Think your 5-6% yield for S-REITs is attractive? Think again. A hurricane is coming for S-REITs.

• Higher interest rates are likely to have significant implications for S-REITs, which are darlings of the Singapore stock market.

• First, higher interest rates make funding more expensive. Rental reversions may be insufficient to make up for the increase in interest expense, resulting in a flattish or negative DPU growth.

• Secondly, higher interest rates also tend to decrease the value of properties held by REITs. This can translate into a lower NAV, and in turn, weaker share prices.

• Lastly, higher interest rates have reduced the appeal of S-REITs to income-seeking investors. Investors are now compensated with a lower risk premium for holding S-REITs due to narrowing yield spreads.

• Against the current backdrop, the valuations of the S-REIT sector could see a further re-pricing. To navigate this new environment of higher rates, investors should remain selective.

REITs are the darlings of the Singapore stock market. With the sector (as represented by the FTSE ST REIT Index) coming down -5% year-to-date, investors might be pondering whether it could be a good buying opportunity. After all, there is the theory that REITs can provide protection during an inflationary environment as rents tend to increase.

Following the fall in share prices, the S-REIT sector is now offering forward yields that are north of 5%. This may look somewhat decent when compared against what investors have been receiving over the last couple of years.

However, amidst the challenging macroeconomic environment of rising interest rates, we believe investors should think twice about the attractiveness of S-REITs. In fact, lo and behold, higher interest rates are likely to have significant implications for them.

(Related article: Quick Take: Expect Fed rate hikes to be more aggressive than before)

Higher funding costs to put DPU under pressure

First, higher interest rates make funding more expensive. In general, REITs tend to take on debt to finance their growth strategy. This also explains why the S-REIT sector possesses a considerable amount of debt, with an aggregate leverage of around 37%.

Interest rates are likely to stay elevated for an extended period of time, with REITs being forced to refinance their expiring loans at higher rates. All else being equal, higher borrowing costs will lower distributable income, thus placing a downward pressure on distribution per unit (DPU).

Currently, the average cost of debt of S-REITs is slightly north of 2% as they have managed to lock in lower interest rates over the last few years. However, with higher interest rates taking hold, S-REITs would eventually face the reality of a higher average cost of debt.

We believe that the average cost of debt could move towards 4% in the next couple of years. This increase in interest expense from higher borrowing costs is likely to result in a decline of over -20% in DPU from today’s levels.

On a slightly more positive note, a mitigating factor could be positive rental reversions, as higher rental income could help to offset the increase in borrowing costs. Now, the million dollar question is whether rental reversions can make up for the impact of rising rates. The short answer is no.

In the first quarter of the year, the rental reversions of blue chip S-REITs such as CapitaLand Integrated Commercial Trust (SGX:C38U) and Ascendas REIT (SGX:A17U) have ranged from around -6% to +4% (Figure 1).

Moving forward, the annual rental reversions across most S-REITs are likely to be within the positive low single-digit range, supported by the elevated levels of inflation. While decent, the rental reversions may still be insufficient to make up for the increase in interest expense, resulting in a flattish or negative DPU growth overall.

By and large, we expect DPU to take a beating due to higher funding cost from rising rates. In particular, REITs that have less ability to make up for the impact of higher funding cost through organic growth (i.e. rental reversions) are going be hit harder.

Figure 1: Rental reversions of blue-chip S-REITs

Lower property valuations to impact NAV

Secondly, higher interest rates also tend to decrease the value of properties held by REITs, which are measured based on techniques including the discounted cash flow method and the capitalisation method (Table 1).

Table 1: Valuation techniques

The concept of how rising rates can affect the discounted cash flow method is relatively simple – discount rate increases due to a higher risk-free rate, which lowers property valuation.

Meanwhile, the capitalisation method is less understood by investors. The capitalisation is essentially dependent on the capitalisation rate, which corresponds to an investor’s required rate of return less the expected growth of the property. Rising interest rates would push the required rate of return up, hence increasing the cap rate.

From this, we can also establish a relationship between the cap rate and interest rates (i.e. cap rate = interest rates + spread). To illustrate, we assume that interest rates (as represented by the 10-year Singapore government bond yield) reaches 4%. Using a spread of 2% (which is around historical levels), we would arrive at a cap rate of 6%. This is higher than the cap rates over the past few years, which were at around 4 to 5%. A higher cap rate will therefore, lower property valuations.

A factor that could cushion the impact of higher cap rates would be a higher net operating income. In spite of this, we opine that the growth in net operating income is generally unlikely to be strong enough to completely offset the impact. Besides mild rental reversions, several S-REITs have reported a rise in operating expenses as a result of higher electricity costs which could dampen the growth in net operating income.

Overall, we expect property valuations to decrease, which can translate into a lower net asset value (NAV). In turn, share prices are likely to weaken, considering that investors ideally should still be paying a similar P/NAV multiple for the same REIT.

Yields are no longer looking attractive

Lastly, higher interest rates make the yields generated by REITs look less attractive as compared to less risky investments like fixed income, thereby reducing their appeal to income-seeking investors.

Currently, the yield spread between the S-REIT sector and the Singapore 10-year government bond has narrowed to 2.6% (Figure 2). This is much lower than the five-year average of 3.7%, meaning that investors are now compensated with a lower risk premium for holding S-REITs.

Figure 2: Yield spread has fallen dramatically this year

Even as government bond yields rise, investors should be compensated with the same risk premium as before. To maintain the same yield spread, the yields of REITs would have to expand, which also implies that share prices have to decline.

At present, the Singapore 10-year government bond yield has surpassed 3%. We believe that the yield could go higher, and arrive at 4%. Coupled with the historical yield spread, investors should be expecting a yield of at least 7%. To get to such levels of yield, the share price of the S-REIT sector clearly has plenty of room to fall from today’s levels.

Still think that your 5-6% yield for S-REITs is attractive?

In a nutshell, when it comes to investing in REITs, looking at the yield alone is not enough to determine its attractiveness.

We would like to caution investors that as much as rental rates tend to increase in an inflationary environment, rising rates will have a profound impact on S-REITs. This impact can be measured in terms of DPU growth, NAV, and yield spread – all of which can ultimately affect share prices.

Against this backdrop, valuations of the S-REIT sector could see further re-pricing. Nonetheless, not all REITs are created equal; some could be hit harder as compared to others due to their portfolio positioning (e.g. debt structure, weighted average lease expiry). Hence, investors of S-REITs should remain selective.

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.