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NRA Capital Pte Ltd

Written by: NRA Team

Tuesday 7 Jul 2015

MAS Announces new guidelines for the Singapore REIT sector

Changes offer greater flexibility for REIT operators

Adoption of a unified gearing cap unlikely to result in accretive acquisitions given interest rate concerns

The Monetary Authority of Singapore (MAS) on the 2nd of July announced a slew of changes to strengthen the REIT market in response to industry feedback. The changes are:

1.       Strengthening corporate governance

2.       Alignment of incentives

3.       Allow greater operational flexibility

Details on the changes implemented by MAS can be found here. Of these three categories of changes, the most important set investors should take note of are those covered under the increase in operational flexibility. The two points of note in that section are:

1)      Adopting a single-tier leverage limit of 45%, as opposed to the current upper tier limit of 60% for REITs with credit ratings and 35% for those without,

2)      Increasing the development limit, whereby a REIT can undertake development activities on up to 25% of its deposited property, compared with the current 10% limit. The additional 15% must be used solely for the redevelopment of an existing property that has been held by the REIT for at least 3 years and which the REIT will continue to hold for at least 3 years after the redevelopment. Redevelopment in this scenario refers to works that have the same meaning as “building works” as defined under section 2(1) of the Building Control Act (Cap.29), with the exception of air conditioning works or other development works that do not affect the earnings ability of the asset being developed.

Between the two factors, the adoption of a single-tier leverage limit of 45% is going to have the more immediate effect on Singapore REITs.

Effect of debt cap increases

The theoretical advantage of increasing the debt cap is that it allows a REIT to increase its asset base without the dilutive effect that would occur as a result of issuing new units. The old regulations that segregated the market into credit rated versus nonrated REITs and having different caps of borrowings was to allow better rated companies to expand their asset base significantly.

In practice, the debt caps have little actual effect on the actual amount of debt that the REITs have on their balance sheets. According to Moody’s, all the S-REITs that they have rated are well below even the 45% gearing limit as of 30th June, much less the 60% limit they were theoretically allowed to borrow up to. This is indicative of the degree of discretion REIT managers are employing when considering their debt servicing ability and a lack of accretive properties available for acquisition.

source: Bloomberg

The primary advantage of obtaining credit ratings is allow REITs to have better financing options, either through having preferential rates or being allowed to access lending institutions whose mandates require that borrowers have a credit rating before any debt can be issued. In both cases, the primary advantage of the credit rating would be to reduce its interest rate liability, as opposed to allowing the REIT to load up on more debt for acquisitions.

Interest rate sensitivity:

This brings us to the more relevant point about an increase in the debt cap: the effect of rising interest rates on gearing. Property asset values are calculated based on the total income derived from the rental of said properties, which means that rising interest rate and total debt costs will affect gearing ratios by lowering the asset value if rental yield increases do not keep pace with the increase in interest costs. This will lead to the gearing ratio increasing for the REIT, even if there is no increase in net borrowings.

Given that interest rates globally have been increasing, we find it likely that property revaluations and interest rate expenses are a large concern for REITs with non-accretive properties within their portfolios. As such, we find it likely that the increase in gearing caps is more in the interest of allowing unrated REITs whose borrowings are close to or at the 35% limit currently to prevent themselves from being in breach of MAS regulations in the event of an increase in interest rates.

Conclusion

The increase in financial flexibility by having higher gearing caps is by no means an unwelcome development. However, the net benefit that REITs can enjoy from having this increase is minimal in the short to medium term due to a lack of opportunities for accretive acquisitions, and the prevailing outlook that indicates interest rates are likely to rise will increase interest expenses and can lead to a squeezing of asset values down the line.

On balance it can be read that the changes in the regulatory requirements are there to set the boundaries for a new normal wherein interest rates rise above the sub 0.2% overnight rate that prevailed from 2011 till 2014. Rising interest rates will squeeze the gearing for unrated companies operating close to their current gearing limits, and the lifting of the gearing cap to 45% allows companies financial flexibility to move on more.

With no companies having more than 45% gearing currently, there is no environment for accelerated debt repayments by rated REITs that have a 60% gearing allowance. Conversely, unrated REITs operating at 35% gearing which subsequently announce an intention to increase their gearing by acquiring new assets should be viewed at cautiously by investors, as the financial expense liability may render new acquisitions non-accretive. 


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