Singapore REITs - OCBC Investment 2016-12-07: Fortune Favours The Brave (Part B) Industry Outlook

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Singapore REITs - Industry Outlook

Headwinds will continue to weigh on operational performance 

• Looking ahead into 2017, we believe the operating environment would remain challenging, with each sub-sector facing some forms of headwinds. 
• The vagaries of the geopolitical and macroeconomic landscape have affected both corporate and consumer sentiment. This has resulted in longer decision making processes over the renewal of leases and expansion plans, while supply pressures have also exacerbated the situation. Hence, we believe 2017 will continue to be a tenant’s market and REIT managers will have to remain flexible in their rental negotiations and work closely with their tenants to address their needs. 
• Maintaining occupancy rates will be a key priority even if that means accepting a lower rental rate, as downtime caused by the non-renewal of leases will result in a loss of income and margin pressure. 
• In light of the aforementioned factors, we would prefer REITs with strong balance sheets, longer WALEs, resilient portfolios and good track records, as these would provide stronger support for the sustainability of DPU growth for unit-holders.

Retail REITs – Headline figures daunting, but retail REITs still showing resilience 

Rentals on the decline and vacancy rates have increased 

• According to statistics from the URA retail rental index, there was a 1.5% QoQ decrease in rentals of retail space in 3Q16, and this was the seventh consecutive quarter of sequential decline. However, the dip in 3Q16 was lower than the 3.9% fall in rents suffered in 2Q16. 
• In terms of vacancy rates, this came in at 8.4% in 3Q16, and was the highest level since 3Q06. These data points reflect the pressures facing Singapore’s retail scene, amid growing caution amongst retailers and ongoing consolidation of business operations as cost cutting measures.

E-commerce a secular threat, but do not write off brick-and-mortar assets 

• We believe the growth of e-commerce will continue to shape the competitive scene of Singapore’s retail sector, and evolving consumer preferences will continue to create challenges for traditional retailers. As a result, we expect more retailers to explore avenues to create an omni-channel experience for consumers.
• Media sources have highlighted that Amazon plans to launch its services in Singapore, and this may include its Prime delivery service and AmazonFresh grocery service1 . This news has coincided with the recent share price underperformance of retail REITs versus the sector.
• According to a report by Google and Temasek, Singapore’s e-commerce market formed 2.1% of total retail sales in 2015 with a value of US$1b. This is projected to increase at a CAGR of 18% to reach US$5.4b in 2025, and is expected to contribute 6.7% of Singapore’s retail market. Hence, although e-commerce sales are forecasted to increase at a faster pace as compared to traditional retail channels, we can see that the latter would still have significant weight in the value chain.

Retail REITs have showcased their resiliency, but rental reversions have unsurprisingly moderated 

• Notwithstanding the challenges facing the sector, we believe retail REITs have largely remained resilient, which we attribute to their well-positioned malls with good accessibility in their portfolios. 
• REIT managers have also sought to refresh the tenant mix of their malls and to enhance the shopping experiences of consumers. However, given the downtrend in market rents, it was unsurprising to see a moderation in rental reversions for most of the retail REITs. There were mixed data points on occupancy rates, tenant sales and shopper traffic amongst the retail REITs. 
• Looking ahead, we expect prime Orchard Road rentals to decline by 2%-2.5% in 2016, with a further 3%-5% dip in 2017; while suburban rents are projected to slip 1.5%-2.0% this year, followed by a decline of 2.0%-3.0% in 2017.

Frasers Centrepoint Trust and Mapletree Greater China Commercial Trust our preferred retail REITs 

• We prefer retail REITs with a stronger focus on the suburban space, and recommend Frasers Centrepoint Trust (FCT) and Mapletree Greater China Commercial Trust (MGCCT) as our top picks. 
• We like FCT for its defensive portfolio and robust track record of having delivered positive DPU growth every year since its IPO in 2006. We have a BUY rating on FCT with a fair value of S$2.33. 
• For MGCCT [BUY; FV: S$1.15], we believe Festival Walk, which contributed 69.4% of its 1HFY17 NPI, would continue to perform resiliently, while MGCCT also offers an attractive yield spread of 239 bps vis-à-vis its HK-listed peers (+1.6 standard deviations above 3-year mean).

Office REITs – Lingering supply concerns, but situation not be as bad as previously feared 

Rents still on decline; supply concerns remain 

• The average Grade A CBD office rents in Singapore attained its last peak in 1Q15 at S$11.40 psf per month. It has since declined for six consecutive quarters to reach S$9.30 psf per month in 3Q16, which translates into an overall dip of 18.4% from the peak. The initial downtrend momentum caused the share prices of office REITs to be the worst performing sub-sector in 2015. However, office REITs have recovered strongly in 2016 YTD, led by CapitaLand Commercial Trust (+13.3%) and Keppel REIT (+12.9%). We believe this has been driven by bargain hunting by investors following the underperformance in 2015, coupled with largely positive DPU growth delivered.
• Supply concerns which had plagued investors’ minds previously remain largely valid, but we note that there has been progress made on the leasing front. Guoco Tower (890,000 sq ft Premium Grade A office tower) has seen its pre-commitment levels move up to 80%, as at October, versus 10% at the start of the year. This trend underscores the ‘flight to quality’ theme, whereby corporates have made use of the soft leasing environment to secure Grade A specification space in prime locations.
• As for Marina One, there has been increasing market talks of new tenants taking up or exploring the possibility of taking up space for this development2 . According to an official media release in Jun this year, over 550,000 sq ft of take-up had been secured, which implies a pre-commitment level of approximately 30%, based on our estimate. Office REIT managers have been proactive in engaging their tenants for forward renewals of leases expiring in 2017 and even 2018.

Rents likely to continue declining in 2017, but at a moderated pace 

• As M+S Pte Ltd, the developer of Marina One, continues to ramp up its occupancy rate, this may exert further pressure on market rents. A total of 2.3m sq ft of office inventory is expected to enter the market next year, while average annual net demand over the past five years (2011- 2015) has been 1.0m sq ft. 
• We forecast a -12% to -15% dip in Grade A CBD office rents in 2016 and a further correction of -5% to -10% in 2017.

Only BUY within office REITs space is Frasers Commercial Trust 

• Within the office REITs space, our only BUY rating is Frasers Commercial Trust (FCOT). 
• FCOT offers investors a decent distribution yield of 7.8% for FY17F and 7.9% for FY18F. However, the key downside risk to our forecasts is the non-renewal (in full or in part) of the HewlettPackard leases at Alexandra Technopark which expires in Sep and Nov 2017. We have a BUY rating and S$1.48 fair value on the stock.

Hospitality REITs – Expect another challenging year 

Recovery in tourist arrivals and receipts has not translated into better performance for hospitality REITs 

• International tourist arrivals to Singapore have seen positive YoY growth every month this year from Jan to Sep. However, this growth has been moderating, with an increase of 2.5% in Aug and 1.1% in Sep, as compared to double-digit growth from Jan to May. Overall visitor arrivals are up 9.4% for 9M16. There was also a robust 12% improvement in tourism receipts to S$11.6b for 1H16, underpinned by higher expenditure in shopping, accommodation and F&B. 
• In terms of hotel statistics, occupancy was stable at 85.0% from Jan-Sep 2016 (-0.1 ppt), but RevPAR was down 3.3% to S$201.90. This was likely due to tepid corporate sentiment and competitive pressures from a higher supply situation. 
• Hospitality REITs largely recorded uninspiring RevPAR/RevPAU and DPU figures during the recent financial period.

RevPARs could face further downward pressure in 2017 

• Looking ahead, industry watcher Horwath HTL has estimated that there would be a 4.1% and 6.1% increase in hotel rooms in Singapore in 2016 and 2017, respectively. 
• In addition, given the uncertain geopolitical and macroeconomic environment, we believe travel budget from the corporate segment may remain cautious. This would impact the margins of hospitality REITs as the average room rate for the corporate segment is typically higher than the leisure segment. Hospitality players may adopt more aggressive pricing strategies as they grapple for market share to maintain their occupancy rates. 
• We expect single-digit RevPAR declines in 2017.

Positive on Ascott Residence Trust, CDL Hospitality Trusts and OUE Hospitality Trust 

• We like Ascott Residence Trust (ART) for its extended-stay business model, which we believe is more resilient. However, the weaker GBP would likely have a negative translation effect on its financials and assets value. We have a BUY on ART with a fair value of S$1.24. 
• For CDL Hospitality Trusts [BUY; FV: S$1.48], we like it for its broad-based geographical diversification and FY17F distribution yield of 7.1%. 
• We are optimistic on OUE Hospitality Trust’s (OUEHT) FY17 DPU performance, given a full-year contribution from the Crowne Plaza Changi Airport extension and from the commencement of operations by anchor tenants Michael Kors and Victoria’s Secret at Mandarin Gallery. We have a BUY rating and S$0.73 fair value on OUEHT.

Industrial REITs – Cautious on outlook; prefer business parks exposure 

Cautious outlook on Singapore’s economic growth 

• Singapore’s economy grew 1.1% YoY in 3Q16, and this was softer than the 2.0% growth achieved in 2Q16. On a QoQ seasonally-adjusted annualised basis, Singapore’s GDP fell 2.0%, which was a reversal from the 0.1% expansion in the preceding quarter. 
• Looking ahead, Singapore’s Ministry of Trade and Industry (MTI) has narrowed its 2016 economic growth forecast to 1.0%-1.5% from 1.0%-2.0%. For 2017, although global growth is projected to pick up slightly, MTI believes there are downside risks which include uncertainties caused by Brexit, rising corporate credit levels in China and higher political risks which may impact global trade. Singapore’s growth is expected to remain modest.
• However, an improvement is expected in the manufacturing sector, tourism-related sectors and ICT sector. Overall GDP growth for Singapore is projected to come in at 1.0% to 3.0% in 2017, according to MTI.

Supply pressures remain 

• Drawing reference from JTC’s data, the rental index of all industrial space in Singapore fell 2.0% QoQ in 3Q16, and this was the sixth consecutive quarter of decline recorded. The rental indexes for multiple-user factory, single-user factory, business park and multiple-user warehouse declined by 1.3%, 2.1%, 0.2% and 4.4% QoQ, respectively. 
• Besides the moribund macroeconomic environment, supply concerns have exacerbated the dim prospects of the industrial sector. According to JTC, approximately 3.0m sqm of new industrial supply is expected to enter the market from 4Q16 to 2017. This is ~7% of current available stock and is higher than the average annual demand and supply of industrial spaces of 1.2m sqm and 1.9m sqm, respectively, over the past three years. We expect this to exert further pressure on occupancy and rental rates. 
• Out of the 3.0m sqm of upcoming supply, only 0.6% will be contributed by business parks. Hence, we are most positive on this subsector’s outlook within the industrial sector. We expect business park rental growth to come in within the range of -3% to 0% for 2017. 
• On the other hand, we expect the factory and warehouse segments to fare worse, with forecasted rental declines of 8%-15% next year.

Better industry dynamics for Australia’s industrial sector 

• According to property consultancy firm Jones Lang LaSalle, the supply of industrial assets in Australia is expected to come in below the 10-year annual average of 1.7m sq m in 2016. This pipeline is largely contributed by projects in the planning stages. 
• On the other hand, demand, as measured by occupier take-up, was 2.3m sq m in 2015. This exceeded the 10-year average of 2.0m sq m. Hence, the current demand-supply dynamics are favourable for Australia’s industrial real estate market, in our view.

Ascendas REIT and Frasers Logistics & Industrial Trust our preferred industrial REITs 

• We like A-REIT [BUY; FV: S$2.67] for its significant business and science parks exposure. On 5 Dec this year, A-REIT proposed to acquire the leasehold interest in the property located at 12, 14 and 16 Science Park Drive from its sponsor for a purchase consideration of S$420m. We are positive on this transaction as we expect it to be DPU accretive and the acquisition would boost A-REIT’s portfolio WALE to 4.4 years from 3.7 years. 
• Frasers Logistics & Industrial Trust (FLT) recently reported its maiden results since its IPO which beat its Prospectus forecast. We like FLT’s defensive portfolio, backed by its WALE of 6.6 years, as at 30 Sep 2016 (since increased to 7.0 years following an acquisition on 30 Nov this year). Its gearing ratio is also healthy at 28.2%, as at 30 Sep 2016, which provides it with ample debt headroom to fund inorganic growth opportunities. Management has hedged 84% of its debt and has no near-term refinancing risks. We have a BUY rating and S$1.10 fair value estimate on FLT.

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