How S-REITs' new lifeline can improve its cash flow

It will not prompt acquisitions as S-REITs are expected to be more prudent in capital efficiency.

The government’s new measures for S-REITs are expected to benefit these trusts in multiple ways, which will help them weather the COVID-19 storm in the event that its impact will linger longer than expected, according to various analysts’ notes.

The Ministry of Finance (MOF), the Inland Revenue Authority of Singapore (IRAS) and the Monetary Authority of Singapore (MAS) announced three measures last 17 April: first is the extension of timeline for S-REITs to distribute at least 90% of their taxable income from 3 months to 12 months (after the end of FY2020) to qualify for tax transparency; the increased leverage limit from 45% to 50%; and deferring the implementation of a new minimum interest coverage ratio (ICR) requirement to 1 Jan 2022.

So far, SGX stated that S-REITs have maintained an average debt to asset ratio of 35.3% as of 31 March 2020. The worst-hit are the seven retail-focussed S-REITs as they averaged a 29.2% crash YTD.

Over the same period, the FTSE ST REIT Index dropped 19.8%, in line with the average 22.2% decline amongst global REIT indices. SGX added that the annualised 10-year total returns of FTSE ST REIT Index also trimmed to 8%, but remained slightly above the average of 7.2% for global REIT indices.

“[The] extended timeline should allow REITs to manage cash flow uncertainties arising from temporary relief provided to tenants (in Singapore Government’s Budget 2020) to defer their rental payment for a period of up to six months,” said Vijay Natarajan, analyst at RHB.

In addition, Derek Tan, analyst at DBS Group Research, said that whilst some S-REITs have already implemented or may be considering delays in their quarterly dividend payouts, the extension of the timeline to meet tax transparency requirements will give them more flexibility and less urgency to raise funds in a less conducive equity and/or debt market environment.

“We note that this is likely to be one-off given the extraordinary circumstances,” Tan added.

However, analysts warned that this will create a near-term cash flow mismatch in terms of dividend payments, no thanks to the uncertainty in the proportion of tenants that may choose to defer their rental payments.

Another risk is that the move is at the expense of S-REIT unitholders in the near term with a higher possibility of lower and/or delayed dividend payouts in FY2020. “[T]his is the ‘lesser of two evils’ if the alternative is a risk of deterioration in balance sheets and cash flows of S-REITs which may require equity issuance to take place at a wrong time,” commented DBS’ Tan.

No appetite for acquisitions
The raising of the aggregate limit (gearing) to 50% from 45% is not likely to prompt S-REITs’ acquisition appetite as they are expected to focus on securing their portfolios’ returns. Such moves are also not expected to be supported by investors and banks.

“The rise in gearing ceiling limit to 50% and deferral of ICR ratio is more of a preemptive move to prevent REITs from the unexpected breach in gearing threshold (from decline in asset value) rather than a signal to borrow cheaply for further acquisitions in our view,” RHB’s Natarajan said.

He added that S-REITs in general have been more prudent with their borrowings during the current market cycle with an average sector gearing at 35.7% and interest cover of 5.9x. Only three REITs currently have gearing of >40%. “With the increased gearing threshold limit, REITs’ asset values have to decline by 17-44% before a potential gearing limit breach, which we believe is a reasonable buffer,” he stated.

As for the delay in implementing the new ICR requirement to 1 Jan 2022, DBS’ Tan expects it to provide safeguards against careless overleveraging and will benefit unitholders, even as some argue that higher gearing may benefit S-REITS with too high a cost of equity capital.

“We found that ICR ratios of 2.5x are typically higher than typical bank covenants of 1.5x-2.0x but this includes the calculation of perpetual coupons (or interest) in the calculation. Thus, this eliminates the risk of S-REITs “double-dipping” into the higher gearing headroom as perpetual securities are counted as equity rather than debt, as per accounting guidelines,” he said.

Thus, tighter ICR ratios may protect S-REITs against over leverage, and the low interest environment may not be representative of a “normalised” ICR ratio if interest rates normalise in the longer term.

“We note that most REITs still have a good buffer in fulfilling both the proposed gearing limit and minimum ICR after earnings cuts,” Tan commented.