Suntec REIT: Should bond investors rely on the Fountain of Wealth in 2020?

Introduction

Suntec Real Estate Investment Trust, also known as Suntec REIT, is a Singapore-listed REIT that manages 813,753 sq ft of office and retail space in an integrated commercial development known as Suntec City. Within the integrated development, the company owns office units in Suntec Towers One, Two and Three, and the entirety of Suntec Towers Four and Five. In addition, the REIT has a 60.8% effective interest in Suntec Singapore Convention & Exhibition Centre — adjacent to Suntec City Mall, in which the REIT owns 141,959 sq ft of net lettable area (“NLA”).

Suntec REIT also owns a one-third interest in One Raffles Quay, and a one-third interest in Marina Bay Financial Centre Towers 1 and 2. A 30% interest in 9 Penang Road (formerly known as Park Mall), Singapore, and four commercial buildings in Australia (two in Melbourne, one each in Sydney and Adelaide) complete its portfolio.

Suntec REIT is managed by ARA Trust Management (Suntec) Limited. The trustee of the REIT is HSBC Institutional Trust Services (Singapore) Limited.

Recent corporate developments

Suntec REIT has been active in diversifying its revenue base and expanding its presence beyond the shores of Singapore, and recent moves bear this out.

In September this year, the REIT completed the acquisition of a freehold office development at 55 Currie Street in the city of Adelaide, Australia, for a sum of AUD 148.3m. Two months prior to this, Suntec REIT — through a wholly-owned sub trust — entered into a put and call option deed with 21 Harris Street Pty Ltd, trustee of ATF 21 Harris Street Unit Trust, to acquire a freehold property currently under construction located along Harris Street in Sydney Australia. The transaction will cost Suntec REIT AUD 297.0m, and is expected to close in 1Q2020.

Another event with some bearing on Suntec REIT is the ongoing restructuring of WeWork — the embattled co-working space operator — which is an existing tenant. In October this year, shortly after WeWork postponed its IPO due to — as surmised by some market watchers — poor investor demand, the company announced that it would be accepting a bailout from its major shareholder, Softbank Group Corp.

The deal saw Softbank offering to buy over USD 3 billion of equity from existing shareholders, valuing the company at about USD 8 billion and raising its stake in the company to some 80%. The valuation of USD 8 billion was a far cry from what the company was reportedly worth just a few months back, when the figure of USD 47 billion was being bandied about.

In 2018, Suntec REIT signed a 10-year lease with WeWork covering 36,500 sq ft of space. While we understand that some readers might be concerned about the potential impact from WeWork’s restructuring on Suntec REIT’s financials, we do not think there is particular cause for concern, for two reasons. Firstly, the agreement signed between the parties does not contain a break clause, which gives us some comfort about the durability of this contract. Secondly, while WeWork is an important tenant, the amount of space occupied by the co-working space operator is but a fraction of the ~4.3m sq ft of NLA managed by Suntec REIT, and WeWork is not listed among the trust’s top ten tenants.

Review of financial metrics

For the quarter ended 30 September, gross revenue of Suntec REIT edged up 3.5% YoY to S$91.9m (3Q18: S$88.8m). On the other hand, revenue measured on a year-to-date basis (from January to September 2019) flat-lined at S$270.0m (9M18: S$270.1m).

Turning our attention to Suntec REIT’s profit margins, we quickly observe that even though net property income (“NPI”) grew by 3.2% YoY for the quarter, profit margins actually declined slightly. The NPI margin — NPI divided by gross revenue — dipped 20 bps to 63.5% (3Q18: 63.7%). Year to date, the REIT’s NPI margin dropped more than two percentage points from 66.7% in 9M18 to 64.0% in 9M19.

Focusing on another headline profitability metric — net income — fails to reassure. Net income did grow 4.8% YoY for the third quarter, but year to date, Suntec REIT posted a 0.2% decline in net income to S$154.8m (YTD 2018: S$155.1m).

With lacklustre revenue and income growth, it would be of little surprise to learn that Suntec REIT’s interest coverage did decline. Interest coverage — measured by taking the ratio of earnings before interest and taxes (“EBIT”) over finance expenses — dipped from 2.93x in 3Q18 to 2.81x in 3Q19. On a year-to-date basis, interest coverage dipped to a greater extent, from 3.54x in 9M18 to 3.09x in 9M19.

The liquidity position of Suntec REIT — as measured by the REIT’s current ratio —  improved to 0.41x by the end of September 2019, compared to 0.25x recorded in December 2018. As is typical of S-REITs, Suntec REIT’s financial liquidity was tight with S$310m of short-term borrowings as of end-September — comprising entirely of its 3.35% SGD notes due February 2020 — while cash and cash equivalents stood at S$128m.

Suntec REIT’s aggregate leverage — the ratio of total interest-bearing debt over total assets — was at 38.2% at the end of September 2019. This was a relatively high level when compared to its REIT peers. Of particular concern is that the REIT’s aggregate leverage has been on an uptrend, albeit at a slow pace, rising from 36.4% in 2017 and 38.1% in 2018. Figure 1 compares Suntec REIT’s gearing level with the levels posted by comparable REITs in the industry.

Figure 1: Gearing ratios of selected office and retail REITs (as of 30 Sep 19)

Our concern is not limited to gearing levels. It also crosses over to the domain of debt service, an area where Suntec REIT has not outperformed its peers as well.

Figure 2: Interest coverage ratios of selected office and retail REITs (quarter ended September 2019)

Interest coverage was calculated by taking the ratio of the REIT’s property income (the sum of the REIT’s net property income and its share of profit of joint ventures and associates) to the gross finance expenses over the 3 month period ended September 2019. Depreciation is included as part of net property income.

The interest coverage ratio is a measure of the company’s ability to rely on its earnings to service interest payments. With an interest coverage ratio of just 2.81x in 3Q19 (interest coverage for the 9M2019 period was 3.1x), Suntec REIT finds itself in a delicate situation, with a substantially higher part of its earnings going to servicing interest, relative to other commercial REITs in Singapore. Our readers need to appreciate that this situation is far from optimal, because we are already in an extremely low interest rate environment. If and when interest rates start to increase, we can expect finance costs to increase in tandem, which might exert further pressure on the REIT’s interest coverage ratio.

Any hope remaining that Suntec REIT’s riskier credit profile might be compensated by greater underlying profitability is quickly extinguished when we refer to Figure 3.

Figure 3: NPI margins of selected office and retail REITs (quarter ended September 2019)

Relative valuation

Having covered the more important credit and profitability metrics, we now move to another matter of equal, if not greater importance: relative valuation of Suntec REIT’s notes. The REIT has a number of outstanding bonds in the market, details of which may be found in Figure 4.

Figure 4: Selected bonds issued by Suntec REIT

For easier comparison, we have compartmentalised Suntec REIT’s bonds and their comparables into short duration bonds (less than three years remaining) and long duration bonds (more than three years remaining).

Figure 5: Short duration bond analysis

Quite clearly, even though Suntec REIT bears a riskier credit profile, we do not see significant yield premiums over yields offered by comparable bonds in the industry, at least at the short end of the curve. The Frasers Commercial Trust bond maturing in August 2021 even bears a yield that is almost at the same level as Suntec REIT’s 3% notes maturing in July 2021, despite the fact that Frasers Commercial Trust is much more conservatively geared.

Figure 6: Long duration bond analysis

Figure 6 paints a similar picture of less-than-attractive Suntec REIT bond valuations. Despite the higher risk profile in our opinion, we do not see significant yield premiums over comparable bonds. The SUNSP 3.355% 07Feb2025 Corp (SGD)  issue is particularly unattractive, when it is compared with Frasers Commercial Trust 3.185% due Feb 2023. Even though the latter matures two years earlier and is issued by a company with gearing of just 28.6% and a much higher interest coverage ratio, it carries a relatively attractive yield to maturity of 2.67%

Given this backdrop, we see little reason why investors should settle for a Suntec REIT bond that bears no substantial yield premium when there are more attractive alternatives around.

Conclusion

Given the lacklustre earnings growth and the relatively less attractive bond valuations that we currently observe for Suntec REIT, we are minded to recommend that investors hold back on investing in the trust’s bonds until valuations or fundamentals improve.