First REIT’s 80% drop explained: Will I buy this REIT at $0.22?

In case you missed it, this is the 1 year chart of First REIT.

It’s gone from $1.00 in Jan, to $0.22 this week.

For those who are not vested, it’s a very interesting case study. I myself had a lot of fun piecing together the details.

So I really wanted to share the story with you guys, and I hope you enjoy it as much as I did!

BTW – we share commentary on the COVID crisis every weekend, so please sign up for our mailing list, its absolutely free.

It’s a weekly newsletter that goes out every Sunday, and rounds up the week’s posts so you never miss anything.

Don’t forget also to join our Telegram Channel!

[mailmunch-form id=”928667″]

What is going on with First REIT?

First REIT is a Singapore listed REIT that owns hospitals in Indonesia. It’s sponsored by the Lippo group in Indonesia, which is owned by the Riady family.

A brief timeline of what happened:

June 2020

Lippo Karawaci Tbk (a major tenant of First REIT), said that due to the COVID-19 pandemic in Indonesia and its “material negative impact” on business, it would be restructuring its leases with First REIT

20 July

First REIT issues a profit guidance, warning that DPU will drop 40 – 50%.

11 August

SGX queries first REIT on the accuracy of their property valuations. The response, among others, was that “The Board of Directors are of the view that there is no material change to the carrying amounts of First REIT’s investment properties for 1H2020 necessary at this stage”

29 November

First REIT announces a drastic restructuring of the master lease agreements with Lippo Karawaci. Rentals will drop significantly under the new leases. Share price drops 20%

28 December

First REIT announces a massively dilutive rights issue at 98 rights units for 100 units (at $0.2 per unit)

They also dropped a bombshell that the refinancing exercise is to avoid an imminent default of $196.6 million repayment obligation which matures on Mar 1, 2021.

Share price drops 40%+ over the next few days.

19 Jan 2021

EGM to approve the restructuring and rights issue.

Breaking down what happened to First REIT

A lot to digest I know.

But that’s what Financial Horse is here for right?

There are 3 big things that you need to understand about the First REIT saga:

1. Pandemics are not good for business
2. Master Lease Restructuring
3. Massively dilutive rights issue (to avoid a default)

Pandemics are not good for business

You would have thought that hospitals are recession-proof right?

WRONG.

Or maybe you’re right, but as it turns out, hospitals are not pandemic-proof.

The 1H2020 numbers are above, and you can see 46% declines in distributable income for First REIT.

Because as it turns out, pandemics are really, really bad news for the hospital business.

Nobody in their right mind wants to go to a hospital anymore (especially in Indonesia), and they’re postponing any elective surgeries. So only the most essential surgeries are going ahead, which has absolutely crushed hospital profits.

Master Lease Restructuring for First REIT

First REIT’s hospitals are master leased to Lippo Karawaci, which runs the hospitals. It’s like how Parkway Life REIT owns the land, but the hospitals are master leased to IHH as the hospital operator.

The original master lease was split into 2 components:

• Base Rent – Fixed component, payable in SGD
• Variable Rent – pegged to performance of the hospital

But COVID is bad for business right, so Lippo Karawaci cannot afford the rent anymore.

And apparently, if the rent is not cut, Lippo Karawaci is just going to default under the lease, which takes away 72.1% of First REIT’s rental income, and breaches the debt covenants.

Basically, an insolvency event.

The new master leases for First REIT are summarized below.

The bad part is:

• Base rent will plunge from $80.9m to $50.9m
• Base rent is now payable in IDR so unitholders will be exposed to forex risk of the Rupiah

The good part is:

• Security deposit increases from 6 to 8 months
• Rental escalation goes up from 2% to 4.5%
• Variable rent goes up – leaving more upside if the underlying assets do well

And very obviously, the bad parts are MUCH, MUCH worse than the good parts, so the share price plunged 20% in Nov when this news was released.

Valuations for the affected properties drop about 35%, which call into question why just a few months back, “The Board of Directors are of the view that there is no material change to the carrying amounts of First REIT’s investment properties for 1H2020 necessary at this stage”

The new master leases are condition on unitholder approval though, so there is an EGM on 19 Jan to approve this.

Massively dilutive rights issue (to avoid a default)

If you thought things are bad… oh boy, they’re only just getting started.

On 24 December, First REIT announced that it successfully refinanced $260 million in loans with OCBC and CIMB.

Great news right?

On 28 December, First REIT launched a massive equity fund raise – 98 for 100 rights issue, at 20 cents a unit.

The share price was at 41 cents before this, and doing a massive rights issue (almost 1 for 1) at such a low price would be massive dilutive for existing unitholders.

NAV would plunge from 51.8 cents to 36 cents (from 99.6 cents last year), which gives you an idea of how dilutive this is.

But the real bombshell – First REIT announced that the 24 December refinancing with OCBC and CIMB? It is conditional on a successful equity fundraise.

And if the refinancing isn’t successful? First REIT may default on its $196 million loan due on 1 March 2021.

First REIT EGM on 19^th Jan

And coming back to the EGM on 19^th Jan to approve the master leases.

What this means, is that:

• If the new master leases are not approved
• The equity fund raising will not go ahead
• The loan from OCBC/CIMB will not get refinanced
• First REIT will need to scramble to find alternative financing or default on its loan on 1 March (which is an insolvency event)

But hey no pressure right. Your choice.

What went wrong with First REIT?

The Edge has a pretty good take on what happened:

When First REIT first listed, assets were sold into the REIT at what now appears to be inflated prices. In addition, rents were paid in Singapore dollars. The lease period for the initial 15 assets was 15 years. In that period, the Indonesian rupiah has fallen by 48% according to various announcements made by First REIT’s manager and Lippo Karawaci.

Lippo Karawaci is proposing to lower the master lease rents such that FY2019’s rents of $115.3 million would fall to $77.5 million on a pro forma basis, translating into NPI of $75 million compared to $112.9 million in FY2019. As a result of the decline, DPU before the rights issue would fall from 8.6 cents in FY2019 to 4.44 cents on a pro forma basis. If the rights issue units are included, DPU falls to 2.59 cents on a pro forma basis. NAV as at Dec 31, 2019 of 99.64 cents would fall to 51.75 cents on a pro forma basis before the rights issue. If rights units are taken into account, NAV would be 35.95 cents. Lippo Karawaci itself completed a rights issue in July 2019, raising some US$787 million. The Lippo group are shareholders of OUE and OUE Lippo Healthcare which own First REIT’s manager and some 19.72% of units in First REIT.

“OUE as well as OUE Lippo Healthcare have provided irrevocable undertakings to take up their pro rata units and excess rights,” Tan says.

Unitholders get to vote on two resolutions on Jan 19, on the new master lease agreements, and on a whitewash waiver. OUE and OUE Lippo Healthcare will be abstaining.

The choice for unitholders is stark, a Hobson’s Choice so to speak. If they don’t vote for the resolutions, the rights issue cannot proceed, and the REIT may face a financing default. If they vote for the resolutions, they will get terribly diluted in both DPU and NAV, but the REIT lives to fight another day.  

To sum it up:

• The original master leases were in SGD
• Over time, the rupiah fell 48% against SGD, which meant that the original rentals were not sustainable
• COVID was the final straw – it caused revenues for Lippo Karawaci to plunge, and they could no longer afford the rent
• A massive restructuring was proposed to lighten the rental obligations of Lippo Karawaci
• Banks knew that this would impact valuations of the properties, so they wanted to reduce exposure to First REIT (it’s like how if you take a mortgage from a bank and your property value falls 50%, the bank is going to ask you to pay up to reduce the LTV ratio)
• Cut off from debt markets, First REIT had to do a massive equity fund raise at dilutive prices to avoid a loan default

Financial Horse’s view

I’ve always viewed these kind of REITs (small cap with a weak sponsor) like Russian roulette.

5 times out of 6, nothing goes wrong with the REIT, and you walk away collecting a nice 8%+ yield a year. This was First REIT the past 10 years, where the yield was good, and the price was stable.

But when something gets wrong, you really do get killed (metaphorically speaking).

Now that’s not to say they’re a bad investment.

With the right position sizing and risk control, you can still make money with such investments.

For example if you own 10 of such REITs – and 1 suffers complete capital loss. You only lose 10% of your capital, and the 8% yield on the remainder will make up for the loss in 1 or 2 years. If you had a tight stop loss that cut losses after a 15% fall, you could even have walked away with a fair bit of your capital.

So REITs like that can be good investments, you just need to know what you’re doing.

What about unitholders who are still vested in First REIT?

Unfortunately, in this particular timeline, First REIT was the REIT that went bad.

And for unitholders who are still vested, it’s really a tough situation to be in.

If you vote against the restructure, there’s a high chance Lippo Karawaci will just default on the leases. Even if they don’t default, it would be tough for the First REIT to scramble to put together a new financing package to avoid default on 1 March 2020.

If you vote for it, there’s massive dilution from the equity fund raise, so prices will likely never recover to pre-COVID levels.

Will I buy First REIT?

Which brings us to the million-dollar question.

Is First REIT a buy now, after it’s 80% plunge?

For bargain hunters, there is literal blood in the water now.

At the current price of $0.22, the post-restructuring, post-rights issue yield is 11.9%

Price to Book is 0.6x (although if this saga taught us anything, it is to take their valuations with a huge pinch of salt).

The key to me is whether the new master lease agreements are sustainable. If Lippo Karawaci can keep up the new rental rates for the next 5 to 10 years, then maybe this REIT is worth looking into. There will still be FX risk, but FX can work both ways, and is a lot less scary than a default.

Unfortunately, this question requires a deep dive into Lippo Karawaci’s financials and business, which isn’t exactly that straightforward.

And short term – there is real insolvency risk here. If the EGM is not approved, or if the rights issue runs into difficulty, there could be real issues for First REIT.

I’ve generally stayed away from the Lippo group of REITs in 2020 (First REIT, Lippo Malls Trust, OUE Commercial REIT) because of Lippo related risk, but First REIT after the 80% plunge is completely different story.

If the REIT survives, there could be upside.

Btw – My personal portfolio and stock watch are available on Patron for those who are keen.

Lippo Group

For the record, the Indonesian Riady family (Lippo Group) has control over both Lippo Karawaci and OUE Ltd.

They’ve come a long way since founding, and the founder’s son John Riady just took over the business in 2019. Talk about a baptism by fire.

It also owns the manager of First REIT, and a relatively small ~19% stake in First REIT.

This does raise some questions over alignment of interest, which is one of the big points we keep talking about in the REITs MasterClass. Really came to play here.

Whichever way you look at it, an investment in First REIT requires you to take a view on the Lippo Group, and their prospects going forward.

If the Lippo Group does poorly, First REIT will struggle. If the Lippo Group survives and emerges from COVID, all could be well again.

Closing Thoughts: Would I buy First REIT?

The First REIT saga is reminiscent of what happened to many REITs back in 2008 when they couldn’t refinance.

They were forced into massively dilutive equity fund raisings, but after that the share prices soared once the immediate refinancing risk was gone.

Something similar could happen here – if all goes according to plan, and Lippo Karawaci makes good on the new leases.

The key though, is really the creditworthiness of the counterparty – Lippo Karawaci. And without a deep dive I really cannot comment.

My gut feel is that they would have restructured the leases such that the new numbers are sustainable long term, but this is one that I would prefer not to trust my gut. I do want to verify the numbers if I were to invest.

The Indonesian economy is under big pressure from COVID, and the Lippo group is unlikely to be spared. The current saga has already illustrated that the Lippo group is facing financial and cash flow pressures, so any investment into First REIT needs to bear that in mind.

Also worth nothing for all investors in Lippo Group related REITs – First REIT, Lippo Malls Trust, OUE Commercial REIT.

The good news though, is that the Rupiah has stabilised for now against the USD, which removes a big pressure from First REIT and the Lippo Group. Remains to be seen if this will hold up in 2021.

I would love to hear your thoughts though. Do you want me to do a deep dive into Lippo Karawaci and the Lippo group?

Let me know what you think!

BTW – If you’re looking to get diversified exposure to S-REITs, Syfe REIT+ is a great option worth considering, better than the REIT ETFs on the market (in my view). You get exposure to 20 of the largest S-REITs, and there is no minimum investment amount or minimum brokerage fees, which makes this a good option if you’re investing smaller amounts. Find out more here.