios.

Context and Background to the Restructuring of the LPKR Master Lease Agreements

The presentation slides from First REIT summarises the salient restructuring points fairly well showing the current lease agreement and the proposed changes.

Its worth keeping in mind that the LPKR Hospitals account for approximately 72.1% of First REIT’s rental income.

Source: First REIT

Here are they key changes that investors need to be aware of:

• The lease payment currency is changed from SGD to IDR
• The base rent for both the LPKR and MPU will be re-baselined 37.1% and 46.6% lower compared to what was received in 2019 assuming the currency exchange rate maintains at IDR/SGD=10,830
• All the master lease agreements will be renewed on a 15+15 lease term, pushing back the expiry of 66% of the leases (by gross floor area) to 2035 and increasing the WALE from 7.4 years to 12.6 years
• A fixed rental escalation of 4.5% per annum on the base rent
• Increase of the security deposits from 6 months to 8 months

Given the restructuring above, it will take approximately till year 2032 and 2036 for both LPKR and MPU’s hospitals to recover back to the 2019 base rent of S$80.9mil and S$11.3mil assuming the exchange rate remains fixed at IDR/SGD=10,830 throughout the period. Couple with the further doubling of the units, if all else remains constant without any variable or performance income, the DPU could require double that time to recover.

Therefore, it would seem unlikely that First REIT’s share price would recover to the pre-COVID price levels of $1.00 in the short and medium term.

Considering that investors used to enjoy dividends without having to worry about the exchange rate, these changes do make investors feel like they are being short-changed with all the lease agreements being changed all at once rather than changed upon their expiry dates.

Investors should be aware of the difficult situation facing First REIT’s sponsor LPKR who’s financial troubles a mainly attributed to miscalculations of the management when embarking on the highly ambitious Meikarta Project in East Jakarta. The massive US$20bil project faces problems of stalled construction, slow sales and allegations of bribery. LPKR’s cash flow is further put under pressure from its largely US dollar-denominated debt which has been strengthening against the rupiah while interest rates on the greenback further exacerbating the problem. This has resulted the downgrade of its credit rating.

The cash flow crunch has forced LPKR to divest several of its assets to raise cash including:

• Divestment of First REIT Manager and sale of its First REIT shares
• Divestment of Lippo Mall Puri into Lippo Mall REIT
• Divestment of a Hospital in Myanmar

Then came the unforeseen COVID-19 pandemic that put further pressure on LPKR and its subsidiary Siloam Hospitals. In a surprised announcement on 01-Jun-2020, LPKR issued a 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, quote from the press release:

• “COVID-19 has significantly impacted Siloam's revenues and led to a drastic decline in patient volumes across Indonesia. Under the current rental structure, LPKR provides a rental support which guarantees First REIT a certain rental level, such that a decline in Siloam's revenues would increase the support provided by LPKR. Revenues in some hospitals are down as much as 40-50% yoy and we anticipate the impact to be significant and structural over the medium term.
  
  Additionally, the rental support agreements, which were entered into over the past 10 years, also have a currency peg component, which puts further pressure on the arrangement in light of the Rupiah’s depreciation. Even before accounting for the decline in revenues as a result of COVID-19, the rental amounts for almost all the hospitals range of 30-100% of the hospital’s Gross Operating Revenue — and with a weighted average of close to 40% — a level that is unrealistic to sustain and support."

Understanding the Need for the S$158.2mil Rights Issue

First REIT proposes to undertake a rights issue to issue of approximately 791,063,000 new units which is about 98% (98 units for 100 units held) of the present 807,206,351 units in issue at the time of writing in order to raise gross proceeds of S$158.2mil at an issue price of 20c per unit.

The funds raised will be used for the following purposes:

• Repay part of the 2018 Secured Loan Facilities, ~S$140.0mil
• Estimated Professional and Other Fees, ~S$5.5mil
• Master Lease Restructuring Costs, ~S$3.4mil
• Working Capital, ~S$9.3mil

There are also two upcoming loan obligations which First REIT would need to refinance:

• S$196.6mil coming due on 1 March 2021
• S$1mil coming due in year 2022

During the negotiations, First REIT had only managed to obtain a maximum loan of S$260mil, this would not be sufficient to refinance both the upcoming loans of close to S$400mil. To make up the difference, S$140mil would need to be raised through the rights issue.

First REIT cited the reasons for not being able to obtain the full refinancing amount due to, and we quote “lenders’ concerns over the uncertainty relating to the valuations and cash flows of First REIT’s assets and the potential negative impact of any master lease restructuring”. It is also a condition of the refinancing facility that First REIT is required to undertake an equity fund raising exercise to repay the difference, necessitating this rights issue.

Its important for unitholders to note that this rights issue does not in anyway expand First REIT’s portfolio of assets as the funds are not used for any acquisition.

Unitholders should also be aware that the rights issue does not in anyway materially bring down the gearing of First REIT post-restructuring, as the valuations of the assets will also fall correspondingly. Based on First REIT’s illustrative pro forma, the gearing in FY2019 stands at 34.5% and post restructuring and post-rights issue, gearing is expected to marginally reduce to 33.9%, this is despite the total debt falling from S$486.4mil to S$346.4mil. This is because post-restructuring the asset valuation is expected to fall from S$1,340.8mil to S$942.2mil.

Unitholders should also be aware that there is still a further S$60.9mil worth of perpetual securities that First REIT is still have on their balance sheet.

Unitholders of First REIT should also be aware that both the master lease restructuring and the rights issue when taken together is DPU dilutive and yield dilutive to unitholders. As per the illustrative impact, the half-year DPU is expected to fall from 2.3c to 0.55c or about 76% lower. The yield is expected to fall from 5.2% to 3.6% based on the 1H-2020 DPU.

NAV per Unit is also dilutive and is expected to fall from 97c to 34.6c post-restructuring and post-rights issue, approximately 64.3% lower.

It is therefore no surprise that the share price plunged from 41c before the announcement to the current 26c at the point of writing, a fall of 36.6%.

Source: First REIT

If First REIT is not able to raise the S$140mil, the following could possibly be the implications:

• Gearing could rise to ~48%
• First REIT may not receive the refinancing support from its panel of lenders and would risk not being able to refinance the S$196.6mil coming due in 2021 and/or the S$199.1mil coming due in 2022
• First REIT would “face an urgent need to re-evaluate alternate funding sources or face financing default”

Understanding Implications of the EGM Voting Outcome

Revisiting the several scenarios that could occur, we will discuss what each of this scenario could mean to unitholders:

1. Resolution 1 and Resolution 2 are both passed at the EGM
   • In this scenario the restructuring of the master leases will commence; and
   • First REIT would launch a rights issue
2. Resolution 1 passed but Resolution 2 failed
   • In this scenario the restructuring of the master leases will commence; and
   • First REIT proceed to seek an underwriter for its rights issue, only if the underwriter is found then a rights issue will proceed otherwise it will not launch the rights issue
3. Resolution 1 failed and Resolution 2 becomes irrelevant
   • In this scenario, neither the restructuring nor the rights issue will take place

Scenario 1: Resolution 1 and Resolution 2 are both passed

This would be the ideal outcome from the perspective of the manager and will immediately result in:

• Commencement of the restructuring of the master leases
• Launch a 98-for-every-100 rights issue at 20c per unit

For unitholders, here are some potential and non-exhaustive implications:

• Cough up more cash in this current climate in order avoid a 98% dilution of their portfolio
• Face a DPU and NAV per Unit dilution on their units
• May require a future equity fund raising to fund further portfolio asset acquisitions as this rights issue is purely to repay debts
• Gearing would continue to hover at the 33.9% level
• Accept the risk of foreign exchange risk involving conversion of Rupiah to SGD
• Potentially a lengthy wait till year 2032 to 2036 for DPU to recover to 2019 levels assuming there is no change in the exchange rate
• First REIT likely to continue to receive steady and predictable dividends from its master tenant and sponsor - LPKR

At this moment, the rights issue is not underwritten but the major shareholders namely OUE Limited who presently owns 19.72% of First REIT has promised to subscribe to all its rights and also to the excess rights that where not subscribed to, in effect playing the role of an underwriter instead of a 3rd party financial institution.

Scenario 2: Resolution 1 passed but Resolution 2 failed

This would not be ideal from the perspective of the manager as First REIT is now forced to source for a potential underwriter for the rights issue. The manager has made clear that if Resolution 2 fails, it would not proceed with the rights issue as there is a very high risk that OUE Ltd may end up subscribing to too many units resulting in an automatic trigger of a mandatory takeover and privatisation of First REIT which is not the intention.

Sourcing for an underwriter may not be easy as First REIT is under very tight timeline to secure a 3rd party underwriter. Under pressure, it may be forced to accept less favourable terms in the underwriting, perhaps resulting in higher fees or perhaps issue the new units below 20c while increasing the number of new units issued.

For unitholders, here are some potential and non-exhaustive implications:

• Accept the risk of foreign exchange risk involving conversion of Rupiah to SGD
• Face the uncertainty and changes in the rights issue proposal due to the inclusion of a 3rd party underwriter
  • Potentially the same or higher dilution factor on the DPU and NAV per Unit if more units are issued at a lower price
  • If the same right issue terms are preserved with the underwriter, then implications for unitholders would be similar to Scenario 1 above
• Risk of First REIT defaulting on the maturity of the loans due in 2021 and/or 2022 if it is unable to secure an underwriter for the rights issue
  • Should a default occur, it is likely that future financing would be much harder to come by as other lenders would shun First REIT
  • A rights issue may still need to be raised in the future in order to restructure and pay down the loans
  • Forced to divest a part of their hospital assets in order to raise funds to pay down the debts due
  • First REIT risk having their shares suspended from trading while the restructuring takes place

Scenario 3: Resolution 1 failed and Resolution 2 is irrelevant as the rights issue will not proceed

This would be the most severe outcome for the manager as it has neither unitholder approval to restructure the master lease agreements nor the confidence to proceed with a rights issue.

For unitholders, here are some potential and non-exhaustive implications:

• LPKR and its subsidiaries will be forced to continue to honour the original master lease agreement and take on the exchange rate risk
• LPKR due to its severe cash flow pressures may potentially default on their rental obligation
  • This would directly impact 72% of First REIT’s rental income
  • Result in lengthy and costly legal disputes
  • First REIT’s panel of lenders may decide to withdraw financing from First REIT due to uncertainly in the REITs ability to collect its rental
  • First REIT risk having their shares suspended from trading while the matter is being sorted out, reminiscence of another REIT – Eagle Hospitality Trust

Given this background and context, investors can appreciate the extend of the problem that LPKR is facing. Unfortunately, First REIT is “collateral damage” from the confluence of these problems with the sponsor. Without this restructuring, we quote from the Chairman’s message to unitholders: “there is a real risk and high probability that it would default under the existing LPKR MLAs”.

What Options do Unitholders Have?

Unitholders at this point of time have a few options:

1. Accept the situation and vote to approve both Resolution 1 and 2
   • Accept and prepare to support First REIT in the long term through dilutive rights issues
   • Trust the management to steer the REIT in a turnaround in the long term akin to what happened to MacarthurCook Industrial REIT (now known as AIMS APAC REIT).
2. Divest all their shares now and cut losses in First REIT
3. Vote Yes to Resolution 1 and No to Resolution 2 forcing First REIT to seek an underwriter under pressure for the rights issue which could make matters worse for all parties
4. Vote No to Resolution 1 and call LPKR’s bluff on their cash flow situation
   • If LPKR continues to fulfil their rental income obligation thing could return to status quo
   • If LPKR defaults on its rental income obligation to First REIT, unitholders face a potential share suspension and a lengthy restructuring process akin to what Eagle Hospitality Trust is going through

In our opinion, Option 3 does not sound logical at all as this scenario appears to be a lose-lose situation for all parties except for LPKR. Why force First REIT into such a position as to find an underwriter under time pressure?

Option 4 appears to be playing poker in an “all or nothing” bet. Either call LPKR’s bluff on their cash flow situation or face potential defaults and trading suspension.

This leaves Option 1 and Option 2 to be the only logical option for unitholders, we would have to accept the reality of the situation and choose to either:

• Cut and realise our losses and sell out now and use whatever is left of our capital to invest elsewhere to recover our losses
• Prepare fresh cash to support the REIT, perhaps multiple times throughout this difficult crisis and trust the management to do what is best for the REIT

In the S-REIT history, investments have gone wrong due to sponsor issues such as Eagle Hospitality Trust may result in closure and liquidation of the asset.

On the other hand, MacarthurCook Industrial REIT was successfully turned around after many years and a lengthy process and now rebranded as AIMS APAC REIT. The same could happen for First REIT, but expect that the journey will be a long, slow and painful one with likely more equity fund raising to come.