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).

Rising Risks But Slower Growth

In 1Q13, the FSTREI performed slightly better than STI, with a YTD appreciation of +12% vs the latter +7.5%. During this period, the low interest rate and high liquidity environment have prompted investors to continue their chase for yield plays. In this report, apart from providing a recap and an outlook on the sector, we also examine the effects in the event if any/all the three main drivers of the S-REITs sector changes.

Stable results – grew through AEIs and acquisitions. The latest SREITs results posted market cap weighted average growth of +3.5% y-o-y and +1.4% q-o-q in DPU for the sector. Among the 23 REITs (excluding MAGIC) listed in Singapore, only four REITs reported a lower y-o-y DPU. Among the REITs that recorded a positive growth in earnings, 61.1% of them grew as a result of AEIs (16.7%) and new acquisitions (44.4%).This is inline with our earlier view that most REITs will focus on growing their earnings inorganically, on the back of a low interest rate and high liquidity environment.

Flattish outlook in the various subsectors of SREITs. Although the rental market continues to be well-supported by the various industries, the outlook for possible positive reversion appears dampen in the industrial, hospitality and retail market as the global economy remains uncertain. Coupled with ample supply of commercial buildings over the next two years, we retained a flattish outlook on these sub-sectors. However, in a mid-term timeframe, we remain positive on the outlook of the Grade-A office sector in Singapore as demand remains limited coupled with an expected uplift in rental rates as the economy recovers.

Risk in the SREITs sector increases. Although we do not expect the i) global outlook, ii) high liquidity and iii) prolonged low interest rate environment to change in the near term, a closer examination indicated that if any of these factors are to change, it could potentially result in a sell-down in SREITs. In our view, given the high sector valuations, the risk-reward profile is less sanguine than before. We, therefore, introduce a new return gearing metric that takes these factors into account to study the relationship between share price, risk and return.

Maintain NEUTRAL on rich valuations; positive bias remains. On the back of i) flattish outlook in the various SREITs subsectors; ii) high valuations of S-REITs; iii) lack of growth catalysts in the near term; and iv) rising risks in the SREITs sector, we maintain our NEUTRAL view in the SREITs sector. However, positive bias remains if more liquidity flows into the market due to the latest QE program from Japan.

THE BURGEONING MARKET

• S-REITs continue to perform
  
• Sector currently trading at 1.24x P/B
  
• Prefer S-REITs with strong fundamentals and compelling valuations
  

Firm 1Q13 performance; mostly in line

In our latest assessment of the S-REITs sector, we continue to see familiar trends. REIT managers have generally maintained firm growth in their trusts’ rental income, on the back of contributions from past investments and improved operational performance. Of the 16 SREITs under our coverage, 10 of them reported results that were in line, three exceeded our expectations, while the remaining three fell short of our forecasts.

Leasing activities remained largely healthy

1Q13 operating metrics for most of the S-REITs had stayed resilient. Average portfolio occupancy was stable at 96.9%, whereas the weighted average lease to expiry improved from 4.3 years in 4Q12 to 4.5 years. In addition, positive rental reversions were also clocked. This clearly illustrates the healthy rental market demand and proactive lease management on the part of the REIT managers, in our view.

Active capital management

We also observe that S-REITs have been very active in refinancing its existing debts and maintaining an optimal capital structure. There were a slew of private placements in 1Q, which helped keep the aggregate leverage healthy at 32.1%. Going forward, we believe that the sector’s aggregate leverage is set to trend upwards. As such, SREITs may continue to tap the equity capital market to fund their proposed investments. The cost of debt is expected to maintain at current levels or increase marginally, as S-REITs trade possibly higher interest costs for diversified funding sources, longer term debt, and/or an improvement in their unencumbered asset ratios.

Sector outlook remains sanguine

For 2013, we are maintaining our view that S-REITs are likely to continue to deliver firm performance. All the S-REITs are either involved in asset enhancement initiatives/development projects, pursuing yield-accretive acquisitions, or enhancing their portfolio metrics through active leasing efforts, which should lead to continued strong numbers for their financial scorecards. For our coverage, we expect the S-REITs to post 6.6% growth in aggregate DPU for the current fiscal year, before experiencing another 8.6% growth in the next year.

Prudent to be selective

Nevertheless, the S-REIT index has been enjoying a good run-up, raking up 36.7% gain in 2012 and another 12.7% increase YTD. Given that the S-REITs are now trading at a 24% premium to book value on average, we feel that it is prudent to be selective on S-REITs. We continue to prefer S-REITs with good growth potential, strong financial position and compelling valuations (relatively lower P/B and decent DPU yields). In this respect, we continue to pick CapitaCommercial Trust [BUY, S$1.80 FV], Fortune REIT [BUY, HK$8.64 FV] and Starhill Global REIT [BUY, S$1.05 FV] as our preferred BUYs. Reiterate our OVERWEIGHT view on the broader SREITs sector.

Rational Temperance

Reiterate NEUTRAL for S-REITs following uninspiring risk-reward profile as: (1) Yield spreads against ten-year bond yields continue to tighten with rising bond yields. (2) Downward pressures on rentals with slowing growth in Singapore.(3) Risk of asset-price declines in the event that monetary tightening is not conducted gradually (a case in point: Japan’s “lost decade” after the Finance Ministry sharply raised interest rates in late 1989). Our top picks remain only with the Retail REITs, in which the mismatch between rentals and physical prices have not proved unnerving. Reiterate BUY for CMT (TP: SGD2.36), SGREIT (TP: SGD0.95), SUN (TP: SGD1.85).

Gravity defying, but will QE-inflated asset prices sustain? S-REITs have registered an impressive price return of 5% YTD and 43% since end-2011. Their stellar performance in FY12 outshone even the major REITs markets in the US and Australia. Nonetheless, the rapid step-up in asset values (fuelled in the past years by quantitative easing [QE] policies) and the gradual creep-up in risk-free rate have skewed risks to the downside.

Let the buyers beware. Fundamentally, we believe that S-REITs stock price performance should be a function of forward DPU growth and physical asset prices. The almost 60% returns generated by S-REITs in 2005-2006 were buttressed by similarly outstanding DPU growth rates of 19-43% pa over 2005-2008 and strong growth in rents and capital values in 2005-2007 (in short, fundamentals-driven growth). However, the recent S-REITs 2012 rally was primarily fueled by QE-inflated asset values and ample liquidity, and not so much driven by underlying fundamentals such as strong DPU growth or rental upside, in our view.

Overheating asset prices but rentals not catching up. Post-GFC, retail and office properties have appreciated but rentals have been slow to catch up. This has in turn caused retail and office cap rates to compress from 5.9% and 4.4% in 2010 to 5% and 3.7% in 2012. Moving forward, we think it is unlikely that rentals will ever catch up in the near-term, given that the growth outlook in Singapore is expected only at 1-3% this year. Tenants are increasingly feeling the heat from escalating business costs and declining profit margins. Limited rental upside means that S-REITs are unlikely to have significant organic DPU growth anytime soon.

Rational Temperance. Unlike the “fundamentals-driven growth” experienced by S-REITs in 2005-2006, we expect the current “QE-inflated growth” to run out of steam once the “artificially compressed” interest rates in the US, and hence Singapore, start normalising sometime next year or early 2015. However, as markets are typically forward-looking, we expect S-REITs prices to rationalise probably in 2H13 or 2014.

Still a safe house

• AEI to take centrestage in driving earnings growth amidst slowing retail sales growth in 2013

• Suburban retail to continue attract good interests despite incoming supply

• Extra earnings kicker could come from acquisitions, particularly from sponsors’ pipeline

• MCT top pick given its superior earnings profile; SGREIT offers an attractive relatively yield to retail peers

AEI malls showed superior rental growth. Underlying fundamentals in the retail real estate sector remain strong. Rents have stayed resilient in the past year, largely supported by annual built-in step up rents. While increasing market shares, as evidenced by decade-high leasing transaction volumes, continue to be the retailers’ main focus despite rising cost pressures, the latter is likely to have a bearing on rental pricing ability with occupancy costs now at 16-17%. With retail sale expected to grow at 2-3% next year, we expect reversion to track inflation rates. Our preferences are for market beaters/outperformers that can exceed this benchmark for rent rolls via successful Asset Enhancement Initiatives (AEI) activities, to deliver superior earnings growth.

Still prefer suburban for its strong leasing interests. From a supply angle, the suburban market segment continued to be at almost “full house” at 98% occupancy. Going forward, c.50% of the new supply will come from suburban locations over the next four to five years but we believe robust consumer sentiment, amid a low unemployment environment, would translate to a keen appetite for new retail space.

Rerating catalyst could come from acquisitions, prefer reits with strong sponsors. Trading at an average P/BV of an average 1.1x and an average implied yield of 5.0%, we believe that certain retail reits could look at acquisitions to spearhead their inorganic growth ambitions. Prime yields are now hovering at between 5.25% and 5.65%, hence with a mix of equity and debt, reits would still be able to acquire accretively. With limited access to good retail assets in Singapore, given the tightly-held market and its stable nature, we believe sponsored reits would have an upper hand with the ability to tap sponsors’ pipeline for new assets to fuel their inorganic growth ambitions.

Stock picks. Within this space, we like MCT for its ability to continue to drive rental reversions as well as inorganic growth capacity from tapping its deep sponsor pipeline such as the recent maiden proposed acquisition of Mapletree Anson. In the small-mid cap space, we believe the completion of AEI works will continue to drive SGreit earnings while valuations at 0.8x P/BV and forward yield of 6%, which is higher than peers is attractive.