Singapore REITs - OCBC Investment 2018-05-23: Rising Yields Negate Improving Industry Fundamentals

Singapore REITs - OCBC Investment 2018-05-23: Rising Yields Negate Improving Industry Fundamentals Singapore REITs Sector S-REITs Outlook FRASERS LOGISTICS & IND TRUST SGX:BUOU FRASERS CENTREPOINT TRUST SGX:J69U MAPLETREE GREATER CHINACOMM TR SGX:RW0U

Singapore REITs - Rising Yields Negate Improving Industry Fundamentals

  • 1QCY18 DPU fell. 
  • Rising bond yields. 
  • Top picks: FLT, FCT and MGCCT. 

1QCY18 DPU decline largely attributed to dilution from equity fund raising last year

  • Looking at the recently concluded 1QCY18 results season, 19 out of the 23 S-REITs under our coverage reported results which met our expectations, while 4 missed (Ascott Residence Trust, CDL Hospitality Trusts, Frasers Commercial Trust and Starhill Global REIT).
  • The average DPU growth came in at -2.6% on a y-o-y basis. Notwithstanding this decline, we believe the operational outlook appears more positive, especially for the office sub-sector, whereby signing rents have improved firmly in tandem with the robust recovery in market rents.
  • Looking ahead, we are projecting stable DPU growth (market-cap weighted) of 1.9% for the current financial year and 1.6% for the next financial year. We continue to believe the office sector would achieve the strongest rental growth this year, while RevPARs for hospitality REITs have been encouraging in 1Q18 and we expect growth to accelerate as the year progresses.
  • Meanwhile, industrial and retail rents have shown signs of bottoming out, but tenants are still largely cautious on their expansion plans.

Key Trends: Expansion into new overseas markets; M&A in focus

  • One of the key trends which emerged late last year and continued through this year was the penetration of S-REITs into new geographical markets.
  • As a recap,
    • Mapletree Industrial Trust (SGX:ME8U) completed its maiden overseas acquisition via a 40:60 joint venture with its sponsor for the purchase of a portfolio of 14 data centres in the U.S. on 20 Dec last year. The purchase consideration was US$750m and partially funded by a private placement exercise.
    • Frasers Commercial Trust (SGX:ND8U) also deemed it strategic to work with its sponsor by acquiring its first business park property in the UK via a 50:50 joint venture at a property value of GBP175m (100% basis) in Jan this year. This was funded mainly by a private placement exercise.
  • Following Mapletree Industrial Trust and Frasers Commercial Trust’s maiden entries into new markets, other REITs have recently followed suit. This includes
  • All the aforementioned acquisitions involved some forms of equity fund raising to raise proceeds. As such, we note that the pro forma DPU accretion highlighted were largely muted. YTD, ~S$2.1b worth of secondary equity offering has been announced by S-REITs. We believe the REIT managers have taken a longer-term view on these acquisitions. 
  • Similar attractive traits underpinning these moves include freehold land, high occupancy rates with long WALEs and lower cost of funding in local currency terms.
  • Another key sector event was the agreement reached between the REIT managers of of ESR-REIT (SGX:J91U) and Viva Industrial Trust (SGX:T8B) on their proposed merger. Should approvals from both sets of unitholders be obtained, this could potentially create the fourth largest industrial REIT in Singapore in terms of asset size (~S$3b) and set the stage for further consolidation in the industry in the future.

Rising bond yields have spooked the REITs market; prudent capital management allays only one part of the equation

  • The S-REITs sector, using the FTSE Straits Times REIT Index (FSTREI) as a benchmark, is down 6.0% YTD (as of the close of 22 May). Including dividends, the sector has posted total returns of -3.4% YTD.
  • We believe this decline has been driven by concerns over a rising interest rate environment, as government bond yields have also seen a spike since the start of the year. This is despite the more positive operational outlook amid firmer underlying industry fundamentals. The U.S. government 10-year bond yield has moved up from 2.41% (as at 29 Dec 2017) to 3.06%. Similarly, the Singapore government 10-year bond yield is currently at 2.67%, a relatively significant increase versus the 2.00% level seen as at the end of 2017.
  • As the U.S. government 10-year bond yield continues to make new highs not seen since 2011, we believe market jitters may persist over the S-REITs sector. Based on Bloomberg consensus forecast, the U.S. government 10-year bond yield is projected to reach 3.2% by end-2018. As a silver lining, we note that REIT managers have largely been proactive in their capital management.
  • For the REITs under our coverage, approximately 74% of their borrowings have been hedged/fixed (as at 31 March 2018), while the average aggregate leverage ratios is healthy at 35.3%, which is below the regulatory limit of 45%. Notwithstanding this near-term buffer, the fact that hedging costs have also increased as illustrated by the movement in SGD interest rate swaps implies that overall borrowing costs will likely trend upwards as REITs roll forward their hedges. From our sensitivity analysis, we estimate that every 100 bps increase in borrowing costs would result in an average 2.2% decline in the DPU of the S-REITs under our coverage.

Tight yield spread poses potential downside risks

  • Furthermore, capital management is just one part of the equation in addressing interest rate concerns, in our view. The other aspect is on valuations, of which REIT managers have no control over. Given that the FSTREI is trading at a forward distribution yield of 6.0% (0.9 standard deviations below 5-year mean), this implies that the yield spread against the Singapore government 10-year bond yield is 334 basis points (bps). 
  • Despite the S-REITs' share price correction YTD, valuations are still stretched, in our view, as this yield spread represents two standard deviations below the 5-year average (410 bps). Maintain NEUTRAL on the S-REITs sector, with a selective stock picking approach remaining key at this juncture.
  • Our preferred picks are 

Retail Sector: Turning the corner?

  • Retail rental growth surprisingly spun into positive territory in 1Q18, despite continued sector headwinds such as manpower shortages and consolidation amongst retailers. 
    • According to the official URA rental index, q-o-q rental growth came in at 0.2% and 0.3% for the Central Area and Fringe area, respectively. This culminated in a slight 0.1% improvement for the Central Region, which we believe is significant despite the small magnitude given that rental growth was negative for 12 consecutive quarters prior to 1Q18. 
    • Similarly, CBRE data also pointed in the right direction, with rents increasing 1.4% q-o-q to S$22.10 psf/month for the City Hall/Marina Centre, 0.5% q-o-q to S$31.45 psf/month and S$28.95 psf/month for both Orchard Road and Suburban, respectively. Rents in the Other City/City Fringe sub-market remained flat sequentially.
    • Meanwhile, Singapore’s retail sales excluding motor vehicles grew 2.6% y-o-y for the month of Mar. The key drivers were Department stores (+9.1%), food retailers (+7.5%), medical goods & toiletries (+6.2%), wearing apparel & footwear (+5.0%) and watches & jewellery (+5.0%). The total retail sales value in Mar was estimated at S$3.8b, of which only 4.1% was contributed by online retail sales, according to the Department of Statistics Singapore.
  • This trend also falls in-line with the operational metrics reported by retail S-REITs
    • CapitaLand Mall Trust (SGX:C38U) delivered positive rental reversions of 0.8% in 1Q18, a reversal from FY17 (-1.7%). Looking at trade mix performance, most of its trade categories performed better in 1Q18 than in FY17. 
    • Frasers Centrepoint Trust (SGX:J69U) had a strong quarter of rental reversions (+9.1%), led by its flagship Causeway Point mall. 
    • OUE Hospitality Trust (SGX:SK7)’s Mandarin Gallery also reversed its fortunes, recording positive rental reversions of 2.2% after almost two years of weakness. 
  • There was, however, some softness on the shopper traffic and tenant sales front for retail REITs. Notwithstanding these largely encouraging signs, we would prefer to await another 1-2 quarters of data points to reaffirm that retails rents have really reached a nadir.

Office Sector: Confluence of positive factors

  • The office sector witnessed another strong quarter, with Grade A core CBD office rents growing 3.2% q-o-q to S$9.70 psf/month in 1Q18, according to CBRE’s data. This was the third consecutive quarter of growth, following 4Q17 and 3Q17’s 3.3% and 1.7% sequential growth to S$9.40 psf/month and S$9.10 psf/month, respectively. 
  • The vacancy rate in the core CBD area dipped 0.3 ppt q-o-q to 5.9% from 6.2%. This was underpinned by positive net absorption of 149.4k sq ft of office space in 1Q18. Positive momentum was also registered in the Grade B core CBD office segment, as rents rose 2.0% q-o-q to S$7.60 psf/month in 1Q18, the second straight quarter which saw growth above 2%.
  • Based on property consultants’ reports and our conversations with office REITs, we believe signing rents have come in above expectations for certain properties. Demand was led by co-working operators, financial services, business consultancy and the Technology, Media and Telecom sectors.

Tapering supply and improved business sentiment a boon

  • Office supply in the Central Area for the rest of the year is expected to be manageable, with Frasers Tower (0.66m sq ft) and 18 Robinson (0.15m sq ft) the only notable pipeline projects. According to Frasers Property Limited’s 2QFY18 presentation slides, Frasers Tower has achieved pre-lease commitments above 70%. Incoming tenants include Microsoft, Total Oil and Sumitomo Corporation.
  • On average, c.695,250 sq ft of new supply is projected to be added from 2018-2021 per annum in the Central Area. CapitaSpring, which is only expected to be completed in 2021, has already secured J.P. Morgan as an anchor tenant for a pre-committed space of 155k sq ft, translating to 24.4% of the property’s office NLA.

Industrial Sector: Big is better

  • According to data from JTC, the rental index for all industrial space inched down 0.1% q-o-q in 1Q18, similar to 4Q17. Business parks continued to outperform, with rents improving 2.4% q-o-q (4Q17: +2.0% q-o-q) and this was also the fourth straight quarter of increase. Delving in to the other sub-sectors, rents for Multiple User Factory was flat, while declines were seen in Single User Factory (-0.8%) and Multiple User Warehouse (-0.3%).
  • In terms of supply, an estimated 1.4m sqm of industrial space is expected to come to the market from Apr-Dec 2018, representing ~3% of current stock, according to JTC. To put things in perspective, over the past three years, the average annual demand and supply were 1.2m sqm and 1.7m sqm, respectively. 
  • Drawing reference from the 1Q18 performances of industrial REITs, it was not surprising that the large cap names continued to exhibit better resilience than the small-to-mid caps. Looking ahead, overseas expansion would remain as a key theme, with 
    • Ascendas REIT (SGX:A17U) highlighting during its analyst briefing that it was exploring further overseas inorganic growth opportunities beyond Australia, with Europe and the U.S. as potential markets. 
    • Frasers Logistics & Industrial Trust (SGX:BUOU) had already obtained unitholders’ approval to acquire a portfolio of 17 industrial properties in Germany and 4 in the Netherlands, which are ranked as the number one and number four logistics hubs globally, respectively, according to the World Bank 2016 Logistics Performance Index Global Ranking. 
    • Meanwhile, Mapletree Logistics Trust (SGX:M44U) looks set to deepen its footprint in China with its proposed acquisition of a 50% indirect interest in 11 logistics properties in China for an approximate price of RMB985.3m (S$205.3m). The top tenants for this portfolio include JD.com, Cainiao Smart Logistics Network Limited and Sinotrans Limited, with potential cross-selling opportunities as a number of them are interested to expand in South-East Asia. 
  • Given the importance of scale in this industry, it was not surprising to see the proposed merger of ESR-REIT (SGX:J91U) and Viva Industrial Trust (SGX:T8B). The enlarged entity (if both sets of unitholders grant their approvals) would potentially reap the benefits of refinancing its debt at lower costs and enhance trading liquidity, while increasing its bargaining power among tenants and brokers. 

Hospitality Sector: Clearer skies ahead

  • Singapore’s tourism receipts grew 5% to S$26.8b in 2017, with the increase contributed by most major components such as Shopping (S$6.2b, +4%), Sightseeing, Entertainment & Gaming (S$5.6b, +5%), Accommodation (S$6.0b, +2%) and Other TR Components (S$6.4b, +11%). The only segmental decline came from F&B, which fell 5% to S$2.6b (10% of total tourism receipts in 2017). Geographically, China was the largest contributor, with tourism receipts (excluding Sightseeing, Entertainment & Gaming due to commercial sensitivity of information) surging 19% to S$4.2b, or ~20% of our market.
  • Following Singapore Tourism Board’s revised methodology on its data computation, revised figures on hotel statistics were published on 29 Jan this year. We note that overall RevPAR in 2017 showed a dip of 1.7% to S$182.3. This was a smaller decline from the -4.9% registered in 2016, but still marked the third consecutive year of decline (2015: -4.5%). 
  • However, the tide appears to be turning, as RevPAR from Jan-Feb this year has finally turned positive with a y-o-y growth of 3.0% to S$190.3. This was driven by both higher occupancy (+1.0% to 85.7%) and average room rates (+1.9% to S$222.1).
  • Looking ahead, we believe corporate demand holds the key to the strength of the recovery in the hospitality sector, as there are still some uncertainties over the demand outlook from our conversations with the hospitality REITs. While there have been encouraging signs from the finance and oil and gas project groups, it remains to be seen whether this can be sustained.
  • Supply-wise, an estimated 3.2k hotel rooms were added to the Singapore market in 2017, representing an increase of 5.1% over 2016. This situation is expected to improve strongly, as market watcher Horwath HTL has projected new room supply to increase at a slower pace of 2.5% (or +1.7k rooms) in 2018, followed by a benign 0.8% (+536 rooms) and 0.6% (+392 rooms) growth in 2019 and 2020, respectively. 

Wong Teck Ching Andy CFA OCBC Investment | Deborah Ong OCBC Investment | Joseph Ng OCBC Investment | https://www.iocbc.com/ 2018-05-23
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