Falling rents may take shine off S-Reits

SINGAPORE-LISTED real estate investment trusts, or S-Reits, are now finding favour with analysts.

UOB Kay Hian, for example, upgraded the S-Reit sector from market weight to overweight earlier this month due to the ‘overwhelmingly attractive’ yield spread. JPMorgan similarly said in a recent report that the Reit model is not broken. The research firm has ‘buy’ calls on seven S-Reits. Analysts from other research firms have also been recently issuing ‘buy’ calls on several Reits here.

This is quite a reversal from a year ago, when the S-Reit sector was considered unattractive. Many Reits were facing concerns about their ability to refinance debt amid the credit crunch. Acquisitions, which had been fuelling growth, were also becoming harder to come by.

But now, some of these Reits are seen to be sources of stable, visible and recurrent income in uncertain times. Yields are also at historic highs as stock prices continue their downtrend.

Analysts are now saying that debt refinancing will not be an issue for all Reits. For one, strong sponsors could act as lenders of last resort for Reits and prevent any fire sale of assets. Retail and industrial Reits are the most exposed to refinancing risk. So investors are encouraged to buy those Reits with strong sponsors and avoid certain sectors.

But the one thing that has been largely overlooked in most analyses is the impact of falling rents.
Rents will fall across most sectors – that much is certain. Office trusts, such as K-Reit Asia and CapitaCommercial Trust, will be among the first to be hit.

The massive upheaval in the banking system means that financial institutions are unlikely to continue with any expansion plans yet to be executed. Other businesses will have reduced access to bank credit and scale back expansion plans. With a reduced appetite for space and looming new office supply coming onstream in 2010, landlords are losing their bargaining power and rents will inevitably fall.

Kim Eng Research, for one, expects prime Grade A office rents to fall by up to 15 per cent by the end of 2009.

Rentals for retail Reits will also fall. Already, there are signs from retailers in Reit properties that they cannot afford the high rents being charged at the moment. Retail spot rents are being hit by slowing economic growth and falling visitor arrivals amid increasing supply. Goldman Sachs yesterday said that it expects retail rental rates to fall 15 per cent between now and 2010.

Reits here typically renew their leases on a revolving basis, with a certain fraction of tenants re-signing every year. So those tenants who signed three-year leases last year could be stuck forking out high rentals for another year or two. But tenants renewing their leases soon will ask for lower rents. In a couple of years – say, by 2010 – the bulk of a Reit’s tenants could be paying lower rents, leading to lower rental incomes for S-Reits. Their yields are not likely to look so attractive then.

Analysts are now beginning to factor falling rents into their calculations. Goldman Sachs yesterday downgraded K-Reit from ‘buy’ to ‘neutral’. ‘We have been positive on K-Reit, given its attractive pricing relative to book value and our expectation that organic growth for the next two years at least will still find good support from positive rental reversions,’ said the firm in a report. ‘However, we underestimated the focus by investors on the direction of spot rents and were not sufficiently conservative in terms of how far Singapore office rents could decline from their peak.’

However, even with falling rents factored in, S-Reits can be attractive, some maintain. After imposing worst-case operating assumptions for each property sub-segment, including a blowout of financing costs and accelerating the rental reversions to the entire portfolio, Daiwa Institute of Research’s David Lum still estimates that all S-Reits could deliver recurrent worst-case yields of at least 6 per cent per year.

But whether making ‘buy’ or ‘sell’ calls for S-Reits, it’s important to factor in the impact that falling rents will have on S-Reit rental incomes over the next 2-3 years. Refinancing is not the only concern.

Credit market freeze raises refinancing concerns

Focusing on refinancing risk for now. Putting aside the defensiveness of S-REITs, we believe the focus is now on their credit health and refinancing risk. Spikes in USD 3M SIBOR rates since mid September signalled continuing stress in the credit market and with the tightness in the credit market not expected to abate any time soon, greater scrutiny has been placed on S-REITs’ gearing and debt refinancing over the next year. Some of the worst-performing REITs over the past month share some similar characteristics- like high proportion of current debt to total debt and relatively higher gearings than their peers.

Greater refinancing risk exposure for retail and industrial REITs. Based on data available, we estimate that S-REITs currently have a combined borrowing S$3.5b due for refinancing within a year. Retail and industrial REITs are the most exposed to refinancing risk. Retail REITs have S$1b of borrowings due for financing within a year, which is about 24.3% of their total borrowings. Industrial REITs have S$1.1b of borrowings due for refinancing within a year, which is about 32.7% of their total borrowings. Among the sectors, retail REITs also have the highest gearing of 39.2%.

Sponsors play a key role in tough times. With the freeze in credit market, REIT sponsors will have increasingly important roles to play as the pillar of funding support for their sponsored REITs. So far, we had seen Mapletree Investments, sponsor of MLT, taking up the excess units during its recent rights issue exercise; and Keppel Corp, a key shareholder of K-REIT, providing a new loan of S$391m to refinance the remaining bridging loan. In a scenario whereby banks freeze refinancing for REITs, we think strong sponsors could act as ‘lender of last resort’ for REITs and preventing any fire-sale of assets.

Refinancing is the key to re-rating. Under current market conditions, we think REITs with little or no near-term refinancing needs and backing from strong sponsors could outperform their peers. Risk-return matrix is turning attractive for the sector and we believe that re-rating should occur either when short-term refinancing needs have been addressed or when the credit market functions normally again. Our top picks for the S-REITs sector are Suntec REIT (Fair value S$1.53, FY08 yield 9.9%) and CapitaMall Trust (Fair value S$3.05, FY08 yield 7.9%).

Link – Table

Fitch Ratings has on Tuesday noted that the Australian Reit (A-Reit) reporting season has concluded with many A-Reits reporting significant declines in profitability due to a reassessment of the carrying values of underlying assets.

S-REITs: High But Not Dry, Cherry Picking The REITs (Overweight)

Respectable latest quarter operating performance, with robust DPU growth from the Office segment. Virtually all S-REITs have released their last quarter results. The sector as a whole chalked up a respectable 24.3% YoY and 6.4% QoQ gain in topline to S$777.0m, with NPI chugging along a similar direction, +24.6% YoY and +4.7% QoQ to S$566.4m. Sequentially, the Retail segment posted the highest growth in both topline and NPI, climbing 9.0% and 5.6% respectively. On a YoY comparison of the two metrics above, the Industrial, Office and Hospitality segments all notched a healthy 20 – 30% improvement. On the back of robust rental reversions, the Office segment was the quarter’s star performer, clocking a 46.1% YoY and 11.4% QoQ increase in DPU, outperforming that of the total DPU growth for the entire S-REITs sector, which measured a 23.0% YoY and 4.7% QoQ improvement.

Growth from within, earnings momentum to roll over into 2H08 and 2009. As a result of lease agreements which are typically signed for two to three years, most S-REITs should have already locked in their earnings at least until 2H08 and 2009, with some even beyond that, from our view. Coupled with 1H08 renewed leases contracted at significantly higher rates, we reckon that earnings momentum should continue into the next 1.5 years. For investors looking into high DPU growth potential for the current year, some of the REITs to watch out for include CDLHT (+24.7%) and MI-REIT (+21.0%). As for the subsequent year, two REITs which have the most DPU upside potential are CCT (+25.6%) and Suntec REIT (20.7%). Essentially, the core component of growth would be organic in nature.

Improved debt profiles and manageable financing costs for now, but refinancing concerns present themselves beyond 2008. The continued credit crunch notwithstanding, most S-REITs have managed to refinance their respective debts, as well as prolonging their debt expiry profiles. Aside from AiTrust, Fortune REIT and LMRT, we estimate that all-in-cost of financing for the remaining 17 S-REITs range from 2.5 – 4.0%, which is relatively healthy, from our angle. Aside from softening short-term interest rates, we believe this is also helped by the REIT managers’ prudent capital management skills. Additionally, the ability for S-REITs’ operating earnings to service their debt obligations remains strong, with virtually all of them having an interest coverage ratio of over 3X. However, as capital markets should continue to remain tight in 2009, or at least in 1H09, this spells heightened difficulties for REITs which need to refinance a major amount of debts due in 2009, including CDLHT, Allco REIT, MI-REIT, CIT, CCT and CMT.

Remain OVERWEIGHT on REITs sector, Suntec REIT as top pick. With unrelenting headwinds facing the property developers (-35.6% YTD), we continue to place our faith in SREITs for their earnings visibility, stable cash flows and defensive nature. Valuations have become more attractive, with the sector trading at a P/B of 0.82x. Further, the recent sector-wide correction of share prices and softening interest rates have led to S-REITs trading at 7.3%, representing a premium of 420 bps over 3.1% of 10-yr bonds. However, we believe that not all is nice and dowdy within the S-REITs space, and now is the ripe time to cherry pick. We prefer SREITs with robust organic boosters and resilient share price performances, namely Suntec REIT (Target price of S$1.87). For more risk-averse investors, we recommend Cambridge Industrial Trust (Target Price of S$0.79), which possesses long average lease tenures with built-in stepped up rentals.

Link – Table