Industrial REITs - DBS Research 2017-07-26: Uneven Path To Recovery


Industrial REITs - Uneven Path To Recovery

  • Manufacturing growth momentum to taper in 2H17; recovery to be more gradual and patchy.
  • Rental reversions are likely to remain negative for most sub-sectors till at least 2019.
  • Acquisitions a key driver to upside but only limited REITs have the ability and propensity to deliver accretive deals.
  • BUY A-REIT, MLT and FLT.

Manufacturing growth momentum to moderate but dissipating supply supports an uneven recovery in 2018. 

  • We believe that the recent improvement in activity in manufacturing sectors will start to moderate in 2H17 after an initial burst in recent months driven by a low base effects and broad improvement in demand mainly from the electronics sector. 
  • A slowing growth momentum could mean that manufacturers might instead choose to pick up the slack in current production capacities first before looking for expansionary plans. 
  • That said, with the industrial sector seeing a supply drop off to mean that operating environment should improve year-on-year but a more sustained recovery will only come from 2H18 onwards.

Street could be too optimistic on reversionary prospects in 2018 as recovery will likely to be patchy. 

  • While investors have turned positive on industrial REITs supported by prospects of higher rents in 2018, we like to caution that the recovery is likely to be gradual and uneven. 
  • While we forecast a c.3-5% growth in market rents in 2018, we believe rental reversions are however, expected to remain negative at least till 2019 where we see a closing of the spread between market and expiring levels. Assuming a 3-year rental reversionary cycle, negative spreads are in the warehouse (-15%) followed by multi-user factory sector (-13%).
  • We project that the business park sector is probably the only sub-sector that will see positive rental reversions in 2018F but upside potential is capped by the high market vacancy rate of 17% (as of 1Q17) meaning that more slack need to be absorbed first before a more meaningful rise in rents can be seen. Therefore, given this trend, we believe that industrial REITs are expected to continue to see at best a flattish DPU growth trend in FY18F (ranging -3.0% to 3.0%) and turning upwards only from FY19F.

Continued pursuit for acquisitions. 

  • With low gearing of c.34%, we see debt headroom to acquire to boost DPUs but competition remains intense for industrial assets given the strong liquidity environment.
  • Given limited investable opportunities in Singapore, diversifying overseas, especially into Australia where longer weighted average lease expiries (WALE) freehold tenures and higher yields should improve industrial REITs’ income visibility and portfolio NAVs remains a core strategy. 
  • In addition, given average P/NAV of 1.1x, we believe that REITs could potentially look at equity raisings to part fund growth opportunities. 
  • Amongst industrial REITs, we believe that A-REIT, MLT, FLT have the availability and propensity to acquire inorganically and still deliver upside to earnings.

Manufacturing growth to taper in 2H17 will dampen growth momentum 

Manufacturing Sector’s expansion gave industrial REITs sector a boost. 

  • The Singapore Manufacturing sector in recent times is showing signs of a rebound in activity with the Singapore’s purchasing managers’ index continued to record an expansion in April 2017, albeit at a slower rate than a month before. The electronics, precision engineering, chemicals and biomedical, and manufacturing clusters registered an increase in output while the transport engineering and general manufacturing clusters contracted.
  • The Ministry of Trade and Industry’s advanced estimates reporting Singapore’s 1Q17 GDP grew by 2.5% y-o-y, above initial estimates Since then, we have seen consensus raising estimates for Singapore GDP since the start of the year. In addition, latest posturing from our Government imply that 2017 growth could come in at the higher end of GDP estimate of 1%-3% can also be read positively.
  • The improvement mainly came on the back of a jump in manufacturing activities which is an encouraging read-through for future demand for industrial space if the positive momentum is sustained for the remainder of the year. 
  • The improvement in manufacturing and steady growth in the services producing industries (up 1.5% y-o-y in 1Q17) should also help drive incremental demand for space in the business park and hi-tech space.

Growth momentum to moderate in 2H17. 

  • That said, DBS economist expects that the explosive growth from the manufacturing sector which is has been driven mainly by electronics cluster will likely taper off in 2H17, as seen by a general softening of the PMIs in the US, China and Singapore, implying that the growth in 2H17 will likely turn sideways.

Industrial REITs: A improved operating climate but still an inorganic growth story 

Absorption remain weak in 1Q17. 

  • As of first quarter 2017, take-up for industrial space still lagged behind the increase in supply, with a net increase in unoccupied space of close to 1.0m sqft. 
  • It is expected that the majority of this space will be taken up progressively by end-user occupiers in the coming quarters.

Supply pressures to abate from 2018 but recovery to be gradual. 

  • Based on the 1Q17 data released by Jurong Town Corporation (JTC), an estimated 46m sqft of new space, implying an increase of 9.0%. The new supply is projected to be completing over the next four years, from 2017 to 2020.
  • Among industrial types, factory space (multi-user and singleuser factories) will see close to 32m sqft (+9%) increase in new space which we estimate that more than 60% to be pre-committed, followed by the warehouse space at 12% (or close to c.12m sqft). The business park space will add another 0.9m sqft. However, most of the space is pre-committed and thus not an issue for existing landlords.
  • While supply growth appears high, we note a majority of supply will complete in 2017 and fall off thereafter. As such, with the industrial market close to the end of a period of supply spikes over 2014-2017, we believe that operating conditions will improve, albeit at a modest pace.

Vacancy rates to bottom in 2018. 

  • Taking into account assumed pre-commitment rates and projected new demand, and faced with an increasing supply outlook, the average vacancy rate is now c.10.6% (as of 1Q17) and we project further weakness in the near term. 
  • We expect market vacancy to bottom at close to 11% by the end of 2017 before improving in 2018 and beyond.

Industrial REITs: Rental reversions to turn positive only from 2019 for most industrial tyes.

Spot rents to bottom in 2018 but rental reversions to turn only 2019. 

  • Taking into account assumed pre-commitment rates and projected new demand for industrial space, we believe that there is improving prospects of a recovery in spot market rents come 2018 for the high specs industrial, business park and warehouse sub-sectors. This is supported by dissipating supply risk from 2018 onwards. 
  • We project rentals increase by 2-5% per annum over 2018F-2019F.

Rental reversions still negative for most sectors. 

  • Rental reversions however are still likely to remain negative in the immediate term as projected expiring rental levels are still below new signing levels. We expect market to turn around only from 2019 onwards.
  • The only exception is in the business park space where we see continued expansionary and new demand from firms looking to set up operations in these suburban locations. With a majority of new supply pre-committed, the lack of available space will be supportive of landlords raising rents going forward.

Inorganic growth still a key driver. 

  • With organic growth still expected to remain anemic in the near term, we believe that industrial REITs will look for acquisitions and developments are likely to remain key earnings drivers for earnings and NAVs.
  • On average, gearing is at c.35% (ranging between 29%- 42%), this implies acquisition upside of up to S$2.3bn or up an increase of 20% in their respective portfolios, assuming that the REIT decides to gear up to acquire. 
  • With most of the REITs trading at a yield of 6.8% and are generally trading above book values, we believe that the amount of equity fund raisings (EFR) could also increase as REIT manager’s look to recapitalize their balance sheets to fund growth initiatives.

Derek TAN DBS Vickers | Singapore Research Team DBS Vickers | Mervin SONG CFA DBS Vickers | http://www.dbsvickers.com/ 2017-07-26
DBS Vickers SGX Stock Analyst Report BUY Maintain BUY 2.780 Same 2.780
BUY Maintain BUY 1.940 Same 1.940
BUY Maintain BUY 1.280 Same 1.280
HOLD Maintain HOLD 0.600 Same 0.600
HOLD Maintain HOLD 0.730 Same 0.730