Singapore REITs - OCBC Investment 2019-07-03: Potential Re-rating Catalyst?

ASCOTT RESIDENCE TRUST (SGX:A68U)

Singapore REITs - Potential Re-rating Catalyst?

On 2 Jul, MAS published a consultation paper on proposed amendments to the requirement of REITs, and has invited comments on the proposals. This has to be submitted by 1 Aug 2019. See consultation paper.
The main consideration surrounds the leverage (total borrowings and deferred payments of a REIT divided by its deposited assets) limit for S-REITs, which currently stands at 45%. This is to prevent REITs from overstretching their balance sheets and to mitigate the risk of a REIT having to liquidate a major asset in its portfolio during downcycles in order to service or repay debts. As S-REITs typically maintain a buffer of ~5 ppt, they would generally keep their leverage to within 40%.
After taking in feedback, MAS is reviewing the leverage limit so as to provide REITs with better flexibility to optimise their capital structure as the cost of debt is lower than the cost of equity and debt also takes less time to raise. This has become more pertinent as S-REITs are increasingly sourcing for acquisitions overseas and some of these deals may require a competitive bidding process and/or are time sensitive.

However, MAS also recognises that safeguards must be put in place. One possible approach is to allow REITs to take on higher leverage only if they are able to meet a minimum interest coverage ratio (EBITDA excluding fair value changes divided by interest expense). For example, a REIT’s leverage may be allowed to cross 45% but not exceeding 50% if it has an interest coverage ratio of at least 2.5x after taking into account the interest payments arising from the new debt.
Taking this a step further, MAS is also seeking views on whether REITs with good financial discipline (interest coverage ratio above a certain level) should be allowed an even higher leverage limit, for instance 55%.

We believe the move to improve flexibility for S-REITs would be a re-rating catalyst for the sector if implemented, provided that REIT Managers remain prudent on their capital management.
We note that in the past, even when REITs were allowed to gear up to 60% if they had a credit rating, they chose to remain conservative and kept their leverage below 45%. Furthermore, based on the S-REITs under our coverage, average interest coverage ratio was healthy at 5.2x, as at 31 Mar 2019 (range from 2.5x to 12.9x).
Other more developed REIT markets such as US, Australia and Japan currently do not impose any leverage limit. We believe there is a self-regulating market mechanism to this, as market participants may choose to penalise REITs which have gearing ratios which are deemed too high by ascribing lower valuation multiples, such that the REITs would seek to find the right balance.
We maintain NEUTRAL on the S-REITs sector for now on valuation grounds.

OCBC Research Team OCBC Investment Research | https://www.iocbc.com/ 2019-07-03

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