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S-Reits' performance recovers on expected rate hike delay

Analysts say DPU risks are contained, but unit prices and property valuations may fall if interest rates rise

The performance of real estate investment trusts (Reits) in Singapore has recovered this year, reflecting what analysts say is market confidence that rate hikes will probably happen much later than previously thought.


THE performance of real estate investment trusts (Reits) in Singapore has recovered this year, reflecting what analysts say is market confidence that rate hikes will probably happen much later than previously thought. (see infographic)

When the US Federal Reserve first hinted that it may curtail its bond-buying stimulus programme in May 2013, the 10-year Singapore government bond benchmark surged from 1.4 per cent to 2.8 per cent over the subsequent six weeks, while the FTSE ST Reit Index slumped 19 per cent.

But since February this year, the FTSE ST Reit Index appears to have bottomed out and even outdone the Straits Times Index (STI). It rose by 9 per cent year to date, outperforming the STI which is up 5.8 per cent for the same period.

For now, economists seem to be expecting a 25 basis-point increase in interest rates starting from mid-2015, and some analysts think that Reit prices have started to partially price in this expectation.

There are broadly two major ways that higher interest rates affect Reits. First, it raises borrowing costs, thus heightening their re-financing risks. Secondly, it leads to greater discount rates employed in asset valuations, thus lowering the valuations of physical properties.

Fortunately, most Reits in Singapore have had ample time to react since the first hint of an oncoming taper surfaced. They have taken advantage of low interest rates to put most of their debt on fixed rates, as well as extended their loan tenures while spreading out their maturities, so that no more than a certain amount - and DMG & Partners Research puts the figure at S$7.4 billion for the collective sector - needs to be refinanced each year.

Reits have also conducted early financing by issuing fixed-rate medium-term notes, as well as hedged using derivatives such as interest rate swaps and interest rate caps.

Eli Lee, an investment analyst at OCBC Investment Research, estimates that about three-quarters of the sector's debt exposure has been hedged into fixed rates.

"According to our sensitivity analysis, for every percentage point increase in interest rates, the DPU (distribution per unit) impact among the Singapore Reits (S-Reits) is contained within a 10 per cent decline," he said.

The Monetary Authority of Singapore surfaced similar findings in its financial stability review released last week. It showed the weighted-average debt maturity of the S-Reit sector at 3.2 years, an improvement from just 2.1 years during the 2008 global financial crisis.

"Stress test results indicate that S-Reits are currently well placed to weather interest rate hikes. Under a stress scenario of a three percentage point increase in interest rates and 10 per cent fall in Ebitda (earnings before interest, taxes, depreciation and amortisation), the sector's median interest coverage ratio would still be relatively healthy at 3.6 times."

This means that the sector's profit is enough to cover 3.6 times of total interest on its outstanding debt. Currently, the sector's average interest coverage is at a fairly healthy 5.9 times, according to OCBC's Mr Lee.

Two other factors further enable Reits to lock in low rates for longer periods of time. The first is greater competition among banks for corporate loans, especially amid slower growth for residential loans; the second is a growing demand for long-dated stable yield instruments from insurers, pension funds and sovereign wealth funds, UOB Kay Hian said in a recent report.

But while DPUs are likely to be shielded, the bigger risk is that from a valuation perspective, higher interest rates would lead valuers to adjust the risk premium for real estate and employ greater discount rates in their property valuations.

This will impact the capital values of the Reits' underlying real estate assets and thus the book values on their balance sheets.

Explaining the link between higher interest rates and lower valuations, Ivan Looi, a DMG & Partners Research analyst, said: "Property play is very much a leveraged play. Generally, when interest rates go up, some buyers - especially those with high loans-to-value who cannot meet interest payments or are already breaking covenants - may be forced to sell. The selling pressure thus causes cap rates (capitalisation rates) to go up, and prices to come down."

At the same time, the market may also price Reits lower as well, which means their unit prices may fall. This is because when interest rate risks go up, the Reits' yields will have to adjust and go down or they will become too expensive for yield investors to buy.

Reits tend to be benchmarked to longer-term rates, yet the latter do not always move in lockstep with the central banks' actions on shorter-term rates.

For instance, in the previous rate hike cycle from mid-2004 to mid-2006, when the Federal funds rate was increased by 430 basis points from one per cent to 5.3 per cent, yields on 10-year Treasuries barely rose 50 basis points from 4.7 per cent to 5.2 per cent, and US Reit prices actually doubled.

In Singapore, the three-month Singapore Interbank Offered Rate (Sibor) went from 0.75 per cent to 3.44 per cent, but 10-year Singapore Government Securities yields didn't move, and the FTSE ST Reit Index surged 83 per cent, according to UOB Kay Hian.