After "Crazy Rich Asians", hospitality REITs are the next big investment opportunity

For Singapore's hospitality REIT sector, 2018 has largely been a year to forget (Figure 1). Despite its dismal performance last year, we continue to remain positive on hospitality REITs as we expect Singapore's tourism industry to continue its cyclical upturn heading into 2019. With the share price decline last year also bringing valuations down to more attractive levels, we believe the time is ripe for investors to take a closer look at hospitality REITs.

Figure 1: Hospitality REITs Had A Disappointing 2018

Visitor Arrivals To Remain Strong In Coming Years

Singapore's hospitality sector continues to register healthy tourist arrivals, with close to 17 million visitors arriving in Singapore in the first 11 months of 2018 – that's a 6.6% increase over the same period in 2017, and not too far away from the Singapore Tourism Board's (STB) projection of about 17.6 – 18.1 million tourist arrivals in 2018. With just one more month to go, Singapore remains on track to achieve yet another record-breaking year for international visitor arrivals (Figure 2).

Figure 2: Singapore Remains On Track For Another Record-Breaking Year For Tourist Arrivals

Based on estimates by the Pacific Asia Travel Association, Asia Pacific is expected to enjoy a steady 5.5% average increase in international tourist arrivals per year over 2018 – 2023, reaching a record high of almost 900 million by 2023. Given that Singapore is the gateway to Asia and is a popular stopover destination for travellers heading further afield, Singapore is well-placed to benefit from this positive trend. Moreover, the continued efforts and investments by the STB to develop the local tourism landscape (Figures 3 and 4) is also expected to help drive visitor growth in the coming years.

With the leases for Singapore's three container terminals – Tanjong Pagar, Keppel and Brani – expiring in the coming decade, the land that will be freed up will be re-developed together with Sentosa Island as part of the Greater Southern Waterfront project, a sprawling 1,000 hectare area offering an expanded set of themed destinations and experiences. The Mandai eco-tourism hub featuring five wildlife parks is also expected to attract more than 10 million visitors each year when completed in 2023.

Figure 3: Recent Developments In Singapore's Tourism Landscape

Figure 4: Upcoming Developments In Singapore's Tourism Landscape

Singapore really had it going in 2018 – not only did it steal the international spotlight after hosting the historic Trump-Kim summit, it also served as the backdrop for Hollywood box-office hit "Crazy Rich Asians", both of which generated strong publicity for the city-state. While it may be too early to quantify the impact of these events, they have certainly placed Singapore on the map for international audiences and reinforced Singapore as an ideal destination for both leisure and business travel, all of which bodes well for the hospitality sector in the longer term.

Tapering Hotel Room Supply In Coming Years

The expected increase in visitor arrivals also coincides with a tapering of hotel room supply over the next few years. Based on estimates by Horwath HTL, the total hotel room supply in Singapore is expected to grow by a compounded annual growth rate (CAGR) of 1.3% over 2018 – 2020, a dramatic slowdown from the 5.1% CAGR over 2005 – 2017 (Figure 5).

Figure 5: Hotel Room Supply To Taper In Coming Years

A total of 1,914 hotel rooms are expected to be completed this year, with the bulk of it coming from three hotel developments in Sentosa by Far East Hospitality (Table 1). In 2020, only 651 new hotel rooms are expected to come on-stream. Given the improving fundamentals of Singapore's hospitality sector, especially with tourist arrivals projected to surge in the coming years, we expect the increase in hotel room demand to be able to absorb the limited new supply.

Table 1: Hotels That Will Be Completed In Coming Years

With the outlook of Singapore's hospitality sector looking positive, the Urban Redevelopment Authority (URA) has released one hotel site at Club Street, as well as one 'white' site at Marina View, as part of its 2H18 government land sales (GLS) programme. Developers have also been shifting their attention to hotel development amidst a slower residential property market, with two en-bloc sites having obtained permission to change their land use for hospitality. While these developments are expected to further increase hotel room supply, they will only hit the market in 2022.

RevPAR At Inflection Point

Revenue per available room (RevPAR) – an important performance metric used in the hotel industry – has been on a down-cycle for the past few years due to tepid tourist arrivals and supply pressures. This has resulted in a sustained decline in the 12-month rolling average RevPAR since peaking in 2013 (Figure 6). However, we see clear signs of a hospitality sector upturn heading into 2019.

Despite a surge in hotel room supply over the past few years, the overall occupancy rate has remained relatively stable, and has started to see an uptick since 2016 – an indication that demand has been picking up. Concurrently, a tightening hotel room supply should also lead to improved room rates for hoteliers. As such, we believe RevPAR should continue its rebound over the next few years.

In fact, we reckon that the multi-year RevPAR recovery has already started, with Singapore hotels experiencing a 2.3% growth in their RevPAR (as of end-November 2018), as compared to the same period last year. November 2018 also marked the sixth consecutive month of RevPAR growth.

Figure 6: RevPAR Has Started To Recover Since 2017

Hospitality REITs To Have Highest DPU Growth In 2019

Given the bright outlook of Singapore's hospitality sector, we believe the sell-off in hospitality REITs last year was overdone and see current price levels as an attractive entry point for investors. The sector offers an average distribution yield of about 6.71%, one of the highest in the Singapore REIT universe (Table 2). Moreover, the sector is currently trading at a price-to-book ratio of 0.90, which we believe is undemanding given that it is expected to have the highest distributions per unit (DPU) growth in 2019.

Table 2: Hospitality REITs Have Highest DPU Growth In 2019

Against this backdrop, hospitality REITs that have significant exposure to the domestic hotel market will be the main beneficiaries of Singapore's tourism recovery. As such, we prefer Far East Hospitality Trust (SGX:Q5T) due to its pure-play focus on the Singapore market. Its distribution yield of about 6.5% and price-to-book ratio of just 0.72 are also looking quite attractive at this moment relative to its peers (Table 3).

Table 3: Hospitality REITs Listed On SGX

Far East Hospitality Trust's (FEHT) is currently the few REITs that offer investors pure exposure to the Singapore hospitality sector. Its property portfolio consists of 13 properties (9 hotels and 4 serviced residences), all strategically located within close proximity to train stations, business districts, leisure attractions, MICE facilities and healthcare facilities (Figure 7). With a continued recovery in Singapore's hospitality sector, we believe the prospects for FEHT remain bright.

Figure 7: FEHT's Property Portfolio

Benefits From Strong Sponsor Presence

FEHT benefits from the presence of a strong sponsor, the Far East Organisation group of companies, which is currently the largest private property developer in Singapore, with extensive experience and strong hospitality capabilities that FEHT can capitalise on to enhance its portfolio. Notably, the sponsor has a solid pipeline of assets, which FEHT has a first right of refusal (ROFR) to, that could potentially be injected into the REIT (Table 4).

Table 4: Strong Pipeline Of ROFR Properties

FEHT also has a 30% stake in three upcoming mid-tier and upscale hotel developments in Sentosa – Village Hotel, The Outpost Hotel and The Barracks Hotel – and has the ROFR to the rest of the stake when the hotels are completed. Given that the bulk of hotels in Sentosa cater to the luxury crowd, the three hotels face limited competition as the mid-tier and upscale segments remain underserved, and could benefit immensely from the Greater Southern Waterfront project in the longer-term.

Downside Risks Remain But Likely Factored Into Valuations

Singapore's hospitality sector is an exciting area to be in, but macroeconomic headwinds brought about by the ongoing US-China trade war could weigh on tourist arrivals and RevPAR growth in 2019 despite an improving supply outlook. As such, the performance of FEHT's hotel portfolio and its distributable income could be adversely affected.

Furthermore, unitholders should note that FEHT is moderately exposed to interest rate risk as slightly less than half of its borrowings are on variable rates. In a rising interest rate environment, FEHT may incur higher debt servicing costs, putting downward pressure on distributable income.

At 40.4%, FEHT's gearing ratio is also high relative to its peers, leaving little debt headroom and any future acquisitions could be funded by equity raising. However, we note that FEHT's Sentosa properties are currently valued at cost basis. When completed, the properties will be valued on a completed basis, and the resulting revaluation gains should help to bring down its gearing ratio. In any case, we believe that the increased downside risks have already been baked into its low valuations.

The good news for investors? Each of FEHT's 13 properties is under a Master Lease Agreement (Table 5), where the master lessee, all of whom are members of the sponsor group, will pay FEHT rental payments that comprise a fixed and variable component, ensuring that unitholders receive distributions with a certain level of stability. The term of each Master Lease Agreement is for 20 years (from listing date in Aug 2012) with an option to extend for another 20 years.

The fixed component provides downside protection to unitholders, while the variable component, which is pegged to a percentage of the property's gross operating revenue (GOR) and gross operating profit (GOP), enables unitholders to participate in any potential upside from increased hotel room demand in the future. If the variable component yields a negative value, unitholders will not be expected to bear any operating losses as variable rent will simply be zero.

Table 5: Terms Of Master Lease Agreements

Undervalued REIT With Attractive Distribution Yield

As FEHT pays regular distributions to its unitholders, the dividend discount model can be used to estimate its intrinsic value. Assuming a discount rate of 8.0% (calculated using the capital asset pricing model) and a constant dividend growth rate of about 2.0% (in line with long-term inflation expectations), the simplified model yields an estimated target price of SGD 0.73 (Figure 8), which seems to suggest that FEHT may be undervalued at its current price of SGD 0.63 (as of 28 January 2019).

Figure 8: Using The Dividend Discount Model To Estimate Intrinsic Value

Its price-to-book ratio of just 0.72 also appears to have priced in much of the downside risks facing the REIT, and with the cyclical upturn in Singapore's hospitality sector expected to continue, we believe it is time for investors to seriously consider stocking up on FEHT. To sweeten the deal for investors, FEHT offers an attractive distribution yield of about 6.67% this year (as of 28 January 2019).

Declaration:

For specific disclosure, at the time of publication of this report, IFPL (via its connected and associated entities) and the analyst who produced this report hold a NIL position in the abovementioned securities.

The Research Team is part of iFAST Financial Pte Ltd.