Unfortunately the answer is Yes, albeit with consequences.
A REIT is a structure that has been accorded certain tax benefits. But inherently, a REIT is still a company that owns properties. It generates income and pays expenses just like any other company. It also has to pay tax unless it can qualify for tax transparency status.
A REIT needs to distribute at least 90% of its income in the same year in which the income is derived to qualify for tax transparency status.
REITs that distribute less than 90% of their income will lose their tax transparency status. This means that they will be taxed on the entirety of their income. Singapore’s corporate income tax is 17%.
Why do REIT investors think S-REITs must distribute dividends?
Investors think that S-REITs must distribute dividends because a REIT needs to qualify for tax transparency status, for the REIT status to make sense. That is why a REIT will endeavour to distribute at least 90% of their income so as to make sense!
However, this does not mean that the distribution is enshrined in law. This is not the case!
Additionally, many investors think the gearing ratio limit of 50% is an unbreachable line in the sand.
The Property Fund Appendix (PFA) in the Code on Collective Investment Schemes (CCIS) does state that the total borrowings should not exceed 50% of the property value.
However, the gearing ratio limit is not considered breached if the following occurs due to circumstances beyond the control of the REIT:
a) a depreciation in the asset value of the property fund; or
b) any redemption of units or payments made from the property fund.
This just means that the REIT cannot, by their own doing, exceed the gearing ratio limit of 50%. However, if a depreciation in asset value happens, reduction in equity is mandated or mandatory payments arising from expenses previously entered into are made from the REIT, these events can lead to the REIT exceeding the gearing ratio limit without breaching the PFA.
In the limit is exceeded as a result of (a) or (b), the REIT should not incur additional borrowings or enter into further deferred payment arrangements.
Additionally, refinancing of existing borrowings is not construed as incurring additional borrowings. A REIT may raise debt for refinancing purposes, provided that the funds are set aside solely for the purpose of repaying the maturing borrowing. The REIT must place these funds in a separate trust account which shall be drawn on only to repay the maturing borrowing.
This means that the REIT can still refinance existing borrowings without going into default or breaching covenants with the existing banks.
However, if a bank knows that the REIT cannot raise any additional borrowings and can only refinance existing borrowings, the bank will likely be very careful before providing the REIT with funds to refinance the existing borrowings.
Who has withheld dividends?
1) Manulife REIT – breach of covenant
The distributions was halted due to the following 2 reasons:
(i) the breach of a financial covenant in some of MUST’s financing documents relating to the ratio of consolidated total unencumbered debt to consolidated total unencumbered assets, resulting in all of the REIT’s loans reclassified as current liabilities, and
(ii) the fact that the REIT would not be able to certify that it is satisfied on reasonable grounds that, immediately after making the distribution, MUST will be able to fulfil its liabilities as they fall due
2) Keppel Pacific Oak US REIT (KORE) – premature suspension
KORE’s aggregate leverage increased to 43.2% as at 31 December 2023. The 50% aggregate leverage limit applies if KORE has an adjusted interest coverage ratio of a minimum of 2.5 times, lenders are generally unwilling to extend loan facilities to KORE for the US market if KORE’s aggregate leverage exceeds 45%.
Given the aggregate leverage limits and adjusted interest coverage ratio, the REIT believes that funding future capital investments to maintain its property via debt is not sustainable for KORE and it is necessary to recapitalise KORE’s balance sheet.
There were 3 options being considered by KORE – divestments, equity fund raising (EFR) and a reduction in distribution to unitholders. The first two options were not deemed by KORE to be suitable, and KORE determined that it is in the best interest to suspend distributions beginning 2H2023 and expects the period of suspension will be through to 2H2025 in respect of distributions that would otherwise be paid in first half of 2026.
KORE believes that this option is expected to provide significantly more capital for KORE over the next two years compared to the capital that an EFR can raise in the current market condition.
3) Prime US REIT – distributing a mere 10%
With capital preservation being a key component to the REIT’s deleveraging strategy, Prime made the decision to announce a distribution of approximately 10% of the distributable income for 2H 2023. This is to balance the objectives to preserve a substantial proportion of distributable income to meet Prime’s capex needs and provide creditors with the assurance that Prime will reinvest cash flows in the business alongside its lenders.
Takeway Lesson #1 – A REIT is not a group of property.
Repeat after us (a 100 times) – a REIT is not a group of property.
Financial bloggers have been saying that buying a REIT is better than buying a property because a REIT is a group of properties.
Yes, it is true that the risk of rental collection reduces as the portfolio of assets becomes diversified.
However, a REIT is a leveraged vehicle with different requirements. There are also bank covenants as well as unique contractual arrangements between the owner of the property and the manager of the property.
For example, a hotel or hospital asset tends to guarantee a minimum fixed rent from the management to the landlord, however, should vacancy or utilisation plumet and the situation changes permanently, do you think the management would be in a position to fulfil the contract? Would the management not seek to void or restructure the contract to more palatable terms?
In 2020, First REIT restructured the master lease agreements (MLAs) of its 11 Indonesian hospital assets leased to former parent company Lippo Karawaci (LPKR).
This was because the pandemic severely affected the hospitals who saw revenue and profits decline as a result of lower inpatient traffic. Additionally, the Indonesian Rupiah depreciated against the Singapore Dollar by approximately 44.8% since the IPO of First REIT which put pressure on LPKR as rent payments under the existing LPKR MLAs have to be made in SGD.
Takeaway Lesson #2 – A REIT has no reserve
Repeat after us (a 1000 times) – a REIT has no reserve.
If a REIT distributes 100% of its income, the only way it can grow its equity base is via equity fund raisings or a gain in valuation.
In a positive environment, a valuation gain, which may arise either from higher rental income or lower capitalisation rate, would decrease the gearing of a REIT as the REIT’s property value increases while the loan remains the same.
A REIT would then be able to borrow more money, which can be used for further capital distribution to unitholders or use the funds to enhance the properties, through initiatives such as asset enhancement initiatives.
However, in a negative environment, should the valuation decline, the REIT would see its gearing increase when the loan remains the same. In such a situation, the REIT is forced to either carry out an equity fund raising or sell assets to repay loan.
To avoid falling into such traps, join Chris as he shares how he uses a simple strategy to identify the best REITs for stable dividend income.
We spotted these 3 REITs back in July 2023 – Manulife US REIT, Prime US REIT, Keppel Pac Oak US REIT – Buy, Hold, or Sell?
Alvin has also cautioned readers against overseas REITs back in April 2023 – Are Overseas REITs worth the risk? Mostly no.