REITs - CIMB Research 2017-02-13: Darkest before dawn

REITs - CIMB Research 2017-02-13: Darkest before dawn S-REIT 2017 Outlook REIT Valuation MAPLETREE INDUSTRIAL TRUST ME8U.SI PARKWAYLIFE REIT C2PU.SI

REITs - Darkest before dawn

  • We maintain Underweight on S-REITs, retaining our view of rising yields and steepening curves. Given current valuations, we are wary of capital depreciation. 
  • Operational performance continues to deteriorate on a sequential quarterly basis. 
  • Physical market moving towards the tail-end of the supply cycle. But first, there is  the 2017 tower of supply to contend with. We project DPU growth to be muted. 
  • We believe business parks would recover first, followed by Grade A offices. Suburban retail should remain resilient. We would avoid warehouses and hotels. 
  • We advise investors to trim their holdings and hold cash. Given their defensiveness, we would only add MINT and PREIT. 

4Q16 review and 2017 outlook 

4Q16 review: operational performance continued to deteriorate 

  • Surprisingly, 4Q16 results for most of the hospitality REITs under our coverage were ahead of our expectations. That said, the outperformance mainly came from one-offs for both ART (4QFY16 DPU included a one-off net FX realised gain) and CDREIT (4QFY16 DPY included a consumption tax of 0.25 Scts/unit). Otherwise, underlying trends remained largely the same, and the set of results were insufficient to convince us to move hospitality up among our sub-sector ranking preference.
  • Other beats came from 
    1. CCT which benefited from the inclusion of CapitaGreen; 
    2. AREIT due to higher-than-expected contributions from the acquisition of the Australian portfolio and One@Changi City; and 
    3. OUEHT as it benefited from the enlarged Crowne Plaza Changi Airport and higher qoq retail contributions. 
    The miss came from KREIT as it was impacted by revenue vacuum from the sale of 77 King St, lower occupancy at Bugis Junction Tower and absence of capital distribution from asset divestment gains.
  • Operationally, we observed that performance continued to deteriorate on a sequential quarterly basis. Even though portfolio occupancies were somewhat stable, REITs experienced a larger degree of negative rental reversions towards the end of the year (also a function of time-lag). Meanwhile, the hospitality REITs announced sharper decline in RevPARs as visitor arrival momentum decelerated in 2H16.
  • In addition, we note that the small-cap industrial and hospitality REITs have made fair value losses on their respective investment properties, reflecting the continued headwinds of both sectors. Meanwhile, the office and retail REITs have made slight fair value gains on their investment properties. Valuation cap rates have been supported by transactions in the physical market; and there is a slight divergence between the rental market and capital values. Lastly, we noticed that all-in financial expense has crept up by c.5-10bp qoq.
  • Other than a slightly higher rate environment, the increase was also driven by higher hedging costs due to volatility at both rates and FX markets. Nonetheless, we believe REITs remain watchful, and would look at suitable windows to refinance or hedge their borrowings.

2017 outlook: near the tail-end of supply cycle; but first, the tower of supply to contend with 

  • In general, rents and prices of the various sub-sectors fell at a faster clip in 2016 than in 2015, while vacancies rates also worsened. We are cognisant that the physical market is moving towards the tail-end of the supply cycle. However, there is still the 2017 tower of supply to contend with. As such, we expect rents to decline by a further c.5%, and for vacancies to peak in 2017, before recovery can take place.
  • Our expectation of a broad-base decline in rents by 5% also implies a bottoming-out scenario, as rents across the various sub-sectors fell by c.5-10% in 2016. Hence, we are expecting a smaller magnitude of declines. With passing rents near spot rents, we expect greater downward pressure on rental reversions in 2017, though pressures could alleviate going into 2H17.
  • In terms of 12-month forward DPU growth, we project flat growth. Admittedly, we found it difficult to ascribe a sub-sector preference given that DPU growth among industrial (+0.7% yoy), retail (+0.5% yoy) and office (+0.6% yoy) are all largely muted. However, we would avoid the hospitality sub-sector in 2017, despite anticipating supply to be minimal in 2018. We expect industry RevPAR to further edge downwards by 3% in 2017 as completions were pushed back from 2016 to 2017, resulting in higher supply pressure for the year.
  • Among the sub-classes, we believe business parks would be the first to recover, followed by Grade A CBD offices. It is difficult to say whether retail, griped by structural challenges, would recover but we expect well-positioned suburban malls to remain resilient. For 2017, we would avoid warehouses and hotels.
  • With negligible supply post-16 and Singapore’s focus on higher-value activities, we are most positive on business parks. Furthermore, we are encouraged by the qoq improvement in occupancy in 4Q16. We project that occupancy could improve to 88.5% by end-17 (end-16: 83%), which would strengthen median rent by 3% yoy. 
  • Bolstered by “flight to quality”, increased take-up at new developments and a tapering of Grade A supply post-17, the office market could evolve into a twospeed market in 2017, in our view. We expect Grade A rents to bottom by end- 17. However, we believe that rents of older/Grade B offices would continue to languish as these buildings have persistent high vacancy of over 20%, and that their products are not as competitive as the new Grade A offices. 
  • We are cautious on warehouses as 2017 is set to be a peak year of completions, with 0.9m sqm of new supply vs. past 5-year average of 0.5m sqm. 
  • Longer term, we believe the secular trend of e-commerce propelling the rise of fulfilment centres and demand from third-party logistics providers should remain intact, and mop up excess supply. Lastly, hotels face another year of strong supply and soft demand. We believe recovery would only take place in 2018, when the supply tap cuts off.

Outlining rental reversion methodology 

  • In place of the usual capital management section, we put our attention this time on the topical issue of REITs’ rental reversion methodology. 
  • In our strategy note “Navigating Singapore-Rocky is the new status quo on 5 Dec 16, we detailed that capital management of REITs remained sound; and that the high proportion of fixed-rated debt (c.80%) insulated the REITs from rising rates over the next 12-18 months. We estimated that a 50bp rise in interest rate could shave off 0- 2.9% of the REITs’ distribution income. That said, interest cover could slightly weaken, due to the challenging operating environment. 
  • Gearings are also creeping up, especially for some of the small-cap industrial REITs. These REITs are actively recycling some of their assets to pare down borrowings. In addition, refinancing risk – a key risk indicator given the asset-liability mismatch of REITs – remained well-spread, with c.9% of debt due for refinancing in FY17F. 
  • Instead, the recent disclosures by KREIT on its rental reversions have placed this operating metric under scrutiny. 

Rental reversions tell us the change in rents upon lease renewal, and are one of the indicators to assess the health of leasing activities.

  • However, such operating metrics are not a mandatory disclosure requirement, and there is no standardised way to compute rental reversions. 
  • For example, some REITs include new leases in the rental reversion computation as that allows them to track the revenue direction of the space. However, some only include renewal/forward renewal leases so as to track the revenue direction from the perspective of the existing tenant.

The actual mathematics behind rental reversions also differs. 

  • A straightforward and conservative approach would be taking the first-year rent of the new lease period over the last payable rent of the expiring lease period. However, some REITs compare the average rents of the new lease period over the preceding rents of the expiring leases as they want to factor in the annual rental escalations. 
  • Things could also be more complicated for the retail sub-sector with gross turnover (GTO) rents being more prominent in recent years. The shift towards GTO rents could exaggerate the downwards pressures on headline rents.

Furthermore, the principle behind reversions could also differ. 

  • Some REITs do not include newly created or reconfigured units when computing rental reversions, since there is no past record for these spaces. However, some include these units as they argue that while the lines are redrawn, the space is still generating revenue. From a psf perspective, revenue trend can still be tracked.

Lastly, some REITs such as CCT and MINT do not disclose the quantum of rental reversions. 

  • Instead, they provide other holistic data such the average expired gross rent and a range of committed gross rents as well as the average rent of expiring leases for investors to put a finger on the pulse of the leasing activities.
  • To save you time, we outlined a cheat sheet on how rental reversions are calculated across the REITs, though there are still nuances between the REITs that investors should take note.
  • At the end of the day, we view that rental reversion is one of the several operating metrics that should be considered when assessing the performance of the trust. It is difficult to judge which reversion methodology is “better” or “worse” but we feel that the methodology should remain consistent for investors to use. 
  • When looking at reversions, investors should also be mindful of the context of the REIT and its sub-sector, and the principles behind the data point.
  • In other words, what does the REIT desire to communicate to the market with regards to its leasing activities? For the analysts, rental reversions are a confirmation tool that indicates to us the direction of the passing rent of the property, whether our reversion assumptions are reasonable, and also implies the annual yoy change in spot rents for the property.

S-REIT Rental Reversion Cheatsheet - CIMB Research 2017-02-14

Investment strategy and preferred picks 

YTD performance 

  • Although the REIT index is up 4.7% YTD, it has underperformed the developer index (FSTREH), which is up 13.2%, and the FSSTI (+7.6%). S-REITs’ rebound since Trump won the US presidential elections has been led largely by the bigcaps.
  • The top three outperformers are MCT (+9.3%), CREIT (9.3%) and AREIT (+8.8%). We believe CREIT’s performance has been driven by corporate actions. E-Shang Redwood, one of the leading owners and operators of modern logistics assets in North Asia, has acquired an 80% stake in the manager of CREIT. It also acquired 10.65% of CREIT at an exercise price of S$0.70/unit.
  • Meanwhile, the underperformers are RHT and FEHT.

Maintain Underweight; keeping our three rate hike scenario for 2017 

  • We maintain our Underweight rating on S-REITs, and retain our view of rising yields and steepening curves. Our target prices factored in a scenario of three rate hikes in 2017. Higher interest rates could pose: 
    1. higher financing expenses, which will eat into distributions; 
    2. a more difficult environment to raise financing; and 
    3. potential cap rate expansion in the medium term. 
    These, plus a challenging operating environment, would be akin to an albatross around the sector’s neck. 
  • Furthermore, a strengthening US$ could induce capital return back to the US, spelling risk of capital depreciation for S-REITs.
  • In addition, the sector is trading around mean valuations, at 6.6% dividend yield (vs. its long-term average of 6.3%) and 0.96x P/BV (vs. its long-term average of 1.03x), suggesting limited upside. 
  • In terms of yield spreads, S-REITs are trading at 430bp against the long-term average of 380bp, and past 5-year average of 430bp. This suggests that the market could expect interest rates to be dialled back, or only pricing in a benign scenario of 1-2 rate hikes.
  • Lastly, even when sensitising our target prices to scenarios of one and two rate hikes, respectively, we found upside to be limited, given YTD unit price performance of the REITs. The exercise underscores our Underweight positioning.

Capital preservation is key 

  • Given the current valuations, we are wary of capital depreciation, and advise investors to trim their holdings and hold cash. While we foresee business parks and Grade A offices to be the first to recover, we believe the respective Big-cap proxies, AREIT and CCT, have already priced in the recovery. We would not recommend entering at these levels.
  • Instead, we are only able to throw up two names for income-funds. In a rising rate environment, we believe MINT’s visible DPU growth would enable the REIT to buffer against rate hikes while PREIT’s rental structures make it the most defensive REIT in the sector.

Maintain Add on MINT, with unchanged TP of S$1.68 

  • Through BTS (build-to-suit) solutions and AEIs, MINT has focused on growing its hi-tech buildings since FY14. As it is, it is ready to harvest what it has sown.
  • Phase one of the BTS for Hewlett-Packard has completed and started to contribute at end-16. We expect phase two to contribute from Jul 17. Altogether, we forecast MINT to deliver a 3-year CAGR of 2.7% through FY16-19F, one of the highest in the sector. There would be another growth kicker come FY19 when the AEI at Kallang Basin 4 is completed. All in, we forecast hi-tech buildings to account for 30% of the group’s NPI by FY19 (from 20% in FY16).
  • We maintain our Add rating. Our DDM-target price implies a total return of 7.5%.

Maintain Add on PREIT, with unchanged TP of S$2.58 

  • PREIT offers investors earnings stability from its long average lease expiry profile of 8.4 years. In addition, it has one of the most resilient income streams amongst S-REITs, thanks to its deflation-protected Singapore revenue stream and defensive long-term lease structure in Japan. 
  • Its balance sheet is strong, with a gearing of 36.3% and low effective cost of debt of 1.4%. As a result of its asset monetisation exercise, it generated S$5.3m of net disposal gain, to be distributed in FY17. 
  • We maintain our Add rating given the total return of 10.6%, based on our DDM-target price of S$2.58.

S-REIT Overview - Financial & Valuation - CIMB Research 2017-02-14

YEO Zhi Bin CIMB Research | LOCK Mun Yee CIMB Research | http://research.itradecimb.com/ 2017-02-13
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