Singapore REITs - DBS Research 2019-01-02: Defensive The New Offensive


Singapore REITs - Defensive The New Offensive

Sector outperforms for fifth consecutive year despite interest rate fears

Yield plays were at the forefront in 2018.

  • As we headed into 2018, the market and our DBS economists were expecting the global economy to enter a period of synchronised growth, and in Singapore, the residential property market would rebound given diminishing supply and aggressive bidding of land by developers. Thus, investors were positioned into the more cyclical stocks. However, as the year progressed, growth expectations were dialed back on account of escalating trade tensions between the US and China.
  • Furthermore, due to the 9% jump in Singapore residential prices, the Singapore authorities introduced additional property cooling measures which is expected to chill future demand for new launches. This caused investors to turn cautious on developer stocks.
  • Consequently, due to macro uncertainties, investors refocused on yield, with S-REITs back in favour despite concerns over the impact of rising interest rates. Nevertheless, with the overall market down for the year, S-REITs on an absolute basis have declined c.4% (including distributions as at 31 December 2018) but still outperformed the STI and Developers index which fell c.6% and 16% respectively. This is the fifth consecutive year that SREITs have outperformed the STI.
  • See S-REITs share price performance and also Straits Times Index Constituents share price performance.

A more gradual hike normalisation in 2019.

  • Our DBS economists recently revised the US Federal Reserve to increase interest rates twice in 2019 in line with consensus compared to a more hawkish four hikes before. The reason for the revision is due to the current global economic uncertainties brought about by the trade war between US and China. The US Federal Reserve is close to end of the current normalisation of interest rates with our DBS economists projecting no further rate hikes until the end of 2020.

Impact of higher interest rates to filter through but have limited impact on distributions.

  • To combat the threat of rising interest rates, S-REITs have conservatively hedged a large proportion of their debt into fixed rates estimated at c.75% as at end-Sep 2018. This level has been maintained by the S-REITs over the years.
  • We note that the sector’s average cost of debt has been fairly stable at c.2.7% during 2014-2018 despite the increase in base interest rates over the same period. This is mainly due to a compression in credit spreads that S-REITs have been able to obtain when loans came up for renewal during the period, with average spreads over the 3M-SOR declining by an average of 1.74% (1.66%-1.79%) over 2015-2017 to 1.18% (as of 3Q18), implying a compression of over 50bps.
  • Looking ahead, with credit spreads at a multi-year low and base rates expected to rise on the back of continued hikes in the FED funds rates, we see limited room for spreads to compress further from current levels. While selected S-REITs may prefer to refinance their loans to shorter term maturities in order to keep interest costs low, in general, S-REITs will be faced with higher interest costs as their debts fall due after the increase in benchmark interest rates over the last two years. In our sensitivity analysis, a 1% hike in interest rates will cut FY19-20F distributions by 1.1%-1.2%.

But cyclical upturn in rents will see DPU growth accelerating.

  • Despite expectations of higher borrowing costs, we believe S-REITs on average can still deliver DPU growth, which is projected to accelerate from 1.9% in 2019 to 2.3% in 2020. This is largely due to the boost from acquisitions made in 2018, but more importantly the cyclical upturn in rents across the different property submarkets as supply pressures ease, offsetting headwinds from higher borrowing costs.

Long bond yield to peak in 2019 with interest rate overhang easing thereafter.

  • While investors have been fretting about a spike in the 10-year bond yield, we are approaching a peak soon according to our DBS economists. They expect the Singapore 10-year government bond yield to rise from c.2.45% currently to 2.90% by end-4Q19. Thereafter, with downside risk to US growth in 4Q20, they expect the Singapore 10-year bond yield to fall to 2.7% in 3Q20 and 2.5% in 4Q20.
  • While there may be short term volatility in share prices as we approach the 2.90% level, but after hitting the peak, we believe the overhang from rising interest rates both at the short and long end should dissipate over time.

Improving rental outlook translating to stronger DPU prospects

Recovery in office and hotels.

  • Prior to 2018, there was an oversupply in the office, retail, industrial and hotel segments following the release of land by the government 5-6 years ago in response to the rapidly rising spot rents which impairs Singapore’s global competitive position. However, in 2018, this oversupply situation reversed for the office and hotel sectors as new supply moderated and will remain low going forward.
  • On the back of healthy demand for office space due to robust GDP growth (2018 GDP growth of c.3.5%), this translated to Grade A Office rents hitting S$10.45 psf/mth at end September 2018, c.17% from the lows in 1H17. Likewise, strong tourist arrivals (+7.5% in 9M18), resulted in revenue per available (RevPAR) jumping c.3% in 9M18, after declines over the last few years.
  • With modest new supply and healthy growth in the Singapore and regional economies projected by our DBS economists, we expect office rents and hotel RevPAR to increase 5-10% and 3- 4% y-o-y respectively in 2019.

Upturn to extend to industrials and retail.

  • Heading into 2019, we believe the positive momentum in the office and hotel sectors in 2018 should also spill over to the industrial and retail sectors. Industrial supply is expected to peak in 2018, and moderate from 2019 onwards. This in turn should translate to 2-3% growth in spot rents. Meanwhile, retail rents should bottom out in 2019 and recover thereafter as supply is expected to peak during 2019 and fall from 2020 onwards.
  • While near term supply is a major concern for some investors, we note that c.90% of the new supply has already been precommitted, there should be limited pressure on rents from the new malls opening next year.

Positive boost from organic rental growth.

  • While we and the market had expected DPU growth to resume in 2018, this did not materialise. This was largely due to the underperformance of the hospitality REITs as the upper scale and mid-tier hotels lagged the overall market recovery, and impact from equity raisings this year.
  • Nevertheless, for 2019, we remain confident that DPU growth will show positive growth as the S-REITs recognise the full year impact from c.S$10bn worth of acquisitions made in 2018, and more importantly a more convincing recovery in spot rents across most subsectors.
  • Overall, we expect the S-REITs to deliver steady 1.9% DPU growth in 2019, increasing by a further 2.3% thereafter in 2020.

Retail and commercial REITs to grow the fastest in FY19.

  • We expect the retail/commercial sectors to deliver the fastest growth supported by inorganic growth from CAPITALAND MALL TRUST (SGX:C38U)’s recent acquisitions and reopening of its Funan mall, and MAPLETREE COMMERCIAL TRUST (SGX:N2IU)’s recently completed asset enhancement initiatives (AEIs).
  • Meanwhile, positive rental reversions achieved in the office sector in 2H18 should start to filter through, leading to a recovery in DPU growth in 2019 for most office REITs. Besides the recovery in spot rents, the industrial sector should continue to maintain its track record of steady DPU growth largely due to acquisitions made in 2018.
  • Finally, following a disappointing 2018, the hospitality REITs should finally benefit from an overall uplift in the Singapore hospitality market but at a more modest pace.

Acquisitions tougher to come by in 2019

Record year for acquisitions.

Further shift outside Singapore.

More balanced mix between Sponsor and third party acquisitions.

  • In 2018, the proportion of acquisitions sourced from S-REITs’ Sponsors and third parties stood at 54% and 46% respectively. This is more balanced than the 27%/73% spilt between Sponsor and third party acquisitions in 2017. The increased share of Sponsor related acquisitions was largely attributed to acquisitions made by REITs under Frasers Group, Mapletree North Asia Commercial Trrust and CapitaLand Mall Trust.
  • However, as more S-REITS venture into UK/Europe where S-REITs’ Sponsors are not as well established or yet to commence greenfield developments, the share of third party acquisitions may increase over time.

First S-REIT takeover.

Market volatility and higher borrowing costs to contain acquisitions.

  • After a record year in 2018, we believe acquisitions will be more difficult to execute in 2019. This is due to the higher cost of capital making it more challenging to conduct equity placements. Furthermore, there may be push back against S-REITS conducting rights issue, given the negative market reaction to such equity raisings in 2018.
  • In addition, with rising borrowing costs and relatively tight asset yields globally, it will be tougher to find attractive assets which will be DPU accretive.

A modest rally in SREITs in 2019; safety to be the driver for share price re-rating

Growth fears in 2018.

  • At end 2017, yield spreads stood at c.3.7% and we had expected yield spreads to compress due to a combination of faster DPU growth and an increase in the Singapore 10-year bond yield. However, due to growth fears arising from trade wars and earnings boost from acquisitions, absolute forward yields increased to c.6.2% from c.5.8%, resulting in yield spreads expanding to c.4.2%.

Modest compression in yield spreads ahead.

  • Going into 2019, we believe growth fears arising from the US-China trade tensions are unlikely to fully dissipate. However, we believe there is still potential for S-REITs in general to rally, resulting in a modest compression in yield spreads.
  • Our positive stance is premised on investors seeking yield assets in the midst of macro uncertainties, positive reaction to an acceleration in DPU growth from the full year of earnings contribution from c.S$10.5bn worth acquisitions made in 2018, reduced indigestion from less equity raisings, and increased positive rental reversions. Furthermore, the S-REITs stand tall among other regional REIT markets with higher absolute yields and yield spreads.

Prefer retail and industrial sectors

Sector preferences – 1) Retail, 2) Industrial, 3) Office and 4) Hospitality. 

  • Going into 2019, on the back of healthy Singapore GDP growth of c.3% and easing supply pressures, we believe this should translate to a sustained upturn in rents and RevPAR for the office and hotel sectors. The positive momentum should also result in spot industrial rents increasing for the first time in 4-5 years, and bottoming of retail rents. Furthermore, S-REITs should benefit from c.S$10bn worth of acquisitions made in 2018. All in, the organic improvement and boost from acquisitions, should result in a stronger DPU outlook.
  • Nevertheless, while fundamentals for S-REITs should improve on average, we believe investor sentiment remains fragile stemming from concerns over the potential impact from the trade tensions. Thus, in our view, investors in 2019 should seek more defensive and resilient REITs, with lower volatility in earnings/DPU. Consequently, our top sector pick is the retail REITs.
  • Despite retail malls facing structural headwinds in the form of competition from e-commerce, we believe the suburban malls owned by the retail REITs are typically well located, and are connected to MRT stations which have a natural catchment of consumers and account for a large proportion of non-discretionary spending which is more difficult for online plays to dislodge. Furthermore, potential downward pressure from new supply is mitigated by the 80- 90% pre-committed occupancy for new malls opening over the next 12 months.
  • Our defensive stance is also reflected by our picks in industrial REITs, our second preferred sector. We believe the recovery in industrial rents should provide positive newsflow, more importantly, the higher absolute yield spread of between 6-8% should provide a larger buffer against the impact of rising interest rates and volatility in the equity markets. The industrial sector should also benefit from the larger industrial REITs being able to raise equity to pursue DPU accretive acquisitions.
  • Finally, potential consolidation among the smaller industrial REITs may boost the share prices of the industrial REITs.
  • We believe the Office and Hospitality sectors should experience an improvement in spot rents and RevPAR which in turn should result in decent DPU growth. However, it may take some time for the market to fully recognise the improvement in fundamentals in the office REITs and hospitality REITs given fears over a slowdown in global growth, thus causing the share prices of these REITs to lag the retail REITs and industrial REITs.

Top Picks

Resilient and steady performers.

  • Given our more defensive stance, CAPITALAND MALL TRUST (SGX:C38U), the largest retail S-REIT, is among our top picks. We are bullish on CapitaLand Mall Trust given its exposure to suburban malls in Singapore which provide for a resilient income base. Furthermore, near term, CapitaLand Mall Trust should deliver one of the fastest DPU growth (c.4% p.a. over the next 3 years) among S-REITs, led by the reopening of Funan and the recent acquisition of the remaining interest in Westgate.
  • Likewise, we also like MAPLETREE COMMERCIAL TRUST (SGX:N2IU) given its ownership of Vivocity and Mapletree Business City I, the best in class retail mall and business park in Singapore respectively. The ability of both these assets, which contribute c.77% of NPI, to attract prospective tenants and drive rents enables Mapletree Commercial Trust to deliver a steady increase in earnings and rents.
  • Within the industrial sector, our top pick is MAPLETREE LOGISTICS TRUST (SGX:M44U). With the upturn in its key markets of Australia, Hong Kong, Japan, and Singapore, Mapletree Logistics Trust should benefit from c.S$1.3bn worth of acquisitions made in 2018.
  • FRASERS LOGISTICS & IND TRUST (SGX:BUOU) is also one of our favourite industrial REITs given its long weighted average lease expiry (WALE) of 6.9 years and inbuilt rental escalations which underpins a resilient and steady growth in DPU. In addition, Frasers Logistics & Industrial Trust offers an attractive yield of c.6.5%.
  • We also like MAPLETREE NORTH ASIA COMM TR (SGX:RW0U) given its attractive valuations of 6.7% yield and c.15% discount to book. Considering its quality portfolio, strong track record of performance, we believe the large discount to its HK peers, which are trading on a forward yield in the mid 5%, is unwarranted. Furthermore, with Mapletree North Asia Commercial Trrust’s key asset Festival Walk (c.60% of NPI) reporting very strong rental reversions over the last few quarters, we expect this should translate to healthy growth in DPU ahead.

Changes to Target Price and Recommendations

Pricing in a more conservative interest rates profile.

  • Given that S-REITs are likely to be faced with higher interest costs as they refinance their debt going into 2019, we have incorporated higher cost of debt in our DCF valuations resulting in generally lower target prices. Nevertheless, for some S-REITs which have exposures to Europe and Japan, the impact of higher US interest rates is likely to be muted given their ability to manage the overall borrowing costs by increasing the proportion of JPY and EUR debt.
  • In addition, our target prices have also been reduced due to delays in potential acquisitions and the impact of recent rights issues. Please refer to the PDF report attached for the revisions we have made to our target prices following the recent 3Q18 reporting season and reasons for the change. For more details please refer to the individual company guides.

Derek TAN DBS Group Research | Mervin SONG CFA DBS Research | Carmen TAY DBS Research | https://www.dbsvickers.com/ 2019-01-02
SGX Stock Analyst Report BUY MAINTAIN BUY 2.440 SAME 2.440