Singapore REITs - OCBC Investment 2016-12-07: Fortune Favours The Brave (Part A) Key Themes in 2016 and What to Expect in 2017

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Singapore REITs 2017 Outlook

Singapore REITs - Key Themes in 2016 and What to Expect in 2017

Expect the unexpected 

• 2016 has been a tumultuous and unpredictable year for financial markets, and the REITs sector has similarly not been spared. The year started off negatively, as concerns over China’s growth sparked a rout in equity markets before recovering as some of these concerns were allayed. The next significant event which took place was the U.K. referendum vote on 23 Jun, which resulted in a surprising victory for the ‘Brexit’ camp. This created uncertainties over the global economic growth outlook. 
• Within our coverage, we highlighted our belief that Ascott Residence Trust (ART) would be the most affected, as it derived 10.3% of its total assets (as at 30 Sep 2016) and 10.8% of its 9M16 gross profit from the U.K. Based on our understanding, ART does not hedge its estimated distributable income in GBP, although there is some natural hedge on its balance sheet. Following the ‘Brexit’ vote, there were also expectations that the pace of interest rate hikes would be further pushed back. Hence ‘hunt for yield’ became the flavour amongst investors, and this provided a rerating catalyst for the S-REITs sector.
• Unfortunately, this euphoria was short-lived as another shocking event unfolded, which came in the form of Donald Trump’s victory in the U.S. presidential elections. Before the election results, the investment community believed that a Trump victory would spark uncertainties and result in stronger demand for safe-haven assets and yield plays. The antithesis of this happened instead, as bond prices tumbled and yields spiked due to concerns that inflationary pressures may be more intense than previously expected. Similarly, the S-REITs sector also saw a sharp fall in share prices.

YTD gains largely erased, but REITs have still outperformed the STI 

• At its YTD peak, the FTSE ST REITs Index (FSTREI) was up as much as 11.2% (achieved on 7 Sep). On the other hand, the STI’s YTD peak was only 2.7% (attained on 21 Apr). 
• The recent correction in share prices has resulted in the FSTREI erasing a substantial portion of its gains, with the index now up 4.0% YTD. However, this is still an outperformance as compared to the STI’s 2.3% increase. 
• On a positive note, in our report titled “Uncertainties post-election; time to bargain hunt” (dated 15 Nov), we recommended investors to bargain hunt for quality REITs, especially those which have underperformed the sector. Since then, the FSTREI has rebounded 2.6%.
• From a total returns perspective, which we believe is a better comparison parameter since REITs are dividend yield plays, the outperformance of the FSTREI YTD was more significant, coming in at 10.8%, versus the STI’s 6.0% total return.

DPU performance YTD largely muted 

• Looking back at the financial performance of the S-REITs sector YTD, we see a common trend of a moderation in DPU growth, with some REITs even recording negative growth for 9MCY16. 
• The key factors driving the softer performance can be attributed to slowing rental reversions, higher operating costs and dilution arising from equity fund raising exercises and issuance of units as payment for management fees. 
• Within our SREITs sector coverage, overall DPU growth for 9MCY16 came in at -0.4% on a YoY basis. If we take into account significant one-off items, adjusted DPU would instead have declined by 0.5% YoY, based on our estimates.

Operational headwinds to limit DPU growth ahead 

• The headwinds facing the S-REITs sector are likely to persist into 2017, in our view. Supply pressures are likely to ease for most of the subsectors only in 2018. 
• According to Bloomberg consensus forecasts, the S-REITs sector's DPU growth (market-cap weighted) is expected to come in at 0.3% YoY for FY16/17 (depending on the financial year end of the REIT), which is softer than the 2.6% historical growth achieved in FY15/16. 
• Moving into FY17/18, growth is expected to pick up to 1.8%. This would be driven by a full-year contribution from properties acquired this year, completion of development/redevelopment projects and a low base comparison as a result of rights issue/preferential offering exercises which are usually completed before contribution from the proposed acquisition kicks in. For FY18/FY19, DPU growth for the sector is forecasted to be 1.4%.

Aggregate leverage at comfortable levels; REIT managers to seek further inorganic growth opportunities 

• The appetite for inorganic growth continued in 2016, as the low interest rate environment remained supportive for debt funded acquisitions. However, given the outperformance in the share price of the S-REITs sector this year, some REITs also utilised equity financing to fund their acquisitions. 
• Major equity fund raising exercises carried out include Mapletree Commercial Trust’s private placement and preferential offering in Jul (total gross proceeds of S$1.0b raised), Keppel DC REIT’s preferential offering exercise in Oct (gross proceeds of S$279.5m raised), Frasers Hospitality Trust’s rights issue exercise in Sep (gross proceeds of S$266.3m raised) and Ascendas REIT’s (A-REIT) private placement in Aug (gross proceeds of S$154.7m raised). 
• There were also a few perpetual securities which were issued, which includes Mapletree Logistics Trust (S$250m 4.18%), Lippo Malls Indonesia Retail Trust (S$140m 7.00%) and First REIT (S$60m 5.68%). Perpetual securities are treated as equity on the balance sheet of REITs, and hence do not increase their gearing ratios.
• For REITs under OIR’s coverage, the average aggregate leverage ratio was 34.9%, as at 30 Sep 2016, which is still a comfortable level as compared to the regulatory limit of 45%, in our view. Comparing apples to apples, the aggregate leverage ratio of our S-REITs coverage (excluding Frasers Logistics & Industrial Trust since it was listed in Jun this year) would have increased only slightly from 34.9% (as at end- 2015) to 35.2%. 
• Moving into 2017, we believe REIT managers would continue to seek further acquisition opportunities as organic growth remains muted. Overseas expansion would likely gain traction, and whether equity financing is aggressively utilised would depend on market conditions.

Expect continued prudent capital management given vagaries in the macro environment 

• REIT managers have largely put in place sound hedging strategies to manage their FX and interest rate risks. For the latter, the proportion of debt which has been fixed/hedged for REITs under our coverage was 77.9%, as at 30 Sep 2016, while interest coverage remained high at 5.4x. This is important, as following the recent jump in interest rates, we note that hedging costs have also increased. This is illustrated by the steepening in the SGD interest rate swaps (IRS) curve. 
• However, we continue to caution that S-REITs will not be immune to a higher interest rate environment, as REITs will still face increased hedging costs when they roll over their IRS contracts. Based on our coverage, REITs which have the lowest proportion of their debt fixed or hedged (as at 30 Sep 2016) are CapitaLand Retail China Trust (52.8%), Frasers Centrepoint Trust (59.0%) and Suntec REIT (60.0%).

Capital recycling strategy to continue 

• We also expect capital recycling strategies to gain further momentum, especially for REITs which have a large and diversified portfolio. 
• Proceeds from the divestment of older assets would likely be used to pare down debt given expectations of a higher interest rate environment, fund new acquisitions, AEIs and redevelopment of existing properties. This allows REITs to refresh their portfolios, and the redevelopment of older properties would come at an opportune time, in our view. This is because demand currently remains subdued, hence upgrading the buildings to higher specifications would allow REIT managers to capture the recovery cycle in the future when the redevelopment is completed. For example, CapitaLand Mall Trust has closed its Funan DigitaLife Mall for a redevelopment project which will comprise three components: retail, office and serviced residences. Coming at an estimated total cost of S$560m, management estimates an incremental NPI per annum of S$36.6m, which translates into a projected ROI of 6.5%. Ascendas REIT has divested all three of its properties in China in Jun, Jul and Nov this year, and has been actively pursuing acquisition opportunities in Australia, including the purchase of its first business park property in Sydney Dec rate hike a foregone conclusion; focus will be on 2017. 
• In our view, a rate hike during the Dec FOMC meeting appears to be a foregone conclusion, drawing reference from recent strong economic data points and the fed funds futures rate. The probability of this happening now stands at 100%. 
• The key question on investors’ minds would be the pace of normalisation in interest rates in 2017, and this has been compounded by uncertainties raised after Donald Trump’s victory in the U.S. presidential elections. In our view, although there are concerns that his expansionary fiscal policy plans may result in interest rates rising faster than previously anticipated, it remains to be seen how aggressively he would push through these policies, while it would also take time to successfully implement the stimulus measures and for the effects to be felt.

Rate hike cycles need not necessarily be a drag on REITs sector performance 

• During the last major rate hike cycle in the U.S. which took place from Jun 2004 to Jun 2006 (excluding the last Dec 2015 rate hike since it was a one-off event), the U.S. Government 10-year bond yield actually saw an initial downward trend, and moved within a relatively tight range (+/- 0.5 ppt). It took approximately 20 months before the 10-year bond yield convincingly exceeded the level when the first hike occurred. Meanwhile, the FSTREI saw an appreciation of 25.8% from the start of this rate hike cycle till the period when the peak of the fed funds target rate was first reached. We believe the performance of the REITs sector also depends on the general health of the global economy.
• While there are uncertainties in the macroeconomic landscape, we note that based on Bloomberg consensus median forecasts, global economic growth is projected to come in at 3.1% in 2017 and 3.3% in 2018, which is faster than the 2.9% forecast for 2016. Most regions are expected to experience stronger growth next year as compared to this year. Likewise, for the case of Singapore, real GDP growth is forecasted to be 1.9% and 2.4% in 2017 and 2018, respectively, versus 1.6% this year.
• Our key concern would be a scenario of stagflation, which may pan out if Donald Trump’s policies fail to ignite economic growth but result in higher inflation instead. This would have the unwanted effect of higher interest rates to curb inflationary pressures.

Andy Wong Teck Ching CFA OCBC Investment | http://www.ocbcresearch.com/ 2016-12-07