• FIRT will be re-positioned to identify more strongly with the new co-Sponsor, OUELH.
• No compromise on paying distributions to unitholders, against the backdrop of extended receivables days.
• Price overhang as fund-raising is likely in the near-horizon in order to execute portfolio diversification strategy of acquiring from new co-Sponsor, OUELH.
• De-rating catalyst: expiring leases likely to be re-negotiated with a lower quantum and/or on IDR-denominated terms (currently on SGD-denominated terms).
• Maintain Neutral; new target price of $0.88 (previously $1.30).

What is the news?

The Manager of First REIT (FIRT) hosted a briefing in Dec 2018 to provide updates on 1) the REIT’s new co-Sponsor, OUE Lippo Healthcare Limited (OUELH), 2) receivables collection and 3) portfolio rebalancing strategy. In Oct 2018, OUELH and OUE Ltd acquired 40% and 60% respectively of the Manager of FIRT, Bowsprit Capital Corporation Limited (Bowsprit). OUELH and PT Lippo Karawaci (LPKR) each hold approximately 10.6% of FIRT. In Nov 2018, LPKR announced its intention to divest its remaining stake in FIRT.

Key takeaways

• Re-alignment of partnership with co-Sponsor, OUE Lippo Healthcare. The Manager explained that the REIT now has two co-Sponsors, namely, LPKR and OUELH. FIRT will be re-positioned to identify more strongly with the new co-Sponsor, OUELH.
• No compromise on paying distributions to unitholders, against the backdrop of extended receivables days. The Manager was resolute that distributions to unitholders would be declared and paid accordingly. There will not be any compromise to cut distributions. If necessary, short-term loan would be used to pay distributions; with OUE Ltd’s backing of any such loans (OUE Ltd owns 64% of OUELH).
• Upcoming expiries in 2021 with limited vacancy risk. These are Sarang Hospital in Korea (August 2021) and four other properties in Indonesia: Siloam Hospitals Lippo Village, Siloam Hospitals Kebon Jeruk, Siloam Hospitals Surabaya and Imperial Aryaduta Hotel & Country Club (December 2021). These hospitals are doing well, and the Manager believes that even if LPKR does not renew the leases, the incumbent operator, Siloam Hospitals (Siloam) would – thus suggesting that vacancy risk is not particularly high. It was also communicated by the Manager that there could be the possibility of recording lower rents, should the latter scenario occur.
• Portfolio diversification strategy via OUELH’s pipeline. The Manager intends to diversify its geographical and tenant concentration risk by acquiring assets from OUELH. This is likely to be from OUELH’s stabilised Japan portfolio of 12 nursing homes. The intention is to lower the portfolio’s income derived from Indonesia (96% of portfolio rental income) and from LPKR (82% of gross rental income). The Manager stressed that any acquisition will have to be DPU-accretive.
• Acquisition likely to be a portfolio of properties and not piecemeal. Acquisitions from OUELH pipeline would constitute as a related party transaction and an extraordinary general meeting (EGM) will have to be convened to seek unitholder approval. As such, it would make more sense to acquire a portfolio instead of piecemeal. Moreover, a larger acquisition portfolio is required to meaningfully minimise existing geographical and tenant concentration risk.

How do we view this?

The Negatives

• Lease renewals likely to be renegotiated with a lower quantum and/or on IDR-denominated terms, in our view; effectively killing the proverbial golden goose. FIRT’s current rentals are heavily reliant on Sponsor-tenant LPKR, which had been issued multiple credit rating downgrades in the past few months on concerns over its cash flow and liquidity. On the back of this, we believe that all Indonesia leases will likely be progressively renewed on IDR-denominated terms (currently on SGD-denominated terms) and/or with a lower quantum (should the leases be transferred to Siloam). Consequently, FIRT will have to bear currency exchange risk and hedging costs going forward. We have adjusted our revenue assumptions to account for a 80% currency hedge, with the remaining 20% exposed to IDR/SGD movements (for context, the IDR has depreciated c.44% relative to SGD since 2006 – when the four hospitals’ leases commenced – to date (figure 2)). This has resulted in a c.6% drop in our revenue projections.
• Current 34.9% gearing inhibits accretive acquisitions; a call for fresh equity capital is likely in the near-horizon. We estimate a debt headroom of c.S$280mn assuming 45% gearing. To put this into context, this is just nearly sufficient to acquire OUELH’s entire Japan portfolio of 12 nursing homes valued at S$287.8mn.
• Substantial new capital will be dilutive. We think that it would make sense to simultaneously lower the gearing with this fund raising. Assuming this acquisition of Japan nursing homes were to take place and were to be funded with a 20/80 debt/equity mix (lower debt to avoid stressing the balance sheet), this would result in a pro-forma gearing of c.33%. About c.S$230mn of fresh equity (c.258.8 million new units) would be required. There are currently 786.68 million units. NAV per unit will drop to $0.98, from the existing $1.01. Thus, there is an overhang of share price, on an impending equity fund raising (EFR).

Outlook

• Acquiring yield-accretively into a developed market will be a challenge. Net property income (NPI) yield in the existing Indonesia portfolio is higher, compared to that in Japan, which is a developed market. This will pose a challenge to conduct accretive acquisitions. Capitalisation rate for Indonesia investment properties is 10.0%, according to FIRT’s FY17 annual report (Note 12). Meanwhile, the capitalisation rate for Japan investment properties range from 4.6% to 5.1%, according to OUELH’s FY17 annual report (Note 7).
• Manager’s base fee structure will put pressure on margin and DPU-accretion when acquiring in lower-yielding market. Bowsprit’s base and performance fees are 0.4% of assets and 5.0% of NPI, respectively. The base fee component takes the same margin, even if acquiring a lower-yield asset. This will add further margin compression to unitholders and result in lower DPU-accretion.

Remain Neutral; new target price of $0.88 (previously $1.30)

We have: 1) lowered our revenue assumptions on the belief that the Indonesia leases would progressively be renewed with a lower quantum (if transferring leases to Siloam) and/or on IDR-denominated terms; and 2) raised our discount rate to factor credit risk associated with LPKR, referencing the spread between the latest mid-yields of LPKR’s two outstanding (USD) bonds above the 10-year U.S. government bonds (figure 1).