S-REIT yield spread compressed 49bps YTD in July and registered a MoM decline of 20bps. This has dragged it further below the -1SD range – historical average is 360bps. The 10YRSGS yield currently stands at 2.46%. Rising interest rates will be a headwind for S-REITs, but can be mitigated by rental growth.
3-month SOR near 10-year highs in June. Currently at 1.60%, the 3-month SOR is near 10-year highs, and will continue to rise with another expected Fed rate hike in September. The S-REITs have been increasing their hedging activities in this regard, with an average of 78.6% of debt being hedged as at 2Q18 as compared to 77.0% in 1Q18, while keeping all-in finance costs in check at c.3%.
Retail: Tenant sales per square foot were down for 1H2018, as evidenced at both CapitaLand Mall Trust and Frasers Centrepoint Trust, underscoring subdued demand against supply which is at a 4-year high. Moody’s also attested in a July report that the onset of new retail space would further impede retail rent recovery. Retail sales (excl. motor vehicle sales) continued to be lacklustre with the Retail Sales Index remaining flat in June. Fashion was up 2.4% YoY while declines were posted by department stores, supermarkets and F&B.
Office: Office rents remain buoyant and are on an upward trajectory following its bottoming in 2017. CapitaLand Commercial Trust and Keppel REIT both reported strong rental recovery and portfolio valuations. Office capitalisation rates have been compressing despite rising interest rates, due to valuers’ assessment of recent office transactions. Upcoming supply is currently below the 10-year historical net demand of 110k sqm. Strong demand is still expected from the consultancy, technology and financial services segments.
Industrial: 2Q18 sector occupancy ticked down 0.3ppt QoQ to 88.7%. Rental Index appears to be stabilising, as it declined ‑0.1% QoQ to 91.0. Business park rents have risen 0.5% QoQ, the fifth consecutive quarter of growth and the strongest among the various industrial sub-markets. Tapering of new supply in 2018 is a tailwind for the sector, but absorption of vacant space is still slow. Ascendas REIT has made its maiden foray into Europe with the acquisition of 12 logistics properties in the UK. The REIT will also be acquiring a logistics property, Cargo Business Park, in Brisbane, Australia, for A$33.5 million (S$33.9 million).
Hospitality: RevPAR has been trending upwards YoY, up 5.7% to S$185 in June, on both higher occupancy and average room rate. YoY RevPar growth for 2QCY18 was at +4.4% while that of the listed hospitality REITs ranged from -4.1% to +6.7% YoY. Our sensing from the results briefings is that the Trump-Kim summit in June was a net negative to hoteliers as the tightened security had affected demand, as was also cited by one of the REIT Managers. The Competition and Consumer Commission Singapore (CCCS) has issued a Proposed Infringement Decision (PID) against the owners/operators of Capri by Frasers Changi City Singapore, Village Hotel Changi (owned by Far East Hospitality Trust), Village Hotel Katong and Crowne Plaza Changi Airport Hotel (owned by OUE Hospitality Trust) for exchanging commercially sensitive information from 2014 to 2015. The parties (including those who applied for lenient treatment under CCCS’s Leniency Programme) have six weeks from the receipt of the PID to make their representations to CCCS.
Remain NEUTRAL on the S-REITs sector
While S-REITs are currently trading below the -1SD level since the global financial crisis, strong rental growth should offset any adverse effects from rising interest rates. As such we have identified pockets of opportunities within each sub-sector that would inhibit these characteristics of healthy reversion rates and strong leasing activity.
Panning back to the S-REITs sector as a whole, we maintain Neutral on the S-REITs sector on declining tenant sales in the Retail sub-sector and slower-than-expected net absorption of Industrial space. A marked improvement in tenant sales would allow the retail S-REITs to improve occupancy levels at sustainable rental levels. However, tighter e-commerce competition and the oncoming retail supply glut would continue to weigh on retail rentals in the medium term. While Industrial rents have been stabilizing, occupancy still has some catching up to do in order to provide a meaningful catalyst for a sub-sector upgrade.
We like the Commercial and Hospitality sub-sectors due to tapering supply after the surge in supply in the prior two to three years. We are cautious on the Retail sub-sector as retail sales and shopper footfall both remain lacklustre, due to e-commerce competition.
Tactical bottom-up view (unchanged)
For investors with concerns on rising interest rates, look for REITs with:
……such as CapitaLand Retail China Trust (ACCUMULATE, TP:S$1.66), Frasers Logistics & Industrial Trust*, Keppel DC REIT (ACCUMULATE, TP:S$1.45), and Keppel-KBS US REIT*
* Currently not under PSR coverage