First REIT Review PART 2- Super High Yield of Over 8% And Possibility of 80% Drop in Rental Income For Upcoming Renewal Of Expiring Hospitals

During my last posting on First REIT, I have mentioned the shocking analysis by Phillip Securities Research team that there is a potential 80% rental income gap once Lippo Karawaci exit itself from the upcoming lease renewal exercise of the first batch of expiring hospitals and leave negotiation to between First REIT and Siloam group. I have written an email to the Investor Relation team of First REIT to seek further clarifications on the assertions that were being made by the analyst. 

This morning, I received a return call from First REIT Investor Relation officer. I must say that they are very professional and prompt in their response. This actually speaks volume of the type of good management philosophy and values of the First REIT team lead by their CEO, Victor Tan.

The below are the key highlights of my discussion with the Investor Relation Officer of First REIT this morning:

·        Yes, it is true. There is an 80% rental income support by the sponsor Lippo Karawaci to Siloam. This is not a typo in Phillip Securities Research report. This issue was first raised up about a year ago by OCBC’s Research team.

·        Background was that Siloam used to be a business division under Lippo Karawaci. Hence master lease was signed between First REIT and Lippo Karawaci. After listing of Siloam Hospital Group in 2013 as a separate legal entity, new leases began to be negotiated directly between Lippo Karawaci and First REIT.

·        There are many investors who have been also asking this question at various investors road show.

·        There are a number of stakeholders involved in the negotiation, namely, Lippo OUE, Lippo Karawaci and Siloam Group. Many teams of lawyers representing the different stakeholders are trying to reach a draft agreement. The targeted date to present out a first cut for EGM to shareholders will be around December 2020 which is one year before the expiry of the master lease for the first batch of properties. However, First REIT is aware of the concern by many shareholders and is trying to present a proposal for shareholders’ approval way before the 1 year expiry target date. In the event that the proposed new lease agreement is rejected by shareholders (Lippo will abstain their votes for this EGM), they will go back to the drawing board. 

·         80% drop in rental in the worst case scenario is unlikely. According to the Investor Relation Officer, if the rental is so low, they might as well decide to let another healthcare group to come in to operate the hospital.

  

My Personal thoughts:

I can only conclude that there are various ticking time bombs inside First REIT that I was unaware of until the recent turn of events. The first one that is set to go off will be the first batch of expiring hospitals and hotel under Lippo Karawaci in December 2021.

I think that the probability the renewal will be done at a lower rate is almost 100% given that the financial statements of Siloam is clearly showing that its financial resources will not be able to cover the entire huge gap of 80% subsidy by Lippo Karawaci based on the detective work done by the analysts combing through the 2018 annual report of Siloam.

The only question is how much will be the drop in rental income? The first batch expiring is due only in December 2021 and make up only 22% revenue of total revenue. Hence assuming a 50% confirmed drop in rental income from Siloam during the lease renewal exercise, it will translate to only a 11% decline in overall property income of First REIT. Remaining lease only expire in year 2025 to 2032 which is still a long way to go.

Has this been priced into the current market price per unit of First REIT?

Before the issue of the credit crunch and lease renewal came up, First REIT units were trading at a range of of $1.30 to S$1.40 range in 2018. Its price dropped to almost S$0.90 during the credit default risk period but eventually recover to hold at around S$1.00 to S$1.10 after the rights issue by its sponsor, Lippo Karawaci. This is approximately a 25% to 30% correction in price by the market due to the uncertainty over the upcoming lease renewal exercise. It would appear that the market had already priced in most of the reduction from the original 6.5% yield as risk premiums. The yield has now shot up to 8.4% based on current market unit price of S$1.01 per unit.

The risk is price may drop by another 11% in line with the net decreased impact of the first batch of renewed properties by 50% or worse, investors may extrapolate and automatically price in expected future declines in all properties to derive a more sustainable property income and associated dividends. It will be hard to visualize the equilibrium point to be reached if investors views are so pessimistic.  

What if renewed lease is no longer in SGD but IDR denominated?

Also, on the issue of new lease contract being in IDR instead of SGD which gives rise to forex fluctuations, the CEO Victor Tan had mentioned previously that he can peg the rental adjustment to  higher inflation rates benchmark in Indonesia rather than Singapore in order to close up the exposure in forex risk.

Parting thoughts

First REIT remained a higher risk REIT relative to other REITS due to the many variables surrounding it. For me, I will gradually be doing a partial paring down of my stakes in First REIT over the next 1 year to reduce concentration risk in view of the latest information but I maintain an optimistic view that much of the negative information has already been priced into this REIT with a long WALE of 8 years in the medium term. Also, 8.4% yield up to Dec 2021 before the first batch of hospital properties reached expiry represented an almost 17% (2 years’ worth of dividends compensation) to cover any further downside. Part of my optimism comes in from the new CEO John Riady who confirmed that Healthcare will be one of Lippo’s key business unit (which is at lower risk of technological disruption). It also does not make sense for both Lippo Karawaci and Lippo OUE to dramatically destroy their own reputation by dropping the rental to the extreme scenario of 80% as they still need to tap capital from the market.