Defensive amidst turbulent times

Since 2H07, credit concerns and a US-led slowdown have cast a pallover the market, both globally and domestically. To tide over this period, we suggest investors take a look at the S-REIT counters, given their earnings visibility, attractive yields and prospect of positive rental reversions. With the 10-year SGS bond currently offering an all-time low of 2.08% and S-REITs trading at a decent average yield of 6.4%, we believe that investors should begin to place emphasis on the sector. Our key recommendations are Suntec REIT, Frasers Centrepoint Trust and Cambridge Industrial Trust.

Going defensive with REITs. Since the inception of the first REIT in 2002, the Singaporean REIT story has been buttressed by stable yields that are higher than government bonds, structurally robust economic fundamentals, as well as a transparent regulatory environment and attractive tax policies such as remission of stamp duty. REIT managers worldwide, not least in Singapore, have consistently undertaken their respective growth strategies through the acquisition of more developments using cheap credit.

Nonetheless, amidst the current volatile climate and liquidity squeeze, they are experiencing a heightened difficulty in raising new funds –both debt and equity. Most notably, rising capital values of properties and higher costs of capital cannot only erode yields, but also lead to dilutive acquisitions. As such, investors are advised to tread with caution when placing their funds in this high-yield asset class. Taking into account the present sentiments, we single out a few positive factors/themes and the accompanying REITs which could benefit from them.

A possible hedge against inflation. In 2007, Singapore registered an annual inflation rate of 2.1%, which represented the first time it edged past 2% since 1997. Therefore, it sparked off looming concerns of inflation, whichwere partially vindicated when the Jan 08 CPI jumped 6.6% YoY – a 25-year high, mainly attributable to higher housing and food costs. Given the US-led global slowdown, the Singapore government has decided against further accelerating its October-adjusted currency policy.

We do not see the inflationary pressures cooling off in the near term. Reason is that a bulk of the upswing in prices is imported, and the demand for raw materials, commodities and food is not expected to taper off, especially from the emerging economies. Additionally, the continued trimming of fixed deposit rates and sliding SIBOR rates imply that stashing of savings is not the most encouraged alternative to upkeep the strength or purchasing power of one’s currency. Combined with the current weak equity markets, we therefore suggest investors park their funds in REITs with yields ranging close to or above the existing inflation rate.

No halt to S$ strengthening. Back in Oct 07, MAS marginally raised the slope of the S$ policy band. This is not illogical given the ongoing concerns over inflation. However, a rising S$ would likely dilute the accretive impact from any foreign-based assets and their accompanying income. At the same time, investors should be able to enjoy currency gains from the strengthof the S$, which is also fuelled by Singapore’s strong structural growth story. As such, we recommend REITs which are highly geared to the domestic property arena.

Capital preservation. Although SIBOR rates are dwindling, corporate spreads arewidening simultaneously, on the back of unabated concerns of more writedowns of CDOs. As such, credit markets have taken a beating, triggering a gain in the cost of capital. This implies that REITs, being essentially consumers of credit, would find it tougher to issue debt. Even if debt is successfully raised, the higher costs of capital would impact its yield. In light of this, we would prefer to go for low-geared REITs (20% -50%) which have lower holding costs and are more able to wait for the credit markets to improve.

Growing via organic routes. Upping rental lease renewals and occupancy rates are usually two avenues which REIT managers would execute to increase income. However, they are only applicable to under-rented developments and presently, occupancy rates are still above 90%, accompanied by the fact that most of the current tenants (commercial, retail and industrial) are only slated to renew their leases the next calendar year or after. In our opinion, it is best to examine REITs with well-formulated asset enhancement initiatives (AEIs), specifically those with properties under the retail umbrella. These AEIs could comprise of optimizing space utilization or fine-tuning tenant mix to keep up with shoppers’ needs and preferences. Ultimately, these should lead to yield accretion.

Ripe for M & A. As mentioned previously, the present credit crisis has soaked up a substantial amount of liquidity from the market, in turn raising the costs of acquisitions of new properties. Coupled with cheap valuations brought about by a downslide in the domestic bourses, as well as an extension of the Singapore Code on Takeovers & Mergers to REITs, 2008 could finally be the ripe year for consolidation in the form of a merger or acquisition within the S-REIT universe. Typically when a company merges with or acquires another firm, the key merit of the transaction lies in its earnings accretive nature. For S-REITs, it refers to DPU (Distribution per unit) accretive, which can only be achieved if a lower-yield REIT acquires a higher-yield one. The higher the spread between their yields, the more accretive the transaction will be for the acquirer.

By the same token, REITs which are trading at steep discounts to NTA (Net Tangible Asset) could be fancied as acquisition targets. Ownership structure could also be a relevant area to consider. REITs with a loose shareholding structure, meaning those where the majority shareholders own less than 20% of the units and interested parties can always make open market purchases, normally are less difficult acquisition targets. Another ownership-related factor to note is the presence of sponsors. Poison pills or other deterrent covenants aside, independent REITs are generally less difficult to buy into compared to REITs with a sponsor,which usually would divest part of their assets into the REIT with the aim of attaining an asset-light balance sheet.

Challenging capital raising environment. The sub-prime debacle continues to weigh on the already-soured global credit markets, which has begun to spread its claws onthe Asian credit markets as well. This does not augur well for REITs in general, which rely on the capital markets for external growth. The credit tightening situation indicates that capital raising activities would become more challenging until rescue measures lead to more visible and protracted improved results. Several recent events bear testimony to the above. As a result of lackluster interest from investors, both Allco REIT and K-REIT witnessed difficulties in their respective equity offerings in 4Q07. The pessimism continued through Jan 08, as MI-REIT, Saizen REIT and MLT all postponed their refinancing/equity issuance plans. In our view, the lukewarm response is most likely due to the weak and volatile condition of the current equity markets.

Even if S-REITs manage to successfully raise debt, we surmise that lenders’ terms would be less favorable than before. Although SIBOR rates have been retreating, this has been offset by higher spreads required by lenders. To sum up, this means that debt servicing costs would become more expensive, which in turn increases the overall cost of capital, as well as the hurdle rate for any proposed acquisitions.

Nonetheless, we hold the opinion that credit markets should recover gradually beginning 2H08, notably after financial institutions worldwide have announced their 1Q08 and 2Q08 results. By then, we should be able to obtain a clearer picture of the effectiveness of the Federal Reserve’s initiatives and if the issue of writedowns have finally been resolved. Coupled with economic policies at the forefront of the US Presidential candidates, as well as the resilience of global emerging economies, the credit train should begin to move along again.

Suntec REIT (Price: S$1.40, Target Price: S$2.05)
Sunshine on the office front. The forward-looking investment case for Suntec REIT (STR) is characterized by several optimistic factors, in our view. For one, STR will recognize full-year maiden contributions of its recently-acquired One Raffles Quay (ORQ). Aside from providing earnings visibility, the ORQ acquisition could set the tone for more acquisitions from Cheung Kong’s Singapore portfolio. SRT has also further magnified its office footprint within the Marina area through the acquisitions of 11,736sf in 1Q08, with another 16,082sf in the offing.

Given that 64% of its office NLA is scheduled for renewal over FY08-09, SRT should be well-poised for positive rental reversions as there is currently a dearth of office supply in the CBD area. This suggests higher yields in the near term. Asset enhancement initiatives are also slated to bump up its retail rents. At present, SRT is trading at a P/B ratio of 0.5, which we believe represents an attractive investment case, especially given its strong organic growth potential. This is sweetened by its low leverageratio of 32% following a new issue of S$32.5m fixed rate notes. As such, we maintain our BUY rating with a target price of S$2.05.

Frasers Centrepoint Trust (Price: S$1.27, Target Price: S$1.61)
Centered on retail momentum. Despite the current US-led slowdown, the retail train in domestic malls does not appear to have lost its steam. As a retail-centric trust, we are confident that Frasers Centrepoint Trust (FCT) would enjoy further DPU growth, helped mainly by a few organic factors. With an approximate 57% of its total NLA up for renewals over FY08-09, FCT shouldsee positive rental reversions. Its recently completed asset enhancement of Anchorpoint Mall has also paid off handsomely in the form of higher average rents (+35%) and increased portfolio occupancy rate to 99.3%.

In the longer term, it should also rake in higher rentals from Northpoint’s increased NLA, following a refurbishment cum expansion which is expected to be completed by late 2008. Another enticing growth catalyst would be a potential injection of 0.6m sf worth of 4 retail properties, courtesy of its reputable sponsor – Frasers Centrepoint. The ability to fund these acquisitions through debt raising should also not be hampered by its balance sheet, which has a low leverageratio of 29.6%. At 1.1 P/Book NAV, we believe that the market has yet to fully price in FCT’s organic and acquisition potential, especially so given a decent forecasted yield of 6.4% and 7% in FY08 and FY09 respectively. In view of that, we reiterate our BUY rating with a fair value of S$1.61.

Cambridge Industrial Trust (Price: S$0.645, Target Price: S$0.88)
Industrial evolution.From an initial 27 industrial assets in FY06, Cambridge Industrial Trust (CIT) has ratcheted up its portfolio by 48% to hit a sizeable 40 in FY07. With full year contribution from the 13 new assets only set to sink in this year, as well as built-in rental escalation from its current leases, CIT should notch a respectable increase in DPU for FY08. In the longer term, CIT can either look to CWT Limited, which holds 3.15% of the company, for potential foreign opportunities or take advanced steps in its current S$126m of MOUs in Singapore.

Although current capital markets remain stymied, CIT’s low leverage of 36% is certainly a welcome sign should the credit status improves and cost of capital returns to more decent levels. On a peer-to-peer comparison within the industrial sphere, CIT’s investment highlights have to be its cashflow stability from a longer average lease term and higher quantum of security deposits. From our angle, the market has overlooked both of them, which should garner greater recognition in the current volatile market. We continue to like CIT for its defensive and stable qualities, as well as its palatable FY08-09 yield of 9.4-9.7%. As such, we reiterate our BUY rating at S$0.88, a 36% upside potential from its current price of S$0.645.

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