Did Keppel Pacific Oak US REIT Tried To Kill An Ant With A Sledgehammer?

During its 4Q2023 results release, the Manager of Keppel Pacific Oak US REIT (‘KORE’) announced that it was voluntarily suspending dividends for 2 years as part of its recapitalisation plans. This came after it had requested to postpone the scheduled results announcement date. Both news came out of the blue and sent shockwaves to the investing community in Singapore. The damage was brutal as its unit price dropped an alarming > 60% (from USD 0.32 to USD 0.126) since these events. After studying its recapitalisation plan, I am left wondering if the Manager of Keppel Pacific Oak US REIT (SGX: CMOU) decided to kill an ant with a sledgehammer?

Why Was It Shocking?

As recent as Oct 2023 in its Presentation slides for a forum hosted by REITAS, nothing in the content indicated that a doomsday scenario was fast approaching. Instead, choice words such as “ample headroom” and factual statements such as “portfolio valuation need to fall by 23% to reach the 50% leverage limit” were expressed as shown in Diagram 1. Fair to say that anyone reading such materials would not have foreseen what’s to come just 3 months later.

Even during AGM, the Board expressed confidence that it does not expect to “approach the leverage limit”. A reading of the minutes of the AGM suggested that unitholders were generally satisfied with the performance of the Manager and cognisant that the macro-economic environment was not rosy. Multiple assurances were given such as the one highlighted in Diagram 2.

Heading into the start of 2024, the share price was doing well as it rebounded to USD 0.36 over the past quarter. The mood and outlook was one of optimism. Even various analyst reports were touting target prices in the range of US$0.48- US$0.56 before 4Q2023 results date. Hence, when those announcements were made, they caught many retail unitholders off-guard and a quick fall from grace ensued. It was a bloodbath.

I am curious to learn if the scale of the problems at hand necessitate such a strident measure that is usually reserved for the worst-case scenario?

Is The Enemy An Ant or A Giant Foe?

In its year-end results announcement, the Manager revealed that the portfolio valuation declined 6.8% and this has already factored in the US$45 million (3% of AUM) incurred as capital expenditure. As a result, its aggregate leverage increased to 43.2% and that is the source of the problem at hand.

43% leverage is still a comfortable distance away from 50%

With an aggregate leverage of 43%, it is still a reasonable distance away from the 50% limit set by MAS and its lenders. Valuation would have to fall by an approximately USD 126 million or a further 14.3% to breach this limit. Is that likely to happen in the next few years? Let us gaze into a crystal ball.

As I have explained in my article on REITs, leverage is defined by dividing total debt over total assets. Debt is a known quantity and Diagram 4 illustrates KORE’s debt maturity profile as well as its overall financial position.

a) No issue with 2024 term loan

The facility that is closest to being due will be in 4Q 2024 at an estimated quantum of US$75 million. At that point, it is very unlikely that it will not be rolled over as its aggregate leverage will be unchanged until the next year-end valuation exercise is concluded. Even then, with a combination of internal cash, future operating cashflow and its revolving credit facilities, it should be able to pay off this term loan if required. Therefore, no refinancing risks till end of 2024.

In my opinion, the uncertainty lies in the facilities that need to be rolled over in 2025. This is when the Manager indicated in its recapitalisation plan that banks “are reluctant to lend above 45% leverage for the U.S. market”. Will KORE ever get there? It is possible but unlikely in my opinion and here’s why.

b) Valuation unlikely to decline significantly in 2024

Broadly speaking, valuation is affected by the underlying portfolio performance as well as macro-economic environment. The discount rate to be applied to future cashflows is indirectly linked to the risk-free rate, i.e. Federal interest rate. KORE’s portfolio performance is stable and has outperformed its peers as well as the broader market as shown in Diagram 5. The Manager went on to add that it “does not foresee major decline in occupancy in the near term.”

The other variable to check is the discount rate to be applied. It is well documented that the Fed would start tapering in 2024, it is a matter of when and not would. This is also the view that the Board held last year.

Interestingly, the CEO revealed in a recent SIAS corporate connect seminar that a 125 bps decline in Fed lending rate may only translate to a 25 bps compression in the discount rate. While I am not here to speculate the extent of the Fed tapering in 2024, the discount rate is likely to be the same or decline (which would be for the betterment of the REIT). When you combine the outlook for both variables, I am led to believe that valuation at end 2024 is likely to remain stable and unlikely to experience the catastrophic decline of 14% required to breach the limit.

On a side note, valuation was also a topic heavily discussed when I attended Fifth Person’s Dividend Machines when the demands of the paymaster are weighed against the professionalism of the valuers.

My assessment is that it would have no issue refinancing the 2024 debt facility and the aggregate limit would not be breached. Therefore, the immediate problem staring down the entire year of 2024 is not insurmountable.

However, if the leverage threshold is 45%, which has been the focus of the recapitalisation plans, then the problem indeed metamorphosed into a giant foe. Yet, if 45% has always been the threshold that the Manager benchmarks its capital management metric against, then why was it never expressed explicitly in any of its investor relations materials previously (see Diagram 1)? I wonder if it was only being bandied now to impress upon unitholders the magnitude of the problem is commensurate with the measure that the Manager have taken?

More Appropriate Solutions

As a REIT, distributions to unitholders (DPU) forms the very basis of its existence as a business model. It is like a scared cow that should not be slaughtered but it has unfortunately come to that end for KORE’s unitholders. Perhaps, other solutions, particularly those of a cash-conservation nature, should have been explored in tandem.

A) Slash Directors Fee and Senior Management Salaries

During a crisis, it is not uncommon for Directors to forgo their fees while Senior Management of the team have their salaries slashed to share in the pain of unitholders. This can be done by electing to waive certain components of the Manager’s fee payable by the REIT.

The amount saved is not huge (maybe just a million, more if bonuses of other staff are involved) but the gesture of solidarity would have spoken volumes.

B) Withhold 10% of Distributable Income From 2020 onwards

I say this with the benefit of hindsight but surely the Manager is well aware that the perpetual cycle of tapping the debt market to fund annual capex is unsustainable in itself. Therefore, the Manager should have acted more responsibly and started withholding 10% of the distributable income a few years after its IPO. This would have amounted to an average of USD 6 million per annum, financing 25% of the capex budget in 2021 and 2022.

Admittedly, the share price might have declined if such as measure was first introduced, However, I am confident that any decline is unlikely to be on the same scale as we are witnessing today. Furthermore, once the act of withholding 10% of distributable income happens, unitholders would be conditioned to it thereafter.

C) Sponsor support

In the unlikely scenario that any immediate debt is not rolled over, the sponsors could have stepped in to offer corporate guarantees to provide the assurances. The likes of Keppel and KORE are credible and reputable fund managers and few banks would want to run the risk of ruffling their feathers.

Conclusion

After my review and analysis, I still feel that more appropriate solutions could have been explored in 2024 before the decision to suspend distributions. There is no need to use a sledgehammer to kill a bull dog ant. Afterall, an outright suspension of dividends is a very bitter pill for KORE’s unitholders to swallow. It is not an overstatement that it is potentially the lifeblood for some as they could be retirees who depend on these payouts to fund their daily expenses.

What I am more worried is the continuous requirement for KORE to spend on defensive capex and maintain the attractiveness of its aged buildings. For FY2023, that has amounted to over 80% of distributable income and I wonder if this is sustainable in the long run.

This article is published on 3 Mar 2024.

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