The S-REIT sector has returned 14.2% in the first 9 months (excluding dividends) this year despite the threat of rising interest rates. With interest rate continuing to rise, will S-REITs continue to perform? We answer some of the common questions S-REIT investors have in mind in the current environment.
Figure 1: S-REITs returned 14.2% in 9M17, the sixth best performing sector within STI
We are less worried about tightening monetary policies and US rate hikes if they are in response to better economic data instead of runaway supply-side inflation. The previous rate hike cycle from 2004-2006 saw phenomenal returns for S-REITs with a CAGR of 26.5% vs STI’s 15.9% (Figure 3). This demonstrates that REITs can perform in rising interest rate environments. What is important is whether the accompanying economic growth is able to drive rental income higher for the REITs, which could then offset the increased borrowing costs for the REITs.
Figure 2: Last rate hike cycle occurred in 2004-2006
Figure 3: …. But S-REITs managed a CAGR of c.26.5% during the period (2004-06)
Increase in long-term interest rates decreases the yield appeal of REITs as an asset class. However, in terms of financing costs, due to the competitive banking landscape so far, banks are tightening spreads for loans to REITs despite slightly rising SORs over the past 2 years. This has kept borrowing costs in check for REITs. The SGD strength also meant the uptick in SOR rates had remained relatively muted over the last two years.
Apart from retail, all other sectors – office, industrial and hotels – generally face a positive scenario of tapering supply after a peak/surge in supply in 2017. The easing of supply post-2017 should build a base for rentals to start climbing up (Figure 5 to 12).
Figures 5 and 6: Retail is facing increased supply amidst falling demand and the threat of online retailers like Amazon. Nonetheless, retail sales showing signs of stabilization. We expect rents to bottom in 2018.
Figures 7 and 8: Office Supply tapering off after 2017. Office rents showing signs of stabilising. We expect office rents to rebound this year
Figures 11 and 12: Hotel Supply is tapering off after the 4% increase in 2017. SG Hotel RevPAR showing signs of stabilisation over the past half year.
On an absolute yield basis, S-REITs trade at the highest yield of 5.9% vs the other major REIT markets (Figure 13). Nonetheless, the yield spread of 3.8% is third behind that of HK and Japan REITs. With the exception of Hong Kong (using data available from 2012-present), the yield spreads for all other major REIT indices are trading above post-GFC average (Figures 14-18).
Figure 13: Regional REIT markets absolute and yield spreads – S-REITs offer the highest absolute yield and also one of the highest yield spreads
Figure 14: S-REITs yield spread at 3.8%, close to post-GFC average spreads // Figure 15: Australian REITs yield spread at 2.3%, close to +1 s.d.
Figure 16: US-REITs yield spread at 1.8%, close to +1s.d.
Figure 17: HK-REITs yield spread at 4.2%, below post-GFC average spreads (using data available from 2012)
Figure 18: J-REITs yield spread at 3.9%, above post-GFC average
S-REITs currently trade at a yield spread of 3.8 (S-REIT average yield 5.9% – Risk-free rate 2.1%) which is around post-GFC (2010-present) average (Figure 19).
Figure 19: S-REITs yield spread close to post-GFC average
Price/NAV is one metric to determine the valuation of a REIT. It is useful to across the industry vs peers and also compares a REIT’s own historical P/NAV vs the economic outlook too. Big cap REITs typically trade at higher valuations than smaller REITs. Mapletree Industrial, for example, trades at an average Price/NAV of 1.23 post-GFC. Reasons being these big cap REITs typically are able to obtain lower costs of funding, which makes it easier for accretive acquisitions. They also enjoy economies of scale in the management of a larger portfolio. A more meaningful comparison is if you compare it with a basket of similar size market cap peers instead of widely across the sector. Even similar size companies can have portfolios with different geographic exposures too so it is important to take that into account when comparing. When comparing over its own historical P/NAV investors should note if the macro environment is similar to the historical period and whether changes in the environment can justify it trading at a premium/discount to the average over the historical period.
So a REIT trading at a huge discount to book and high yield may mean that the market is pricing in potential future deterioration in rental power of the portfolio properties and not necessarily imply it is a value buy. Investors will need to access market conditions to judge if the discount/premium is warranted.
Unlike telcos and utilities whose fees and tariffs are more highly regulated necessities, REITs are exposed to commercial rents and prices which are more market-driven, based on demand and supply. Therefore REITs will also be able to capture upside in rents in an improving economy, and at the same time still continue paying out at least 90% of rental income. This would appeal to investors desiring stable passive income, and at the same time participate in growth from improving economies.
Land tenure is only one consideration but just by looking at the land tenure of the REIT portfolio alone is insufficient to conclude if the portfolio is better or worse off. Typically, when we compare like-for-like two properties in the same vicinity, one with a freehold tenure vs another with a shorter leasehold, the freehold building usually trades at a lower cap rate (i.e. higher valuation, valuation is inversely related to cap rate) than the shorter leasehold property. So the NAV of the REIT would have already priced in the freehold factor. Another example of REIT pricing already reflecting the shorter land tenures is this: one of the reasons industrial REITs trade at higher yields is due to the fact that industrial properties in Singapore tend to have shorter 30-year leases vs retail or office properties. The higher yield compensates investors for the shorter tenure and the lower potential for capital gains over the long run.
Unlike fixed income, REITs do not have fixed “maturities”, so calculating a duration that measures the sensitivity of the REIT’s price to fluctuations in interest rates in not as straightforward. An easier metric for investors to watch out for instead is the sensitivity of the REIT’s earnings (not price) to fluctuations in interest rates or forex movements in the annual report under “sensitivity analysis”.
Accelerating inflation could lead to faster than expected rate hikes/tightening by the Fed. So far inflation has been tepid despite improving economic data, presenting a Goldilocks situation of moderate economic growth with low inflation that is able to accommodate market-friendly monetary policies. This has supported the strong performance in S-REITs. Any sharp upturn in inflation could reverse these trends.