Lendlease REIT recently released its FY2024 financial results and the numbers do not look good at all.
While full-year gross revenue and net property income saw positive year-on-year increases, it includes a significant one-off supplementary rent recognised upfront due to the lease restructuring of Sky Complex.
Excluding this one-off item the increase would be more modest at 3.2% and 1.3% respectively.
Currently, we do not know how much of this supplementary rent was included (if at all) in the distributable income as Lendlease REIT does not display distribution adjustments in its financial statements or results presentation. This information would only be displayed in its annual report.
Thus, if the supplementary rent was recognised fully in the distributable income and consequently the DPU for FY2024, the y-o-y decrease would have been much worse than illustrated without it.
A large part of the huge decrease in distributable income and DPU is due to finance costs and an enlarged unit base. And the bad news? It will likely get worse before it gets better.
The debilitating impact of interest rates
To say that interest rates have negatively impacted Lendlease REIT would be a massive understatement.
From FY2022 till FY2024, Lendlease REIT’s finance costs have ballooned by around 324.6%.
The reason for this huge increase in finance costs is mainly due to the rather low proportion of fixed-rate borrowings that Lendlease REIT has. For FY2023 and FY2024, the proportion of Lendlease REIT’s borrowings on fixed rates was only 61%.
While the proportion of fixed-rate borrowings would increase to 70% post-FY2024, I think it is too little too late as the REIT already felt the full brunt of the high interest rates. Nonetheless, with rate cuts expected to come soon, there might be marginal improvements in the finance costs moving forward.
In addition to the low proportion of fixed-rate borrowings, Lendlease REIT is also negatively impacted by its own credit rating and size during refinancing. As compared to bigger and more reputable REITs that have been in the market for a while (ie. your Capitaland, Keppel & Mapletree REITs), Lendlease REIT’s interest rate margin on its loans would likely be higher than its more established peers.
This perhaps explains why the weighted average cost of debt jumped by almost 90 bps compared to FY2023, mainly due to the refinancing of the Euro-denominated loan from a lower interest rate and the drawing of revolving loan facilities.
Source: Lendlease REIT FY2023 and FY2024 results presentations
Also, looking at the actual total cost of debt (after accounting for debt-related transaction costs) for FY2024, it was much higher at 4.4% than the illustrated 3.58% per annum.
With around S$360 million of debt to be refinanced in FY2025, the cost of debt could continue to increase, though much would also depend on the interest rate environment in which Lendlease REIT refinances the loan.
As per the DBS analyst report, Lendlease REIT management expects a 20 to 30 bps increase in debt cost for FY2025, without factoring in the SGD loan refinancing. Thus, this would result in an approximate 2.7% to 4.3% decrease in FY2024 DPU on a pro forma basis.
Besides the negative impact on DPU, Lendlease REIT’s high average debt cost also resulted in a lower interest coverage ratio (ICR) and adjusted ICR. With an adjusted ICR of 1.7 times for FY2024, the REIT’s resultant aggregate leverage limit would be at 45% instead of 50%.
While MAS is proposing a fixed aggregate limit of 50% and a minimum adjusted ICR of 1.5 times for all REITs moving forward, this proposal remains in the consultation stage and has not yet been implemented.
Negative implications of an enlarged unit base
In addition to the negative impact of high interest rates on Lendlease REIT’s future earnings, the REIT is also hampered by its enlarged unit base. It is also one of the factors behind the huge 17.7% y-o-y DPU decline in FY2024.
If we look into the management fees for FY2023 and FY2022, we can see that a majority of it is paid out in units.
Based on the unitholders’ transactions for FY2024, this trend looks set to continue in FY2024.
On one hand, having most of the REIT’s management fees paid in units negates a larger DPU decline as compared to if cash had been paid out instead. On the other hand, the REIT is left with an enlarged unit base which makes future DPU increments via organic or inorganic means a tad harder.
Adding to this conundrum is that the REIT also has a distribution reinvestment plan (DRP). If you ask me, I think it is foolish to set up a DRP when the REIT is trading below its NAV per unit. By doing this, the REIT management is effectively diluting its unitholders at will.
As a result of both the DRP and the majority of management fees being paid in units, Lendlease REIT’s FY2024 unit base increased by 2.3%.
The enlarged unit base also resulted in the decline of Lendlease REIT’s NAV per unit in FY2024.
If Lendlease REIT continues enlarging its unit base going into FY2025, its DPU will likely continue to decline. This is on top of the possibility of a lower distributable income for FY2025 due to the reset of one of its perpetual securities.
Renewal of perpetual securities at higher rates?
Lendlease REIT’s series 2 perpetual securities would reach its first reset date on 11th April 2025. With the reset rate being the prevailing 3-year SORA OIS + 3.043%, it would likely take the perpetual securities yield past its original yield of 5.25%.
While Lendlease REIT can issue new perpetual securities under its S$1 Billion multicurrency debt issuance programme to redeem older perpetual securities, there is no guarantee that the yield of new perpetual securities would be lower than 5.25% or the corresponding reset yield, given the financial health of the REIT and prevailing interest rate environment.
Thus, with the expectation that the yield would be higher than 5.25%, I foresee that distributable income for unitholders in FY2025 would be lower than FY2024 on a pro forma basis. Coupled with the previously mentioned enlarged unit base, we could see another substantial decline in DPU for FY2025.
Nevertheless, any negative impact on distributable income and DPU can be avoided (or reduced) if Lendlease REIT records exceptional operational financial numbers. To assess the possibility of this, let’s look into the REIT’s property performance and future growth drivers
Lendlease REIT’s property performance
While Lendlease REIT’s bottom line numbers were poor, its Singapore properties actually did really well.
Both 313@Somerset and JEM recorded close to full occupancy as of the end of FY2024.
Retail rental reversion also came in at a high positive number of 14%, with tenant retention coming in at 84.9%.
These figures tell us that Lendlease REIT’s two main shopping malls continue to be attractive to current and potential tenants. This is further evidenced by the increased valuations of these two malls in FY2024.
With retail market rental rates seeing slight y-o-y increases in 2Q 2024, Lendlease REIT’s positive rental reversion trend might hopefully continue for longer.
However, it should be noted that the high rental reversion figures experienced by Lendlease REIT could have been from the renewal of leases that were on rental rates negotiated during the COVID-19 pandemic. As the lease renewals were negotiated from a relatively low rental base, it thus contributed to a high rental reversion figure.
While I hope that the positive rental reversion continues for the good of the REIT, investors shouldn’t be too overly optimistic about it nor should they expect another double-digit rental reversion figure.
Also, based on tenant sales and visitation figures (which recorded modest increases from FY2023), it might allude to a potential slowdown in the pace of rental increases.
Future rental growth drivers
Besides relying on positive rental reversions for growth, there are also other growth avenues for Lendlease REIT, in the form of its commercial office properties and the multifunctional event space at 313@Somerset.
Growth from commercial office properties
With the lease restructuring of Sky Complex in Milan, Lendlease REIT has taken back Building 3 and will be leasing it out as a regular commercial office building. This provides a potential upside to both gross revenue and net property income as Sky Italia was previously paying below-market rents for all 3 buildings of Sky Complex.
Furthermore, annual rental reviews for Sky Italia would also likely provide incremental improvements to rental income every year.
However, as per the DBS analyst report, it might take some time for Building 3 to be filled out. DBS predicts a 25% occupancy rate in FY2025 and 50% in FY2026.
Besides Sky Complex Building 3 in Milan, financial upside could also come from the office building of JEM.
Currently leased to MND till 2044, its once in five years rental review is set to take place in FY2025. With the rental rate likely to be revised higher, it should provide further upside to Lendlease REIT’s top-line figures.
Growth from multifunctional event space (when it is completed)
Since the announcement of Lendlease REIT being awarded the tender to redevelop the previously Grange Road car park into a multifunctional event space in June 2020, there has been no further news or official update regarding its construction progress.
If you were to visit the construction site, you would be greeted with a piece of empty land with patches of overgrown grass.
During the last AGM back in 2023, Lendlease REIT’s CEO informed that construction should start by the end of 2023 or early 2024 after confirmations from LiveNation. Looking at the current state of the event space…I think it is safe to say nothing has started at all.
With an expected net lettable area of around 40,000 sq ft, the event space could provide some upside to Lendlease REIT’s financial figures once it is completed. The only question is when Lendlease REIT can start reaping this benefit as construction on the event space would take 12 to 18 months to complete.
Conclusion
After considering both the negatives and positives regarding Lendlease REIT, I foresee that FY2025 DPU will likely see another decline.
While Lendlease REIT could benefit from the previously discussed potential rental upsides, I do not think these can outweigh the negative impacts of an enlarged unit base and continued high finance costs.
Also, if the supplementary rent from Sky Italia was recognised in FY2024’s DPU, then FY2025 DPU would naturally be lower due to its absence.
Hence, if you are a current unitholder of Lendlease REIT, be mentally prepared that the share price could continue declining as the market would likely demand a high-yield premium for the REIT.