Keppel Pacific Oak US REIT (SGX: CMOU), or KORE, is facing a tough time.
The US office REIT just announced that distributions will be suspended for two years as it works on a recapitalisation plan.
KORE’s unit price promptly plunged by 40% when the news broke, taking its year-to-date decline to close to 63%.
With pessimism swirling around the troubled REIT, should investors sell the stock?
A mixed financial performance
KORE reported a mixed set of financial results for 2023.
Gross revenue inched up 1.9% year on year to US$150.8 million with net property income rising 2.2% year on year to US$86.1 million.
Distributable income, however, fell by 13.8% year on year to US$52.2 million.
The drop was mainly due to higher financing costs in line with overall higher interest rates.
US office space also requires a substantial amount of capital to build out and lease because the landlords, rather than tenants, are responsible for funding tenant improvements, leasing commissions, and other costs.
If KORE does not do so, it will compromise the REIT’s ability to retain tenants and attract new ones, thereby negatively impacting its overall occupancy rate and disrupting the flow of rental income.
Should this happen, KORE’s portfolio valuation will plunge while its aggregate leverage will rise in tandem.
A fall in valuation accompanied by higher gearing
Speaking of valuation, KORE’s portfolio saw a 6.8% year-on-year fall in valuation from US$1.42 billion to US$1.33 billion.
The REIT’s gearing level stood at 43.2% as of 31 December 2023, an increase of 4.1 percentage points from 39.1% as of 30 September 2023.
KORE’s all-in average cost of debt is also creeping up, going from 4.06% to 4.12% over the same period.
The need for recapitalisation
According to KORE’s manager, lenders remain concerned about the state of the US commercial market and are reluctant to lend above 45% leverage.
With necessary capital investments to maintain its portfolio, it is not feasible for the REIT to continue drawing on debt as it may trigger a bank covenant breach and result in the inability to refinance its loans.
Several options, such as divestments or equity fundraising (EFR), were considered to strengthen the REIT’s balance sheet.
The problem with divestments in such a challenging environment is that KORE’s properties will fetch unfavourable prices.
An EFR will also not solve KORE’s leverage concerns on a long-term basis with the REIT possibly needing to tap on unitholders again soon.
The REIT’s trust deed stipulates either a 10% or 100% reduction in distributions but a 10% reduction is not feasible as it will be more than the profits recognised by the REIT.
Hence, the only other option is to suspend distributions to conserve cash.
KORE will suspend distributions starting from the second half of 2023 (2H 2023) all through the 2H 2025 distribution.
This option will help the REIT retain sufficient capital to strengthen its balance sheet, spend on necessary investments to retain tenants, and keep its gearing below the 45% threshold to avoid breaching any bank debt covenants.
It will also allow KORE to avoid selling its properties at distressed prices and refinance the loans that are due to mature in 2024 and 2025.
Should market conditions allow, distributions may re-commence at an earlier date.
A beleaguered US commercial real estate market
Investors should also note that the US commercial real estate market is facing a tough time.
With deal flow starting to pick up, it is becoming clear just how far real estate prices have fallen.
Some examples include debt marked down by 50% on a Blackstone-owned office building in Manhattan and a prime office tower in Los Angeles being sold at a 45% haircut to its cost a decade ago.
This problem was caused by the pandemic which led to reduced office demand and is being exacerbated by higher borrowing costs.
San Francisco had the highest vacancy rates among the US states at 37% for the fourth quarter of 2023 while in New York, around 20% of its office stock is available for rent.
The double whammy of lower occupancy and surging interest rates will put further pressure on landlords and the banks that lend to them.
This cascade of problems will depress office values further and lead to more foreclosures in the coming months.
Get Smart: Problems may persist
The problems in the US commercial property market may persist and cannot be solved easily or quickly.
KORE’s two-year distribution suspension indicates how long the manager believes the stress will last.
Income investors favour REITs because of their reliable distributions.
As KORE will be suspending distributions for two years and with the near-term outlook being murky, income investors may need to reassess their options and redeploy their capital to other REITs if necessary.
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Disclosure: Royston Yang does not own shares in any of the companies mentioned.
