It’s getting “too hot”in here

We turn non-consensus Underweight on S-REITs. We find valuations un-compelling after the sector’s outperformance. Given rising valuations and low funding costs, we see risks from overpaying, riskier investments and capital-raising as pressure to grow intensifies.

Our picks are geared towards those with higher growth visibility from past AEIs/developments and less risk of expensive or riskier investments. We downgrade CCT and Suntec after their YTD outperformance and upgrade AREIT. Top picks are AREIT and MCT.

It’s getting “too hot”

Whilst above-average yield spreads have been a commonly-cited reason for further yield compression, this can only continue with sustained risk aversion. Risk indicators are, however, turning a net positive, which could prompt investors to switch out of defensive yields. This is particularly so with the sector unlikely to see the strong growth akin to 2004-8 given increased caution towards leverage and acquisitions post global financial crisis. Interest rates are also near the 0%-bound, with upside risks over the longer term. With spreads now just 50bp above the historical average, we think that it does not pay to get too bearish and continue hiding in yields.

Growing for the sake of growing?

As trading valuations rise and make accretive acquisitions easier, pressure to grow could increase. More could thus wind up overpaying for acquisitions or venturing into riskier greenfield developments or overseas purchases in search for higher returns. More equity fund-raisings could also follow, especially with sector gearing heading up to 35% levels. There has in fact an emerging trend of opportunistic equity fund-raising without accompanying new acquisitions or AEIs, which could lead to near-term dilution.

Time to take the heat off

Give poor risk-rewards and risks from acquisitions, we turn a non-consensus negative on S-REITs and downgrade the sector from Overweight to Underweight. We downgrade CCT and Suntec and upgrade AREIT. Our top picks are now AREIT and MCT.

The allure of S-REITs

Gravity Defying: Highest Yield-Spreads and Returns Globally.

• S-REITs has risen 28.7% YTD, outperforming even major REITs markets such as US, Australia and Japan etc
  
• We pointed out that S-REITs has one of the highest yield spreads globally in our previous report dated 3 Sep 2012. We took a deeper look at global/regional peers and below are our assumptions and proposed theses why this may be the case:
  
• Why Asian REITs have much higher yield spreads.
  
  • The Asian REITs (S-REITs, J-REITs, and HK-REITs, excluding M-REITs), outperformed the non-Asian REITs (US-REITs, UK-REITs, A-REITs) in terms of yield spreads partly due to higher borrowing costs in the West (consequence of US/European deleveraging) and Australia.
    
  • With the exception of M-REITs, the Asian REITs incur average cost of borrowing (sector average) of ~1.5%-3.1%, much lower than the 5.5%-6.9% expensed by non-Asian REITs.
    
  • We noted that despite risk-free rates being low in the US (1.7%) and UK (1.8%), the actual borrowing costs to companies on the ground are relatively higher, compared to Asia. Western banks have become parsimonious in their lending vis-à-vis the robust loan growth situation amongst Asian banks.
    
  • From our observations, A-REITs and UK-REITs have average cost of borrowings much higher than normalized1cap rates, rendering DPU yields to be trading near cap-rates levels. As a result, yield spreads are much lower in comparison. For US-REITs, the high borrowing costs are partly offset by their higher cap rates, but this is still insufficient to cover the 178-211 bps yield spread lag behind Asian REITs (excluding M-REITs).
    
  • In M-REITs case, both the cost of borrowing and risk free rates are much higher than S-REITs, J-REITs and HK-REITs, resulting in much lower yield spreads.
    
• What gives S-REITs the edge over other Asian REITs.
  
• Higher Capitalization Rates:
  
  • On a sector basis, Singapore has relatively higher normalised2 cap rates (net property income that can be extracted per annum for each S$ dollar invested in investment properties), compared to Hong Kong and Japan.
    
  • For example in HK, cap rates (net basis) for prime office and prime retail buildings on a stabilized basis are around 3%-3.5% and 3.5%-4% respectively. However, in Singapore, cap rates for prime office and prime retail properties are at least 4.0% and 5.0% respectively.
    
  • This enables S-REITs to offer DPU yields of ~6% without trading at price-to-book discount (1.07x PBR). On the other hand, in order to offer DPU yields of ~5%, HK-REITs and J-REITs have to trade at ~0.8x PBR.
    

  Unlikely interest rates hike until end 2014:
  

  • The MAS manages the Sing dollar’s strength by buying or selling currencies to keep its exchange rate against major currencies within a policy band, and by adjusting the band occasionally to steer the exchange rate. This FX-centred monetary policy regime means that Singapore’s short-term interest rates are essentially a function of US short-term interest rates.
    
  • Most economists do not expect any significant interest rates hike until end of 2014, following the US Fed’s intent to keep short-term interest rates near zero till then. If correct, this would imply that the cost of borrowings for S-REITs (some pegged to SIBOR) will stay at current low levels through 2012-2014.
    

  Others reasons:
  

  • The strong SGD, chasing yields climate and lack of investable alternatives in the market are other factors providing price support for S-REITs. Investors are also drawn to the transparency and predictability of S-REIT dividends, particularly in the midst of the external market uncertainty
    

Yields can compress another 70-90 bps (Peak Valuations).

• S-REITs are presently trading at 5.9% FY12 yield and a yield spread of 463 bps. We think there is downside room for another 70-90 bps compression in view of the following two reasons:
  
  • The S-REITs’ average and stabilized long-term yield spread (excluding the GFC period) is around ~370 bps.
    
  • The effective cap rate for S-REITs is around 5.3%. If we take cap rates as the floor for FY12 DPU yield (since overall S-REITs sector trading at P/B of ~1x), there is another 70 bps for yields to be compressed further.
    
• A yield-spread compression of another 70-90 bps equates to an average price appreciation of 13%-19% for the sector.
  

Maintain OVERWEIGHT on S-REITs.

• We conducted a 2QCY12 results round-up and target price update for S-REITs under our coverage. Most S-REITs reported 2QCY12 distributable incomes that were in-line with our forecasts. Moving forward, we expect DPU growth of 1.4%-9.6% per annum over FY11-FY13F (except Suntec REIT which will likely suffer DPU decline due to ongoing refurbishments at Suntec City).
  
• Our top BUYS remain with the more defensible industrial and retail REITs with total returns of 10%-17%. We think their risk-reward proposition still appear favorable to yield-driven investors. Maintain OVERWEIGHT on the overall S-REITs sector.
  

S-REITS

• Bloomberg has a piece on the S-Reits sector this morning, saying it has been the best performing so far this year: averaging 37% (yield + capital gains), twice the gains in the US, UK and Japan, the other major reit markets. (S-Reits offer an average 6.,46% yield presently.)
  
• One of the reasons cited for this is the pace of acquisitions, accounting for a third of total acquisitions by reits in the region since 2009, second to Japan.
  
• The report also highlights the wide gap between yields of reits and 10-year government bonds: 413 basis points here vs 192 bp in Australia.
  
• While we remain bullish on S-Reits, we believe there are warning signs to look out for, especially when reits gain on every acquisition they make (eg the Mapletree Group of reits). Price to book will be the ratio to watch closely rather than the yield.
  
• For instance, retail reits like CapitaMalls trust, Fraser Centrepoint are trading at >20% premium.

Results Season Takeaways

Sector Overview

The Real Estate Investment Trust (REIT) Sector in our Singapore coverage consists of 23 REITs listed on Singapore exchange with a market capitalization of USD35 billion.

• Majority of S-REITs turned in positive DPU
  
• S-REIT’s dividend yield of 5.5% is less appealing than a quarter ago and there is limited upside given rich valuation based on +1 STD of P/B ratio
  

Earnings Surprise?

Across the S-REITs universe, majority of them turned in positive DPU. Negative rental reversion was not the main reason for the dip in DPU. The drag in DPU was caused by some other factors such as divestment of property assets, issuance of new units, on-going major asset enhancement works and amongst others.

Under our coverage, the DPU estimates for CDL HT, PLife REIT and Sabana REIT were largely in-line, forming 49%, 51% and 50% of our FY12 projections.

Capital management outlook

• The variable-rate loans that are pegged to swap offer rates maintained flat
  
• Liquidity is expected to remain healthy at current loan-to-deposit ratio (LDR) level of 91.9%
  
• Financial position of REITs looks healthy, with comfortable gearing and longer weighted average debt to maturity
  

Recommendation

P/B ratio has progressively moved towards +1 SD and it had served as a strong resistance level for the past four years. From our viewpoint, it is going to be an uphill struggle to break above +1 STD. Given there is no major negative shocks from the western countries, P/B ratio should hover around this level as the current situation is not much better compared to two years before, undermined by lingering Euro debt problems and anaemic US growth.

For investors with mid- to long- term horizon, they may want to place their bet on Suntec REIT which is undergoing major makeover (phase 1-4) at Suntec City, stretching from Jun-12 to 2014. In this regard, return on investment from the refurbishments is likely to stream in in staggered phases. The tax savings from MBFC Phase I and potential ORQ could make up the loss for the drop in vacancy. Valuation is also undemanding and trading at a steep discount of 26.5% relative to Mapletree Commercial Trust (MCT) and Starhill Global REIT.

ARA eyeing yuan Reit listing in S’pore

ARA Asset Management Ltd, part-owned by Hong Kong billionaire Li Ka- shing’s Cheung Kong (Holdings) Ltd, said it is considering the listing of what would be Singapore’s first yuan-denominated property trust.

‘One of the opportunities which the company is exploring includes the possible establishment and listing of a yuan-denominated real estate investment trust (Reit) with assets located in the People’s Republic of China,’ ARA said in a stock market filing.

Sources familiar with the deal said Citigroup, DBS Group and Standard Chartered have already started working on the planned listing. Citi and DBS declined to comment while Stanchart could not be reached.

Dow Jones said in a Tuesday report that ARA will inject Chinese properties now held by its unlisted Dragon Fund II into the Reit. — Reuters