TAKEAWAYS
In July 2024, the Monetary Authority of Singapore (MAS) issued a consultation paper on proposed amendments to the leverage requirements for REITs. Currently, a REIT is required to have an interest coverage ratio (ICR) of at least 2.5 times if it intends to increase its aggregate leverage from 45% to 50%. Under the consultation, MAS proposes to simplify the leverage requirements by subjecting all REITs to a minimum ICR threshold of 1.5 times and an aggregate leverage limit of 50%.
REIT players would likely view this proposal as a “sweet rain after a long drought” – a welcome move that has been long awaited.
The ICR measures a REIT’s ability to meet its interest payment obligations, that is, how easily it can pay interest on its outstanding debt. A minimum ICR of 2.5 times to increase aggregate leverage to 50% means that for every dollar of interest servicing obligation, a REIT needs to demonstrate it is generating at least 2.5 dollars in earnings to pay its interest expenses.
This means that for commercial properties with an annual rental yield of between 3% and 5%, the interest rate cannot be more than 2.4% per annum. This is clearly a far cry from the reality of today’s environment where interest rates have remained elevated. In comparison, the proposed minimum ICR threshold of 1.5 times will allow the interest rate limit to increase to 4% per annum, which is much more realistic and reflective of current interest rates.
The latest consultation is an effort by MAS to simplify leverage requirements for REITs, and this is not the first time it is doing so.
In October 2014, MAS proposed to adopt a single-tier leverage limit of 45% without requiring REITs to obtain a credit rating. Prior to that, REITs were subject to a leverage limit of 35% of their total assets, which could be increased to 60% if the REIT obtained a credit rating and disclosed it to the public. At that time, MAS noted that even though two-thirds of the REITs were rated, most kept their leverage ratios within 35%.
In July 2019, MAS proposed to use the current ICR threshold of 2.5 times in conjunction with a leverage limit. To balance giving REITs more flexibility to optimise their capital structure with the need for them to assess their debt-servicing ability, MAS allowed a REIT’s leverage to exceed 45%, but not surpass 50%, if the REIT achieved an ICR of 2.5 times or more.
Together, the ICR and leverage limit indicate a REIT’s financial strength. The ICR threshold of 1.5 times underscores REIT managers’ responsibility in ensuring that the REIT can adequately service debt obligations, including having sufficient earnings to pay their interest expenses.
In two decades, Singapore has risen to become the largest REIT market in Asia (ex-Japan) and is enroute to becoming a global REIT hub. Hence, Singapore REITs have now to also compete with their global peers in their overseas expansion.
According to the REIT Association of Singapore, over 90% of Singapore REITs and property trusts (by number and market capitalisation) own properties within Singapore and across Asia Pacific, South Asia, Europe and the US1.
It is a balancing act to meet the objectives of ensuring REITs remain relatively low-risk income-generating vehicles while giving them greater flexibility to cope with changing economic conditions and enhance their competitiveness vis-à-vis foreign REITs. No ICR and leverage limits are currently imposed in more mature REIT jurisdictions, such as Japan, Australia and the US. Hence, Singapore REITs not only compete with REITs in foreign jurisdictions but also with other global real estate investors and companies, which are also not subject to regulatory leverage limits.
While financial institutions may be willing to lend up to 60% to 75% of property value to foreign REITs and investors, Singapore REITs have to keep their aggregate leverage at 50% or less at all times due to their regulatory obligation. This impedes Singapore REITs’ ability to borrow and make the necessary investments to grow and compete effectively against their global competitors.
All of these raise the question of whether a one-size-fits-all regulatory leverage limit is optimal. Financial institutions, being in the business of lending and risk assessment, often have more sophisticated and up-to-date information about the borrower’s financial health and risk profile. They also conduct rigorous due diligence and risk assessments before extending loans. Hence, taking a cue from financial institutions could be useful. Given their diverse risk appetites, financial institutions are well positioned to determine appropriate loan-to-asset ratios, rather than being subject to a hard 50% limit.
In more mature REIT regimes, investors make investment decisions on REITs based on their assessment of a REIT’s financial stability including capital structure, and are not guided by regulatory limits. Such an approach allows for more dynamic and competitive market behaviour, and may be considered for Singapore REITs when the time is right.
The proposed changes underscore the responsibility of investors to assess the financial stability of a REIT. To help investors understand how market conditions could affect a REIT’s financial health, MAS proposed that REITs perform and disclose sensitivity analyses on the impact of changes in EBITDA and interest rates on their ICRs.
While this is helpful, more can be done to enhance investor education. REITs are often considered by retail investors as safe investment options and reliable sources of retirement income. Yet, many investors may not quite understand the changes, such as the impact of net property income and interest rates, on a REIT’s ability to service its debt.
A flexible regulatory framework is essential for Singapore’s evolving REIT market as more REITs with different asset types operating in different geographies may invest here in future. This will be instrumental to strengthening the resilience of Singapore’s REIT sector in a global interconnected economy.
Lee Wei Hock is Deputy Head of Assurance, and Low Yen Mei is Assurance Partner. Both are from Ernst & Young LLP and have worked with several REITs. The views reflected in this article are the views of the writers and do not necessarily reflect the views of the global EY organisation or its member firms.
An edited version of this commentary was first published in The Business Times, 14 August 2024.
1Overview of the S-REIT industry, REITAS website
© 2024 Institute of Singapore Chartered Accountants