• Both sector-wide occupancy and rental fell quarter-on-quarter and year-on-year
• Sector’s Rental Index has fallen to 2012 levels, implying negative reversions going forward
• Factory space will be hardest hit in 2H 2016 with an onslaught of new supply
• 2017 going to be worse than 2016 for Warehouse space
• Business Park space should remain relatively unscathed
• “Underweight” on the Industrial sub-sector due to overwhelming new supply of space, without commensurate demand
• Tactical exposure through REITs with strong underlying demand drivers and ability to ride out the oversupply situation; wary of REITs facing significant portfolio exposure to master lease expiries
• Maintaining our “Equal Weight” view on the overall S-REITs sector

What is the news?

• JTC recently released its Quarterly Market Report of Industrial Properties for 2Q 2016.

Key takeaways from the quarter

• Leasing market remains soft; even Data Centre segment saw weakness

Generally negative reversions across the Industrial REITs, as oversupply condition persists. Even the Data Centre segment was not spared – Keppel DC REIT gave a negative reversion incentive, albeit on a forward renewal to a major customer that expanded its space requirement. Exceptions of positive portfolio weighted average reversions during the quarter came from Ascendas REIT (+4%) with Mapletree Industrial Trust (+0.5%) lagging behind.

• Tenant retention is paramount

We heard feedback from the REIT Managers that the key focus in the current soft market conditions is tenant retention. One Manager recounted an instance where it had a prospective tenant in late stage of negotiations and was eventually undercut by the tenant’s existing landlord.

• Tenants are opting for shorter leases and not willing to commit to forward renewals

Tenants are facing an uncertain outlook for their businesses and landlords are also allowing shorter lease to maintain occupancy – all in an effort to cushion the effects of the soft leasing market. Landlords are also resorting to leasing out partial units for short-term lease.

Investment Actions

We maintain our “Equal Weight” view on the overall S-REITs sector, from our most recent sector report (dated: 18 July 2016). We hold an “Underweight” view on the Industrial sub-sector within the S-REITs sector in view of weak demand and onslaught of new supply.

Cache Logistics Trust – Cautious over the possible overhang of Warehouse space.

• We upgraded our rating from “Reduce” to “Neutral” in our results report on 25 July
• Our analysis suggests that the situation for Warehouse space in 2017 will be worse than 2016
• 25% of leases by gross rental income (GRI) expiring in FY18, substantially from the master lease of CWT Commodity Hub
• We forecast 8.03/7.14 cents Distribution per unit (DPU) for FY16e/FY17e, which is 1%/11% lower than consensus expectations of 8.1/8.0 cents

Keppel DC REIT – Proxy to explosive growth in data requirements.

• We maintain our “Neutral” rating from our results report on 19 July
• Price has appreciated c.12% post-Brexit and valuations appear stretched at 1.3x P/NAV
• Positive catalyst: impending acquisition of Keppel DC Singapore 3 (formerly known as T27) in 3Q FY16
• We forecast 6.63/6.38 cents DPU for FY16e/FY17e, which is 4%/9% lower than consensus expectations of 6.9/7.0 cents
• We believe that consensus has not fully factored in the trend of GBP, AUD and MYR depreciating relative to SGD

Mapletree Industrial Trust – DPU growth from pipeline of build-to-suit (BTS) and asset enhancement initiative (AEI) projects.

• We maintain our “Neutral” rating from our results report on 27 July
• Price has appreciated c.11% post-Brexit and valuations appear stretched at 1.3x P/NAV
• Hewlett-Packard BTS expected to contribute c.10% of portfolio GRI (Phase 1: 4Q 2016, Phase 2: 2Q 2017) and Kallang Basin 4 Cluster AEI due to be completed 1Q 2018
• Our analysis suggests that Factory spaces will be hardest hit in 2H 2016; c.57% by GRI of leases expiring in FY17 come from the Flatted Factories segment
• We forecast 11.08/11.50 cents DPU for FY17e/FY18e, which is in line with consensus expectations of 11.1/11.7 cents

Soilbuild Business Space REIT (SBREIT) – Stability from master leases, and negligible vacancy risk for the rest of the year.

• We maintain our “Accumulate” rating from our results report on 14 July
• No master leases expiring within the next two years; next master lease expiry will be for Solaris (23% of portfolio by GRI) in August 2018
• Negative catalyst: Default by tenant at 72 Loyang Way (Technics Offshore); may not be able to fully lease out property to multiple tenants
• Positive catalyst: announced acquisition of Bukit Batok Connection that is subject to Unitholder approval
• We forecast 6.11/5.99 cents DPU for FY16e/FY17e; this is 1%/6% lower than consensus expectations of 6.2/6.4 cents

2Q 2016 JTC market data: Occupancy and Rental Index

2Q 2016 JTC market data: Supply pipeline

Manufacturing Indicators

How do we view this?

• Industrial activity has been in contraction mode, expect weak demand for industrial space

PMI has been below 50 for the most part of 2015, and for the whole of 2016 until July. Industrial Production Index fell 0.3% y-o-y and fell 2.5% on a seasonally adjusted m-o-m basis. These two indicators suggest a weak industrial outlook and we think it is highly unlikely for industrialists to go on a space expansion spree. As such, we continue to expect supply-demand imbalance to weigh against the sector, with cautious demand in the face of an onslaught of new space.

• Further downward pressure on sector occupancy rates expected as new supply outstrips historical supply amidst weak industrial demand

The existing stock of Industrial space is 45.4mn sqm as at 2Q 2016. JTC estimates about 1.60mn sqm and 2.04mn sqm of industrial space to come on-stream in 2H 2016 and 2017 respectively. This additional space in 2H 2016 and 2017 is a 3.5% and 4.5% increase over existing stock respectively. The additional space coming on stream is significantly higher than the average annual supply of around 1.7mn sqm in the past three years. Historical average demand over the past three years was 1.2mn sqm.

• Industrial sector Rental Index is at 2012 levels; aggregate reversions were negative

Industrial leases are typically for a tenure of three years. 2Q 2016 Rental Index (96.2) is lower than three years ago in 2Q 2013 (100.3), and at the levels last seen in 2012. What this means is that lease renewals signed in 2Q 2016 were at lower rents compared to three years ago, implying negative reversions in aggregate. Going forward, we expect aggregate reversions to be in a negative territory all the way into 2017.

• Factory space looking dire; will be hardest hit in 2H 2016; onslaught of supply

Between the three types of industrial space (Factory, Warehouse & Business Park), we opine that Factory space will be the hardest hit in 2H 2016, particularly the Multiple-user Factory segment. 2Q 2016 Rental Index for Multiple-user Factory (93.4) is already lower than four years ago in 2Q 2012 (96.3), against the backdrop of only 16% of Multiple-user Factory space having been completed in 1H 2016; the remaining 84% of planned space will be coming on stream in 2H 2016. Our view is that going forward, subsequent leases signed will be on negative reversion terms probably all the way into 2017.

• Multiple-user Factory space woes exacerbated by new Single-user Factory space

Similarly, only 16% of Single-user Factory was completed in 1H 2016, with the remaining 84% coming on stream in 2H 2016. Single-user space is typically pre-committed of the build-to-suit (BTS) or own-use configurations, and it is quite likely that such users would vacate their existing space to move into the new property once completed. This would contribute to further oversupply woes in the Multiple-user segment.

• 2017 is going to be worse than 2016 for Warehouses

Warehouse Rental Index in 2Q 2016 (95.4) was also lower than three years ago (97.5). This implies that Warehouse lease renewals done in 2Q 2016 were on negative reversion terms. 60% of Warehouses were completed in 1H 2016, with the remaining 40% coming on stream in 2H 2016. Further downward pressure on rent is to be expected in 2H 2016 as the oversupply condition persists. Total planned supply for 2016 is 0.727mn sqm, with a 20% higher supply of 0.876mn sqm in 2017.

• Winner of the pack: limited new supply for Business Park

New supply of Business Park space is limited in 2H 2016 and 2017, with only 0.7% and 0.2% increase over current existing stock respectively. Currently no new supply planned for 2018 and 2019. 1.1% increase in available space in 2020, which is four years out from now. With Business Park Rental Index higher than three years ago, we still see the possibility for positive reversions in 2H 2016.

Strategic top-down view

• Negative on the Industrial S-REITs sub-sector due to oversupply of space

As highlighted, there will be an imbalance in supply/demand dynamics in 2H 2016 going into 2017. This will result in a tenant’s market and apply downward pressure on both occupancy and rent.

Tactical bottom-up view

• Maintain exposure to REITs with strong underlying demand drivers and ability to ride out the oversupply situation, or visible pipeline for inorganic growth

Keppel DC REIT has a unique asset class of data centres with strong underlying demand drivers. Its portfolio is diversified across seven cities, with 41% of FY15 GRI being derived from within Singapore. Acquisition of Keppel DC Singapore 3 (formerly known as T27) is expected to be completed in 3Q FY16. Mapletree Industrial Trust has ongoing BTS and AEI projects due to be completed by 2Q 2017 and 1Q 2018, respectively. Soilbuild Business Space REIT does not have any master leases expiring within the next two years. 3%/15% of portfolio leases by GRI expiring in 2016/2017.

• Wary of REITs with significant portfolio exposure to master lease expiries

AIMS AMP Capital Industrial REIT has master-lease (c.7% of rental income) of 20 Gul Way expiring in FY17 and three master leases (c.15% of rental income), namely 20 Gul Way (progressive expiry over four years from FY17 onwards), 3 Tuas Avenue 2 and 2 Ang Mo Kio Street 65 expiring in FY18.

Cambridge Industrial Trust has five properties (6.3% of rental income) with master-leases that are expiring in 2016. Two are expected to be divested, one to be renewed, one to be converted to multi-tenanted building and one to undergo AEI works.

Sabana Shari’ah Compliant REIT has four properties (20.5% of net leasable area) with master-leases expiring in 2016.

Commentary for quarterly results across the Industrial REITs sub-sector

• Gross revenue growth driven by inorganic growth; completion of AEIs

Gross revenue across the sub-sector grew mainly due to acquisitions, specifically at Ascendas REIT, Cache Logistics Trust, and Viva Industrial Trust. Completed AEI becoming income-producing at Cambridge Industrial Trust helped as well. Flat to negative rental reversions were seen across the board, with the exception of Ascendas REIT (+4%) and Mapletree Industrial Trust (+0.5%).

• Net property income generally in line with Gross revenue

While generally in line across the sub-sector, some impact was reported by Mapletree Logistics Trust and Cache Logistics Trust due to prior conversions from master leases to multi-tenancies, with Sabana Shari’ah Compliant REIT bearing the full brunt of conversions to non-triple-net master lease tenancies.

• Distributable income broadly in line with Net property income
• DPU broadly in line with Distributable income, some impact by dilution and absence of capital distributions

DPU was broadly in line with Distributable income, except for dilutive effect from larger unit bases y-o-y at Cache Logistics Trust, Soilbuild Business Space REIT and Viva Industrial Trust. Absence of capital distribution contributed to lower y-o-y DPU at Cache Logistics Trust and Cambridge Industrial Trust.

Review of Performance Measures of Industrial S-REITs

Average occupancy of 92.0% among the Industrial S-REITs was higher than the JTC sector-wide occupancy of 89.4%.

Peer relative valuation