When perps are considered equity

As local investors have experienced, perps are not necessarily “called”. There are a few key differences for perps to be classified as equity by REITs. Perps are “called” at the option of the issuer. The “call” year is usually set when the perps are issued. Issuers do not have to “call” their perps. There are examples of issuers who have opted to reset the coupon rather than call the perp. These include Ascott Residence Trust (ART), LMIRT and First REIT.

At the reset, if the issuer does not plan to “call “or redeem their perps at the appropriate year, they can reset the coupon to a new rate which is stated in the original document. This is often SOR or SORA plus a spread. To date, ART, LMIRT and First REIT have been able to reset their perps at lower coupons. But this may not necessarily be the case in the next two years as the US Federal Reserve has embarked on a rate hike cycle, which is likely to take the Federal Funds Rate to 2% by the end of the rate hike cycle. Furthermore, the war in Ukraine, stagflation and the inverted yield curve add to an uncertain external environment.

The dividend stopper

A REIT can decide not to distribute to its perp holders. These deferred distributions are non-cumulative. However, most perp distributions have a “dividend stoppers” option. This means that if the issuer fails to pay a distribution to perpetual security holders, unitholders are unlikely to receive distributions.

LMIRT had a dividend stopper which came into effect in 2020. As at Sept 30, 2020, LMIRT’s distributable income less any distribution made to the holders of its perps and unitholders was zero.

According to the terms of the US$250 million ($339 million) 7.25% senior notes guaranteed by LMIRT, if the amount is zero, LMIRT is only permitted to distribute up to US$5 million for the remaining life of the US$ notes due in 2024. LMIRT had distributed $4.9 million in September 2020 to perp holders and $2 million in 3QFY2020 distributions to unitholders. It has thus reached the US$5 million limit. As a result, LMIRT elected not to pay the distribution on December 19, 2020. Distributions resumed following the REIT’s rights issue which was completed in 1QFY2021 ended March 2021.

While distributions to perp holders are not mandatory, issuers are likely to make good on the distributions as failure to do so would have negative connotations. But, since the perps of REITs are structured with resets, their distributions could be variable over time, differentiating them from a bond.

Impact of rising rate cycle

The problem with resets materialises during a rising interest rate cycle. Interest rates affect capitalisation rates, albeit indirectly. Interest rates also affect discount rates used in discounted cash flow (DCF) analysis. Both the income capitalisation and DCF methods are used to value investment properties. Hence, rising capitalisation and discount rates can cause capital values to fall if cash flows are not able to rise and outrun the expansion in capitalisation and discount rates.

If a perp reset occurs during falling capital values, distributions, in particular, DPU for unitholders are likely to be negatively impacted.

Capital management is an important facet of managing a REIT. “Most REITs have their interest cost hedged (see table 1). Most REITs have termed out their average term to maturity. The proportion of floating debt, fixed debt and maturities are staggered, some up to five years to mitigate refinancing risk,” Eng-Kwok points out.

Perps are part of capital management. To date, perps have helped to lower gearing levels. On the other hand, unitholders may not be happy if there are too many perps in the capital structure.

“You cannot tap on perps forever because your unitholders will ask you to explain why there are so many tranches of perps because they eat into distributions and DPU. There is also an expectation the REIT will call the perp so you should not look at them as permanent capital,” Eng-Kwok says.