S-REITs have seen a correction, but you should think twice before buying

• Despite being regarded as an inflation hedge, Singapore REITs (S-REITs) have been battered by rising interest rates.

• In the new economic landscape marked by slow economic growth and higher-for-longer interest rates, DPU growth is likely to be lower, or even negative, putting pressure on share prices.

• Moreover, signs are pointing towards a reduction in property valuation, which can translate into a lower net asset value (NAV) for REITs.

• We also believe that the outlook of the S-REIT sector – spanning the sub-sectors of retail, office, industrial, data centre, healthcare, and hospitality – is mixed.

• At a forward distribution yield of 6%, we think that the yield pick-up provided by S-REITs is insufficient to make up for equity risk. As the allure of S-REITs remains dim, investors on the hunt for yields may consider the fixed income asset class for better risk-reward.

Despite being regarded as an inflation hedge, Singapore REITs (S-REITs) have been battered by rising interest rates. In the middle of 2022, we warned investors that higher rates are likely to have a profound impact on S-REITs.

Fast forward to today, the sector – as gauged by the FTSE ST REIT Index – experienced one of the biggest sell-offs in history, and chalked up losses of -11% in 2022. Consequently, S-REITs have significantly underperformed the Straits Times Index (STI), which recorded a total return of around 8% during the same period (Figure 1).

(Related article: Think your 5-6% yield for S-REITs is attractive? Think again. A hurricane is coming for S-REITs.)

Figure 1: S-REITs have significantly underperformed the STI

New economic landscape is not conducive for REITs

At the macroeconomic level, we do not see a favourable backdrop for REITs. We believe that the world is moving into a new regime where inflation is in a structural shift, characterised by shortages in commodity and labour markets. Inflation will possibly take much longer than expected to moderate, and interest rates will remain higher for longer. With this, REITs are being forced to refinance their expiring loans at higher rates, resulting in a higher average cost of debt.

Take for instance an S-REIT which currently has an average cost of debt of 2.5% (considered as low since it managed to lock in lower interest rates over the past few years). Suppose that the average cost of debt moves towards 4%, not a wishful thinking if the Fed’s terminal rate reaches 5% and rates are held at an elevated level. On a like-for-like basis, the increase in interest expense from higher borrowing costs will likely result in a decline of around -20% in DPU from today’s levels. To be sure, this is for illustrative purposes as in actual practice, the cost of borrowing does not jump immediately and the impact of DPU could be lesser than the estimated -20%.

Persistently high inflation may not be the worst that is to come. The US and Europe are projected to slip into recession due to the Federal Reserve's monetary tightening and the energy crisis, respectively. Closer to home, Singapore’s forecasted GDP growth in 2023 has been reduced to 1.8% amidst concerns over a global economic slowdown, according to the latest survey released by the Monetary Authority of Singapore (MAS). Accompanied with stubborn inflation that a global recession is unlikely to bring down, we believe that the world could be headed for a stagflationary environment.

(Related article: iFAST 2023 Market Outlook: Click here for a must-read guide before you start investing in 2023)

The implication for REITs is the likelihood of a broad slowdown in commercial leasing activity, which could put downward pressure on rental rates and the potential for DPU deterioration. The macroeconomic environment that is fraught with uncertainties may also drag on the pace of acquisitions as REITs exercise prudent capital management. DPU growth could weaken, as acquisitions – besides rental reversion – are deemed as a growth driver for REITs.

Furthermore, property values could be challenged. Property valuations are a function of discount rates or capitalisation rates (cap rates), as well as net income (Table 1). The estimated fair value of a property would decrease if discount rates or cap rates rises due to higher interest rates. On a similar note, a drop in net income in face of recessionary or stagflation challenges would result in a lower property fair value.

Table 1: Valuation techniques

All together, we foresee a perfect storm coming for REITs. DPU growth is likely to be lower, or even negative in the new economic landscape marked by slow economic growth and higher-for-longer interest rates, thus putting pressure on share prices. Moreover, signs are pointing towards a reduction in property valuation, which can translate into a lower net asset value (NAV) for REITs. Investors who are looking at the current PB ratio of 0.9X for the sector should not be fooled into thinking that they are snapping up S-REITs at an attractive discount.

Which sub-sectors should investors be wary of, and which could show some resiliency?

Breaking S-REITs down into different sub-sectors, we recognise that there are diverse factors driving their performances other than the macroeconomic outlook.

Retail

2022 was challenging a year for retail. Even with the relaxation of safe management measures and border restrictions, the Singapore retail market continued to face headwinds stemming from persistent inflation and manpower shortages. As a result, there was some resistance in the recovery of the retail rental market, with rents in the Central Region extending its decline from 2021 (Figure 2). Meanwhile, the largest commercial S-REIT, CapitaLand Integrated Commercial Trust (CICT) (SGX:C38U), saw a negative rental reversion of -4.3% (incoming year 1 rents versus outgoing final rents, year-to-date as of 30 September 2022) for its downtown malls.

Figure 2: Retail rental has been on a downtrend

In our view, the retail market is not going to do any better in 2023. High inflation and the global growth slowdown are likely to weigh on consumer confidence and reduce retail spending. We are also mindful of retailers continuing to face fundamental challenges, such as manpower shortage, higher operating costs, ongoing competition from e-commerce, and an impending GST hike.

That being said, not all retail is the same. Suburban malls that are anchored by essential spending, such as groceries, should provide resiliency amidst the macroeconomic challenges. Traffic at these types of retail assets have also proven to be defensive against e-commerce trends.

Office

In contrast to retail, the Singapore office market saw favourable demand and supply dynamics in 2022, leading to higher rents. Nonetheless, we are cautious about the market’s future performance against the backdrop of a global growth slowdown. The macroeconomic headwinds have caused some firms, particularly those in the technology sector, to announce a hiring freeze or layoff. With firms becoming more conservative in their hiring or expansion plans, leasing demand is likely to be impacted, thus softening the rental growth trajectory.

We believe quality office assets in prime locations are likely to outperform in the flight-to-quality amidst recession concerns. Occupiers should prioritise office space quality to help attract and retain talent. Looking beyond the near-term headwinds, Singapore remains an attractive place for businesses to grow. The nation is also expected to benefit from the relocation of multi-national companies away from Hong Kong as rigid Covid-19 rules and the increasing influence of China lessens the appeal of Hong Kong as a global financial hub.

Industrial

The rental of Singapore industrial properties, too, recorded strong gains in 2022, largely led by warehouses due to favourable demand and supply dynamics (Figure 3). In line with this, CapitaLand Ascendas REIT (SGX:A17U) saw a robust positive rental reversion of 14.6% in 3Q22 for its Singapore logistics properties, contributing to an overall portfolio rental reversion of 5.4%.

Figure 3: Industrial rental is generally on an uptrend

Though growth in the industrial property market is set to moderate in consequence of prevailing global uncertainties and an increase in supply, secular growth trends from elevated e-commerce penetration and supply chain diversification (e.g. “China Plus One”) should sustain demand and provide resilience for the logistics segment.

Data Centre

Data centres are another group of real estate asset class that benefit from secular growth trends. Digitalisation, investment in 5G technology, and rise in the use of social media are some of the major factors driving the data centre market. Notwithstanding the rosy long-term outlook, there are a few things investors need to be aware of in the current environment of high inflation.

First, data centres tend to have long-term leases, which may impede their ability to adjust swiftly to the high inflation. DC REITs with leases that come with rental escalations based on the consumer price index (CPI) should be able to outperform.

Second, data centres are also intensive users of energy, implying that REITs see impact from rising electricity costs. We are wary of rental escalations and reversions not being able to fully offset the impact of such higher costs. DC REITs that are able to pass on higher utilities expenses to customers, or if the customers source electricity directly from power suppliers should be relatively resilient.

Healthcare

Healthcare REITs possess defensive characteristics. Rain or shine, everybody needs healthcare (or will at some point in time), underpinning its ability to weather through rocky economic times. However, there are very few healthcare REITs in Singapore, with the S-REIT sector consisting of only two healthcare REITs – Parkway Life REIT (SGX:C2PU) and First REIT (SGX:AW9U).

While the share price of Parkway Life REIT has retreated by over -20% in 2022, it is still trading at a steep premium to book value (current PB of 1.6X) and remains expensive relative to the broader sector. More importantly, we see PLife REIT as unattractive to income-seeking investors. At a forward distribution yield of around 4%, it hardly provides a reasonable pick-up over risk-free assets.

Meanwhile, First REIT seems more attractively valued. Nonetheless, we are cautious about execution risk as First REIT is currently pursuing a “2.0 Growth Strategy” involving plans to diversify into developed markets, reshape portfolio for capital efficient growth, strengthen capital structure to remain resilient, and continue to pivot to ride megatrends.

Hospitality

Hospitality REITs were among the best performers within the S-REIT sector in 2022, as they benefitted from pent-up travel demand and the return of large-scale events like the F1 Singapore Grand Prix. As compared to the broader sector, hospitality REITs can also provide a more effective hedge against inflation as they are able to raise prices almost immediately (provided that there is sufficient demand). Nonetheless, it should be noted that most hospitality REITs are subjected to master leases comprising of fixed and variable components, hence unitholders may not receive the full benefits of any price increases.

Moving forward, however, we are cautious on whether the strong recovery seen in 2022 can be sustained. We note that business travel is seeing a gradual recovery, and could be hampered by a global growth slowdown. And even if travel demand remains robust, the world is running short of airplanes. Plane-making giants Boeing and Airbus are encountering supply chain issues and labour shortages, leading to backlogs that would take years to fill. The end result of this would be less affordable air fares.

Meanwhile, although China – a key source market – has moved to ease its zero-Covid policy, a deep-rooted fear of the virus presents yet another roadblock. The recovery from Covid-19 measures will likely take time, as we have doubts on whether the Chinese will be keen to travel aboard so soon. Additionally, a growing number of countries have been imposing new restrictions on Chinese visitors due to the rapid rise of Covid-19 cases in China.

(Related article: As China shifts away from zero-Covid, its stock market has rallied near 30%. Will it last?)

Valuations on the whole are still not compelling enough

With the mixed outlook for the S-REIT sector, we are not convinced that it is presenting investors with an attractive risk-reward proposition. While the share prices of S-REITs have fallen since our last update, resulting in higher yields as compared to the start of 2022, we would like to highlight that bond yields have also risen quickly. Thus, the yield spread between the S-REIT sector and the Singapore 10-year government bond remains at a multi-year low, and below the five-year average of around 3.6% (Figure 4). This suggests that investors are now compensated with a lower equity risk premium.

Figure 4: Yield spread remains narrowed compared to historical standards

The “There Is No Alternative (TINA)” narrative is increasingly being challenged, with investors no longer needing to rely on REITs to generate attractive yields for their portfolios. Risk-free assets such as Singapore T-bills (~4%) and Singapore Savings Bond (~3%) are already offering competitive yields. Investors who are willing to take on a little more risk can also generate juicier returns with SGD-centric bond funds.

At present, the Singapore 10-year government bond yield stands at 3%. We see the potential for long-term yields to move up further, due to our view that markets are underestimating the persistence of inflation. If one agrees that the Singapore 10-year government bond yield could reach 4%, and add that with the historical yield spread, investors should be expecting a yield of more than 7%. To get to such levels of yield, the share price of the S-REIT sector needs to fall more than -10% from today’s levels (the sector is currently offering a forward distribution yield of 6%).

Investors should remain selective

In our view, thoughtful selection is required when investing within the S-REIT sector. Besides taking into account valuations, investors should look towards large-scale REITs with sound fundamentals (e.g. be mindful of high gearing ratios), and whose growth are supported by structural tailwinds. We would also like to highlight the risk of investing in small-cap REITs – they may offer higher yields, but lack the scale to adjust to the change in macroeconomic environment.

As the allure of S-REITs remains dim, investors on the hunt for yields may consider the fixed income asset class for better risk-reward. Today’s bond yields are at their highest since the global financial crisis, underpinning the growing attractiveness of fixed income. We have high conviction in SGD-centric short duration bonds as our recommended funds currently hold portfolios that yield at least 5% (Table 2).

Table 2: Recommended short duration funds

(Related article: Stocks are no longer the only option – here’s why fixed income is coming back to focus)

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.