REITs Sector - DBS Research 2016-12-14: 2017 Outlook ~ Interest Rates Deja-Vu

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Singapore Sector Outlook 2017 SREITs Singapore REIT Sector

REITs Sector - 2017 Outlook ~ Interest Rates Deja-Vu

• DBS economist expects four FED rate hikes in 2017 (above consensus), implying that we are unlikely to see a repeat of the sector’s past outperformance.
• Potential risk to 1.3% growth if domestic economy slows further while prospects of higher refinancing costs in the medium term is a headwind.
• Focus on S-REITs with superior growth visibility and valuations. Top picks are Ascendas REIT, Keppel REIT, Mapletree Commercial Trust, Keppel DC REIT, Frasers Logistics and Industrial Trust, and Croesus Retail Trust.

Outlook

Market may be underestimating pace of FED hikes in 2017; DBS economist expects four hikes next year.

• Heightened expectations of a faster rate hike momentum in 2017 under new US President Trump’s administration will likely cast a shadow on Singapore REITs’ ability to maintain its share price outperformance going forward.
• Since the beginning of November 2016, the probability of a further 50bps hike in FED funds to 1.25% by the end of 2017 now stands at 58.7%. DBS expects four hikes in 2017, more aggressive compared to the 1-2 hikes implied in the FED funds futures.

Headwinds to growth as rental outlook weakens on the back of demand contraction. 

• Our DPU growth projection is a modest 1.3% (vs 5-year historical average of c.3.0%), but there is downside risk from a slowing domestic outlook. This is likely to have an impact on rentals and occupancy rates for most real estate subsectors. 
• We project market rentals to decline by 5%- 10% year-on-year, and rental reversion trends to be slightly negative or flattish.

Rising cost of capital a hurdle to inorganic growth; REITs may look to divest assets to fund acquisitions. 

• Based on current share price levels, expected higher interest costs and optimal gearing levels of close to 35%, we see there is limited flexibility for S-REITs to grow their portfolios, given the sector’s reliance on both debt and equity markets to support their growth initiatives. 
• While S-REITs have been heading overseas in search for higher returns, the uncertainties from heightened forex volatility in recent times could cap returns and thus corporate activity level could be subdued. As such, S-REITs may look to recycle assets to re-invest proceeds into newer, higher yielding properties with a longer operational runway.

Interest obligations are generally hedged. 

• The risk to distributions in 2017 is manageable in our view. There is only c.20% of total debt in the sector that is up for renewal. As such, we estimate that a 1% increase in refinancing cost will impact distributions by only c.1.8% in 2017. 
• The key defence to further hikes in refinancing further down the road is the REIT’s ability to grow revenues to lessen the impact from higher interest costs in the medium term.

Risks

Faster-than-expected rate hike momentum. 

• A stronger-than-expected Fed rate hike momentum in 2017 will mean higher-than-projected interest rates (for both shorter- and longer-term rates across the yield curve), posing risks to our estimates. As such, investors are also likely to require higher yields (and thus lower S-REIT prices) for investing in yield-sensitive instruments like S-REITs.

Valuations. 

• Weak operating performance resulting in higher vacancies could mean lower book valuations for S-REITs going forward. 
• In addition, a period of sustained higher interest rates than current levels could also prompt valuers to raise cap rate assumptions although we see this as a medium term risk.

Valuation & Stock Picks

S-REITs’ share prices have priced in two rate hikes. 

• We estimate that current prices have already priced in two hikes and we believe that S-REITs will likely trade at an above-historical average yield spread against 10-year bonds in the immediate term. 
• Yield spreads of close to 4.7% (average yield of 7.0% minus 10-year bond yield of 2.3%) on a 1-year forward DPU yield imply that forward spreads are already at historical mean levels of 4.0% (compared against forward 10-year yield of 3.0%).

Favour S-REITS with good earnings growth and attractive valuations. 

• Our strategy is to go for S-REITs with the ability to still grow in the current environment and offer superior growth visibility (Ascendas REIT, Mapletree Commercial Trust, Frasers Logistic and Industrial Trust and Keppel DC REIT). 
• In addition, valuations of the office REITs are attractive at 0.8x P/NAV with catalysts coming from the expected bottoming out of the office sector. Our pick in the office space is Keppel REIT. We also like Croesus for its valuations and higher yields. 

Derek TAN DBS Vickers | Melvin SONG CFA DBS Vickers | http://www.dbsvickers.com/ 2016-12-14