Can Manulife US REIT (MUST) BTOU 0.00% be saved? Marc Feliciano, Manulife Investment Management&rsquo s global head of real estate, private markets, believes it is &ldquo absolutely&rdquo possible. That sounds like good news to many MUST unitholders. However, it is a tall order for the manager and sponsor and will require a leap of faith.

 

As at Aug 16, MUST is trading at just 8.9 US cents (12.11 cents). Based on its 1.836 billion units in issue, this translates into a market capitalisation of just US$163.4 million. Although this is above the cash of US$133 million on its balance sheet, its current liabilities outweigh current assets by more than US$880 million as all MUST&rsquo s debt is deemed as current by its 12 lenders.

 

MUST&rsquo s latest 1HFY2023 ended June financial statement states that due to the reclassification of loans and borrowings into current liabilities as a result of a breach of a financial covenant, the manager is not in a position to declare any distribution for the half-year.

 

Analysts suggest that MUST should divest assets and raise equity to recapitalise. In July, Tripp Gantt, CEO of MUST&rsquo s manager, said MUST has three options to resolve its financial covenant breach. These were dispositions of assets, equity fundraising (EFR) or refinancing, which the sponsor is exploring.

 

At its current unit price, it does not make sense for MUST to raise equity through either a rights issue or a preferential equity fund raising exercise. Its market cap is just US$30 million more than the restricted cash on the balance sheet, which implies that the buildings are worth just US$30 million but this is not the case.

 

During MUST&rsquo s results briefing on Aug 14, Gantt said the divestment mandate would be packaged together in an EGM &ldquo with whatever form of sponsor support that we&rsquo ve discussed, whether it&rsquo s a transaction of Phipps or another method of sponsor support&rdquo .

 

Sale of Phipps ready for execution

 

On May 24, MUST&rsquo s manager announced the proposed sale of Phipps, a Class A office building in Atlanta, Georgia, to its sponsor at the average of two independent valuations commissioned by the manager and MUST&rsquo s trustee, and subject to unitholder approval in an EGM.

 

Phipps&rsquo valuation as at June 30 is US$178.15 million, down 15.2% from its valuation of US$210 million at December 31, 2022. In 2018, MUST acquired Phipps from the sponsor for US$205 million.

 

&ldquo In late May, there was an announcement that the sponsor would purchase Phipps and that remains on the table and ready to execute,&rdquo says Feliciano.

 

&ldquo But I also want to add the caveat that there are two new important data points that I think any rational manager or sponsor would have to take into account,&rdquo he adds.

 

&ldquo There has been a 15% drop in property valuation since then that has caused a breach of the unencumbered aggregate leverage.&rdquo

 

Indeed, since the May 24 announcement, a couple of new challenges have emerged due to the drop in the valuation of MUST&rsquo s portfolio. In addition to the breach in MUST&rsquo s financial covenant, the drop in valuation will exacerbate MUST&rsquo s debt problems.

 

According to MUST&rsquo s debt expiry profile, a revolving credit facility (RCF) of US$39.7 million can be rolled over till August 2024, US$143 million matures in 2024 and a further US$285 million matures in 2025.

 

Since Phipps was revalued at US$178 million, its sponsor can only buy it back at not less than the lower of the two independent valuations since this would be an interested or related party transaction according to the code on collective investment schemes (CIS).

 

Thus, a sale of Phipps would only be a &ldquo band-aid&rdquo for MUST in 2024, leaving no extra money for capex or tenant incentives. This means MUST&rsquo s manager would find it difficult to sign on new tenants.

 

&ldquo When you look at what the sponsor did earlier in the year, which was the purchase of Tanasbourne, that was not enough,&rdquo Feliciano points out.

 

In April, MUST completed the sale of Tanasbourne to the sponsor for US$33.5 million. This was one of the three campus-like properties acquired in December 2021 that sent MUST over the proverbial tipping point.

 

However, its sale did not dent the scale of MUST&rsquo s debt expiries and the sponsor feels that the sale of Phipps is not sufficient to solve MUST&rsquo s problems too.

 

Sponsor should provide financing

 

&ldquo To be very comprehensive, the sponsor and management need to reflect on the debt maturities in 2024 and 2025,&rdquo Feliciano explains. &ldquo What the sponsor did was take a step back without taking the Phipps purchase off the table and asked Is that enough given the current situation.&ldquo

 

Indeed, MUST requires a plan that takes into account the debt maturities for the next two years. Feliciano explains: &ldquo What the sponsor would like to do with the lenders is to generate a financing alternative and maximise the runway with whatever gets the longest runway, whether it&rsquo s Phipps or through a refinancing approach.&rdquo

 

&ldquo The financing alternative is to maximise the runway for as long as possible so the S-REIT can clear debt maturities through to the first half of 2025,&rdquo he emphasises.

 

The refinancing approach is to provide MUST with sufficient credit to cover the expiries up to June 30, 2025. That is likely to work out to be US$330 million to US$350 million for the sponsor (inclusive of Phipps). This would take care of the US$39.7 million RCF, and US$143 million expiries in 2024, and expiries of between US$150 million and US$170 million due in the first half of 2025.

 

&ldquo The S-REIT needs some of the Phipps proceeds for capex and tenant incentives (TI). The $178 million won&rsquo t even deal with all the debt maturities in 2024,&rdquo Feliciano says.

 

In the US, landlords have capex needs to keep their properties up-to-date with amenities, green features and additional areas for employees to relax in.

 

&ldquo TI allowance is the money that you give to a tenant to fit out their space,&rdquo Gantt said during the media and analysts briefing on Aug 14.

 

As an example, Patrick Browne, chief investment officer of MUST&rsquo s manager, reveals that the manager is in negotiations with a large tenant who is thinking about occupying a space at 500 Plaza in Secaucus which is larger than what former anchor tenant The Children&rsquo s Place had occupied. Such a tenant would ask for TI.

 

This means whatever plan MUST&rsquo s manager and its sponsor agree on would require funds over and above that generated by the sale of Phipps.

 

Both plans have merit

 

Still, Feliciano insists the sponsor is &ldquo willing to move forward with a purchase of Phipps in conjunction with an agreement with lenders on a plan that deals with maturities in 2024 and 2025 and a longer-term agreement regarding potential breaches due to property valuations&rdquo .

 

Ideally, the best would be a combination of the two plans, an analyst The Edge spoke to says.

 

&ldquo Phipps takes care of the short-term and could put a floor to the behaviour of the unit price,&rdquo adds the analyst who declined to be named.

 

Feliciano points out: &ldquo Realistically, the market might react better if we purchase Phipps,&rdquo he says.

 

While credit financing could get MUST past the expiries, it may not do much to reduce its high gearing level. However, if the cost of the credit is at market value, the interest coverage ratio (ICR) which stands at 2.6x would suffer.

 

On the other hand, a sale of Phipps alleviates the immediate gearing issue but not sufficiently. A combination would raise sufficient cash to keep the REIT&rsquo s best properties in good shape and get the REIT past the debt expiries, the analyst adds.

 

Feliciano agrees, &ldquo The management team needs to put out a capital strategy, cashflow strategy and portfolio strategy. It means selectively picking which assets to spend your capital based on cash flow strategy, where you should reinvest through capex to maximise asset value, and which assets you feel you shouldn&rsquo t spend that capital on, and sell those assets.&rdquo

 

Office sector to trough in 2025

 

Indeed, the post-pandemic office property cycle has been brutal for MUST and there are little signs of the situation abating.

 

Various US office benchmarks like the NCREIT Office subindex continue to deteriorate in 2Q2023, declining 18.4% y-o-y. The NCREIT Office subindex is appraisal-based and does not take into account transactions.

 

During the global financial crisis, the NCREIT index&rsquo s peak was in 2Q2008 and its bottom in 2Q2010 with a 31% decline for office, compared to &ndash 18.4% currently. Feliciano believes that the office cycle decline started in 1Q2022. However, instead of a two-year decline, the decline could persist for three years as workers continue to work from home. As such, the trough could be sometime in 2025.

 

&ldquo What provides the greatest certainty? Refinancing that clears all the debt maturities through the first half of 2025 or sell Phipps to the sponsor, which only deals with the 2024 maturities?&rdquo Feliciano wonders.

 

Adds Feliciano: &ldquo Which option we go with will be conditional on what we can reach with the lenders. I want to create the longest runway and we&rsquo re indifferent to whether it is Phipps or alternative financial debt.&rdquo Or a combination of both.

 

In a recent discussion on the outlook on the US office sector, a JLL consultant said &ldquo REITs with a majority of investments in East Coast gateway markets are seeing leasing volume grow&rdquo .

 

Of the groups with a majority of holdings in East Coast gateway, JLL says &ldquo SL Green, Vornado, COPT, Brandywine, Empire State, Paramount saw 77% q-o-q growth in leasing volume&rdquo .

 

Interestingly, rents at Hudson Yards are reportedly higher than pre-Covid levels and MUST&rsquo s Exchange, a 30-storey Class A office building located along the Hudson River in Jersey City, is just a Path stop away from Hudson Yards.

 

Finding the best solution

 

Feliciano says: &ldquo Whether it&rsquo s Phipps or the financing approach that clears off the debt maturities and provides the right amount of capital for capex reinvestment into the right properties, that&rsquo s what we need the management team to put together.&rdquo

 

However, time is of the essence as a solution is needed before the end of the year.

 

&ldquo We would like to get some resolutions with lenders in the next couple of months and before the year-end, the management will put it to the unitholders. We would like to have a resolution in an EGM and unitholders will decide,&rdquo says Feliciano.

 

&ldquo The sponsor is committed to helping the manager to steer through the current challenges. It&rsquo s never wavered from its commitment. Before you can create unitholder value, you have to stabilise unitholder value and deal with the lenders first. They have all the control because of debt covenants,&rdquo he adds.

 

Manulife US REIT (MUST) BTOU 0.00% is focusing on improving its liquidity position, say CGS-CIMB Research analysts Lock Mun Yee and Natalie Ong.

 

The REIT&rsquo s manager announced at its results briefing on Aug 14 that it is halting distributions for 1HFY2023 ended June, after breaching its unencumbered gearing ratio based on financial covenants. The REIT&rsquo s ratio reached 60.2% at end-1HFY2023, but shrunk slightly to 59.7% in August upon making a &ldquo good faith repayment&rdquo .

 

As a result of the breach, all MUST&rsquo s loans have been reclassified as current liabilities as its lenders are contractually entitled to demand for immediate repayment of the outstanding amounts.

 

MUST indicated it remains focused on negotiations with lenders to lower its unencumbered gearing ratio to below 60%, formulate long-term liquidity plans such as the divestment of Phipps, pursuing a mandate to divest assets to reduce its debts and for capex and undertaking a strategic review of the REIT.

 

This includes discussions with several US and Asia-Pacific-based groups that are exploring asset acquisitions, capital injection and strategic transactions around the REIT platform. &ldquo We believe until there is more visibility on MUST&rsquo s negotiations for a waiver of its financial covenants, its share price could likely remain under pressure,&rdquo write Lock and Ong.

 

In an Aug 15 note, the CGS-CIMB analysts maintain &ldquo add&rdquo on MUST but with a lower target price of 25 US cents (33.96 cents), down from 41 US cents previously.

 

MUST reported 1HFY2023 gross revenue of US$99.6 million, down 0.8% y-o-y. Distributable income fell 17.4% y-o-y to US$37.9 million, due to higher property operating expenses, increased finance expenses and divestment of Tanasbourne in April, though partly offset by higher termination fee and carpark income.

 

Portfolio occupancy, meanwhile, dropped 1 percentage point q-o-q to 85.1% at end-2QFY2023 due to non-renewals of some leases at Diablo and Capitol.

 

MUST leased/renewed 443,000 sq ft of space in 1HFY2023, and executed another 20,000 sq ft of leases after June, including an expansion at Michelson, a renewal at Peachtree and two new leases at Phipps and Capitol.

 

Demand came from finance and insurance, legal, retail trade and information sectors.

 

Overall, MUST posted a positive 3.7% rent reversion in 1HFY2023, though this was negative 2.5% in 2QFY2023.

 

MUST has a balance of 6.2% and 13.5% of leases expiring in 2HFY2023 and FY2024. According to property consultant Jones Lang Lasalle, leasing volumes in MUST&rsquo s submarkets continue to be weak although lease terms are stable and occurrence of tenant concession packages appears to be moderating.

 

Lock and Ong are keeping their distributions per unit (DPU) forecasts at 3.9 US cents for FY2023 and FY2024 and 3.8 US cents in FY2025.

 

They lift cost of equity assumptions to 17.5% from 11.5% to factor in greater uncertainty over its FY2023 dividend payment and financial uncertainties.

 

&ldquo While the outcome of its negotiations with its lenders remains a near-term overhang on its share price, we believe current valuation of 0.23x FY2023 price-to-book ratio (P/BV) has factored in much of its operational and financial challenges,&rdquo write the CGS-CIMB analysts.

 

They are keeping a lookout for a quick conclusion to MUST&rsquo s negotiations with its lenders and a swift recovery of the US office transactions market. However, they also warn of slower-than-expected backfilling of vacated spaces impacting its near-term income visibility, and a protracted slowdown in the US economy, which could dampen appetite for MUST&rsquo s office space.