Singapore REITs - DBS Research 2020-05-11: The Next Big Test For S-REITs

Singapore REITs - DBS Group Research | SGinvestors.io

MAPLETREE INDUSTRIAL TRUST (SGX:ME8U) MAPLETREE LOGISTICS TRUST (SGX:M44U) MAPLETREE COMMERCIAL TRUST (SGX:N2IU) LENDLEASE GLOBAL COMMERCIAL REIT (SGX:JYEU) ASCENDAS REAL ESTATE INV TRUST (SGX:A17U)

Singapore REITs - The Next Big Test For S-REITs

S-REITs have strong balance sheets to withstand near term market shocks.
Heightened risk on interest coverage ratios on the back of COVID-19 temporary measures.
MAS’ higher limit of 50% is a welcome relief in the face of potential asset devaluation at the end of 2020.

Overall financial metrics have improved since GFC

Surviving the test of another recession.

Given the global lockdown of borders and the standstill in economies caused by the ongoing COVID-19 pandemic, the Singapore economy in 2020 is expected to face its worst contraction and first full-year recession since 2009. Many have drawn comparisons to the Global Financial Crisis (GFC) in 2008-2009 but the situation is much worse now with Singapore’s gross domestic product (GDP) expected to decline by up to 5.7%, according to our DBS economist’s projections.

During the GFC, tightening of the credit markets coupled with a downturn in operational conditions resulted in several S-REITs needing to recapitalise their balance sheets. While interest coverage ratios (ICR) remained stable at > 4.0x during the GFC, we saw stress in selected balance sheets.
Over 2007-2009, we noted that asset valuations declined by 2%-15%, with the office sector bearing the brunt of that drop.

Much more financial flexibility to face the 2020 recession.

Since the GFC, REITs have improved their credit metrics and have stronger balance sheets. Based on a comparison of 15 REITs incorporated since FY07, S-REITs have shown improved credit metrics with stronger balance sheets in FY19. Despite an increase in average gearing to 35% (from 31%-33% in FY08-09), ICR and debt tenor have improved to 5.3x and 3.2 years respectively.
The lower average interest rate of 3.0% and lower portfolio encumbrance of 12.3% have also provided S-REITs with more flexibility to negotiate new loans or borrowings due for refinancing. Looking at the S-REIT sector (30 S-REITs covered in this report) as a whole, the credit metrics are very similar with an improvement seen on most fronts.

Revision of MAS leverage limits positive for the sector in the medium term.

On 16 April 2020, the MAS revised leverage limits set on S-REITS from 45% to 50%. This provides the sector greater flexibility in managing its capital structure in the near term in the face of operational and financial stress.
The higher leverage limit will also create additional buffers for gearing levels in the short-term (amid the COVID-19 pandemic) in the event of a lower valuation at the end of 2020. In the medium term, S-REITs may utilise the headroom to expand their portfolios and compete internationally.

Minimum 2.5x ICR to accompany the increase in leverage limit.

While the MAS has instituted a minimum ICR ratio of 2.5x accompanying the increase in gearing limits, this requirement has been delayed by two years to 2022. Based on latest reported ICRs, all S-REITs meet the minimum 2.5x requirement. Even with the moderation in FY20-21F earnings due to the COVID-19 outbreak, most S-REITs are still able to meet the ICR requirement, based on our calculations.
We have taken this a step further to include obligations for perpetuals and notes in our adjusted ICR projection for FY20; and, note that most REITs will still meet the requirement. Only three S-REITs (Suntec REIT (SGX:T82U), CDL Hospitality Trusts (SGX:J85) and Frasers Hospitality Trust (SGX:ACV)) may have ICRs below 2.5x FY20, but they have the next two years to improve this ratio, hence we do not see any major risk in the short-term.
Moreover, ICRs should improve after the COVID-19 situation is successfully contained, and earnings return to normalcy in the next one to two years.

Introducing our S-REIT Framework

Framework to assess the S-REITs. Faced with one of the steepest recessions since the Global Financial Crisis (GFC), Singapore REITs (S-REITs) are being tested again and we believe they are in a stronger position to tackle the downturn. We introduce 6 key metrics to assess if S-REITs are able to maintain their interest and dividend obligations; and, if need be, the risk of a potential recapitalisation exercise.
In our analysis, we look at the risk of potential asset devaluations on gearing level and lower cashflow on interest coverage ratios (ICR). Despite the higher gearing limit for S-REITs of 50%, we have assumed a conservative leverage threshold of 40%, a level that investors are comfortable with.
We also look at S-REITs which may potentially need to raise funds to recapitalise their balance sheets. Overall, we think that greater caution should be placed on S-REITs with current gearing levels above 38% as they run the risk of a potential equity fund raising exercise if portfolio valuations decline by 10% or more.
S-REITs which we believe have very robust credit metrics and offer good value based on current share price - the S-REITs that fare well based on our metrics (meeting at least 5 out of 6 metrics) include the likes of CapitaLand Mall Trust (SGX:C38U), SPH REIT (SGX:SK6U), Ascott Residence Trust (SGX:HMN), Ascendas India Trust (SGX:CY6U), Mapletree Industrial Trust (SGX:ME8U), Keppel DC REIT (SGX:AJBU) and Prime US REIT (SGX:OXMU).

Metric 1: Conservative capital structure

Lower gearing is appreciated in current climate.

Given the worsening operating climate with risks of asset and earnings deterioration in the near term, S-REITS with a lower than average gearing level should appeal to investors as interest obligations (as part of fixed operating costs) will be lower. A lower gearing also implies
1. financial flexibility to tap debt capital markets if required,
2. cost of funds will be more competitive,
3. ability to seize on opportunities to acquire destressed assets.
In our analysis, we look at overall capital structure across S-REITs over time to ascertain if the S-REIT managers have maintained a consistent capital structure strategy and if gearing has trended higher/lower over time. We found that only two have kept their gearing below 30% (SPH REIT (SGX:SK6U) and Ascendas India Trust (SGX:CY6U)), with most of the others within 33%-38% range.
We point out that this analysis ignores the efficiency of having overseas denominated debt to naturally hedge its foreign investments.

Metric 2 & 3: Majority of S-REITs pass the ICR and “cash-ICR” test

Effects of decreased earnings on ICR.

One of the biggest risks to S-REITs amid the COVID-19 pandemic is the disruption to cashflows brought about by the COVID-19 Temporary Measures Act. The Act caters to tenants materially impacted by COVID-19 to seek a deferment of their rental obligations for up to 6 months from the passing of the Act on the 7th April 2020. This creates a potential cashflow mismatch between accounting revenues and collections for S-REITs. Delays in the collection of rents will affect cash flows and impact the REITs’ ability to service debt obligations.
Amid the COVID-19 pandemic, Singapore and many other countries have closed off their borders and suspended non-essential businesses. As such, we had cut earnings on the various sectors:
1. Hospitality: 40% - 45%,
2. Retail: 20% - 30% and
3. Office and Industrial: 10% - 15%.
Even on our revised estimates, ICR ratios still remained fairly healthy, ranging 1.7x – 15.9x.

Looking at “cash ICR”.

Given the risk of potential delays in collections, we look at cash-backed ICRs. We have assumed that every quarter of delay in collections will lower EBIT by approximately 25%. As such, in our scenario analysis of a 6- month and 9-month delay, EBIT will reduce by 50% (unlikely) and 75% (highly unlikely). In these extreme scenarios, we found that ICRs ratios stood at 1.1x – 7.9x for most S-REITs except Suntec REIT (SGX:T82U) (assuming 6-month delay of rental collections) but could be at risk of turning < 1.0x on a 9-month deferral in rents.
While the scenarios of a 50% and 75% cut in EBIT would mean a significant cut in distributions, or almost no distributions for some S-REITs, the ability to continue to meet their interest obligations will mean that banks will likely want to maintain their banking relationships with most S-REITs.

Metric 4: Assessing recapitalisation risk

Balance sheet stress anticipated.

While the initial feedback from managers and valuers appear to suggest that it is too early to reset cap rates higher come year end, we believe that asset valuations may be impacted at a similar rate as seen during the GFC. While there is no yardstick on how cap rates may move given the lack of asset transactions, we believe that most valuers may rely on the more traditional DCF methods in assessing market values.
With the reset in rental cycles due to COVID-19 and the more gradual recovery back to pre-COVID-19 levels, we believe that asset values may decline to the tune of 3% to 10% by the end of 2020.

Stress-testing gearing on the back of a decline in property values; enhanced MAS headroom provides S-REITs with enhanced buffers.

We analysed three scenarios where we assumed that portfolio valuations will fall by 5%, 10% and 15%. As shown in the table below, gearing levels for all S-REITs will not breach the 50% leverage limit even with a 15% decline in valuation.
If we adopt a more prudent gearing threshold of 45%, S-REITs that are at risk of exceeding this include OUE Commercial REIT (SGX:TS0U), Suntec REIT (SGX:T82U), Far East Hospitality Trust (SGX:Q5T), ARA LOGOS Logistics Trust (SGX:K2LU), ESR REIT (SGX:J91U), Mapletree Logistics Trust (SGX:M44U), Soilbuild REIT (SGX:SV3U) and EC World Reit (SGX:BWCU) on a 15% decline in valuation. However, we believe that a 15% valuation decline is unlikely, and we do not expect valuations to decline by more than 10%.
We note that S-REITs with a current gearing of 38% and lower will not breach the 45% threshold even if valuations fall by 15%. Assuming valuations fall by 10%, those REITs with a current gearing of up to 40.5% will not exceed 45% leverage.
At the previous regulatory gearing limit of 45%, there would have been a handful of S-REITs potentially breaching the leverage limit. However, with the MAS relaxation of gearing limits to 50%, all S-REITs now have an additional buffer and debt headroom even if portfolio valuations weaken.

Metric 5: Ability to sustain dividends

Funding dividend payments with short-term loans? Possible but not preferred. Despite the relaxation in gearing limits to 50%, S-REITs will likely put their acquisition plans on hold and keep capital expenditure to a minimum in the current business climate. However, S-REITs may face liquidity pressure with the recent introduction of the Temporary Measures Act. The Act allows tenants to defer rental payments by up to 6 months, while S-REITs will still have to pay out dividends based on accounting profits.
To manage this mismatch in cashflows, the MAS has allowed S-REITs to withhold dividend payments for up to a year without the risk of losing their tax transparency status.
Alternatively, S-REITs could also tap on short-term debt financing to meet the mismatch between dividend payments and actual cash flows. But at this point, most managers have indicated that they are unlikely adopt this route to maintain dividends as it is not sustainable.
We performed a stress-test by assuming that S-REITs would rely on debt to finance up to 50% of projected FY20 distributable income in the short-term. Although unlikely, this example shows that S-REITs have ample headroom to do so, and only eight REITs may exceed our conservative 40% threshold gearing level.
Given the current low interest rate environment and the boost to debt headroom (from the increase in leverage limit set by MAS), we will not rule out this alternative for a selected group of S-REITs, albeit not ideal.

Metric 6: Recapitalisation unlikely even if property valuations fall by 15%

Risk of fund raising when gearing levels increase.

We have considered how a decline in portfolio valuations increase gearing levels, and this may lead to a potential balance sheet recapitalisation exercise. Again, we have used a more conservative approach in formulating some of our assumptions:
1. equity fund raising if gearing goes above 40%,
2. minimum equity fund raising done to bring gearing back down to 40%, and
3. units in equity fund raising issued at a 25% discount to current trading price.
In general, S-REITs which are trading below their current NAVs will experience a greater dilution to book value when equity is raised at our assumed 25% discount. Based on our assumptions, almost half of the S-REITs in our coverage will not require any equity fund raising even if property valuations decline by up to 10%. Assuming a 15% decline in valuations,
S-REITs which may need to recapitalise will see NAVs dropping by 23% - 34%. However, 10 of them (highlighted in green) are currently trading at prices that are even below our revised NAVs.
Of the 10, majority of the S-REITs are in the retail and hospitality sectors, which have been affected more by the COVID-19 epidemic.
However, within the industrial and US office sectors, only Soilbuild REIT (SGX:SV3U) and Keppel Pacific Oak US REIT (SGX:CMOU) are trading below our revised NAVs (15% decline in valuations). With the relaxation of the regulatory gearing limit, there is value in these two S-REITs as they are unlikely to require any recapitalisation even if property values decline by 15%.

Value in many REITs trading at steep discounts to NAV currently

Changes to NAV when valuation falls. Based on the scenario analysis below, we noticed that S-REITs trading at price-to-book ratio of 0.8x implies a 10% decline in portfolio valuation. S-REITs trading at a price-to-book ratio of 0.7x and 0.9x are comparable to NAVs with 5% and 15% declines in portfolio valuations respectively. As a general observation, a 5% change in portfolio valuation translates to an approximate 10% change in the implied NAV.
We compared each S-REIT’s current trading price against its revised NAV (based on 5%-15% property value declines). See attached PDF report for details.
On a NAV basis, we believe that there is value in many of the S-REITs that are currently trading at an implied 15% decline in portfolio valuation. CapitaLand Mall Trust (SGX:C38U), Starhill Global REIT (SGX:P40U) and Lendlease REIT (SGX:JYEU) are trading at even a greater than 15% implied decline in portfolio valuation compared to its peers in the retail segment (at 10% implied decline in valuations). Keppel Pacific Oak US REIT (SGX:CMOU) and Prime US REIT (SGX:OXMU) are also trading at a higher implied valuation decline of 15% which we believe is unlikely given its well-diversified quality portfolio.

Selected S-REITs have priced in recapitalisation

Equity fund raising’s impact on DPU.

For S-REITs that are currently trading at a discount to book value, the dilution to DPU arising from any fund raising exercise will be more significant. At current prices, S-REITs are trading at dividend yields that are above their historical average. As such, implied dividend yields remain relatively healthy despite the potential dilution in DPU as shown in this analysis.
See attached PDF report for details. We highlighted 8 S-REITs that even with an equity fund raising when portfolio valuations decline by 15%, these S-REITs still offer a revised yield that is above the historical 10-year average yield.

Mid-cap industrial S-REITs have priced in equity fund raising.

Assuming the worst-case scenario of a 15% decline in portfolio values, S-REITs which would need to conduct equity fund raising to shore up their balance sheets will see DPU yield declining by of 1%-2%. The S-REITs which would experience the largest declines in DPU yields are ARA LOGOS Logistics Trust (SGX:K2LU) (c.1.3% decline), ESR REIT (SGX:J91U) (c.1.3% decline), and Soilbuild REIT (SGX:SV3U) (c.1.1% decline).
Despite the risk of a dilution to DPU yield, these three REITs are still projected to generate very healthy dividend yields of 9.6%, 7.7% and 9.0% respectively (based on current share price and earnings projections), which are above their historical average.

Our picks & risk.

We pick Mapletree Industrial Trust (SGX:ME8U) and Mapletree Commercial Trust (SGX:N2IU) for its strong overall scores in our assessment framework. Ascendas REIT (SGX:A17U), Mapletree Logistics Trust (SGX:M44U) and Frasers Logistics & Commercial Trust (SGX:BUOU) for its leverage into structural growth trends and Lendlease REIT (SGX:JYEU) for relative value in the retail space.
Risks are
1. a prolonged “U” shape recovery extending beyond 2020 and
2. extension of COVID-19 temporary measures beyond the initial 6 months.

See attached 18-page PDF report for complete analysis for each of the metrics.

Dale LAI DBS Group Research | Derek TAN DBS Research | Rachel TAN DBS Research | https://www.dbsvickers.com/ 2020-05-11

SGX Stock Analyst Report BUY MAINTAIN BUY 2.700 SAME 2.700

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