Be selective in S-REITs as rates stay higher for longer

Higher capitalisation rates to dilute property values and increase leverage

To illustrate the potential downside risks, we first looked into the impact of a 1% increase in capitalisation rates on property values. We stress-tested the top 10 S-REITs by market capitalisation as shown in Table 1 below.

Table 1: Top 10 S-REITs by market capitalisation

We found that a 1% expansion in cap rates will result in property valuations falling by an average of -20%. Despite this, we recognise that Mapletree Industrial Trust (SGX:ME8U) and Capitaland Ascendas REIT (SGX:A17U) are less vulnerable against cap rate expansion. On the other hand, a greater impact on property valuations was seen in Keppel REIT due to its lower existing implied cap rate.

Figure 2: Adjusted property valuation after cap rate expansion

A lower value of assets will automatically increase a REIT’s leverage. Thus, we computed the adjusted property values and then calculated the amount of buffer available for these REITs before they will breach the regulatory gearing limit of 50%.

We note that the average available buffer stands at only 4%, which is likely to be insufficient. That said, Frasers Logistics & Commercial Trust (SGX:BUOU) would have the largest buffer of 29%, largely attributed to the fact that it has the lowest reported leverage of 27.8% (as of 1HFY2023) relative to the average peer gearing ratio of 38.5%.

On the flip side, S-REITs with no buffer are Mapletree Pan Asia Commercial Trust (SGX:N2IU), Suntec REIT (SGX:T82U), and Keppel REIT due to their high gearing ratio of 40.7%, 42.6%, and 39.2% respectively in 1HFY2023.

This may sound like bad news for investors. We caution that this is only the tip of the iceberg as we look to capture the near-term refinancing risks in the next layer of our stress test.

Figure 3: Buffer available before breaching threshold

Refinancing risks persist, dragging down interest coverage ratios

In this layer of stress test, we estimate S-REITs’ new cost of debt in accordance with the prevailing high interest rate environment. We compute the cost of debt after refinancing in 2025, with interest rates based on a credit spread over the MAS Singapore Overnight Rate (SORA).

Through our analysis, we find that some S-REITs who locked in a low cost of debt a few years ago and have a huge proportion of their debt maturing in the next two years would face the greatest refinancing risks. These include Frasers Logistics & Commercial Trust and Capitaland Ascott Trust (SGX:HMN), which would both see an increase of over 50% in their cost of debt.

Figure 4: Cost of debt after refinancing

Thereafter, we estimate the higher interest expense that will be incurred, assuming that no new debt would be taken on. It is worth highlighting that higher interest expense lowers the interest coverage ratio (ICR).

It is crucial to look into the ICR as it determines which leverage threshold a REIT would be subjected to. On 16 April 2020, MAS announced that it would raise with immediate effect the leverage limit for S-REITs from 45% to 50%, to provide S-REITs greater flexibility to manage their capital structure amid the challenging environment created by the COVID-19 pandemic. MAS also proposed to require S-REITs to have a minimum ICR of 2.5 times before they are allowed to increase their leverage to beyond the prevailing 45% limit (up to 50%).

We note that Suntec REIT is currently subjected to a limit of 45% due to its ICR of 2.1X (as of 1HFY2023). Our findings have also shown that some S-REITs would see their ICR fall below 2.5X because of higher interest expenses, which would lower their leverage limit from 50% to 45%. They are Mapletree Pan Asia Commercial REIT, Capitaland Ascott Trust, and Keppel REIT, as highlighted in red in Figure 5.

So, the next question would be if these S-REITs have enough buffer for their property valuations to fall, relative to the new threshold of 45%.

The short answer is no.

Suntec REIT, Mapletree Pan Asia Commercial REIT, and Keppel REIT already have no buffer at a threshold limit of 50% after adjusting for cap rate expansion. On the 45% limit, we note that Capitaland Ascott Trust would also have no buffer. Hence, as we estimate that the ICRs will fall below 2.5X for these S-REITs, the downside risks now appear even larger.

Figure 5: Interest coverage ratio after refinancing

Financial implications upon breaching the threshold

Upon breaching the regulatory gearing limit, the financial implications faced by these S-REITs include distressed sales of properties, equity fundraising, and abandonment of distribution policy.

In the event of distressed sales of properties, it could potentially cause a ripple effect in the market and widespread falling property valuations. Meanwhile, net property income will be reduced.

Moreover, to further lower its leverage, a REIT may seek equity fundraising, which may not be desirable at the current low share price. This move could also dilute the equity value of its existing shareholders.

Lastly, S-REITs are also at risk of eventually breaching other debt covenants, forcing them to abandon their distribution policy.

An example is Manulife US REIT, which breached its debt covenants, leading to the abandonment of its distribution policy. More S-REITs are also at risk of following suit, and we believe it is only a matter of time before it actualises.

Conclusion

After running stress tests involving cap rate expansion and refinancing risks on the 10 largest S-REITs by market cap, we believe investors should be selective on S-REITs as the downside risks have not been fully priced in.

Based on our analysis, we recommend investors to consider S-REITs with greater resiliency such as Capitaland Ascendas REIT and Mapletree Industrial Trust, which have a greater buffer against cap rate expansion and would experience a relatively smaller increase in cost of debt after adjusting for refinancing.

On the other hand, we advise investors to avoid Mapletree Pan Asia Commercial REIT, Capitaland Ascott Trust, Suntec REIT, Keppel REIT as we believe that these S-REITs would suffer greatly from cap rate expansion and near-term refinancing risks.

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.