I have decided to start this series of analyzing REITs on a deeper level and I will give a overall summary of what I have learnt. Hopefully you might find the information useful if you are a novice investor like me. I prefer to go in-depth to fully understand, learn and explore one particular area at a time with examples RATHER than covering the whole spectrum of REITs but only understanding briefly what it is all about for each topic. This post would be focused on Debt Financing in REITs.
So let’s jump into it. What’s financing in REITs? A REIT has to buy assets, lease out to tenants, collect rental income and distribute its earnings back to unit holders. So where does it get the money to buy such assets? Answer is either through debt or equity. Within debt, there are many different ways of issuing debt and within equity, there are also many different ways to issue equity. Often times, we hardly attempt to differentiate what is good and what is not or even the reasons behind their financing methods. So let’s hope that by the end of this series, you would gain a higher awareness on the various type of financing and critique its implications on the financial statement or balance sheet.
In debt-based financing, there are 4 main ways a REIT raise capital:
- Bank Borrowings
- Medium-Term Notes(MTNs)
1. Interest-Bearing Loans
Interest-bearing loans are things like bank loans or any borrowings with a contractual obligation to pay back principal and interest payments. This is the most basic and common type of financing ranging anywhere from 1 year to a long-term loan. A Interest-bearing loan can be further classified into secured/encumbered vs unsecured/unencumbered.
A secure loan is a loan backed by a collateral such as a property or asset. That is to say if the borrower defaults on its loans, lenders have right to sell the collateral and repay any outstanding debt. With this assurance, lenders are thus willing to lend out its money at a LOWER interest rate because their risk of collecting back their money are significantly reduced. On the other hand, the REIT borrower would also gain an advantage by having its cost of borrowings REDUCED, but it comes with a cost as it now has lesser flexibility and control over the asset that is being pledged as a collateral.
An unsecured loan on the other hand is a loan backed WITHOUT a collateral asset. It is based solely on the creditworthiness and full faith on the borrower to repay back its loan. A REIT should have a good credit rating, good track record and ideally a strong sponsor for them to secure more favorable rates from borrowers. For example, MCT is rated Baa1 by Moody and its interest rates from bank loans are relatively low between 2.12% – 2.77%.
Generally speaking, assuming all things being equal and 2 companies have the same credit rating, interest rates for secure loan would be LOWER as compared to an unsecured loan. A REIT with a high credit rating and strong sponsor usually sees little incentive to encumber significant portions of their assets for a secure loan. It is simply not worth imposing the additional risk on its assets to lower their cost of borrowing MARGINALLY. But, there are also reasons for taking up a secure loan. For example, to reduce its average-weighted cost of borrowing, to reduce its interest coverage ratio, or when its cash flow is tight.
Let’s apply these info into one of my favorite REITs: the MAPLETREE FAMILY! I will be doing a comparison between MCT and MNACT.
We can see that Mapletree Commercial Trust finance its assets through borrowing $2.3 billion from a mixture of Bank loans and Medium Term Notes. The full loan quantum is UNSECURED meaning no assets are encumbered which is why it showed 100% throughout the quarters highlighted below. Negative pledge is a provision in contract which prohibits the lender to gain control and economic interests over MCT’s assets. Let’s take a look at its brother Mapletree North Asia Commercial Trust (MNACT).
MNACT borrowed $2.9 billion BUT encumbered 11% of its Japan’s assets for its JPY Borrowings as at 30 Sep 2018. Thus, you can see a mixture of “secure” and “unsecured” bank loans/bonds under the breakdown of their borrowings. Therefore, MNACT may not have as much freedom and flexibility over its assets in Japan as compared to MCT. In the scenario if there is a buyer who is willing to pay 3 times its cost price of the pledged collateral, MNACT has limited rights in its decision-making judgement as the possessions of the assets are now under the lender’s hands. As you can see, its interest coverage ratio remains the same at 4.1 for the 2 quarters from 31 Mar 2018.
Another interesting point to bring up is when investing foreign properties in foreign land should you borrow in foreign currency or local currency? Hmmm… well it depends.
If you borrow in local currency, the foreign exchange risks on loans are eliminated. If you borrowed $100 million in SGD you would still pay back $100 million in SGD regardless of the FX rates. But your rental income in Japan is exposed to FX volatility. In the scenario when SGD weakens against JPY (1 SGD = 80 JPY), then your rental income, when converted back to SGD INCREASES due to foreign exchange differences.
Conversely, if SGD strengthens against JPY (1 SGD = 85 JPY), your rental income DECREASES when converted back to SGD due to foreign exchange differences. So it works like a double-edge sword, either you make a translation gain or loss depending on the direction of FX rates.
If you borrow in foreign currency, what you are doing is actually setting up a natural hedge against the assets you are acquiring. What do i mean by that?
For example if you borrow in JPY and invest in JPY properties, in the event that SGD strengthens against JPY (1 SGD = 85 JPY), rental income from JPY properties are REDUCED when converted back to SGD, BUT at the same time your loan payable in JPY now requires lesser SGD cash outflow to repay back, thus making an exchange gain on the JPY loan borrowed.
Conversely, if SGD weakens against JPY (1 SGD = 80 JPY), rental income from JPY properties INCREASES when converted back to SGD but the JPY borrowings now require higher SGD cash outflow to repay back. As you can see, the foreign exchange effect on the loan would offset the foreign exchange on the rental income, thus setting up a natural hedge.
I would think most REITs Manager, being risk-averse, would choose the latter and borrow in foreign currency when investing in foreign properties because there is lower risk and its bottom line is subjected to less volatility from foreign exchange differences.
Bonds are borrowings with a contractual obligation to pay periodic interest payments (Coupons) until the maturity date where the capital (Principal) is also paid back. Very similar to Bank loans borrowings except that loans are usually borrowed from the banks while bonds are issued and sold to institutions or individuals like you and me. A famous example of REIT that loves to issue bonds is Capitalmall trust. It has done one in 2014 and Capitalland Retail China trust did another one again this year in 2018. Some examples of it can be found in the following links:
3. Convertible Bonds
Convertible Bonds are similar to Bonds EXCEPT that it can be converted into equity subsequently at a conversion price if the unit holder realizes the value and growth prospect of the REIT. Thus, it provides the guaranteed coupon payments of a bond and the option or flexibility to convert it into units and hold for the long term. While this is beneficial for the person buying Convertible Bonds, it is dangerous for EXISTING unitholders because now they face the risk of share dilution. This element of uncertainty is created as you can never know when the convertible bonds are being converted to equity at any point of time to dilute your shares. One example of a REIT that issued convertible bonds is Suntec REIT:
Suntec REIT issued convertible bonds in 2017 raising $300 million in capital with a interest payment of 1.75% to bond holders. The maturity date is 2024 and UP to 159,890,360 new units could potentially be issued if a full conversion takes place. The recent Q3 results showed that un-adjusted NAV is $2.082 (Calculated by taking net assets of $5,561 mil / 2,670,632,751 units). Assuming that everyone converts their bonds into units, the total number of units issued would increase by 159,890,360 and this would cause NAV per unit to be REDUCED from $2.082 to $1.965. Hence, as existing shareholders of Suntec, they face the risk of share dilution which could lead to decreased NAV and DPU PER unit.
But, the advantage of convertible bonds is interest rates are much LOWER as compared to regular retail bonds because it has the benefit of an embedded stock options. Suntec’s convertible bonds are only paying a mere interest of 1.75%, that is less than a 10-year Singapore Government Bonds or any fixed deposits. If the spread between the cap rate of the property and the cost of interest on convertible bond can make up for the loss from share dilution, then it might not be a bad idea after all, so it depends on the REIT management on how they efficient they use their debt to generate returns.
4. Medium-Term Notes (MTN)
Medium Term notes is a popular source of financing and most REITs in Singapore would have used MTNs in their debt financing one way or another. This form of financing allows a REIT to tailor its debt issuance to meet its financing needs continuously or intermittently and they can be offered under varying structures, currencies and maturity date. Unlike Bonds which are issued in one lump sum of cash amount at one go, MTNs can be issued as and when along the quarters, refinanced, pay off thus providing more flexibility to utilize capital. For example, MCT uses a mix of Bank loans and MTNs to finance its assets and operations.
In summary, we have covered the 4 main methods that a REIT would generally raise capital through debt-financing (Bank Loans, Bonds, Convertibles and Medium-Term Notes). Hence, in the future when you look at a REIT’s presentation slides of their debt maturity profile, you can better appreciate and understand what are the various kind of debt instruments they use, analyze it or question whether there are any encumbered assets / significant portion of convertibles etc. This is the end of REIT’s Financing Structure (Debt), do keep a lookout for my next post: Equity Financing in REITs.
Credits to Tam Ging Wien for sharing his insightful knowledge in REITs. You can learn more about REITs from www.ProButterfly.com, www.REITScreener.com and his best seller book REITs to Riches: Everything You Need To Know About Investing Profitably In REITs