REITs - A Sense Of Deja Vu
- We view any share price weakness on rate hike concerns as an opportunity to accumulate at attractive levels, even as we reduce our target prices by about 5% to factor in weaker growth ahead.
- The longer debt maturities and higher proportion of fixed rate debt will further mitigate impact. Historical gap between US and domestic interest rates suggests a healthy buffer.
- We prefer deep value and diversified REITs, with ARET, CCT and FLT as our top picks.
- Maintain OVERWEIGHT.
- The US Federal Reserve Open Market Committee (FOMC) will conduct its final meeting for 2016 next week. Futures traders place the probability of a rate hike in Dec 16 at 100%, as data from Bloomberg Fed Fund Futures show.
- The Ministry of Trade and Industry cut the top end of growth forecast for 2016 by 0.5ppt, with the economy now expected to grow 1.0-1.5%. It expects the Singapore economy to grow 1.0-3.0% in 2017.
Maintain OVERWEIGHT, interest rate hike priced in.
- Since last December’s rate hike by the US Fed, the market has been awaiting the next announced rate hike. Fed fund futures imply a 100% likelihood of a hike next week, a view largely shared by the equity market.
- We have lowered our target prices by an average 5%, reducing terminal growth and rental assumptions to account for a slower growth ahead, and increasing our financing cost assumptions by 25-50bp.
- Despite the revision, we see value in the REITs and view any share price weakness on rate hike concerns as an opportunity to accumulate at attractive levels.
- We upgrade MIT to a HOLD on valuation grounds and prefer deep value and diversified REITs with AREIT, CCT and FLT as our top picks.
Likely hike next week, although jury is still out on 2017.
- All signs point to a rate hike next week, with both futures traders and the equity market in broad agreement. This view is also bolstered by a stronger US labour market, with US unemployment rate down to 4.6%, after 74 consecutive months of job growth.
- However, reasons to give the Fed pause on accelerating rate hikes in 2017 include:
- continued volatility in Europe with rising anti-globalisation sentiment post Brexit,
- depressed growth prospects in mature Asian markets like Japan, where interest rates are only marginally positive, and
- slowing growth in China, with overall exports for 11M16 declining 7.5% yoy.
Prefer deep value and diversified REITs to bottom-fish.
- In the light of a potential depressed global growth outlook hampering further interest rate acceleration, we opine that REITs could continue to be an attractive asset class.
- We prefer deep value and diversified REITs like CCT and FLT, and those with significant business park exposure, namely AREIT. We opine that AREIT’s business/science park portfolio (33% of overall) will position it defensively against the slowdown in Singapore from the unprecedented simultaneous supply glut across other sectors.
Financing impact also minimised due to diversified sources of funding.
- The average debt maturity across REITs within coverage has about doubled to 3.4 years, from around 1.7 years during the global financial crisis in 2008, implying lower likelihood of near-term debt refinancing. The lengthening debt maturity has been bolstered by tapping on debt markets, as REIT managers issue bonds ie Medium-Term Notes.
- Examples include AREIT and CMT, with MTN loans maturing as far back as 2029 and 2031 respectively.
Historical gap between US and domestic interest rates suggests healthy buffer.
- Data stretching back to 2002 highlights an average 73bp spread between 10Y Treasuries and 10Y SGS. This leaves room for 10Y SGS to stay put while 10Y Treasuries rises by up to 73bp for the relation to revert to its long-term trend.
- Besides, FFTR rate hike impact has been muted on 10Y Treasuries in the past. When the Fed raised the FFTR by 430bp from 1% in mid-04 to 5.3% by mid-06, yields on 10Y Treasuries barely rose 50bp from 4.7% to 5.2%.
- We are likely to see a flattening of the yield curve with long end (10Y SGS) relatively unchanged and the short end rising following FFTR. As a result, REITs that typically derive their interest cost from the 3Y to 5Y SGS will be less affected.
Positive US REIT and S-REIT returns during rate hike cycles
- Positive US REIT and S-REIT returns during rate hike cycles, with the US REITs (FTSE NAREIT All Equity Total Return Index) doubling from mid-04 to end-06 when US FFTR rose 425bp from 1% to 5.25%.
- US REITs also gained 3% during the previous rate hike cycle in mid-99 to mid-2000 when FFTR rates were hiked 175bp to 6.5% from 4.75%.
- Similarly, S-REITs rallied in the last rate-hike cycle, with the FTSE ST REIT Index surging 83% from 500 in mid-04 to 914 by end-06, despite the 3M SIBOR more than tripling, rising from 0.75% to 3.44% over the same period.
- As REITs rallied, yields were compressed by 230bp, falling from 7% in mid-04 to 4.66% by end-06. The present cycle is different with regard to the outlook of growth being relatively better for US economy.
- However, the interdependencies as highlighted earlier would limit the number of rate hikes planned by the Fed, keeping REITs attractive as yield instruments. When the rates eventually rise on back of global growth, REITs will come in focus as equity instruments.