Price action indicates AREIT may show more resilience compared other S-REITs

US stocks ended lower and treasuries yield inched higher as concerns about QE3 continued to weigh. Investors will closely monitor the FED statement at the outcome of the FOMC meeting next Wednesday night. With triple witching

(expiration of stock index futures, stock index options & stock options) next Friday, US equity indices will be rocky, either way, over the next one week. China and HK markets re-open today.

S-REITs have been one of the worst affected in recent weeks as investors sold down yield names on concerns about QE drawdown. Recall that QE3 was announced in Sept last year. A check back on the price action shows that in line with STI’s

U-turn up, many S-REITs started to further their climb from last November as they benefited from the liquidity inflows.

S-REITs that have declined back to their respective Nov12 lows in the current correction would have effectively reversed and wiped out all the positive price action from the liquidity inflow prior to their decline. Chances are these would be

more resilient going forward compared to those that have yet to decline to their respective Nov12 levels. One SREIT that has fallen back to Nov12 level is AREIT. The stock’s Nov12 low is at $2.28. The stock undershoot that level yesterday to $2.22 but in an indication of bargain hunting, returned back to $2.30 by day’s end. Our analyst upgraded the stock to Buy earlier this week. We expect shares of AREIT to show more resilience going forward compared to other S-REITs. One

example of a S-REIT that has yet to fall to its Nov 12 low level, and thus more vulnerable to weakness, is Cambridge. The stock’s Nov12 month low was around $0.64.

As the dust settles, value emerges

• Rising bond yields generally negative; but S-REITs’ ability to grow distributions a compensating factor
  
• Impact of rising bond yields more “expected than real”
  
• Buy Growth. Picks MCT, MAGIC, FCOT and Cache
  

S-REITs’ ability to grow distributions to compensate for rising bond yields/interest costs a key consideration. We believe that fears of the impact of rising bond yields on S-REITs are an over-reaction at this point as our economists do not expect QE to taper off anytime soon. Over the medium term, a rise in long bond yields is likely to be more gradual than abrupt and S-REITs’ continued ability to grow distributions (estimated at 4.0% y-o-y) is a compensating factor. Thus, we believe that the knee-jerk reaction seen in the S-REITs’ share prices (FSTREI index was down 10% YTD vs STI 5% dip in the past few weeks) is unwarranted.

Impact of rising bond yields “more expected than real”. We have assessed the impact of rising bond yields on our target prices, and the conclusions are: (i) Our analysis indicates that SREIT yield spread of 3.9% based on current share prices have factored long bonds of >2.5%. Prior experience shows that SREITs trade at a 350-390 bps spread when long bonds were above 2%. (ii) Impact from higher interest costs is managable at <3%. Active capital management has resulted in most S-REITs locking in >50% of their debt costs for the next 1 – 2 years. We estimate a 0.5% increase in interest rates to have a <3% impact on distributions, which we see as managable. (iii) NAVs appear safe for now. Worries of cap rate expansion impacting S-REITs’ book values negatively are valid but we do not see it as a concern at this point. Other than for office, we note that higher valuations for S-REIT portfolios (retail, industrial sub-sectors) are underpinned by higher income, which we believe make S-REITs’

NAVs more resilient.

Translation losses a potential risk. The INR, AUD and JPY weakened 2%, 7% and 27% against the S$ respectively since the start of 2013. Thus, S-REITs with exposures in these currencies might see earnings downside and NAV declines from translation losses. From the earnings front, we note that most SREITs have taken hedges to minimize impact.

S-REITs sell-off is over-done, Selective BUYs. We have been advocating a selective stance, and limit our picks to REITs which offer growth that is achievable and visible. We like Magic (BUY, TP S$1.22), MCT (BUY, TP S$1.53), FCOT (BUY TP $1.69) and Cache (BUY, TP S$1.47) for their better than peers’ growth prospects. We have also upgraded A-REIT (BUY, TP S$2.60) and MINT (BUY, TP S$1.63) from HOLD to BUYs on valuation grounds.

Volatility Here To Stay; Underweight

Clear and present danger. We expect the current “QE-inflated growth” to run out of steam in the months ahead and S-REIT prices will continue to rationalize. Despite our regional economics’ team’s expectations that QE will persist through 2013, the fact that Bernanke’s mere hint1 of QE tapering on 22 May had driven the S-REITs down by 9.4% by 3 Jun showed how jittery investors have become with yield plays. While some will find S-REITs to be still attractive, we believe fears of impending stimulus withdrawal and rate hikes overhang will cap further upside. Downgrade to Underweight and switch to developers (prefer CapitaLand, Keppel Land, CMA and Wing Tai). For those who must be in S-REITs, we prefer the retail REITS (Suntec REIT, CapitaMall Trust and StarHill Global REIT).

Interest rate risk rising. The SG government ten-year bond went up from 1.56% on 22 May (the day of Bernanke’s Congressional testimony) to 1.86% (30 bps) within a span of five working days, while the DPU yields of S-REITs expanded from 5.1% to 5.7% (60bps). It appears that the market was then pricing in future rate hikes of 30 bps, pending uncertainty over US exit strategy, especially since Bernanke left the door opened to both downward AND upward adjustment depending on how the economy actually does. Another risk could also be the more crowded space amongst S-REITs investors (including private wealth clients), some of whom we understand to have geared up (and thus more susceptible to interest rate hikes) for a “carry trade” on S-REITs. At this writing, the market has since narrowed DPU yields back to 5.6%, ~20bps higher than the 30bps rate hike correction.

Ample QE till September at least but… Our regional economics team believes that current ample liquidity conditions will continue till Sep 2013 at least. They expect QE3 to persist through 2013 and no rate hike in the US before 2015. The Fed is expected to continue its unprecedented USD85 billion a month bond buying (comprising USD40b in mortgage securities and USD45b in treasuries) as long as two key indicators – unemployment and core PCE (personal consumption expenditures) inflation – remain beyond the Fed’s selfimposed tolerance limits of 6.5% and 2% respectively. Nonetheless, given the forward pricing nature of markets, we believe that sporadic corrections for S-REITs are still imminent in 2H13 and take a closer look at trough valuations for FY13.

Volatility will not subside. In this economic climate, we believe SREITs’ trading will get more volatile. In terms of trough valuations, we benchmarked against average yield spreads of S-REITs with the highest FY13 street estimate for SG government ten-year bond of 2.25%. If risk-free rate rises to that level, the downside risk to S-REITs will be a fall in prices down 10% from current levels and most severe for Office REITs (-11%), followed by Industrial (-5%) and then retail (-2%). This assumes negligible DPU growth, which is modest for S-REITs in FY13 (sub-par 7% from 10% in FY12).