Are The Distributions From Manulife US REIT (MUST) Sustainable? Clarifications from MUST's Investor Relation Team

This is a follow up to my last post on "Are The Distribution From Manulife US REIT Sustainable? Payouts Seems Greater Than Free Cashflow for Past Two Years". As mentioned previously, I have sent out an email to seek the comments of the management team of Manulife US REIT ("MUST"). I was surprised at the quick response within 2 working days by their Investor Relation team which is an excellent reflection of the dynamic culture and tone at the top. I should summarize and share the key comments by the MUST Investor Relation team here.

1. MUST Comments on 1H 2020 Income Statement Net Losses
Accounting recognition of fair valuation through P&L does create volatility in the P&L. In the case of 1H 2020 results, the accounting loss is due mainly to fair value loss of investment properties and derivatives - itself does not create a cashflow issue.

For the purpose of distribution computation, certain adjustments has to be made to the accounting numbers to derive what should be paid out to Unitholders i.e. non-cash items such as unrealised fair valuation losses and fees paid in units (no impact on operational cashflow generated from the properties net of expenses). Refer to note (g) on page 6 of 1H 2020 results announcement – reconciliation of accounting to distributable income.

The derived distribution to Unitholder is sustainable and supported by net cash from operating activities, refer to page 10 of 1H 2020 results announcement. Its higher than what was distributed in 1H 2020.

2. MUST Comments on classification of distribution to Unitholders in the form of  (i)Tax-exempt Dividends and (ii) Capital
The "Capital" component of the payout isn’t distribution in excess of earnings. It’s a result of tax structuring. Both elements are in fact supported by the underlying net property income.  

In terms of capital structure into US, it’s in the form of equity and shareholder loan. The shareholder loan carries a higher interest cost providing effective tax shield in addition to other onshore deductions to neutralise US taxable income to nil. The shareholder loan interest paid to Manulife US REIT is free of 30% withholding tax due to the portfolio interest rate exemption rule, upon receipt in Singapore is classified as Tax-exempt. The balance of earnings in US is extracted through shareholder loan redemption, upon receipt in Singapore is classified as "Capital". 

MUST Structure

2A. Additional query to MUST Investor Relation arising from the comments on Pt 2 as aforesaid mentioned above- Is the distribution sustainable if the shareholder loan is fully redeemed in future and part of the earnings thus get exposed to additional US taxes? 
One very interesting thing to note from the above comment is that the capital distribution of the half yearly payout is actually from property income and is actually part of recurring earnings. The only reason why it is deemed "Capital" in distribution nature is due to tax transparency planning to mitigate tax leakages. MUST extract this back via half yearly partial redemption of the shareholder loan given to the Parent REIT setup in the USA. 

This naturally give rise to another grave concern, which is, what if the shareholder loan is eventually exhausted due to constant redemption? Does it mean then that the tax shield setup will breakdown and the distribution will be subject to additional taxation hence eventually lowering it in future?

The investor relation team gave further insights into the MUST organizational structure being setup with regard to the above query:

"It will take a long while before the existing shareholder loans are exhausted. This will be further extended when we acquire more properties. 

For example, 
a) We acquire a property in US for $100, we inject capital into US in the form of $40 equity and $60 shareholder loan;

b) The property yield 6% which mean there is $6 annually (6%*$100) to be paid out from US to Manulife US REIT (“MUST”);

c) Say shareholder loan interest rate is 7%, 7%*$60=$4.2 out of the $6 will be repatriated to MUST via this route; 

d) Balance of $1.8 will be extracted via repayment of shareholder loan each year. $60/$1.8 = 33.33 years. It will take 33+years for this to be exhausted.

On (c) above, effectiveness of the tax shield should reduce over time as the shareholder loan reduces but it’s a long while. To reiterate, this will be replenished with further acquisitions. 

New shareholder loan can also be created when we refinance our loan as well".

3. Clarification with regard to the sustainability of the distribution going forward if we consider it from the perspective of the more stringent Free Cashflow assessment methodology? I noticed that in FY2019, the free cashflow (Operating CF net off CAPEX) less distribution to unitholders is negative of around <USD44MIl> and this is financed through bank borrowings and rights issues proceeds.
The reply from MUST Investor Relation is that " On capital expenditure, the response would still be to fund it via borrowings, which is a more efficient use of capital and that we have managed gearing prudently, well within MAS gearing cap of 50%."

Summary and personal thoughts:
The 1H total distribution pay out of 3.05 cents (dividends + "Capital") will give an annualised 6.10 cents payout from its recurring earnings. This is an 8.2% dividend yield based on the last 5 trading days average price of US$0.746 per unit. 

The question of sustainability of this 8.2% will depend on how fast MUST grow its earnings organically such as positive rental reversion of renewed tenancy agreements in order to get sufficient additional future returns on the use of borrowings to fund office capital expenditure, if we adopt the stricter free cashflow perspective. Growth can also be via inorganic M&A. 

In addition, any additional unrealized fair valuation losses will lead to the gearing hitting the MAS allowed maximum of 50% which will lead to the inability of the REIT to drawdown any further borrowings to finance capital expenditure. The aggregate leverage ratio of MUST at group level as at 1H 2020 is around 40%. Will be keeping a close look at this ratio for the upcoming year end results that will be released on 8th Feb 2021. 

Based on the current known conditions and historical track record of MUST, their performance has been remarkable and growth focus with M&A being carried out. This should mitigate the downside business risks and ensure sustainability of the distribution of 8.2% yield.