Investing can be rewarding but can also cause a lot of pain. It was not too long ago that Manulife US Reit’s shareholders were informed on 2 Nov 2022 via the 3Q 2022 Operational Update and Briefing that as per GRESB 2022, the Reit is 5 Star with a score of 92, and ranked ‘A’, 1st out of 10 U.S. listed offices. See below.
Note: GRESB is an independent organization providing validated ESG performance data and peer benchmarks for investors and managers to improve business intelligence, industry engagement and decision-making.
The gearing though not fantastic (at 42.5%) was not near the 50% limit. In the 1H 2022 Corporate presentation on 10 Aug 2022, the gearing was at 42.4%. Comparing the 2 Nov 2022 announced gearing to the gearing announced on 10 Aug 2022, it was only a marginal 0.1% increase.
The next earnings report date for Manulife US Reit’s fourth quarter 2022 financial results will be in early Feb 2023, and shortly around the end of March 2023, Manulife US Reit shareholders will receive the dividend payout.
Frankly, the weakening of occupational performance in the office real estate submarkets in the U.S. is known to many and according to the management, occurring where MUST’s properties are located. Physical occupancy percentage has weakened considerably as many companies pivot to the remote working or hybrid working model in lieu of the in-person working model.
Personally it seems to be a structural decline that appears permanent.
However, on 30 Dec 2022, many of the shareholders were probably shocked when the manager of Manulife US REIT (MUST) announced that the real estate valuation of its portfolio has declined by 10.9% to US$1.95 billion ($2.62 billion) based on the year-end valuations for 2022. This is compared to the US$2.18 billion valuation as of Dec 31, 2021.
And its aggregate leverage will be approximately 49% (though still within the regulatory limit of 50%). This is taking into account additional borrowings, fair value changes in investment properties and certain projections in the value of other total assets from 30 June 2022 to 31 Dec 2022.
The announcement was released via their website in the Newsroom section (read here).
In short, gearing has suddenly shot up in less than 2 months (announcement dates). Flash back to 3Q 2022 update on 2 Nov 2022, the gearing only increased marginally by 0.1%.
At 49%, it is just a whisker shy of the Regulatory 50% limit. Too close for comfort.
Investing for yield
Personally, I think there are 2 kinds of dividend investing.
The first kind is often known as dividend growth investing. Typically we are willing to settle for average or below-average yields of 3% to 5% (maybe even 6%), however on the assumption that dividend payout will increase over time, often based on the past increasing dividend payouts through the years.
The other version is to invest in high-yield dividend stocks (eg. min 9% to 10%). In the book titled “The Income Factory – An Investor’s Guide to Consistent Lifetime Returns”, by Steven Bavaria. Steven termed this as the Income Factory.
To quote the book:
These are companies with little or no growth, however, the high yield would more than compensate for the investor’s required returns (percentage) per year. Assuming a 9% yield, by reinvesting the dividend, the income stream will double every 8 years. However, the caveat here is that there should not be an abrupt dividend cut and that the underlying company must survive.
Typically for me personally, I would view exceptionally high dividend yields as a warning sign (value trap) and stay away from it. However, some people may treat it as a turnaround play or net-net play (in theory it is not the same) and invest in it. Having said that, this is not distressed debt investing, which Howards Mark specialized in. Oaktree (co-founded by Howards Mark) is known for its strategy of investing in “good companies with bad balance sheets”. Shareholders being the lowest rung of the capital structure, bear losses first.
Prime US Reit
This brings me to Prime US Reit. Its current yield (on 7 Jan 2023) is at 18.11%! If it qualifies as an Income Factory stock, you can potentially double the income stream in less than 4 years!
See the below screenshot from StocksCafe.
Kore, Prime US Reit unlikely to hit gearing limit even as US office assets face waning valuations (read here)
To quote the above article (see below):
The current gearing ratio (on 7 Jan 2023) is 37.9%.
Prime US Reit made a tepid debut on the Singapore Exchange (SGX) on Friday 19 July 2019, closing at its initial public offering (IPO) price of US$0.88.
In recent years, the share price has been trending down. In fact, the price has gone below the low as seen on 3 April 2020.
For people interested in this high-yield play, there is a few critical pieces of information that I think they need to be aware of first.
1) Falling Occupancy
The portfolio occupancy as a whole has been steadily dropping since the onset of the pandemic. The actual physical occupancy rate of each building would be lower.
Some of the occupancies of Prime US Reit’s buildings are startlingly low. As at Sept 30, the occupancy of Reston Square in DC (Virginia) was 47.1%, Village Centre Station I (Denver) was 69.9% and Tower 1 at Emeryville near San Francisco was 77.1%; all three are below their sub-market average.
Although the WALE (Weighted Average Lease Expiry) is a healthy 4.1 years as reported on 29 Nov 2022 (see below). An anchor tenant that occupies large sections of a building can skew the WALE for the property either upwards or downwards, depending on how long a lease the tenant has agreed to.
In fact, if we look in detail, quite a number of the properties’ WALE is within 1 to 3 years, but these properties have less percentage contribution by Asset Carrying Value. Nevertheless, the clock is ticking fast.
WALE is measured across all tenants’ remaining leases in years and is weighted with either the tenant’s occupied area or the tenant’s income against the total combined area or income of the other tenants.
To quote this article: “Work From Home and the Office Real Estate Apocalypse” (read here), emphasis mine:
The Covid-19 pandemic led to drastic changes in where people work. Physical ofﬁce occupancy in the major ofﬁce markets of the U.S. fell from 95% at the end of February 2020 to 10% at the end of March 2020, and has remained depressed ever since, only gradually creeping back to 47% by November 2022. In the intervening period, work-from-home (WFH) practices have become more established, with many ﬁrms announcing permanent remote or hybrid work arrangements associated with shrinking physical footprints.
Nevertheless, Prime’s occupancy rate is still higher than the overall US office occupancy rate of 86%. And most of Prime’s tenants are legal and financial services, which tend to be more defensive at this point of the economic cycle.
2) Rising Gearing Ratio
Likewise, since the onset of the pandemic, the gearing ratio is been steadily climbing.
As reported in Nov 2022, the weighted average debt maturity was at 3.1 years.
To again quote this article when they modeled the Physical Occupancy, Contractual Occupancy, and Lease Expiration, emphasis mine:
These large drops in physical occupancy did not translate into large immediate drops in commercial ofﬁce cash ﬂows, as shown above. The reason for the delayed and gradual reaction is the staggered nature of commercial leases. Because most commercial leases are long-term, and not up for immediate renewal, only a fraction of ofﬁce tenants has had to make active choices about their future ofﬁce demand so far. Among all in-force leases as of the end of December 2019, only 38.23% came up for renewal in 2020 and 2021 combined. Nearly all of the tenants not up for renewal have continued to make rent payments, despite their lack of physical occupancy. When more leases come up for renewal in the future, the ofﬁce demand of tenants who have made limited use of ofﬁce space during the pandemic remains highly uncertain and is a crucial determinant of ofﬁce valuation.
So in other words, we have yet to see the full financial impact of this structural shift due to WFH practices, from the Reits’ financials.
It is like watching a giant oil tanker crash, you can anticipate the inevitable crash miles away yet subsequent actions will be futile.
3) Crunch time for DPU
Talking about tankers crashing.
While Prime’s debt is mostly “fixed”, and it has enough credit lines to refinance its debt, the issue is most of its debt is due in 2023 and 2024 which are the critical years when Fed rates could hit 4.5% or higher.
As reported in Nov 2022, Prime’s borrowing costs are only ~3% (the weighted average interest rate at 3.34%), the average cost that US property investors borrow to buy office properties. If rates remain elevated or go up much higher, Prime’s interest payments will spike and DPU will drop.
Yes, the dividend yield will likely remain high, probably due to the falling share price.
4) Properties in the hot zones
Ultimately a Reit is only as good as its properties. Ask any serious property investors and the three main important points are location, location, and location.
Let’s think back to what Manulife US Reit management stated in their announcement back on 30 Dec 2022 (when it was announced that gearing has risen to 49%) – see below:
Personally for me, as a foreign retail investor observing from far at the US Office real estate, I would be worried if some of these properties are in the ‘troubled’ areas. Especially when I see articles like the below mentioned:
Office Vacancies Keep Climbing as Recession Threat Looms (read here)
One-Third of San Francisco Offices Now Available for Lease (read here)
As per this article dated May 2022, due to various reasons, Houston, Dallas, San Francisco, Atlanta, Northern New Jersey, and Los Angeles are some of the cities with the highest office vacancy rates. See below.
According to its website, Prime US REIT owns a high-quality portfolio of 14 Class A freehold office properties which are strategically located in 13 key U.S. office markets. The buildings are found in the business district of key urban centers such as Washington DC, Atlanta, and Dallas.
By Asset valuation and percentage contribution by Asset carrying value, the top five properties are (see below):
1) 222 Main (13.7%)
2) 171 17th Street (12.4%)
3) Park Tower (9.5%)
4) Village Center Station II (9.3%)
5) Sorrento Towers (9.0%)
Many of its top 10 tenants are located in 222 Main, Sorrento Towers, and 171 17th Street, Park Tower. See below.
Now, where are these properties located?
1) 222 Main: 222 South Main Street, Salt Lake City, Utah 84101
2) 171 17th Street: 171 17th Street NW, Atlanta, Georgia 30363
3) Park Tower: 980 9th Street, Sacramento, California 95814
4) Village Center Station II: 6360 S. Fiddler’s Green Circle, Greenwood Village, Colorado 80111
5) Sorrento Towers; 5355 & 5375 Mira Sorrento Place, San Diego, California 92121
FYI, Sacramento and San Francisco are only 87 miles (140km) apart. San Diego Office market vacancy rates are also high.
Downtown San Diego’s Office Vacancy Expected To Remain Elevated (read here)
In gist, some of Prime’s top five properties are in the ‘hot’ zones where office market vacancy rates are elevated. The outlook is negative.
Nevertheless, for Park Tower, the top tenant is the State of California (Government), while 171 17th Street top tenants are in the legal services and financial services, which might provide some form of stability as compared to Tech firms (which are currently in the news for cutting headcounts in view of a slowing US economy and also holding back their expansion plans). However, whether there will be positive rental reversion rates moving forward, is another story.
Whether or not shareholders of Prime US Reit will be surprised (shocked) by unpleasant news (as in the case of Manulife US Reit), I do not know and can only guess.
However, from a dividend investing point of view, it is neither dividend growth investing nor high dividend / ‘Income factory’ type of investing, since dividend cuts seem inevitable. It may be a turn-around play, but things will probably get worse before turning around… not an easy counter to hold on to. To be frank, turnarounds (as optimistic as we are as stock investors) seldom happen.
Well, I may be wrong. Nevertheless, it pays to understand more about what we are investing in before investing or staying vested.
Prime US Reit’s Full Year Announcement Analysts, media, and investor briefings should be in Feb 2023. We shall know more then.
So what do you think? Will Prime US Reit be the Optimus Prime or Sentinel Prime?
Thank you for reading.
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