S-REITs still a growth story

• No surprises in 4Q10 results; weaker earnings from Office REITs

• Hospitality REITs offer strongest organic growth while Industrial & Sponsored REITs have portfolio growth visibility

• BUY FCT, P-Life, Cache, MLT, CDL HT

S-REITs collectively delivered 11% y-o-y distribution growth in 4Q10. 4Q10 results were a continuation of the strong showing in 3Q10 with the sector reporting topline, net property income and distributable income growth of 10%, 13% and 11% respectively. Hospitality REITs continued to outperform with strong organic driven growth while acquisitions completed during the course of 2010 lifted distributions for the remaining S-REITs. While retail & industrial S-REITs continue to deliver single digit growth, Office REITs reported weaker results both y-o-y and q-o-q, as passing rents remained below the peak rents signed in 2007-2008. We expect this trend to continue in the coming quarters, only to reverse in 2012.

The forward picture – Growth strongest in Hospitality REITs. We believe that S-REITs are good inflation hedges given their ability to grow rental income above inflation, which is expected to average 4.2% in 2011. Except for office REITs, which could see topline pressure in 2011, S-REITs generally are forecasted to deliver FY10-12F DPU CAGR of 5.5%- 9.2%, which is above inflation. We maintain our view that Hospitality REITs will continue to exhibit the strongest earnings potential (+9.2% FY10-12F CAGR, +5ppts above inflation) stemming from expectations of strong tourists arrivals in 2011. CDL HT (BUY, TP S$2.30), with over 82% of its income from its Singapore hotels, remains our pick to leverage on the robust growth from this sector. In addition, P-Life REIT (BUY, TP S$1.90) offers downside protection as higher inflation bodes well for rental reversions going forward.

Industrial & Sponsored REITs have potential for further accretive acquisitions. Acquisitions will likely feature in 2011 given the current low interest cost environment and relatively low leverage of S-REITs of 34%. In fact, since the beginning of 2011, cS$880m worth of deals have been tied up by S-REITs. We prefer S-REITs with ability to grow accretively and believe that the Industrial REITs and Sponsored REITs can deliver on this front. We like MLT (BUY, TP S$1.07), Cache (BUY, TP S$1.11) and FCT (BUY, TP S$1.73) given their visible pipelines from their respective sponsor, which could be tapped in the medium term.

Sanguine outlook; maintain OVERWEIGHT

Increasing rentals. Singapore’s industrial property market closed the year on a positive note, with 4Q10 rental values experiencing their fastest pace of growth since recovery. According to Colliers International, average monthly gross rents of factories and warehouses rose by 4.1%-5.0% QoQ, the fastest pace of growth since their recovery a year ago. YoY, rentals grew by a healthy 8.1%-11.9%. There was also increased demand for business parks and high-specs industrial space. Companies that are not sensitive to CBD locations are increasingly looking at high-specs space as office alternatives because of rental savings as well as the narrowing gap in terms of offerings between the two spaces.

Acquisition spree continuing. In 4Q10, we also witnessed the acquisition spree continuing from early quarters, with the economy awash with liquidity and low interest rates. MLT acquired three more properties in Singapore at a total consideration of S$85.6m. A-REIT made its foray into Shanghai with the forward-purchase of a Jinqiao business space property at S$117.6m. AAREIT also completed its acquisition of 27 Penjuru Lane at S$161m and recently announced the acquisition of Northtech (S$72m) in Feb 2011. CIT completed its acquisition of 1 & 2 Changi North Street 2 and 511 & 513 Yishun Industrial Park A. These acquisitions were in line with the manufacturing sector growing at a brisk pace. Manufacturing output increased 10.5% YoY in Jan 2011, while PMI was 50.5-52.3 from Oct 2010-Feb 2011, which indicated an expanding manufacturing sector for the fifth straight month.

Singapore Land Acquisition Act. The last quarter also saw some REITs affected by SLA’s compulsory land acquisition for the construction of the Tuas West MRT extension and road works along PIE. CIT has three properties affected to varying degrees by the acquisition, which will be possessed by the government by Jan 2013, affecting 58,439 sqm (12.8% of portfolio) of total land area. Sabana REIT’s property at 1 Tuas Avenue 4 is also affected, with 691.7sqm (5.04% of total land area of property) to be possessed by the government by 25 Nov 2011. Both REITs are entitled to receive compensation based on the market value of the acquired land.

Sanguine Outlook. The outlook for industrial segment remains sanguine on the back of strong economic fundamentals, as well as the government’s continued commitment to stimulate growth in the manufacturing sector. Demand for high-specs space is expected to trend upwards as companies move up the value chain from manufacturing and assembly activities to innovation-related development works. At 1.04x P/B versus a historical P/B of 1.10x, valuations remain compelling. Maintain OVERWEIGHT for the industrial-REITs subsector.

Impact of interest rates hike on S-REITs

Debt profile varies among the S-REITs. We consolidated the debt profiles of the S-REITs under our monitor, and we think that any impending interest rates hike will add on to borrowing costs, and thus affect distributable income for unitholders. However, not all S-REITs will be impacted similarly. Some of the S-REITs have more fixed-rate borrowings than others (using instruments such as fixed rate CMBS, fixed rate term loan, fixed rate MTN, convertible bonds, retail bonds etc.) S-REITs also have varying degrees (as % of total borrowings) of hedging their outstanding loans using interest rate swaps. The debt maturity profiles are different for different S-REITs. Some are weighted more towards short-term borrowings, while others are contracted on longer-term basis, which may or may not be fixed rated. The resulting refinancing risks are thus different for different S-REITs.

Impacting S-REITs differently. We think any rate hike is likely to have a greater impact on S-REITs that 1) have a lower percentage of fixed rate borrowings, and 2) have a substantial amount of borrowings maturing near the interest rate hike period (likely 2H11-FY12), or if they still have not refinanced to a latter date. Any refinancing done thereafter will be at much higher rates, even for fixed rate borrowings.

Mitigation tactics. Generally, all S-REITs under our monitor have some form of fixed rate contractual agreements or hedge using interest rates swaps to mitigate the effects of interest rate risks. For FY10/11, some S-REITs have taken the following actions in anticipation of the interest rate hike, 1) lengthening the debt term-to-maturity with more fixed rate borrowings, 2) hedging using Interest rate swaps, and 3) cash hold-up for some since FY10, in anticipation of borrowings maturing in 2011-2012.

Conclusion. Overall, we think fundamentals for the majority of the S-REITs remain strong, and any increase in interest rate will have some, but not material impact on their financials (since most of them are already expecting a hike in interest rate and have been preparing for it). This is corroborated by our correlation analysis of the percentage change of the FSTREI index vis-à-vis pp change of the 3-month Sibor, which registered a low -3.4% from 2006 till to-date. Factoring in delay effects of 1-24 months, the correlation is also marginal, ranging from -7.8% to 8.6%. Maintain our OVERWEIGHT rating on the S-REITs sector.

Debt turns from foe to friend for many Reits

Debt has turned from foe to friend for many real estate investment trusts (Reits) as they pursue acquisitions again at a time of low interest rates.

This can be seen in the rising levels of borrowings among Reits against their assets. Out of a sample of 16 Reits in Singapore, as many as 10 had a higher aggregate leverage or gearing ratio at end-December 2010 compared with the previous year.

Several Reits had relied considerably on debt to fund growth until the global financial crisis hit in 2008, which forced them to cut borrowings as credit markets froze. Investors developed a phobia of highly-leveraged Reits, worried that they would collapse without sufficient financing.

But this is no longer the case. Ascendas Reit’s (A-Reit) shifting level of indebtedness, for instance, illustrates how tolerance for debt in the industry – and among Reit investors – has changed.

Between 2008 and 2009, A-Reit strove to lower its aggregate leverage from 42 per cent to 31 per cent through equity fund raisings and other capital management strategies. But as the economy grew last year and credit markets improved, so did its aggregate leverage, which crept up to 35 per cent by end-2010.

Take Suntec Reit as another example. Its aggregate leverage had dipped from 37 per cent at end-2008 to 35 per cent a year later, but jumped to 40 per cent at the close of 2010.

For a handful of Reits, the debt-to-asset increase is slight. CDL Hospitality Trusts is one which has maintained a relatively conservative debt profile over the last few years.

But many other Reits took on much more debt to feed their resurgent appetite for inorganic growth. ‘2010 was the most active year for new asset acquisitions that the market has seen in years,’ said Jason Kern, HSBC managing director and head of real estate investment banking for Asia Pacific.

K-Reit Asia was one which went on an acquisition spree last year. Its buys included a $1.4 billion one-third stake in the first phase of Marina Bay Financial Centre (MBFC). Consequently, its aggregate leverage rose to 37 per cent at end-December from 28 per cent in the previous year.

Suntec Reit also paid around $1.5 billion for a stake in properties at MBFC Phase One.

‘We are seeing more office Reits shoring up their aggregate leverage ratios,’ said OCBC Investment Research analyst Ong Kian Lin in a recent note. ‘We think that 40 per cent will be the new norm for FY2011.’

Reits outside the office sector, such as A-Reit, Mapletree Logistics Trust and Parkway Life Reit, also snapped up assets last year.

The low cost of debt, helped by sustained near-zero interest rates in the US, has facilitated borrowing.

Most Reits ‘are quite comfortable with the credit conditions’, said CIMB analyst Janice Ding. She believes that the average aggregate leverage among Reits could reach the high 30 per cent range.

While the credit environment is friendlier, market watchers do not expect Reits to ratchet up aggregate leverage to levels seen before the financial turmoil anytime soon.

Increasing gearing levels are a sign that property investors are gradually becoming more comfortable with leverage as they move further away from the financial crisis, said HSBC’s Mr Kern.

Nevertheless, he does not think investors are ready to see Reits revisiting the 40-50 per cent aggregate leverage that was common earlier. ‘Reits that are seen pushing the envelope on gearing too much will be punished with a lower equity valuation,’ he said.

The credit crunch had been a ‘very painful’ lesson for the Reit sector, Ms Ding said. As a result, Reits ‘will definitely be a lot more cautious’.

S-Reits likely to continue buying assets: Moody’s

But it calls for guard against risk of rising rates

MOODY’S Investors Service expects real estate investment trusts in Singapore (S-Reits) to continue purchasing assets this year as interest rates stay low and funding remains available.

But the credit rating agency also reminds Reits to guard against the risk of rising rates through hedging and other strategies.

‘S-Reits will use their well-capitalised balance sheets to continue acquisitive growth strategies this year amid an environment of low interest rates,’ said Moody’s associate analyst Alvin Tan in a report.

Some S-Reits, sponsored by developers, will also have access to a pipeline of assets, he added. Moody’s foresees interest rates staying low this year, and this makes it attractive for S-Reits to borrow more. Nevertheless, given the Reits’ experience with strained balance sheets during the global financial crisis, they are likely to remain conservative.

Also, any rise in interest rates will increase S-Reits’ acquisition and refinancing costs and hurt their credit profiles. ‘Trusts must manage the risk of any upward spike in rates by balancing their debt maturities, proper hedging and using an appropriate debt/equity mix to fund acquisitions,’ Mr Tan said.

He noted that most S-Reits had gearings of 30-40 per cent, which should rise with further acquisitions, but remain within their long-term targets of 40-45 per cent.

S-Reits went on a shopping spree last year as growth returned to the agenda with the sharp economic recovery. According to a DBS Vickers analysis in December, the sector bought around $7 billion worth of properties in Singapore and abroad in the year.

Several S-Reits have announced plans for further growth this year. For instance, Frasers Centrepoint Trust is looking to acquire Bedok Point while Parkway Life Reit recently announced the acquisition of a nursing home in Japan for around $8.9 million.

Moody’s is keeping its ‘stable’ rating on the S-Reit sector given ample liquidity in the market, high occupancies and rising rents this year.