Singapore REITs - DBS Research 2018-05-08: The Time Is Now

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Singapore Property Stocks SREIT ASCENDAS REAL ESTATE INV TRUST SGX: A17U CAPITALAND COMMERCIAL TRUST SGX: C61U CDL HOSPITALITY TRUSTS SGX: J85 FRASERS CENTREPOINT TRUST SGX: J69U

Singapore Property/REITs -  the Time Is Now 

• The tide has turned for S-REITs to expand overseas. 
• Boosting growth not the only consideration, protection against capital dilution is also critical. 
• Scale and presence of sponsor in overseas markets key criteria for success. 
• Acceleration of DPU growth enhances the attractiveness of S-REITs. 

Market becoming receptive to overseas expansion.

• Many investors have frowned upon S-REITs expanding overseas and moving away from a pure single country or Singapore focus, given concerns over FX risks but also unfamiliarity with an overseas market. However, that view is changing after our analysis of recent overseas ventures. 
• This change of view among investors comes from a greater understanding that S-REITs’ overseas expansion mandates have generally resulted in more sustainable DPU growth and in our view, builds resiliency across business cycles. 

Re-visiting the benefits of remaining a pure-play in Singapore.

• While the conversation surrounding expanding overseas sometimes devolves into investors' preference to have the ability to pick and choose their country allocation, we believe this has the unintended consequence of leaving S-REITs and other longer-term investors vulnerable. 
• In particular, we believe that it opens the REIT to a risk of a Singapore downturn or in any particular sector. This is especially in the industrial sector where capital values will be under pressure due to the relatively short land lease of 30 years. 
• If industrial S-REITs are not proactive in expanding overseas, the risk is that NAV might be diluted over time. 

Delivering a well-calibrated overseas strategy a key success factor; ability to tap sponsor a further positive.

• A successful overseas expansion strategy will hinge on the S-REIT manager delivering a well-calibrated strategy that focuses on value creation on a risk-adjusted basis. 
• We believe S-REITs with the support from a sponsor or local partners, offering scale and deeper market knowledge of an overseas market, will be better received by investors. Furthermore, a tighter focus on several countries rather than a scatter gun approach is key, in our view. 
• Selective Singapore-focused S-REITs which we believe could potentially expand their mandate in the medium term include CCT, CMT, FCT, SPHREIT, SBREIT, FEHT and OUEHT. 

Expansion will support S-REITs' performance.

• We believe with more S-REITs expanding overseas, the boost to DPU growth is supportive of the overall S-REIT sector's performance and our view that yield spread should compress throughout the year towards the 3% level. 
• The lack of growth has been a key concern and we believe that a well-thought overseas expansion strategy with a focus on delivering positive risk-adjusted returns will benefit and help REITs negotiate past operational hurdles going forward. 

Should S-REITs expand overseas? 

Less investment opportunities in Singapore 

• Given the reduced amount of investment opportunities in Singapore, both managers and investors in pure-play S-REITs have been grappling with the question of whether these S-REITs should expand their mandate and acquire assets overseas. For a variety of reasons several S-REITs such as KREIT, Suntec, AREIT, Cache, MINT have already expanded their mandate. 
• The question over the expansion of an investment mandate is also relevant for other single-country-focused REITs and REITs which decide to add additional countries or regions. 

Rationale for expansion overseas or investment mandate 

• Beyond the usual investment rationale for an acquisition being DPU accretion, a common theme for expanding a REIT’s investment mandate and into a new country is income and geographical and income diversification. In addition, it is often argued by REITs that a change in strategy will provide exposure to an attractive and growing market as well as accelerating the earnings/DPU growth outlook. 
• Furthermore, a key reason for an expansion is gaining access to freehold properties as most of the properties available in Singapore are typically on 30- to 99-year leasehold land. 

Why S-REITs should not expand overseas 

• However, some investors are against S-REITs expanding outside Singapore or moving beyond a single asset class or geographic region, given the lack of expertise, knowledge and insufficient scale to add value in a new country or region. 
• Furthermore, some investors prefer to make their own asset class and country allocation, by having a selection of single-asset-class or single-country REITs to choose from. In addition, investors have pushed back due to the increased risk profile arising from potential volatility in earnings arising from foreign exchange rate movements, as well as investors' lack of familiarity with overseas markets. 

Market reaction to expansion overseas thus far 

• Based on the REITs which have announced a change in mandate or expansion overseas, there is typically a short-term negative market reaction as investors are fearful of a new market they are unfamiliar with, believe there is a change in risk profile and potential equity raising to fund this growth. The first day reaction can include up to a 3% fall in share price and on rarer occasions up to a 2% increase in share price. However, in recent times, the initial market's reaction to S-REITs such as MINT and MAGIC expanding their investment mandate has been positive. 
• Over a 1, 3, 6 and 12-month period the market reaction is mixed, with no clear sign of whether the market is 100% for or against the expansion overseas. The share price weakness over 1 and 3 month seen for some REITs is also influenced more by fears over a potential equity raising rather than a pure reaction to a change in investment mandate 

Our thoughts – growth should not be the only consideration but mitigating downside risks is also important

• While acknowledging the potential increased risk with expanding overseas arising from potential forex volatility and different country risk factors, we believe in general there are merits for S-REITs to expand overseas to accelerate their medium-term growth. In addition, we believe overseas expansion should also be pursued to mitigate the downside risks for a REIT. These include:
  1. Management and protection of net asset value (NAV) – Investors have traditionally focused solely on DPU with scant consideration for NAV erosion arising from the running down of a land lease. Thus, on a holistic basis, we believe managers of S-REITs should have the flexibility to recycle capital from properties with short leasehold tenure into longer leasehold or freehold properties, thereby protecting the downside of NAVs for unitholders over the medium term.
  2. Flexibility in managing property cycle – The rationale for expanding overseas usually results in immediate DPU accretion and/or acceleration in the REIT’s medium-term growth profile. However, in our view a strong rationale for REITs expanding overseas is the ability to manage downside risk to DPU during a property downturn in Singapore/REIT’s original country as property cycles across countries are typically different. While many institutional investors would not ascribe to this view as they have the ability to sell ahead of a downturn and switch into another asset class or country, we believe tying management’s hands opens the REITs to greater volatility in earnings/DPU and goes counter to the REITs' main aim of providing sustainable DPU’s and steady capital appreciation.

Criteria for market acceptance and successful expansion

• While we appreciate the merits for S-REITs moving overseas, we believe there are also several criteria that S-REITs should consider beforehand. These include:
1. Expansion into countries with similar country risks – In our view when an S-REIT expands into another geographic region, in general it should move into a country with a similar country risk profile to Singapore or its original geographic exposure. This is to ensure that cost of capital does not materially change after the acquisition and the investment thesis remains clear to investors. Thus, a Singapore-focused S-REIT expanding overseas should stick to developed markets such as Australia, Europe/UK, US, Japan and Tier 1 cities of China such as Beijing and Shanghai. Conversely, REITs which predominantly have emerging market exposure should likewise stay within the same country risk profile. Without this discipline there may be a risk that the market starts attributing a higher yield of a REIT which has expanded from a developed country into an emerging country, which then over time forces the REIT to acquire higher yield but “riskier” properties to achieve DPU accretion.
2. Focus on the same asset class – Generally we would prefer S-REITs to stay with the same asset class, be that office, retail, industrial or hotel, unless the S- REIT already has a blend of different assets at its starting point. In our view, a combination of different assets classes would make it more difficult for investors to blend the different risk profiles and derive an appropriate target yield or P/Bk.
3. Backing from sponsor with scale in the respective countries – Ideally a REIT expanding into new geography should also be in conjunction with a market where a REIT's sponsor has scale and already has an established presence or in the worst-case, intentions to build significant capability, and its management team has experience managing assets in foreign jurisdictions. This would not only alleviate potential investor concerns over the lack of market knowledge in a new geography but more importantly ensure that the REIT has the right support and relationships with prospective tenants and partners to maximise value.
4. Focus country lists – Another key criterion to ensure success when expanding overseas is for the S-REIT to be focused on a few key countries to ensure that its resources are not spread too thinly and management gives sufficient time for each country.

• Beyond the above qualifications for overseas expansion within each asset class, we believe the following issues should also be given due consideration given the unique attributes for asset class:

Retail: Value to remain a pure-play 

• We believe with the Singapore retail market being relatively more defensive in nature as consumers are not as “adventurous” and due to the nature of where the malls are located, e-commerce while growing remains a smallish share of the market. 
• Consequently, retail S-REITs should avoid repositioning their portfolio into countries where the threat of e-commerce is larger and should not target stabilised retail assets but rather malls which provide significant upside through AEI’s or are under-rented.

Hotels: Go forth and multiply!

• In our view there is greater imperative for hospitality REITs to expand overseas to counter the seasonality in the hospitality industry in Singapore. Furthermore, due to the volatile nature of the hospitality industry, we believe to ensure a more stable and sustainable DPU profile, expansion into overseas markets should be subject to the right price. 
• In addition, the hospitality industry is unique in the sense that hotels are typically managed by global hotel chains which already have presence and expertise in the various overseas markets.

Industrial: Overseas expansion a “necessary evil”

• Similar to the hotels, the industrial sector is also a volatile one which would benefit from repositioning the portfolio into another country/countries to provide an offset should the core Singapore market undergo a downturn. 
• More accutely for the industrial sector is the fact that land tenure for new industrial land in Singapore is short at 30 years which, over time, will erode NAV per unit for REITs.

Office: Merits as overseas market typically improves earnings visibility.

• In contrast to the industrial sector, commercial land in Singapore has a land tenure of up to 99 years. Thus, the pressure to protect NAV dilution over time is not as severe. However, we believe there is some merits to providing a counter weight should there be a downturn in the Singapore office market.

Mervin SONG CFA DBS Vickers | Derek TAN DBS Vickers | https://www.dbsvickers.com/ 2018-05-08

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