Singapore REITs - OCBC Investment 2017-08-22: No Major Surprises; Remain Selective

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Singapore REITs To Buy CAPITALAND MALL TRUST C38U.SI OUE HOSPITALITY TRUST SK7.SI FRASERS CENTREPOINT TRUST J69U.SI KEPPEL DC REIT AJBU.SI FRASERS LOGISTICS & IND TRUST BUOU.SI

Singapore REITs - No Major Surprises; Remain Selective

• Stable DPU.
• Cap rate compression.
• Top picks: FCT, KDCREIT, FLT and OUEHT.

2QCY17 DPU growth came in flat 

• All the 24 S-REITs under our coverage reported 2QCY17 results which came in within our expectations. 
• On average, DPU growth was flat on a YoY basis, which was a moderation from the 2.4% increase registered in 1QCY17 but similar to the flattish performance for 2016. 
• From a sub-sector perspective, positive DPU growth was driven largely by the data centre, industrial and healthcare REITs, but offset by the hospitality, office and retail REITs. 
• Individually, OUE Hospitality Trust recorded a stellar 31.5% YoY growth in its DPU, while Viva Industrial Trust (+6.3% YoY) and Frasers Logistics & Industrial Trust (DPU beat IPO prospectus’ projections by 6.7%) also had good showings.

Firm Cap Rate Compression Seen in Retail and Office Sub-sectors 

• We observed a few key trends during this earnings season. 
  • Firstly, the office and retail space saw some cap rate compressions by about 10-40 basis points and 40-50 basis points, respectively, based on the valuation exercise conducted by independent valuers. This was driven by a number of robust transactions in the market carried out at firm cap rates. 
  • Secondly, looking across the various sub-sectors, operating metrics have shown some positive signs. For example, office rents appear to be bottoming out. From the retail front, there has been some improvement in shopper traffic and tenant sales, while RevPAR for the hospitality players have shown a smaller decline in Singapore and there was actually positive growth in overseas markets such as China, Malaysia and Japan in local currency terms for most of the hospitality REITs.
  • Thirdly, REIT managers remain proactive in unlocking value for their unitholders, as illustrated by capital recycling activities undertaken.

Continued Prudence in Capital Management 

• REIT managers continued to practise prudence in their capital management, with some taking advantage of the still low interest rate environment to refinance their debt early either via bank borrowings or issuance of bonds and MTNs. 
• The average aggregate leverage ratio for the S-REITs under our coverage stood at 34.5%, as at 30 Jun 2017, a tad lower than the previous quarter (34.9%). Meanwhile, 78.4% of their borrowings have been hedged, a slight increase from end-1QCY17 (77.0%).

RETAIL SECTOR: Outlook still muted but some bright spots observed 

• Retail rents remained under pressure, with a QoQ decrease of 1.2% registered in 2Q17, based on statistics from URA. This represented the tenth consecutive quarter of sequential dip, although we note that the magnitude of decline was slower than what was recorded in 1Q17. 
• Looking at the operating metrics of the retail REITs with Singapore exposure, there was improvement in occupancies on a QoQ basis seen across the board, except for Frasers Centrepoint Trust (-0.1 ppt). 
• Rental reversions were mixed, with moderations seen for Frasers Centrepoint Trust, Mapletree Commercial Trust and SPH REIT, but the rental reversions for CapitaLand Mall Trust and OUE Hospitality Trust’s Mandarin Gallery came in less negative than what was seen in the preceding quarter. The major surprise came from Starhill Global REIT, which turned in a robust rental reversion of 7.8% for Wisma Atria (retail) despite headwinds facing Orchard Road retailers. This was attributed to the renewal of leases for some of the mall’s prime frontage façade space. 
• There was also improvement seen in tenant sales and shopper traffic in general as compared to 1Q17’s trend, although these figures were still negative for Frasers Centrepoint Trust and Starhill Global REIT.

OFFICE SECTOR: Rentals appear to be stabilising 

• Office rental trends have come in better than we had expected. Based on data from CBRE, core Grade A CBD office rents was S$8.95 psf/month in 2Q17. Although this was unchanged from the preceding quarter, it was a welcome reprieve considering the fact that rentals had declined sequentially for eight consecutive quarters since 2Q15, representing a cumulative dip of 21.5% from the last peak. 
• Other industry watchers such as JLL painted a rosier scenario, highlighting that Singapore rents had bottomed out with a 0.7% QoQ growth in 2Q17. On the other hand, based on URA’s data, the office rental index for the Central Region still fell 1.1% QoQ in 2Q17. 
• At the start of the year, we had expected core CBD office rents to dip 5%-10% this year. We now forecast 2017 rental growth to range between -3% to 0%. 
• Notwithstanding the improved office outlook, we are still expecting negative rental reversions for the office REITs in the near-term, as leases up for renewal are typically committed three to five years ago. A silver lining is that the office REIT managers have been proactive in their forward renewals, thus bringing down the number of lease expiries in 2H17 and 2018.

INDUSTRIAL SECTOR: Challenges from navigating through the large supply 

• The industrial REITs were largely able to exhibit resilience in maintaining their occupancy rates, with the exception of AIMS AMP Capital Industrial REIT, which saw a 3.6ppt QoQ dip in 2QCY17. This was attributed to the expiry of the master lease at 3 Tuas Ave 2 and higher vacancies for its logistics portfolio. 
• Due to the large addition of new inventory, pressure on rentals was apparent. According to JTC, the rental index for all industrial space fell 0.8% QoQ in 2QCY17, marking nine straight quarters of decline. However, rental for the business park segment bucked the trend and rose 2.1% QoQ, while the single-user factory segment came in at 0.2%, reversing six consecutive quarters of negative growth. 
• Rental reversions for Singapore properties owned by the industrial REITs were largely negative, but one standout performer was Viva Industrial Trust, which managed to clock in positive rental reversions of 4.3%.
• Looking ahead, approximately 1.38m and 1.13m sqm of industrial supply is expected to come on-stream in 2H17 and 2018, respectively. To put things in perspective, the average annual demand and supply of industrial space was ~1.3m sqm and 1.8m in the past three years, respectively. Although the supply in 2018 is expected to be lower than in 2017 (2.43m sqm), the actual effect on rents next year would depend on how quickly the stock in 2017 is taken up. We believe industrial rents are unlikely to bottom out until 2H18.

HOSPITALITY SECTOR: RevPARs largely resilient 

• For the hospitality REITs under our coverage, 2QCY17 Singapore hotel RevPAR growth ranged from -1.4% (CDL Hospitality Trusts) to +5% YoY (OUE Hospitality Trust’s Mandarin Orchard Singapore). The latter made a strong recovery from its low base last year, while CDL Hospitality Trusts and Far East Hospitality Trust’s hotel portfolios both recorded slight declines YoY. 
• Meanwhile, 2QCY17 Singapore Serviced Residences RevPAU, which is more dependent on corporate demand, fell 5% YoY for Ascott Residence Trust and 5.7% YoY for Far East Hospitality Trust.
• According to industry watcher Horwath HTL, hotel room supply in Singapore is expected to increase by 2,559 rooms (+4.0%) in 2017, down from the +5.9% projection as disclosed in 1Q17. In 2018, room supply is now expected to grow by 1,127 rooms (+1.7%), higher than the previous +0.1% forecast. We believe this may put a slight damper on the RevPAR rebound we expect in 2018. 
• We generally expect leisure demand to remain healthy going into next year, but note that corporate demand appears to remain weak despite seeing a mild improvement as compared to last year. As such, we believe the strength of corporate demand would be the key variable for hospitality players going into 2018.

Valuations Still Stretched; Be Selective 

• Based on the Fed funds futures rate, the probability of a third rate hike by this year has dipped to just 32.3%, versus 51.6% at the end of Jun. This has been largely driven by the relatively cautious tone sounded by a number of Fed Committee members over the soft inflation data points as revealed in the latest FOMC minutes. The total consumer price inflation and core inflation continued to come in below 2%. Many participants saw the possibility that inflation might remain below the 2% level for longer than they currently expected, and several highlighted that the risks to the inflation outlook could be tilted to the downside. 
• Moreover, during Federal Reserve Chairperson Janet Yellen’s testimony to Congress in Jul, she highlighted that the neutral level of the fed funds rate in the longer run is likely to remain below levels seen previously. This implies that the fed funds rate may not have to increase much further to reach the neutral policy stance.
• Coupled with ample liquidity in the markets and continued tight bond yield spreads, we believe further compression in S-REIT yields remains a possibility in the near-term, but recommend investors to buy on dips as valuations remain stretched. 
• Currently, the FTSE ST REIT Index (FSTREI) is trading at a forward yield spread of 386 bps against the Singapore Government 10-year bond yield, which is one standard deviation below the 5-year average (421 bps). Maintain NEUTRAL on the S-REITs sector. 
• Since we added CapitaLand Mall Trust (CMT) [BUY; FV: S$2.20] into our top picks list on 5 Jun this year on the premise that it was a potential laggard play, CMT's share price has jumped 8.4%. Given this outperformance, we replace CMT with OUE Hospitality Trust [BUY; Fair Value: S$0.82]. We like OUEHT as a proxy to the expected recovery in Singapore’s hospitality sector in 2018 and expect it to be a key beneficiary of the opening of Changi Airport Terminal 4 later this year. Current respective FY17F and FY18F distribution yields of 6.6% and 6.7% are also attractive.
• Our other top picks remain the same: Frasers Centrepoint Trust [BUY; Fair Value: S$2.28], Keppel DC REIT [BUY; Fair Value: S$1.39] and Frasers Logistics & Industrial Trust [BUY; Fair Value: S$1.22].

Wong Teck Ching Andy CFA OCBC Investment | http://www.ocbcresearch.com/ 2017-08-22

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