REITs and Business Trusts are supposed to be relatively stable assets that are not subject to significant volatility. However, just before the Deepavali long weekend in Singapore, Mr Market presented a unique opportunity in Eagle Hospitality Trust (ticker code SGX: LIW). Eagle Hospitality Trust (‘EHT’) capitulated a total of 15.5% to close at US$0.545 in a single trading session, definitely a far cry from its IPO price of US$0.78 This was a swift reaction to the damning allegations that ran on The Edge with regards to one of the biggest and most controversial assets in its portfolio, The Queen Mary. Eagle Hospitality Trust certainly did not meet most of the investment criteria in Heartland Boy’s checklist for REITs and Business Trust. Nonetheless, he took a leap of faith that day as he felt that the sell-off was more knee-jerk than rational. Here is his review of Eagle Hospitality Trust and why he decided to embark on Eagle Hospitality Trust’s Queen Mary (pun intended).
The Relationship Between The Stakeholders
The Queen Mary is a decommissioned British ocean liner that has been converted into a 347-room upscale hotel. It is therefore no longer required to sail and is instead permanently moored at Long Beach, becoming an iconic tourist destination in itself. (Closer to home, think of St James Power Station- an iconic entertainment hub operating in a decommissioned power plant)
In April 2016, the sponsor of Eagle Hospitality Trust, Urban Commons, took a 66-year ground lease on The Queen Mary from the City of Long Beach for an assumed consideration of US$140 million. This ground lease governs the use of the land, the submerged water area, and improvements made to The Queen Mary. Specifically, Urban Commons is obligated to cover part of the costs to repair The Queen Mary, with the City of Long Beach bearing the rest. As at end 2018, Urban Commons spent a total of US$23.5 million to renovate the meeting spaces, restaurants, attraction venues etc.
Upon the successful IPO of Eagle Hospitality Trust, Urban Commons transferred the lease to EHT for a total of US$139.7 million (discount of 12% from Collier’s valuation). EHT in turn entered into a sub-lease master agreement of 20 years (with option to extend for another 14 years) with Urban Commons on a triple nett basis. To break down all these real estate jargon, EHT now becomes a passive landlord who simply collects rent from Urban Commons consisting of:
- Fixed Rent of US$10.4 million, with a 2% annual escalation rate
- Variable Rent consisting of 8% of the Gross Operating Profit
Urban Commons is also responsible for maintenance capex, property taxes and property insurance on top of the usual fees such as operating expenses of The Queen Mary.
EHT’s business risk comes from the credit worthiness of the lessee of The Queen Mary- i.e. whether Urban Commons can pay the rent (both fixed and variable components) when they come due. If Urban Commons defaults, EHT would have no income distribution to pay to its security holders.
Urban Commons’ business risk lies in whether it can yield The Queen Mary higher than all the expenses (including its rental obligations) that it costs to operate it. If it is unable to do so, it will have to look for cash elsewhere to subsidise the costs of leasing The Queen Mary.
It is essential to understand the role of each stakeholder in this business model so that we can evaluate the risk-reward profile of this investment.
The Edge’s Report on The Queen Mary
Here is a summary of the viral article (Business Times and Straits Times each ran an extract of it) that was published on The Edge that triggered EHT’s massive sell-down.
- In their most recent inspection, City of Long Beach claimed that the ship has never been in a worse condition, and that its structural integrity is at risk
- It has requested financial paperwork (repair costs ranging from US$235 million – US$289 million) and a plan for making urgent fixes from Urban Commons
- If Urban Commons fails to respond by 31 Oct 2019, it may be found in default of the ground lease
Response From Eagle Hospitality Trust’s Manager
- Neither Urban Commons nor EHT is in default on The Queen Mary ground lease, as confirmed by the City of Long Beach subsequently
- Urban Commons responded and estimates that the repair work required to be done within the next 2 years will cost approx. US$7 million
- EHT has contractual right to perform these obligations if Urban Commons defaults, but there are reserve mechanisms in the leases to fund such expense. If required, EHT can obtain external financing to carry out these repair works and subsequently try to seek reimbursement from Urban Commons as they ultimately remain liable for such expenses
- The Marine Survey cited in the letter from City of Long Beach was conducted in Jan 2017, and did not form the basis for the agreement between the City and Urban Commons regarding the cost of expected repairs
- The Queen Mary remains safe and structurally sound
Heartland Boy’s Analysis Of EHT
1) Cost of Expected Repairs More Likely To Be US$7mil
This seems to be a case of whose professional consultant/engineer to trust and Heartland Boy finds more reason to believe Urban Common’s assessment than the City of Long Beach’s.
Assuming that the findings of the Marine Survey is true, Urban Commons would have forked out a total of US$429 million (purchase price + repairs) for a 66-year lease on a decommissioned ocean liner. According to Eagle Hospitality Trust’s prospectus, it was revealed that The Queen Mary generated Gross Operating Profits of US$7.1 mil, US$6.5 mil, and US$11.2 mil in Years 2016, 2017 and 2018 respectively. It would take many years (almost 2/3 into the leasehold tenure) to even reach payback. The IRR for such a project would be so poor that it is hard to fathom the Board/Investment Committee ever approving such an investment. Moreover, Heartland Boy found it odd/not very plausible that a survey conducted in Jan 2017 could retrospectively form the basis of a sale of lease agreement executed in Apr 2016. This goes back to the point that any competent management would not have recommended/signed off on an investment when the cost of repairs, which the purchaser is obligated to co-pay, remains an unknown entity.
Having established that US$7 million is more plausible as the cost of repairs required for The Queen Mary in the next 2 years, it is unlikely that Urban Commons would default on this financial commitment.
2) Sufficient Cash To Finance Cost Of Repairs
According to the its IPO prospectus, Urban Commons as the master (sub)lessee is required to set aside cash to fund the Capital Improvement Fund (‘CIF’) Reserve. Failure for Urban Commons to make the required CIF contribution would be an event of default. For The Queen Mary, CIF contribution is mandated at 2% of Total Revenue in 2019 and 3% of Total Revenue in 2020 and onwards. Based on its forecast and Heartland Boy’s internal estimates, this works out to US$4.7 million in CIF reserves that can help to part-fund the expected cost of repairs for The Queen Mary in the next 2 years as shown in Diagram 2.
Additionally, Urban Commons have established the Historical Preservation Capital Improvement Plan (HPCIP) fund with the City of Long Beach that can help to fund the repairs to ensure The Queen Mary’s viability. According to UOB KayHian research report, its interaction with EHT’s Manager indicated that these twin sources of funds can help fund capex of up to US$4.5mil p.a. for The Queen Mary.
3) Share Price Capitulation Provides Sufficient Margin of Safety
Assuming a worst-case scenario that The Queen Mary is completely written off, it will be interesting to analyse the financial metrics. After studying its prospectus and the latest results announcement, Heartland Boy did a comparison of a business-as-usual scenario vs worst-case scenario of EHT as show in Diagram 3.
Under the worst-case scenario, a 9% dividend yield seems about fair in current environment given that (i) it is a hospitality reit, (ii) an overseas REIT with exchange rate risks and (iii) relatively high gearing. This seems to suggest that the likelihood of upside is higher than the downside and the margin of safety (from its NAV) seems adequate.
On the basis of the 3 reasons outlined above, Heartland Boy took a small position on Eagle Hospitality Trust at a share price of US$0.555. Of course, since this is an extremely volatile stapled trust, Heartland Boy will implement a 15-20% stop-loss if it turns out that he is sipping from a poisoned chalice.
This article was published on 3 Nov 2019.
Update: Heartland Boy cut loss at $0.475 on 4 Nov 2019.
Disclaimer: The information contained herein is the writer’s personal opinion on his blog and do not constitute an investment advice, an offer or solicitation to subscribe for, purchase or sell the investment product(s) mentioned herein.