OUE Hospitality Trust - Why does it need rent support for 15 years?

3/8/2013 – OUE Hospitality Trust (OUE-H Trust) has held onto its issue price, after listing on the Singapore Exchange on July 25 at the lower end of its indicative price range at S$0.88 per unit.

The IPO was 19.1 times subscribed by retail investors and fully subscribed by institutional investors.

UOB KayHian Research suggests a trading range of S$0.90 to S$0.94.

Maybe, but in the short term Goldman Sachs, the stabilising manager, purchased 8.9 mln stapled securities at S$0.88 on the day the Trust listed.

The Trust consists, at the moment, of just the Mandarin Oriental Hotel and associated Mandarin Gallery shopping mall, and followed just a day after SPH listed its REIT.

SPH REIT's Paragon Shopping Centre is just down Orchard Road.

Investors of OUE-H Trust with a long term view will be interested to know the properties have 43 years of lease life left.

Like SPH REIT, the OUE-H Trust will receive income support from the sponsor.

However, for OUE-H Trust that support will come for 15 years, not just five.

And the Trust has right of first refusal (ROFR) for three of the sponsor's other properties.

Units in OUE Hospitality Trust come with one stapled unit of OUE H-Business Trust, which will remain dormant.

In simple terms, OUE H-BT exists primarily as a master lessee of last resort.

The business trust will become active if the hospitality REIT is unable to appoint a master lessee for the hotel at the current lease agreement ends in fifteen years, or for a newly acquired hospitality asset.

In such circumstances, the business trust will be appointed by OUE H-REIT as a master lessee for that hospitality asset, and OUE H-BT will in turn appoint a professional hotel manager to manage the day-to-day operations and marketing of the hospitality asset.

Further details can be found on page 139 of the prospectus.

FINANCIALS

The company has disclosed these results for Q1 FY13:

Gross revenue: -0.5% to S$26.6 mln
Net property income: +2.9% to S$23.6 mln
Distributable income: +1% to S$19.9 mln

The gross revenue consists of lease income from the hotel under the master lease agreement, and retail income from individual tenants at the Mandarin Gallery.

The decrease in gross revenue was mainly attributed to 2.2% lower lease income from Mandarin Orchard Singapore.

Gross revenue and property income for FY13 and FY14 are expected to grow in a low-to-mid single digit range.

Occupancy rate at the hotel is expected to be 89.7% for FY13 and 87.7% in FY14, while the Mandarin Gallery will have an expected occupancy rate of 99.6% and 98.9% respectively.

The trend in occupancy rate is similar to its historical levels.

In future, the REIT will receive lease income, comprising a fixed rent and a variable rent from Overseas Union Enterprise Limited, who is also the sponsor.

The rent of the hotel is fixed at S$45 mln and variable rent is pegged at 33% of gross operating revenue plus 27.5% gross operating profit minus the fixed rent.

And if the calculation of the variable rent yields a negative figure then the variable rent will be zero.

Question

1. Why is downside protection required from the sponsor?

The REIT Manager is of the view that a commitment of 15 years provides stapled security holders with stability and certainty of cashflows.

By providing a minimum rent, the lessee reduces operating risk for OUE H-REIT and consequently needs to be compensated with economic profits from the hotel during the lease term.

Question

2. Why is the sponsor funding the capital expenditure requirement in FY13?

The projected capital expenditure of the master lessee for FY13 is budgeted to be in the region of S$4.3 mln, with an additional S$23.1 million expected to be spent on an additional upgrading work.

This sum of S$27.4 million will be funded by the sponsor.

About S$2 mln worth of upgrading in FY14 will be funded by the REIT.

Over at SPH REIT, around S$14 mln worth of renovations in the current year will be funded by the REIT itself.

Question

3. Will its cash flow from operations support its distribution, part debt repayment and interest obligation in FY14?

We wonder how the trust will be able to fund its part debt repayment, interest obligations and distributions to unit holders, without taking on more debt.

Here's why: cash flow from operations for FY14 should be around S$95 mln, based on the S$98.6 mln it generated in FY12, cross-checked by annualising the S$22.9 mln it generated in Q1 of FY13.

It distributed S$61.3 mln in FY12 and S$20.4 mln in Q1 FY 13.

So, annualising the Q1 figure and taking an average of FY12 and FY13, we get a figure of around S$70 mln.

Let's say interest payable is S$10 mln, lower than the S$13 mln actually paid because partial debt repayment would reduce the interest payment.

We have assumed a debt repayment of at least S$100 mln out of total S$587 mln in FY14 as the weighted average tenure is three years.

This boils down to cash utilisation of S$87 mln in FY14 to service its obligations.

But this results in a cash shortage of at least S$50 mln after other factors remaining constant.

Cash balance as at Q1 FY13 is S$10.3 mln.

Further details can be found on page 97 of the prospectus.

GROWTH DRIVERS

Overseas Union Enterprise will be the sponsor

Owned by Indonesia's billionaire Riady family, Overseas Union Enterprise (OUE) is a Singapore-listed real estate owner, developer and operator with a market capitalisation of S$2.6 bln.

The group focuses on the hospitality, retail, commercial and residential segments in Singapore, Malaysia, Indonesia and China.

Post-listing, OUE will hold a 47.9% stake in the REIT.

Sponsor's properties could be offered in future

OUE H-Trust has the Right of First Refusal (ROFR) over the sponsor's pipeline of assets, such as Crowne Plaza at Changi Airport, 100%-owned Meritus Mandarin Haikou and 80%-owned Meritus Shantou China.

These assets, in addition to the planned addition of 200 rooms to Crowne Plaza, would add an additional 1,156 rooms to the REIT.

These three properties are valued at S$413.0 mln.

Downside protection from fixed rents

The master lease agreement for Mandarin Orchard Singapore has a fixed rent component of S$45 mln and a variable rent of 33% of gross operating revenue and 27.5% of gross operating profit.

The master lease is for 15 years with an option to extend for another 15 years.

Question

4. When does it intend to acquire the three ROFR properties?

In the near term, management will focus on refurbishment of the Mandarin Orchard hotel to increase revenue per available room (RevPAR), and add 26 rooms.

Over the long term, management will likely leverage on its sponsor ROFR to acquire three potential hotel properties with a total of 1,156 rooms.

Question

5. Will it issue new units to acquire the ROFR properties?

OUE H-Trust has aggregate leverage of 33.2%.

However, it can borrow up to 35% of the property without a credit rating and up to a maximum of 60% of the value of the property if a credit rating from Fitch, Moody's or Standard & Poor's is obtained and disclosed to the public.

The Managers believe that OUE H-Trust will be able to enjoy flexibility in respect of future capital expenditure or acquisitions.

Further details can be found on page 133 of the prospectus.

MANAGEMENT

Mr Chong Kee Hiong is the CEO of the REIT Manager and an executive director of the board of the managers.

He has more than 20 years of financial and REIT management experience.

He was the CEO of The Ascott Limited from February 2012 to May 2013.

He was also the CEO of Ascott Residence Trust Management Limited from 2005 to February 2012.

From May 2001 to September 2004, he was with Raffles Holdings as CFO.

Mr Chong is currently the president of the Orchid Country Club General Committee and is a member of the audit committee of Sentosa Development Corporation.

Hanshakes reveal his association with more than 150 companies as a director.

Mr Christopher James Williams is the chairman and non-executive director of the board of directors.

He is also the deputy chairman of the sponsor and has been the non-executive chairman of Food Junction Holdings Limited since 2009.

Further details can be found on page 173 of the prospectus.

KEY RISKS

The hospitality industry in Singapore is highly competitive, which will further intensify in future

The hospitality industry in Singapore is highly competitive and the completion of new hotels or renovations of competing hotel properties may reduce the competitiveness of older properties.

For instance, four new hotels on Orchard Road, with a net supply of 1,484 hotel rooms, are expected to enter the market by the end of 2014.

Net supply of 4,238 rooms island-wide is expected to be completed in 2013, with 220 rooms in the Orchard Road area in the vicinity of Mandarin Orchard Singapore.

Reliance on Mandarin Orchard Singapore for a substantial portion of its gross revenue

While the initial portfolio of will comprise Mandarin Orchard Singapore and Mandarin Gallery, the trust will majorly rely on Mandarin Orchard Singapore for its gross income.

It estimates that the hotel will account for 67.8% in FY13 and 68.1% in FY14 of the gross revenue.

No assurance that a new leasehold title to the properties will be granted

Both Mandarin Orchard and Mandarin Gallery have a leasehold tenure of only 43 years left.

OUE H-Trust may incur a substantial cost to top up the new leasehold title.

Also, the ultimate title of the land rests with the Ngee Ann Kongsi, and there is no guarantee that the Ngee Ann Kongsi will renew the lease at the end of the tenor.

Question

6. What happens if the leasehold title is not renewed?

Question

7. What would be the expected cost to top up the new leasehold title?

In the event that the master lease agreement is terminated, the REIT may have to pay a termination fee to the master lessee

The REIT trustee has entered into a long-term master lease agreement with the Master Lessee.

OUE H-REIT may sell its interests in Mandarin Orchard Singapore subject to the terms of the master lease agreement.

If the REIT trustee requires such sale to be free and clear of the master lease agreement, it may terminate the agreement whereupon the REIT Trustee shall pay the master lessee a termination fee equal to the fair market value of the master lessee's leasehold interest in the remaining term and the option term.

Risk of loss of key tenants or a downturn in the businesses of the tenants in Mandarin Gallery

The top 10 tenants in Mandarin Gallery occupy 35.5% of the occupied net lettable area (NLA) of Mandarin Gallery.

By rental collection, the top 10 tenants contributed 58.7% of the total retail rental income for Q1 FY13.

Based on these tenants' lease tenures, the leases for these top 10 tenants will expire between 2014 and 2016.

Further, 50.9% of Mandarin Gallery's leases are expected to expire in
2015.

Question

8. How soon will it mitigate the concentration risk at the Mandarin gallery?

Competition for Mandarin Gallery from other retail properties and also from new retail development projects in the Orchard area

Mandarin Gallery faces competition from Ngee Ann City, Wisma Atria and Paragon, which are all located close to Mandarin Gallery.

This could lure shopper traffic away from the vicinity of Mandarin Gallery, leading to a drop in demand for tenancy.

In addition, four retail projects with over 800,000 square foot of NLA in the Orchard Road area are expected to enter the market by the end of 2014.

Risk of adverse developments or negative publicity of "OUE", "Mandarin" or "Meritus" brand names

The trust is closely associated with the "OUE", "Mandarin" and "Meritus" brand names as it belongs to the Riady family.

Any degradation or adverse market developments relating to the "OUE", "Mandarin" or "Meritus" brand names or any negative publicity affecting the "Mandarin" or "Meritus" hospitality properties could adversely affect the results of operations of the Initial Portfolio.

Strong Singapore Dollar will slow down tourism

UOB Kay Hian Research says the appreciation of the Singapore Dollar versus other inbound tourism markets will make Singapore a less favorable destination among peers and will result in lower visitor arrivals and tourism spending.

Slowdown in global economy

Visitor arrivals to Singapore are closely correlated with global economic growth, with nearly one-third of it coming from the business travel segment.

For Mandarin Orchard, about 30% comes from the corporate segment and a downturn will affect occupancies and room rates.

Question

9. How is it dealing with the labour cost pressure?

The recent increase in foreign worker levies in the tight labour market is negatively impacting the sector.

Industry players are seen countering the effects by increasing job productivity and hiring more local staff.

However, UOB KayHian Research says the impact of the labour shortage and cost pressures is marginal on REITs due to their better managed lease structures and tighter cost controls.

Further details can be found on page 56 of the prospectus.

ONGOING LITIGATION

None of OUE H-Trust, OUE H-REIT, OUE H-BT, the REIT manager, the trustee-manager, the property manager or the master lessee is currently involved in any material litigation.

But there may be conflicts of interest where the sponsor group owns properties in Singapore which may be in competition with the REIT for customers and tenants.

These properties are Crowne Plaza Changi Airport, Marina Mandarin and 6 Shenton Way Towers One and Two, which will not be included in the initial portfolio.

Crowne Plaza Changi Airport was not included in the initial portfolio as the sponsor has undertaken to the landowner, Changi Airport Group (Singapore) Pte. Ltd., to carry out substantial development of an adjacent site with a proposed additional 200 hotel rooms.

After completion, it will offer a total of 520 rooms.

However, Crowne Plaza Changi Airport is a ROFR Property and is not managed by the sponsor group.

Marina Mandarin was not included in the initial portfolio as the sponsor only has an effective stake of 30% in it, so it lacks majority control over this property.

6 Shenton Way, the former DBS Towers, was not included in the initial portfolio and is currently not a sponsor ROFR Property, as it does not fall within OUE H-REIT's investment mandate under the category of "hospitality related purposes".

So, to demonstrate the commitment of the sponsor and as a means to mitigate any potential conflicts of interests which may arise in the future, the sponsor has granted a ROFR to OUE H-Trust.

Further details can be found on page 171 of the prospectus.

DISTRIBUTION POLICY

OUE H-REIT will distribute 100% of its taxable income for FY13 and FY14.

Therefore, the distribution yield is 7.36% for FY13 and 7.46% for FY14 at the issue price.

Thereafter, it will distribute at least 90% of its taxable income.

Separately, there will be approximately 4.5% stable distribution yield from hotel fixed rents and retail rents.

Further details can be found on page 93 of the prospectus.

IPO PROCEEDS

S$ 1.7 bln for acquisition of properties
S$ 4.4 mln for working capital
S$ 29.5 mln for expenses relating to listing and debt facility

In addition to the IPO proceeds, an amount of S$587 mln of the term loan facilities is drawn down to partially fund the acquisition of the initial portfolio.

Further details can be found on page 87 of the prospectus.

ISSUE DETAILS

Total Offer Size: 434.6 mln stapled securities
Price per share: S$0.88/ stapled securities
Placement shares: 383.5 mln stapled securities
Public shares: 51.1 mln stapled securities
Cornerstone shares: 247.2 stapled securities

Concurrent but separate from the offering, the sponsor will receive 626.8 mln consideration stapled securities in part satisfaction of the purchase price for the initial portfolio.

This constitutes 47.9% of the total number of securities issued.

KEY FINANCIALS AT LISTING

Key financials at listing

Market cap: S$ 1.2 bln
Price/NAV: 0.98x (based on an issue price of S$0.88 and a net asset value of S$0.903 per share)
Price/DPU (FY13): 18.5x (based on a DPU of 4.77 cents)
Price/DPU (FY13): 13.4x (based on a DPU of 6.57 cents)

There are only four (4) reasons companies list:
1. Raise fresh capital for expansion. This is the most virtuous reason, because new shareholders can take part in the growth of the company.
2. Allow existing shareholders to (partially) exit. Frequently this means the best growth days of the company are behind it.
3. Change in laws and regulations. Such as when revised foreign ownership restrictions force existing shareholders to pare down their stakes, even though they might not want to do so. While this gives you the opportunity to buy into companies, you must ask yourself whether how the company is impacted by excessive regulation.
4. Raise the company's profile. New shareholders must ask themselves whether an ego-trip by existing shareholders is a good enough reason to buy into a stock.

"Sharing the growth" is frequently stated in the IPO's publicity material as the reason for listing, but that's just the marketing pitch.

The real reason is only ever one of the four stated above.

Download the prospectus here.

We have sent these questions to the company to invite them for an on-camera interview, and/or seek their written response.

The PR agency for the REIT promised a reply, but – one week later – we have not heard back (which is why you are seeing this message).

If/when we get a reply, we will publish it without delay.


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