Amid high interest rates, Reits may want to forgo acquisitions for organic growth instead

PRICES of real estate investment trusts (Reits) have been battered by rising interest rates. And the acquisition growth engine has slowed substantially for many acquisitive trusts. But prospects are not all bleak for Singapore’s Reits. 

In 2021, Mapletree Industrial Trust (MIT) significantly scaled up its data centre presence with a US$1.32 billion portfolio acquisition of 29 data centres in the United States. To help fund this acquisition, the trust completed an S$823.3 million equity fund-raising exercise. 

MIT is posting decent results: for the six months ended Sep 30, 2022, net property income and distribution per unit (DPU) rose 15.6 per cent and 0.4 per cent, respectively, from a year ago. Yet MIT, like many other Reits and business trusts, has been much less acquisitive recently.

Rising interest rates probably help explain why many Reits are slowing down on acquisition growth. Compared to the start of 2022, the three-month compounded Singapore Overnight Rate Average rose by around 290 basis points to 3.1 per cent per annum as at value date Dec 22, 2022.

The acquisition growth driver for Reits works well when borrowing costs are low and yield-driven investors have few choices. Making DPU accretive acquisitions is much easier if debt costs under 2 per cent per annum, versus over 4 per cent per annum.

Moreover, Reits are subject to borrowing limits. As such, Reits which make big acquisitions or go on acquisition sprees will likely need to raise equity. With higher interest rates, raising equity is challenging as investors are spoilt for choice.

For example, investors can currently get decent returns from risk-free Singapore dollar-denominated instruments such as fixed deposits, Singapore Savings Bonds and treasury bills. In the last six-month treasury bill issuance of 2022, the cut-off yield was at 4.28 per cent when auction closed on Dec 21.

Sponsor support 

Daiwa House Logistics Trust (DHLT), which made its trading debut in late 2021, recently completed its maiden acquisition that is expected to be DPU accretive. This deal shows the pain that a Reit’s sponsor may need to bear in order to make acquisitions work in the current climate.

On Dec 8, DHLT completed buying two freehold logistics facilities – DPL Iwakuni 1 & 2 and D Project Matsuyama S – and a freehold land parcel, D Project Iruma S Land, from its sponsor, Daiwa House Industry Co Ltd (DHICL), for a total consideration of 4.68 billion yen (S$47.7 million). The properties were bought at an 11.8 per cent discount to their aggregate appraised value as at end-June. 

Financing was largely via borrowings and subscription of units by the sponsor. The subscription issue price was the higher of S$0.77 per unit – the adjusted net asset value (NAV) per unit as at end-June – or the 10-day volume-weighted average price. New units were issued to the sponsor on Dec 8 at S$0.77 per unit, 19 per cent above DHLT’s closing price that day.

Will other sponsors emulate DHICL by selling assets at discounted prices and taking up equity at a premium to the trading price, to enable listed trusts to bulk up via acquisitions?

Sponsors who cut good deals for their Reits to buy assets receive some payback when Reit managers – typically owned by the sponsors – see their management fees grow as a trust’s asset size increases. Nevertheless, with rising interest rates, expect many Reit managers to focus on refinancing debt instead of raising more debt or equity to buy assets.

Organic growth drivers

Still, higher interest rates do not mean Reits lose their relevance for investors, especially as trading prices have fallen substantially. Some Reits can bank on organic growth in 2023 and beyond.

Firstly, property asset classes such as warehouses and data centres ride on the tailwinds of strong structural drivers. The growth of e-commerce and supply chain diversification, which have been amplified by the Covid-19 pandemic, drive demand for warehouses. The war in Ukraine and heightened geopolitical tensions have upped the need for supply chain security and near-shoring of manufacturing bases.

Secondly, property asset classes such as hospitality assets will benefit from the relaxation of Covid restrictions in many places in recent months. More people are back to travelling for business and leisure, possibly with bigger budgets amid a flight to quality. With the relaxation of Covid restrictions, malls are also seeing better patronage.

Thirdly, many Reits own Singapore assets. Singapore’s strong management of the pandemic and its safe haven status in a chaotic world are boosting the Republic’s position as a business hub, which helps drive demand for office space. With Singapore’s stability driving robust demand for properties, property valuations are well-supported and the negative impact of higher interest rates is mitigated.

Fourthly, rising inflation, which is driving higher interest rates, may help some Reits that have lease agreements where rental rates adjust in line with inflation. In certain cases, higher utility costs are also borne by tenants, thus helping to insulate landlords from higher inflation.

In just over 20 years, Singapore’s Reit sector has grown substantially – Reits now account for seven of the 30 constituents of Singapore’s benchmark Straits Times Index. Facing higher interest rates, Reits have to fight hard with other instruments for the attention of yield-driven investors. 

The slowing of the acquisition growth engine weakens the investment case for Reits. Still, Singapore Reits merit serious consideration by investors as they are well regulated and tax efficient, with high levels of governance and transparency. Numerous trusts have strong sponsors and good track records.

One can enjoy a spread of about 240-310 basis points to the five-year government bond yield of around 2.8 per cent from investing in large cap Reits – CapitaLand Integrated Commercial Trust and CapitaLand Ascendas Reit, respectively – based on annualising the first-half DPU and unit prices as at Dec 23, 2022. And DPU and NAV will grow, provided organic growth drivers chug along.