S-REITs are losing their appeal, you shouldn’t be satisfied with an average yield of 6%

• While most S-REITs generated positive DPU growth in FY2022, we note that the performance varied across sectors. Excluding hospitality S-REITs, the sector delivered lacklustre growth.

• While the collapse of SVB suggests that there may be fewer rate hikes than previously expected, the Fed is unlikely to change course significantly. Interest rates will remain higher for longer, leading to a higher average cost of debt.

• We believe property valuations have scope to fall. S-REITs are also vulnerable to negative price reactions from earnings disappointment, as current estimates remain overly optimistic.

• Besides, the banking crisis has raised fresh concerns regarding the reverberations of higher interest rates. Tighter financial conditions suggest trouble for REITs with high leverage.

• For investors who wish to retain exposure to S-REITs, we believe it could pay to be selective. Those who find security selection to be overwhelming may consider a diversified REIT ETF, such as the NikkoAM-StraitsTrading Asia ex Japan REIT ETF (SGX:CFA).

After one of the biggest sell-offs in history, Singapore REITs (S-REITs) were rather resilient year-to-date. The interest rate-sensitive sector, as gauged by the FTSE ST REIT Index, booked a gain of roughly 5% year-to-date largely due to the banking crisis which fuelled a dramatic re-pricing of interest rate expectations.

However, this may not be the time for investors to rejoice. We believe that the current macroeconomic environment remains challenging for S-REITs.

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

Rebound in hospitality masks challenges faced by the overall sector

Looking back at the DPU growth in FY2022, we note that the performance varied across sub-sectors (Figure 1). Growth was mainly contributed by the hospitality sub-sector, whose operating performance saw substantial improvements due to the reopening of international borders. Meanwhile, other sub-sectors delivered median DPU growth ranging from merely 1.6% to -7.8%. These trailed far behind Singapore’s core inflation which averaged 4.1% in 2022.

Figure 1: Median DPU growth across sub-sectors

Retail and office REITs caught our attention. First, retail REITs were generally the worst performers. In particular, BHG Retail REIT (SGX:BMGU) suffered a -46.1% drop in DPU year-on-year mainly due to rental rebates, higher interest expenses, and one-off refinancing expenses. That being said, large-cap retail S-REITs performed relatively better as Frasers Centrepoint Trust (SGX:J69U) recorded a 1.2% increase in FY22 DPU (ended 30 Sep 2022).

Second, within the office sub-sector, only Keppel REIT (SGX:K71U) generated positive growth of 1.7% in FY2022, helped by an anniversary distribution of USD 10 million. Excluding this special dividend, its growth would have been negative at -2.9%. Moreover, a glaring mention includes Manulife US REIT (SGX:BTOU), whose DPU fell -10.9% due to an enlarged unit base from its December 2021 private placement, lower rental income, and higher finance costs.

Overall, higher operating expenses and borrowing costs have been commonly cited by S-REITs as headwinds to their distributions moving forward.

Impact of high interest rates and slowing growth is underestimated

While the pace of hikes may become more measured, rate cuts are unlikely this year even if a recession comes as inflation is likely to take much longer than expected to moderate. Consequently, interest rates are likely to remain higher for longer.

Hence, although the majority of REITs’ existing debt is on fixed rates, they will eventually be forced to refinance their expiring loans at higher rates, resulting in a higher average cost of debt. The Fed funds rate is currently 4.75% to 5%. Assuming rates are held at an elevated level, it is not wishful thinking to see the average cost of debt moving towards 4% from the present 2-3%.

Another big issue now is that the odds of a recession have increased. This, coupled with high inflation and interest rates, has created a backdrop that is especially challenging for REITs.

S-REITs mostly reported stable capitalisation rates in 2022. This resilience, however, is only here to stay in the short term. Capitalisation rates are likely to expand as interest rates remain elevated, with little reason to suspect they will decline meaningfully, and as growth prospects are dampened. As such, property valuations have scope to fall. At a PB ratio of 0.95X, it is implied that S-REITs are only trading at a 5% discount to their current book value, providing little margin of safety.

Meanwhile, the slowdown in commercial leasing activity is likely to put downward pressure on rental rates, and consequently the potential for DPU deterioration. On aggregate, consensus estimates indicate that DPU growth of the S-REIT sector will only come in at a modest 1.6% in FY2023. Excluding the still-recovering hospitality sub-sector, the growth remains positive at 0.3%.

Conversely, in the last two global recessions (Covid-19 and the global financial crisis), the S-REIT sector recorded double-digit negative growth (Figure 2). Thus, we believe that S-REITs are vulnerable to negative price reactions from earnings disappointment as the macro backdrop weakens.

Figure 2: DPU growth during past recessions

Banking turmoil raises refinancing worries in real estate

Besides, the banking crisis has raised fresh concerns regarding the reverberations of higher interest rates. Even before the SVB saga, Brookfield Corp (NYSE:BN), one of the world’s largest investors in real estate, and Columbia Property Trust defaulted on loans tied to their office buildings in gateway cities like Los Angeles and New York as they battle higher financing costs and elevated office vacancy rates.

Tighter financial conditions, coupled with the slowdown in leasing activity, suggest that REITs with high leverage may find it increasingly difficult to meet their debt obligations or roll over existing debt maturities. US office REITs have well-documented this spillover impact from financial stresses. The trio of SGX-listed US office REITs saw a slump in their share prices as the market reassessed their financial stability and tenant risk. Year-to-date, Manulife US REIT (MUST) is down -33%, Prime US REIT (SGX:OXMU) tumbled -34%, and Keppel Pacific Oak US REIT (SGX:CMOU) fell -15%.

In particular, MUST has found itself in a difficult situation. Its leverage catapulted from 42.8% to 48.8% in a year, which is a hair’s breadth below the regulatory limit of 50%, on lower property valuations after adjusting for higher capitalisation rates and idiosyncratic risks at the property level such as higher vacancy or weak submarket fundamentals. At a portfolio level, occupancy has decreased by a sizable 4.3% amidst a shakier economy.

The REIT has USD 143 million worth of revolving credit facility (RCF) and other loans due in 2024. Higher leverage raises woes over its refinancing capabilities. Downside risks include dilution from equity fundraising or the sale of properties (of late, MUST has already announced and completed the divestment of its property Tanasbourne on 12 April).

You shouldn’t be satisfied with a 6% yield on S-REITs

In view of optimistic DPU estimates and an uncertain macro backdrop, we are still not convinced that the S-REIT sector as a whole is presenting investors with an attractive risk-reward proposition.

The rapid rise in bond yields has provided investors with the opportunity to earn higher yields without taking on the risk associated with equities. The yield spread between the sector and the Singapore 10-year government bond remains at a multi-year low and below the historical average (Figure 3). This suggests that investors are currently compensated with a lower risk premium for investing in S-REITs.

Figure 3: Yield spread remains narrowed compared to historical standards

In our view, investors should be expecting a yield of over 7% from the overall S-REIT sector, based on the historical yield spread and the 10-year government bond yield. High-quality S-REITs could trade below this range, while S-REITs of poorer quality are expected to trade even higher than this figure. Today, the S-REIT sector is currently offering a forward distribution yield of 6%. Therefore, the downside is that share prices could correct by at least -10%.

At an asset class level, we are underweight equities (including REITs) relative to fixed income. Today’s bond yields are at their highest since the global financial crisis, underpinning the growing attractiveness of fixed income. Valuations of bonds have also turned much more attractive as compared to equities.

Table 1: Recommended bond funds

For investors who wish to retain exposure to S-REITs, balance sheet strength ought to be a key differentiator. Amidst tighter financial conditions, it would be prudent to avoid REITs with high gearing ratios (Table 2).

Table 2: Top 10 S-REITs with highest leverage

Security selection can also be made on a sectoral level. Amidst economic headwinds, S-REITs that benefit from strong secular demand should be relatively resilient. For instance, elevated e-commerce penetration and supply chain diversification (e.g. “China Plus One”) should sustain demand and provide resilience for S-REITs that are focused on logistics properties. Digitalisation, investment in 5G technology, and the rise in the use of social media are some of the major factors driving the data centre market. As data centres tend to have long-term leases, those with rental escalations based on the consumer price index (CPI) should be able to outperform.

Although US office REITs are trading at depressed valuations, investors should enter at their own risk. MUST is facing several hurdles, it will take a long period of time to ever recover from this. It is also uncertain whether the REIT’s manager will be acquired by Mirae Asset Global Investments. Meanwhile, PRIME’s leverage is at a dangerously high level. Lastly, while KORE has a stronger financial position as well as properties located in secondary cities that have held up better, it is ultimately a small-cap S-REIT. REITs on a smaller scale could be more vulnerable as the macro backdrop continues to depress.

Table 1: Comparison between US office REITs

Lastly, it remains unclear if China’s post-pandemic surge in spending will be sustainable against the global macro backdrop, which should have an impact on retail and hospitality S-REITs. Investors may want to opt for those with assets of higher quality.

Investors who find security selection to be overwhelming but still wish to retain exposure to S-REITs may do so by investing in a diversified REIT ETF. Our recommended product is the NikkoAM-StraitsTrading Asia ex Japan REIT ETF (SGX:CFA).

Declaration:

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