Singapore REITs - OCBC Investment 2017-11-30: Improving Fundamentals But Valuations Stretched; Maintain NEUTRAL Heading Into 2018

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Singapore REITs 2018 Outlook S-REITs Sector Review FRASERS CENTREPOINT TRUST J69U.SI KEPPEL DC REIT AJBU.SI MAPLETREE GREATER CHINACOMM TR RW0U.SI MAPLETREE LOGISTICS TRUST M44U.SI FRASERS LOGISTICS & IND TRUST BUOU.SI

Singapore REITs - Improving Fundamentals But Valuations Stretched

• More positive DPU growth outlook.
• Selective opportunities remain.
• Top picks: FCT, FLT and MGCCT.

A Look Back At Historical Performance 

• During the recently concluded 3QCY17 earnings season, all the 24 S-REITs under OIR’s coverage reported results which met our expectations.
• Overall DPU growth dipped marginally by 0.2% YoY, with the drag largely coming from Ascott Residence Trust (ART) (-28.1% YoY) due to dilution from a rights issue exercise earlier this year. Encouragingly, 13 of the 24 S-REITs registered YoY growth in DPU, whereas nine registered declines in DPU and two were flat. 
• In terms of sub-sector performance, hospitality REITs fared the worst, recording a 10.8% YoY fall in DPU. Besides ART, Far East Hospitality Trust and CDL Hospitality Trusts saw declines of 8.0% and 6.1% in DPU, respectively. The star in the hospitality sector was OUE Hospitality Trust, with robust DPU growth of 10.6%. 
• Retail REITs and industrial REITs delivered gains in DPU growth, while the office sub-sector was dragged down by OUE Commercial REIT and to a smaller extent Frasers Commercial Trust and Suntec REIT.
• Key rating changes during the 3QCY17 earnings season: 
  1. Upgraded First REIT to BUY (see report: First REIT - Relative Value Emerges)
  2. Downgraded OUE Hospitality Trust to HOLD (see report: OUE Hospitality Trust - Strong RevPAR Growth Continues)
  3. Downgraded Starhill Global REIT to HOLD (see report: Starhill Global REIT - Softness Likely To Persist In Near-term)

Expected Recovery In DPU For Next Financial Year 

• Drawing reference to the full-year historical performance of the S-REITs under our coverage, we note that DPU growth was 0.2% if we use a simple average, or 2.0% if a market-cap weighted average was applied (driven by Ascendas REIT, Mapletree Industrial Trust and Mapletree Greater China Commercial Trust).
• Looking ahead, although we see a mild 0.8% dip (simple average) in DPU for the current financial year for our coverage list, we are projecting a 2.8% DPU growth for the next financial year period. 
• For the entire SREITs universe, based on Bloomberg consensus forecasts, DPU growth (simple average) is expected to come in at 0.7% and 1.1% for the current (FY17/18F depending on the financial year end) and next financial year (FY18/19F) periods, respectively. Thereafter, DPU is expected to improve further in FY19/20F by 1.5%. Should the global economic recovery momentum continue to gain traction, there could potentially be upside to DPU forecasts. This thesis would also have to depend on the interest rates trajectory.

Continued Prudence In Capital Management 

• We opine that the financial position of the S-REITs sector remains healthy, with the average gearing ratio of the REITs under our coverage coming in at 34.0%, as at 30 Sep 2017. This is slightly lower than the gearing ratio of 34.5%, as at 30 Jun 2017. 
• Debt maturity profile and financing costs remained relatively stable on a QoQ basis. However, we note that the proportion of borrowings on fixed rates/hedged fell 4.2 ppt to 74.2%. This was largely attributable to most of the hospitality REITs, Soilbuild REIT and Keppel DC REIT. 
• We believe the lower hedge ratio could also be driven by REIT managers which have taken advantage of the still low interest rate environment to refinance their debt early and hence they may look to enter into interest rate swaps ahead.

Interest Rates Outlook 

• Based on the fed funds futures rate, the probability of a rate hike during the upcoming Dec FOMC meeting is 95.9%. We believe this would be a non-event for the S-REITs sector, as investors have already largely factored in this scenario in their expectations. 
• The next key question would be the pace of normalisation of interest rates in 2018, as more recent optimistic economic data points have been met with persistently soft inflation data. Three rate hikes in 2018 appear to be the base case scenario for now. Notwithstanding this uncertainty, as we have emphasised before, a rate hike cycle need not necessarily be a damper on the REITs sector’s performance. 
• It took approximately 20 months before the 10-year U.S. Government bond yield convincingly exceeded the level when the first hike occurred during the previous major rate hike cycle from Jun 2004 to Jun 2006. The share prices of S-REITs appreciated strongly during this period. We observe some similarities since the Fed raised the fed funds rate in Dec 2016, whereby the 10-year U.S. Government bond yield has stayed relatively close to the level prior to the hike, while the FTSE ST REITs Index has turned in total returns of 23.6% during the same period.
• Nevertheless, the SOR remains volatile and hedging costs have crept up, as seen from the pricing of interest rate swaps. Hence, we expect REIT managers to continue their prudent capital management approach. There is also the possibility of more equity fund raising exercises if valuations continue to stay elevated.

RETAIL SECTOR: Threat from e-commerce apparent but not ominous…for now 

• Retail rents, which had been under pressure for the past 2.5 years, finally saw some breathing space as all the sub-markets tracked by CBRE registered stable rentals in 3Q17 versus the previous quarter. According to URA statistics, the retail rental index still fell 0.2% QoQ, but this was notably a smaller magnitude as compared to dips of at least 1.2% observed over the past eight consecutive quarters.
• The e-commerce threat has been an issue plaguing the traditional retail model. However, as a testament to the viability of the brick-and-mortar retail sector, e-commerce giant Alibaba announced in Nov that it would invest US$2.9b for a 36.2% stake in Sun Art Retail Group, one of China’s leading hypermarket operators (market share of 14.6% as at 31 Dec 2016). Alibaba’s CEO Mr. Daniel Zhang highlighted that “physical stores serve an indispensable role during the consumer journey, and should be enhanced through data-driven technology and personalized services in the digital economy”.
• From our channel checks, we believe there has been improved consumer sentiment on the ground, while the recovery in tourist arrivals and spending also provides room for some optimism as we head into 2018.

Supply pressures to persist in 2018 

• Looking ahead, significant new supply for the rest of the year and 2018 will exert pressure on rents. According to market watcher Colliers, there will be 1.9m sq ft of retail NLA entering the market next year, above the average of 1.1m sq ft over 2012-2016. Supply will subsequently taper off from 2019. 
• Some of the larger new additions include Paya Lebar Quarter (~340,000 sq ft) and Project Jewel at Changi Airport (576,000 sq ft). In our opinion, the former would have a bigger impact on the non-REIT owned malls (One KM, Paya Lebar Square and SingPost Centre), while the latter is unlikely to significantly affect the suburban malls in the East given the strong catchment areas where they are located.
• Overall, we forecast prime Orchard Road rental growth to come in between 0%-2% in 2018, while suburban rents are expected to be flat or decline slightly, but the better positioned malls such as Causeway Point are likely to outperform.

OFFICE SECTOR: Likely to see strongest recovery, but priced in 

• We believe the office sector is poised to see the strongest recovery in rents, driven by improving macroeconomic fundamentals and tapering off of new supply in 2018. 
• Core CBD office rents reached an inflection point in 3Q17, increasing 1.7% QoQ to S$9.10 psf/month, according to CBRE’s data. This was the first sequential uptick in 10 quarters (cumulative dip of 20.2% from the peak in 1Q15). However, vacancies trended upwards to 7.5%, signifying flight to quality (more efficient floor plates) and continued consolidation amongst tenants. 
• Looking ahead, we project rental increments of 5%-10% in 2018. However, negative rental reversions for office REITs are likely to persist in 2018 as rents for leases signed three years ago are still expected to be higher than our spot rents forecast. Furthermore, we believe the positives of a recovering rental cycle have already been priced in by the market, with the major office REITs CapitaLand Commercial Trust, Keppel REIT and Suntec REIT offering unattractive distribution yields of 4.7%, 4.8% and 4.9%, respectively, for FY18F, based on Bloomberg consensus’ estimates.

Supply pressures finally easing 

• Another key reason for the more positive operational outlook for the office sector is the lower supply coming on stream relative to 2016. Approximately 808,000 sq ft of office space is expected to enter the Central Area next year. On average, c.695,000 sq ft of new supply is projected to be added from 2018-2021, which is manageable, in our view, supported by a cyclical upturn in the global economy.

INDUSTRIAL SECTOR: Rents unlikely to bottom out until end-2018 

• Manufacturing Purchasing Managers’ Indexes have been in expansionary territory across all regions for the past several months and this has translated into more enquiries on the ground for industrial landlords. However, negotiations can still take a long time to conclude and rents are still a sticky issue as it is currently a tenants’ market given ample supply. 
• According to data from JTC, the rental index for all industrial space fell 1.1% QoQ in 3Q17, making it 10 consecutive quarters of decline. The only bright spot came from business parks, which saw a slight 0.3% QoQ growth and this was also the second straight month of increase. This is in-line with our expectations as we had previously highlighted our preference for business parks within the industrial sector.

Australia a key market for industrial REITs 

• There has been a noticeable trend of some difficulties in rental collection from tenants, especially for the small-mid cap industrial REITs. Soilbuild REIT is one example. The REIT manager had to issue a letter of demand to one of its master lessees NK Ingredients for arrears and has also called upon an insurance guarantee as a result. There was also approximately seven months of receivables due from another tenant KTL Offshore as at end Sep. Partly due to issues faced at home, Soilbuild REIT recently announced that it is expanding its investment mandate to explore investment opportunities in Australia.
• We believe Australia remains an attractive market for industrial REITs, underpinned by the low interest rate environment, population growth and infrastructure spending by the government which are expected to drive tenants’ demand for industrial space.

Supply in 2018 to taper off, but near-term pressure on rents to stay 

• Looking ahead, approximately 931,000 and 1.36m sqm of industrial supply is expected to come on stream in 4Q17 and 2018, respectively. 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 (2.34m sqm), market players largely agree that rents will likely only bottom out by end-2018.

HOSPITALITY SECTOR: A brighter 2018 awaits 

• Singapore’s headline tourism figures have been robust. For the first eight months of the year, international visitor arrivals grew 4.7% to 11.7m visitors, while tourism receipts jumped 10% in 1H17 to hit S$12.7b.
• RevPAR figures were less stellar, inching up only 0.5% to S$201.5 for 8M17, as growth in occupancy (+1.2% to 86.4%) was partially offset by a fall in average room rate (-0.7% to S$233.1). This was likely due to competition amongst the hotels, as 2.5k new rooms (+3.9%) are projected to be added to the market this year. 
• Similarly, RevPAR/RevPAU figures for the hospitality REITs have been largely soft for their Singapore portfolio. However, there are signs of local corporate demand stabilising with more enquiries regarding the use of function rooms for events and activities. This is in-line with the firmer macroeconomic environment.
• Looking ahead, Singapore’s hotel room supply is expected to increase 1.7% (+1.1k rooms) in 2018 and 2.2% (+1.5k rooms) in 2019, according to market watcher Horwath HTL, a lower magnitude than what is expected in 2017. Coupled with our expectations of a recovery in demand, we forecast RevPAR to rebound slightly in 2018, as there will likely still be some softness in 1H18.
• We do not see any compelling ideas within the hospitality space at the moment as markets have likely priced in this recovery story, in our view.

Improving Fundamentals But Valuations Stretched; Maintain NEUTRAL Heading Into 2018.

• Despite improving fundamentals, we are cautious on valuations for the S-REITs sector, which appear stretched, in our view. 
• The FTSE ST REIT Index is currently trading at a forward yield spread of 374 bps against the Singapore Government 10-year bond yield. This comes in at ~1.3 standard deviations below the 5-year average. However, we believe selective opportunities remain, as liquidity in the markets will continue to drive the yield compression theme for quality names. 
• We retain Frasers Centrepoint Trust [BUY; FV: S$2.40] and Frasers Logistics & Industrial Trust [BUY; FV: S$1.25] as our top picks for 2018. 
• We remove Keppel DC REIT [BUY; FV: S$1.50] on valuation grounds as the stock has performed strongly.
• Our tactical idea of adding OUE Hospitality Trust into our conviction list in Aug this year also panned out well, delivering robust total returns of 10.4%. We now close this tactical position. 
• Finally, we add Mapletree Greater China Commercial Trust [BUY; FV: S$1.28] and Mapletree Logistics Trust [BUY; FV: S$1.35] as our third and fourth preferred picks, respectively. 
• Overall, we maintain NEUTRAL on the S-REITs sector.

Wong Teck Ching Andy CFA OCBC Investment | http://www.ocbcresearch.com/ 2017-11-30

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