Singapore REITs - Maybank Kim Eng 2015-09-08: Still in a De-rating Phase.

Singapore REITs

Still in a De-rating Phase 

  • Globally, REITs de-rate during times of economic/financial uncertainty, SREITs are no exception. 
  • Only halfway through this de-rating, if history is a guide. 
  • Downgrade Suntec, MCT, FCT to SELL. Maintain CMT at SELL. 

What’s New 

  • We initiated SREITs at UW in Mar 2015, warning of oversupply amid a weak economic backdrop, combined with lofty valuations and tight spreads with benchmark rates, leaving REIT prices vulnerable. 
  • SREITs have since fallen 12% YTD. This picture has not changed and economic risks are rising. We believe more downside is probable (c.9%) as SREITs traditionally have de-rated in periods of economic /financial market risk. 
  • We reiterate UW with TPs reduced c.23% as we shift to a yield-targeting framework from DDM, in order to reflect the market period we are in. 
  • We downgrade Suntec, MCT and FCT to SELL, and downgrade MIT, SGREIT, KREIT and Cache to HOLD. Maintain SELL on CMT. 

Only halfway through this de-rating 

  • Globally, REITs de-rate during economic/financial uncertainty, SREITs no exception. We examine three periods of de-rating (2007, 2011 and 2015), and find commonality in rising risks to growth and tightening credit conditions. 
  • Balance sheets were sound in all three periods. On top of all this, 2015 has the added pressure of rising interest cost, USD strength eating into SGD returns, and oversupply of space, none of which were present in 2007 and 2011. 
  • There are more reasons for SREITs to de-rate now than before. SREIT yields have climbed 9% YTD, compared to when they climbed 18% and 19% in 2007 and 2011, implying that we are only half way through this de-rating. 

Most negative on Retail. 

  • We have grown more bearish regarding demand and rising competition. We expect rents to fall 1% pa in 2015-16 which flattens rent reversions and cuts DPUs by c.3.7%. CMT has traded from -1SD to cycle mean; we expect it to complete the move to +1SD, arriving at a target yield of 6.75%. We price FCT, MCT, and Starhill off CMT with target yields of 7%/7.25%/7.75%. 

Neutral Office. 

  • Economy is slowing and supply will be 3x annual demand in 2016. We expect rents to drop 1%/10%/3% in 2015-17, which results in DPU cuts of c.9%. CCT has de-rated halfway between -1SD and cycle mean, and we expect it to complete the move to mean of 7%. We price KREIT and Suntec off CCT at 7.25%. 

Least negative on Industrial. 

  • Light at the end of the oversupply tunnel which will finish in 2016. Still, we expect industrial rents to decline 1-2% pa 2015-16 on a weak economy which results in DPU cuts of c.1.7%. Areit has de-rated halfway between -1SD and cycle mean, we expect it to complete the move to cycle mean of 7.25%. We price MIT and Cache off Areit at 7.5% and 9% respectively. 

REITs have de-rated globally 

August: global REIT yields have de-rated by 9% (40bps) 

  • Following the shock Yuan devaluation and the ensuing doubts over the growth prospects of the global economy, major REIT markets globally – the US, JP, AU, HK, SG – saw strong sell-offs in August. With the US down 3%, JP down 7%, AU down 5%, HK down 9% and SG down 6%, distribution yields on average have moved up 9% or 40bps. Average yield spread to 10yr government benchmarks also widened by about c.37bps (+14.4%) as well - while REITs were sold off, government bond yields remained stable, and in some markets, went lower (US, JP, AU). 

YTD: global REIT yields have de-rated 15% (67bps) 

  • Globally, REITs were already de-rating since the start of the year: US down 10% YTD, JP down 18%, AU down 1%, HK down 4% and SG down 12%. Yields on average have moved up 67bps (+15%), while spreads to respective 10yr benchmarks have increased on average 67bps (+26%). The same trend holds, with REITs selling off, while 10 year benchmarks have either remained stable/range bound. 

REITs de-rate in times of economic and financial uncertainty 

  • Recent moves prompt the question: Are REITs moving into a de-rating period? Comparing SREIT yield behaviour with that of global REITs, we find that: 
    1. SREIT valuations tend to move in line with global REIT yields, and 
    2. REITs in general de-rate during times of economic and financial uncertainty. 
  • Previous bouts of de-rating were in 2007 and 2011, when global REIT yields rose 23% and 13% respectively. SREIT yields rose 18% and 19% during the same period. For 2015 YTD, global REIT yields have risen 15% while SREIT yields have moved up 9%. The 2007 de-rating was the start of the 3Q07-2Q09 bear market where REIT yields already began to rise from Feb 2007, more than 1.5yrs before the GFC hit in 4Q08. 2011 was also a period of uncertainty regarding the global recovery, made worse by the Eurozone crisis. 
  • Today, we have concerns over a China hard landing, EM/Asia underperformance, as well as the US normalising rates during a period of uncertainty. We examine all three periods in order to determine whether REIT yields will continue to de-rate. We analyse credit conditions, balance sheet strength, supply, demand, currency, and interest rates, and find that in 2015 there are more reasons for SREITs to de-rate than there were in 2007 and 2011. 

REITs tend to de-rate when credit conditions tighten 

  • As REITs are leveraged entities that need to refinance their debt, credit conditions need to be benign for investor confidence. To measure this, credit spreads between corporate bond yields and government bond yields of similar maturity are the key indicator. 
  • However, indices for corporate bond yields are generally unavailable for most countries apart from the US. Thus as a proxy for global credit conditions, we track the spread between the yield of the iShares iBoxx Investment Grade Corporate Bond (12yr weighted average debt maturity) and the 10yr Treasury Yield. In 2007 and 2011, credit spreads widened 41% and 18%, coinciding with average REIT yield expansion of 23% and 13% respectively. 
  • Right now, credit spreads have bottomed out since mid-2014, widening 42% so far. For 2015 it has widened 25% YTD, in line with REIT yields expanding 15% YTD. 

De-rating was not due to weak balance sheets 

  • It could be possible that under tight credit conditions, periods of de-rating also require balance sheet weakness. However, we find that in all three periods (2007, 2011, 2015 YTD) SREIT balance sheets were relatively unstretched. The aggregate leverage of the four biggest SREITs which have histories across all three periods averaged 32%, 34%, and 33%, yet REIT yields expanded. Thus, in order for a de-rating to occur, balance sheets do not have to be weak. 

De-rating: when growth concerns outweigh interest rates 

  • The record of interest rates on REIT valuations is mixed. Rising rates imply rising interest costs which eat into DPU. Yet counter-intuitively, REITs have actually re-rated during a rising interest rate environment, 2004-2006. The key factor was that it was a time where the global growth outlook was robust. Investors therefore believed that growth would outweigh interest cost. By 2007, growth began on a decelerating path and by 3Q07, benchmark rates were beginning to come down as central banks cut rates as a counter-cyclical response to the slowing environment. During this period REITs de-rated along with falling interest rates as growth concerns outweighed benefits from reduced interest cost. 
  • The 2011 de-rating period was also a time of sharp deceleration of global growth. Interest rates were on a downward bias, yet REITs de-rated again as growth concerns outweighed, especially with the Eurozone crisis posing additional systemic risk. REIT valuations therefore depend on the net effect between growth and interest cost. 
  • Today, the global growth outlook is again pessimistic: China’s deceleration and possible hard landing, EM-Asia underperformance due to currency woes and stalled reforms, US lead manufacturing indicators signal slowdown with employment a widely acknowledged lagging indicator, and the ECB also downgraded the Eurozone outlook. 
  • On top of this, the Fed is eager to get off zero interest rates despite global turbulence. REITs are therefore faced with a double whammy of low growth and rising interest rates, the risk now is for valuations to de-rate rather than re-rate. 

Oversupply: an additional headwind 

  • On top of the demand risk, we have an oversupply risk. We have documented since our initiation that strong supply is seen in all asset subclasses, from retail, to office, to industrial. These represent a de-rating catalyst that was not present in the 2007 and 2011 periods. 

FX: weak SGD to eat into USD returns 

  • It should be noted that when SREITs de-rated in 2007 and 2011, these were not periods of capital flight from Singapore or Asia. In fact, the SGD and Asian currencies appreciated in 2007 while 2011 was a volatile year that ended flat. But the capital flight that we see today and the ensuing depreciation of the Singapore Dollar are an additional de-rating catalyst now. Portfolios that are denominated in USD will see returns eaten into. 

Putting it all together: 2015 has more reasons to de-rate 

  • Putting it all together, we find that 2015 actually has even more reasons to de-rate than in 2007 and 2011. 
  • Where all three periods had tighter credit conditions and slowing economic growth, 2015 has the added pressure of oversupply risk, rising interest cost, as well as currency depreciation.

Joshua Tan | Derrick Heng CFA | Maybank KE 2015-09-08