AFTER one of the biggest sell-offs in history, Singapore real estate investment trusts (S-Reits) were rather resilient year to date, largely thanks to the banking crisis which fuelled a dramatic repricing of interest-rate expectations.
However, this may not be the time for investors to rejoice, as the current macroeconomic environment remains challenging for S-Reits. For one thing, higher operating expenses and borrowing costs have been commonly cited by S-Reits as headwinds to their distributions.
Impact of higher rates and slowing growth underestimated
While the pace of interest-rate hikes may become more measured, rate cuts are unlikely this year even if a recession ensues, as inflation is likely to take much longer than expected to moderate. Consequently, interest rates are likely to remain higher for longer.
Hence, although the majority of Reits’ existing debt is on fixed rates, Reits will eventually be forced to refinance their expiring loans at higher rates, resulting in a higher average cost of debt.
Moreover, capitalisation rates are likely to expand as interest rates remain elevated – there is little reason to think they would decline meaningfully – and as growth prospects are dampened. Therefore, property valuations have scope to fall. At a price-to-book ratio of 0.95X, it is implied that S-Reits are trading at just a 5 per cent discount to their current book value, providing little margin of safety.
Meanwhile, the slowdown in commercial leasing activity is likely to put downward pressure on rental rates, and consequently there is potential for distribution per unit (DPU) deterioration. Consensus estimates indicate that DPU growth among Reits will be modest in FY2023.
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Excluding the hospitality sub-sector, aggregate growth remains positive. Conversely, in the last two global recessions, S-Reits recorded double-digit negative growth. Thus S-Reits are vulnerable to negative price reaction from earnings disappointment as the macro backdrop weakens.
Refinancing worries
Besides, the banking crisis has raised fresh concerns regarding the reverberations of higher interest rates. Even before the Silicon Valley Bank saga, Brookfield Corp and Columbia Property Trust defaulted on loans tied to their office buildings in gateway cities such as Los Angeles and New York, as they battle higher financing costs and elevated office vacancy rates.
Tighter financial conditions suggest that Reits with high leverage may find it increasingly difficult to meet their debt obligations or roll over existing debt maturities. The spillover impact from financial stresses is well documented in the US office Reit segment. Share prices of the trio of SGX-listed US office Reits – Manulife US Reit, Prime US Reit, and Keppel Pacific Oak US Reit – slumped as the market reassessed their financial stability and tenant risk.
In the case of Manulife US Reit, its leverage catapulted from 42.8 per cent to 48.8 per cent, which is a hair’s breadth below the regulatory limit of 50 per cent, on lower property valuations. With US$143 million worth of revolving credit facility and other loans due in 2024, higher leverage raises concerns over its refinancing capabilities. Downside risks include dilution from equity fundraising or the sale of properties. Of late, it has already announced and completed the divestment of its Tanasbourne property.
Don’t be satisfied with 6% yield for S-Reits
Overall, in view of optimistic estimates and an uncertain macro backdrop, we are still not convinced that the S-Reit sector as a whole presents an attractive risk-reward proposition. The rapid rise in bond yields has provided investors with the opportunity to earn higher yields without taking on the risk associated with equities.
Also, the yield spread between the S-Reit sector and the Singapore 10-year government bond remains at a multi-year low, implying that investors are compensated with a lower risk premium.
In our view, investors should be expecting a yield of over 7 per cent from S-Reits overall, based on the historical yield spread and the 10-year government bond yield. Today, S-Reits offer a forward distribution yield of only 6 per cent. The downside is that share prices could correct by at least 10 per cent.
At an asset class level, we are underweight on equities (including Reits) relative to fixed income. With the growing attractiveness of fixed income, investors may consider bond funds. For investors who wish to retain exposure to S-Reits, balance sheet strength ought to be a key differentiator. Amidst tighter financial conditions, it would be prudent to avoid Reits with high gearing ratios of over 40 per cent.
Security selection can also be made on a sectoral level. For example, logistics properties should see sustained demand from secular trends like supply chain diversification, providing Reits with resilience in this sector. Meanwhile, US office Reits are trading at depressed valuations, and investors should enter at their own risk. Manulife US Reit faces several hurdles, including the uncertainty over the Reit manager’s possible acquisition by Mirae Asset Global Investments.
Lastly, it remains unclear if China’s post-pandemic surge in spending will be sustainable against the global macro backdrop, which should have an impact on retail and hospitality S-Reits.
The writer is an assistant manager with the research & portfolio management team at FSMOne.com, the B2C division of iFAST Financial Pte Ltd. The latter is the Singapore subsidiary of iFAST Corporation Ltd.
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