Singapore Industrial S-REITs - DBS Research 2020-06-25: Making Up Lost Ground


Singapore Industrial S-REITs - Making Up Lost Ground

  • Divergent valuation multiples too attractive to ignore for selected industrial mid-cap S-REITs.
  • DPU growth of mid-cap industrial S-REITs are expected to outperform the large caps in FY21.
  • Selected mid-cap REITs have potential pipeline assets that may more than double AUM, if acquired.
  • Top picks for mid-cap REITs are ARA LOGOS Logistics Trust (SGX:K2LU) and Soilbuild Business Space REIT (SGX:SV3U).

Divergent valuation multiples amongst mid-cap and large-cap industrial S-REITs a time-limited opportunity.

  • While investors have rightfully awarded the larger-cap industrial S-REITs (top5) premium valuations for their strong lineage, acquisition pipelines and stock liquidity, most of their share prices are close to multi-year highs. See S-REITs Share Price Performance.
  • Therefore, we see relative value amongst the mid-cap industrial S-REITs where investors are rewarded with ample valuation buffers at P/NAV multiple gap of 0.8x (vs. historical average of 0.3x) and yield pick-up of 2.9% (vs. historical average of 1.9%).
  • Amongst the mid-cap industrial S-REITs, we like Ascendas India Trust (SGX:CY6U), ARA LOGOS Logistics Trust (SGX:K2LU) and Soilbuild REIT (SGX:SV3U) which are yielding 6.9%, 8.5% and 9.1% respectively; and, we believe have the capacity and availability to tap on their Sponsors for inorganic growth in the longer term.
  • M&A between industrial S-REITs may also spark a compression in yields when it happens.

Valuation spreads between large-cap and mid-cap industrial REITs are too wide to ignore

Divergent price-to-book (P/NAV) performance of large-cap and mid-cap industrial REITs.

  • The 5 largest market cap industrial REITs have collectively been trading at a premium to their book values in the past, except for the Global Financial Crisis years of FY08-09 when average price-to-book fell to as low as 0.6x.
  • Since the correction in March 2020 caused by the COVID-19 outbreak, prices of large-cap Industrial S-REITs have rebounded beyond their book values and are now trading at c.1.7x, or +1.5 standard deviation (SD) since FY06.
  • On the other hand, mid-cap industrial REITs have historically been trading close to their book values, averaging 1.0x since FY06. Similarly, the average price-to-book ratio for mid-cap REITs hit the lowest (0.3x) in FY08-09.
  • During the recent COVID-19 pandemic, mid-cap REITs traded at a discount to book value of 0.8x, the second sharpest decline in their history. Currently, mid-cap REITs are trading at 0.9x, a slight discount to book value or -0.5 SD. Correspondingly, the price-to-book multiple gap between the large-cap and mid-cap REITs stand at c.0.8x. This is significantly higher than the historical average of 0.3x and is the second-widest gap between them since FY06.

Large-cap dividend yields have been compressed.

  • As a result of the higher share prices, large-cap REITs have historically been trading at a 6.4% yield, while mid-cap REITs trade 1.9ppts higher at 8.3%. However, the share price rally focusing on the larger S-REITs has brought average headline yields to 4.7%, the differential between the mid-cap S-REITs has now widened to 2.9%, which we find attractive.
  • See S-REITs Share Price Performance.

Financial Metrics are broadly similar

Positives in the larger-cap S-REITs are priced in; mid-cap S-REITs offer good value.

  • The difference in trading performance between the large-cap industrial S-REITs (“large-cap S-REITs”) and mid-cap industrial S-REITs (“mid-cap S-REITs”) could be attributed to several factors including trading liquidity, portfolio diversification and diversified funding sources.
  • With a market capitalisation of at least S$3bn, large-cap industrial S-REITs have a significantly higher market free float than the mid-cap S- REITs. Moreover, the large-cap industrial REITs are constituents of the various MSCI and EPRA NAREIT indices which help increase trading liquidity. Large-cap industrial REITs also have a more geographically diversified portfolio, with an average of more than 42% of their portfolio contributed by overseas assets in Asia Pacific, Europe and the US.
  • Excluding Ascendas India Trust and EC World REIT, mid-cap industrial REITs only have an average of 22% of their portfolio diversified overseas. The global economic contraction in FY08-09 affected the earnings and DPU growth of all REITs regardless of their market cap. However, events that are more country-specific such as the 2-month Circuit Breaker measures in Singapore will have a larger impact on the earnings of mid-cap REITs as their portfolios are more concentrated in Singapore. Click on "view full report" button below to see more charts in the PDF report attached.

Strong access to funding is not only limited to large-cap S-REITs.

  • While the large-cap industrial S-REITs have access to a larger number of borrowers to diversify their funding sources and enjoy lower funding costs at an average all-in borrowing rate of 2.6% as compared to the significantly higher borrowing rate of 3.7% for the mid-cap industrial REITs (excluding Ascendas India Trust and EC World REIT).
  • However, we do note that the refinancing spread has been compressing over time selectively, especially with the entry of ESR as sponsor of ESR-REIT (formerly Cambridge Industrial Trust), credit spreads have also compressed over time with new banking relationships being established. If potential acquisitions or M&A materialise, we believe that credit spreads will further compress as the mid-cap industrial S-REITs bulk up and diversify their earnings base.

Mid-cap REITs have higher gearing levels on average.

  • While investor perception is that financial metrics for the mid-cap industrial S-REITs are weaker, this is not true given that on a weighted average basis, gearing levels of mid-cap industrial S-REITs are only 0.2ppts higher than that of the large-cap industrial REITs (35.8% vs. 35.6%). The higher gearing ratios only apply to ESR-REIT and ARA LOGOS Logistics Trust at 41.7% and 40.8% respectively. However, other balance sheet metrics are similar with ICR ratios in excess of 2.5x.
  • There are concerns about some mid-cap industrial S-REITs having a higher need to recapitalise their balance sheets, but we see this risk being mitigated by the higher MAS gearing limit of 50%. With the increase in gearing limit to 50%, all S-REITs have a larger debt headroom and would not breach the new limit even if portfolio valuations decline by up to 15%.
  • As highlighted in our previous report Singapore REITs - DBS Research 2020-05-11: The Next Big Test For S-REITs, we estimate that portfolio valuations of industrial REITs should not decline by more than 5%. At this level, the gearing levels of ESR-REIT and ARA LOGOS Logistics Trust would inch up to 44% and 42% respectively, giving them ample buffer to the revised leverage limit.
  • Among the mid-cap industrial REITs, Ascendas India Trust, AIMS APAC REIT and Sabana REIT have the lowest gearing currently.

Growth to converge in 2021-2022

DPU growth of mid-cap REITs expected to outperform in FY21, converge in FY22.

  • Despite some structural and fundamental differences between the large-cap and mid-cap industrial REITs as mentioned in the previous pages, we expect the latter to post strong DPU growth rates in FY21. This is mainly due to a rebound from the sharp decline in the earnings of mid-cap industrial REITs in FY20. Based on our estimates for FY21-22, DPU of mid-cap industrial REITs are expected to grow by 6% and 3% respectively, outperforming the large caps.
  • DPU of mid-cap industrial REITs are expected to decline in FY20 mainly due to the retention of income for rental rebates and deferrals, as well as the lack of geographical diversification. However, the mid-cap industrial REITs have gradually increased their overseas portfolio over the years. ARA LOGOS Logistics Trust and Soilbuild REIT have the most geographically diversified portfolio among the mid-cap REITs. Approximately 27% and 17% of ARA LOGOS Logistics Trust’s and Soilbuild REIT’s portfolios are in Australia.
  • Although the retention of income in anticipation of rental rebates and deferrals is a drag to earnings in FY20, mid-cap industrial REITs are expected to post a strong rebound in FY21. ESR-REIT, ARA LOGOS Logistics Trust and AIMS APAC REIT have made the most significant income retentions (as a percentage of projected FY20 distribution income) of 7%, 5% and 4% respectively. However, in the absence of income retention, the mid-cap REITs are expected to post an average DPU growth of 6% in FY21.
  • Mid-cap industrial REITs have also demonstrated their capital management abilities in coping with tightening credit markets. Amidst the increasing borrowing margins, mid-cap industrial REITs have not been impacted as most have refinanced their debt obligations early before margins started to rise.
  • With more funding sources and access to alternative debt instruments, some mid-cap industrial REITs could in fact lower their cost of debt. For example, ESR-REIT recently redeemed S$160m of MTNs in April and May. At the cost of 4.10% and 3.95%, the replacement of these MTNs with term loans are expected to lower ESR-REIT’s all-in borrowing costs from 3.8% to 3.7%.

Dividend differential between large-cap and mid-cap REITs are unusually high.

  • Currently, the average dividend yield differential between the large-cap and mid-cap industrial REITs is 2.9%, significantly higher than the historical average of 1.9%. This implies that share prices of mid-cap industrial REITs have an average upside of c.18% before dividend yields compress and differentials normalise at 1.9%.

Sponsors of Industrial S-REITs

Sponsor pipeline as a major source of growth for large-cap REITs.

  • Large-cap industrial S-REITs have been able to grow their portfolios at a much faster rate than the mid-cap industrial S-REITs as the former have their Sponsors’ assets to tap. Large-cap industrial REITs have access to highly sought-after assets as well as sizeable portfolios of overseas assets to make their entry into a new jurisdiction meaningful and efficient.
  • With the likes of CapitaLand (SGX:C31), Mapletree Investments, Frasers Property (SGX:TQ5) and Keppel Corporation (SGX:BN4) as Sponsors of the large-cap industrial REITs offering a major source of acquisitions for their S-REITs, we do see emerging opportunities for selected mid-cap industrial S-REITs to tap.
  • Selected mid-cap industrial S-REITs have opportunities to double their existing portfolios. Since ESR replaced Cambridge Industrial Trust’s Sponsor in FY17, ESR-REIT has had access to an enlarged pipeline of more than S$4bn of logistics assets throughout China, Singapore, Japan and Australia. While the S-REIT has yet to tap its Sponsor’s pipeline of properties, the availability is not recognised by investors for now.

ARA LOGOS Logistics Trust (SGX:K2LU) – new pipelines to tap.

Soilbuild Business Space REIT (SGX:SV3U) – attractive assets in Singapore.

Similar portfolio metrics across the industrial S-REITs

Mid-cap industrial REITs’ exposure to SME tenants are contained.

  • Industrial landlords in Singapore are required to provide SME tenants who have been severely affected by the COVID-19 pandemic a one-month rental waiver. Fortunately, most mid-cap industrial REITs have taken the prudent stance of retaining some income in 1Q20 in anticipation of these rental waivers and rebates. Despite this, there are still concerns on whether the income retained is sufficient.
  • Overall, the mid-cap industrial REITs’ exposures to SME tenants in Singapore are between 30-40%, higher than the large-cap industrial REIT’s average exposure of 20-30%. However, the mid-cap industrial REITs had been more proactive in retaining income in the previous quarter and we believe that most have sufficient buffers in place.
  • Assuming that mid-cap industrial REITs have to provide a one-month rental waiver for all SME tenants, this would account for c.3% of their annual revenue. Based on our estimates, mid-cap industrial REITs would be able to cover most of the one-month rental waiver with the income retained so far, and any further income retention in 2Q20 should be lower than in the previous quarter. As such, we do not expect any significant downside risk to our revised estimates for the mid-cap industrial REITs.

Tenant industry diversifications are similar; mid-cap S-REITs have greater weightage in the bio-med and consumer sectors.

  • The COVID-19 pandemic has brought forth some structural changes in the economy and led to acceleration of certain trends. The widespread outbreak has made the biomedical and healthcare sector more crucial than before. The continued drive to digitalise the economy will drive the technology and infocomm sector, and the rise of e-commerce would benefit the logistics and distribution sector. We believe that the consumer goods sector will continue to be a mainstay and remain relatively stable, and so will the government sector and non-profit organisations.
  • However, the depressed oil prices and projected economic slowdown will pose a challenge for those in the oil and gas, commodity and marine sectors. Lockdowns of nations to curb the spread of COVID-19 have weighed negatively on international travel and tourism, and put pressure on the aerospace sector.
  • We compared the exposure of industrial REITs to tenants in the various sectors and noticed that the exposure among the large-cap and mid-cap REITs are actually very similar. The proportions of their exposures to the fast-growing sectors and declining sectors are on par. See summary table in the PDF report attached below.
  • Although it may be too generic to access each REIT’s earning risks according to tenant industry as there will be winners and losers in every sector, we believe that this gives us a very good sense of their tenant diversification. Among them, a large-cap industrial REIT and MLT have the highest exposures to the commodity, marine and aerospace industries, accounting for c.21% and c.10% of their tenants respectively.
  • See the summary table on breakdown of Industrial S-REITs by tenant industry subsectors in PDF report attached below.

Mid-cap REITs hold on to some of the very highly sought-after assets.

  • Again, as a very generic classification, we looked at the various asset types that each industrial REIT holds. Given the limited new supply and structural changes, we believe that business parks and high-tech buildings (including data centres) will continue to see healthy take-up rates and rental growth. Due to the limited existing stock in the market, these assets are usually tightly held by landlords and their capital values are also expected to remain strong. Modern logistics and ramp-up facilities are gradually replacing the less-efficient industrial facilities served by cargo lifts, and this is another asset class that should outperform the older generic warehouses.
  • Overall, mid-cap industrial REITs’ portfolio of these newer and more resilient asset types are relatively similar to that of large caps.
  • Business parks, high-tech buildings, and modern logistics facilities make up c.85% of the mid-cap industrial REITs’ portfolio, marginally lower than the 88% for the large-cap industrial REITs. Interestingly, Soilbuild REIT has the highest proportion of its portfolio in the form of business parks, at 46%.

Remaining land lease tenure increases as REITs diversify overseas.

  • The majority of industrial properties in Singapore sit on a 30-year land lease, while those in Australia, Europe and the US are typically on freehold land.
  • Overseas assets account for approximately 43% of large-cap industrial REITs’ portfolio, while only accounting for 9% of mid-cap industrial REITs’ portfolio. As such, it comes as no surprise that the remaining portfolio land tenures for the mid-cap industrial REITs average 56 years as compared to the large-cap industrial REITs’ 63 years.
  • See attached 14-page PDF report for complete analysis.

See also recent SGX Market Update: S-REITs with Data Centres Amongst World’s Strongest in 2020 YTD.

Dale LAI DBS Group Research | Derek TAN DBS Research | https://www.dbsvickers.com/ 2020-06-25
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