Singapore REITs: Time For Some Caution?

• Singapore-listed REITs have delivered a 27.6% return since our last update in August 2012
• Present valuations indicate that the sector trades at a 22% premium to book value, placing Singapore REITs in the "expensive" zone, although not at the most expensive levels the segment has been at, historically
• Correspondingly, dividend yields for the sector have also fallen to 4.5% (as of 18 April 2013)
• Rising interest rates can negatively affect REITs in two key ways:
• Increasing the cost of funding, as CMBS and MTN yields rise, although we note that some REITs have lengthened debt maturity by issuing longer-dated bonds
• Property values are tied to "cap rates", which are based on the "risk-free" rate; should interest rates rise, cap rates may begin to trend up weighing on property values
• Positive near-term outlook driven by the hunt for yield, although investors may want to avoid being overly-exposed to the sector on its less attractive valuations   

Strong performance for Singapore REITs since our last update

Chart 1: Strong returns for Singapore-listed REITs

In our last update on Singapore-listed REITs (see Are Singapore REITs Still Attractive?) in August 2012, we suggested that the segment was "not expensive", although investors would do well to understand the potential risks and rewards associated with investing in the REIT sector. Since then, Singapore REITs have delivered a healthy 27.6% return (in SGD terms, including dividends as of 24 April 2013), while the Phillip Spore Real Estate Income Cl A SGD has delivered a similarly-strong return of 26.9% over the same period. Following the strong run-up in the segment, we relook valuations for Singapore-listed REITs while also discussing some implications for the sector should interest rates begin to normalise from current depressed levels.

Valuations have risen in tandem with the market

Chart 2: REITs at a "premium" to book value

As per our pervious comments on the REIT market, net asset (or book) value represents the value of the REIT's underlying properties (minus liabilities), and this is usually a fairly current figure, with most REITs choosing to revalue properties on an annual basis. With the strong recent run-up in the Singapore-listed REIT space, valuations have since risen to 1.22X book value, indicating that the sector now trades at a 22% premium to net asset value (as of 24 April 2013). This possibly entails expectations of strong capital appreciation of the REIT's underlying properties, further yield enhancements attributable to equity-based financing (since the REITs are selling for more than what their underlying properties are worth), and is also a function of the premium investors are willing to pay for well-managed REITs which may have the ability to perform asset enhancements on existing properties, thus increasing their value and accruing positively to book value.

Chart 3: Dividend yields have declined

Singapore-listed REITs are required to pay out at least 90% of taxable income as dividends, and the dividend yield on a REIT is thus a function of the rental income which can be achieved from the underlying properties. If the property manager is able to raise rents, the dividend yield could rise from present levels as more rental income is achieved. On the flipside, weak demand could see rental yields decline, hurting dividend yields of REITs. Largely as a result of rising REIT prices (which has more than offset the increase in dividend payouts), the yield on Singapore REITs has declined from a historical peak of over 16% in 2008 to just 4.5% presently (as of 18 April 2013).

Investors should avoid solely focusing on "yield" in the REIT market

The strong recent performance has resulted in more expensive valuations for the sector, which we believe has been driven by an insatiable thirst for yield in the present low-interest rate environment. As investors consider the attractiveness of the sector's dividend yields at present, we think the distinction between fixed income and REITs is worth reiterating here. Unlike fixed income where yields can be "locked-in" and bond principal is fixed, REIT yields are economically-sensitive, while the investor is also exposed to the risk of capital losses should property prices decline, making the segment a rather different investment compared to the bond market. REITs should be seen as more of a proxy to property ownership (see "Understanding REITs"), and investors may wish to question whether paying a hefty premium above net asset value for a portfolio of property assets makes good investment sense.

On a historical basis (see Chart 2), the Singapore REIT sector has certainly traded at a larger premium (between 2003 and late-2007) to book value, while yields have admittedly been lower in the past, which could allow the sector to post further gains going forward if valuations ultimately reach the lofty levels of the past. Nevertheless, we prefer to sound a note of caution on the segment, especially with the potential negative implications of rising interest rates.

Higher interest rates to bring about Higher Financing Costs, Lower Property Values?

With interest rates already near historical lows, it is worthwhile discussing the possible implications on the REIT sector should interest rates ultimately rise from present levels. Two key potential negatives are a higher cost of capital (which could eat away at dividend yields) as well as a possible downward revision to property values, which could result in some capital loss.

The present low interest rate environment has clearly benefited Singapore REITs, which are largely dependent on financing rates at the shorter end of the bond market (via the issuance of commercial mortgage-backed securities or medium-term notes, which usually have a tenor of less than 5 years). Most REITs have thus seen their cost of debt fall accordingly in recent years, reducing their financing costs. Following the harrowing experience of 2008-2009 which saw credit markets seize up (leaving some REITs with limited access to financing), we note that some Singapore-listed REITs have acted prudently in the current environment by issuing longer-term debt to diversify debt maturity, as well as hedging interest rate risk by taking on more fixed rate debt (as opposed to floating); nevertheless, the bulk of REIT financing is still short- to medium-term in nature, given the lower interest paid on shorter tenor. Should interest rates rise from present levels, this may have the effect of increasing financing costs for Singapore-listed REITs, which could hurt dividend payouts.

Chart 4: Bond yields and cap rates

Rising interest rates may also result in higher capitalisation rates ("cap rates"), which could hurt property values. Chart 4 shows the trend between cap rates on US retail and office space against the trend in the 10-year "risk-free" US Treasury, highlighting how cap rates and interest rates have tended to trend together over time (the cap rate is essentially the risk-free rate plus a spread). Should the risk-free rate increase from present levels, this may have the effect of raising the required yield demanded by investors, which could weigh on property prices.

Positive sentiment Still, but watch out for valuations

The insatiable hunt for yield has lifted the prices of yield-generating assets, with REITs being one of many beneficiaries. Anecdotal evidence from our communication with investors suggests that this theme still remains very relevant (despite our suggestion of Dividends Good, But Capital Gains Better?), with many investors continuing to be fervent admirers of REITs, which could continue to be a near-term positive for the sector's performance. Nevertheless, the strong run-up in Singapore REIT prices has left valuations at less attractive levels, while a normalisation of interest rate conditions may result in some potential headwinds for the sector. While we continue to think that REITs offer investors an excellent proxy to property ownership (with superior liquidity), investors should watch out for valuations in the sector, and avoid having portfolios which are overly-concentrated in the segment.

See Also:

Are Singapore REITs Still Attractive?

Understanding Real Estate Investment Trusts (REITs)