Still safe

The first signs of more cash calls to come have surfaced. Whilesome REITs look vulnerable,the sector as a whole is in a much stronger capital positionthan in2008. Portfolio rationalisation is turningout to be a much less painful alternative.

We highlight KREIT, FCOT, ART and Suntec as having weaker financial metrics and as possible candidates for near-term cash calls. We maintain our Overweight position on the sector. CDLHT returns our top pick.

Short-term debt less pressing than before

We assess the capital structures of the sector in 2011 vs. the last crisis in 2008 and conclude that the key difference is significantly lower short-term debt, at 8% of total debt now vs. 38% in 2008. Even though sector asset leverage is not very different (36% in 2011, 34% in 2008), less-pressing short-term liabilities would reduce the likelihood of cash calls, in our view.

Portfolio rationalisation the new alternative

More REITs are recycling and raising funds through asset divestments rather than tapping debt and equity markets. This alternative is made possible by less-pressing impending debt expiries than before.

Top picks: CDLHT, AREIT and PLife

We believe REITs’ attractive yield spreads will remain supported by depressed risk-free rates over the next 12 months. We continue to advocate REITs with strong balance sheets and resilient earnings. Our top picks are CDLHT, AREIT and PLife REIT.

3Q11 results roundup

Quarterly growth within expectations. Industrial REITs ended the financial quarter ended 30 Sep on a positive note, with all companies registering healthy YoY growth in their financial performances. On the aggregate level, we note that REITs under this sub-sector reported a 28.6% YoY and 5.2% QoQ growth in distributable income, reflecting the still buoyant market. Unsurprisingly, contribution from new investments and positive rental reversions were among the key growth drivers, as a number of companies have been actively involved in acquisitions/asset enhancement works over the past year, and have passing rents lower than the market rates. These results were generally in line with market expectations, except for Ascendas REIT (BUY, FV: S$2.23) and Sabana REIT (NOT RATED) which outperformed our and consensus projections, respectively.

Positive operating performance. On the operational level, industrial REITs also put up a strong showing. Overall portfolio occupancy came in at a high range of 94.5-100%, displaying the resilient nature of the industrial rental market (relatively unchanged from 94.3-100% range in the prior quarter). As at 30 Sep, we note that the weighted average lease expiry for the REITs stood at 2.5-6 years, which is still healthy in our view. The only noteworthy concern we felt was AA-REIT’s (NOT RATED) hefty 41.9% leases by NLA that were expected to expire in FY13. However, we understand from its management that it will focus on renewing the leases for underlying subtenancies of the master leases expiring in the period. In fact, progress has already been made, as the percentage lease expiry was reduced to 35.7%, based on a ‘look through’ basis (which includes subleases).

Leverage still at healthy level. Aggregate leverages of industrial REITs as at 30 Sep were between 23.8% and 41.3%. Sabana REIT, we note, had the lowest debt-to-asset level, but is expected to increase to 33.5% upon the completion of the proposed acquisitions in 3Q11. This is also the case for Ascendas REIT, which should see its leverage rise from 31.5% to 34.5% after funding all its committed investments. Only AA-REIT leverage is expected to fall below the 30% mark after the sale of 31 Admiralty Road. Mapletree Logistics Trust (MLT), on the other side of the spectrum, had the highest leverage. However, interest cover of 6.3x (with all loans being unsecured) is still comfortable, in our view. We maintain our OVERWEIGHT view on the industrial-REITs subsector, with Cache Logistics Trust and MLT as our preferred picks due to their high yields and resilient portfolio.

Don’t let Reits be the next wave of governance lapses

SINGAPORE boasts of a thriving real estate investment trust or Reit sector, but recent events have served another reminder that beneath the glowing surface, there are some key fundamental concerns.

K-Reit Asia, last week, pushed through its plan to buy 87.5 per cent of Ocean Financial Centre (OFC), and raise some $976 million through a rights issue to fund part of the cost. It had earlier announced that it would pay some $1.57 billion to buy parent company Keppel Land’s entire stake in the OFC office building. Keppel Land will see a net gain of about $492.7 million from the sale.

Put before shareholders for their approval at an extraordinary general meeting (EGM), the proposal ran into howls of protest. Shareholders questioned the stiff price and timing of the deal, at a time when the economy is facing a slowdown. Shareholders noted that while the prime Grade A office building in Raffles Place has a tenure of 999 years with 850 years remaining on the lease, KepLand is selling its stake with only a 99-year lease. Others questioned why K-Reit is paying its manager (which is owned by KepLand) an acquisition fee – even though it is buying the asset from its parent company. There were also rumblings about the independence of the manager.

In a nutshell, the EGM brought to the fore two key issues relating to Reits here that corporate governance advocates have been highlighting for some time: sponsor groups offloading assets to their Reits on terms that seem disadvantageous to the Reits, as well as the apparent lack of independence of the Reits. K-Reit chairman Tsui Kai Chong’s comment that ‘Our father organisation, Keppel Land, is only willing to sell it (OFC) to us for 99 years’, says it all. And the fact that both resolutions – to buy the OFC stake and for the rights issue – were passed with a show of hands, after a bid by institutional investor to vote by poll was denied, simply drives home the point.

This isn’t the first time – and probably it won’t be the last – that issues like these arise at a Reit. For some time now, there has been growing disquiet among corporate watchers about weaknesses in the corporate governance structures in Singapore Reits.

Earlier this year, a review of Asia-Pacific Reit markets by the CFA Institute produced less-than-assuring results. Looking at the governance of Reits in Singapore, Australia, Hong Kong and Japan, the institute in its report called strongly for Reit managers to be independent. In the current most common scenario, the Reit sponsor wholly owns the Reit manager, and also holds a large stake in the Reit.

And even before the latest K-Reit development, cases of sponsors selling properties to Reits have triggered concerns about conflict of interest, and unitholders have often questioned the purchase of these assets and how they were priced. The CFA Institute said that to better protect ordinary unitholders, most directors on the boards of Reit managers should be independent of management, sponsors and substantial unitholders. This should be made law, rather than just a best-practice guide. There is also the need to have more transparent structures to pay Reit managers and to tie these more closely to performance, and indeed to require all Reits to hold annual meetings for unitholders.

Reits are often presented as defensive plays, and given their yield structures, there is some truth in this. But it would be unfortunate if investors buy into Reits for their relative safety just to have their interests as minorities undermined by weak corporate governance structures. If nothing is done, the Reit sector could be where the next wave of governance lapses emerge, and that would be a pity for a sector that has done quite well so far.

Office, industrial Reits face rental squeeze

About 933,000 sq m of gross floor area of office space is in the pipeline from GLS sites awarded this year

IN current volatile times, real estate investment trusts (Reits) have emerged as favourites for defensive plays. But analysts caution that investors should still be highly selective with Reits, as not all will be equally resilient to economic shocks.

In particular, rents might be an area of concern for office and industrial Reits, analysts say.

According to URA statistics, about 933,000 square metres of gross floor area (GFA) of office space is in the pipeline, with more to come, from the Government Land Sales (GLS) sites awarded this year.

With 62 per cent of the space, or 574,000 sq m currently under construction, this could add stress to rents.

Median office rental rates rose by 9 per cent in the third quarter, to $9.49 psf per month. Occupancy rate for prime offices improved 2.7 per cent quarter on quarter.

In October, K-Reit Asia announced that it was purchasing an 87.5 per cent interest in Ocean Financial Centre from its parent company, Keppel Land – for a period of 99 years – for $1.57 billion.

Following the announcement, Moody’s Investors Service changed its outlook on K-Reit’s ‘Baa3’ corporate family rating to positive from stable. Standard & Poor’s Ratings Services (S&P) has initiated coverage with a ‘BBB’ long-term corporate credit rating and a ‘stable’ outlook.

DBS Group Research too was largely positive on the deal, which values the asset at $2,600 per square foot, inclusive of income support. ‘Although timing was a little unexpected, we see this deal as a strategic long term positive for K-Reit with the ability to deepen its presence in the prime CBD area, upgrade its portfolio quality and ensure strong and stable income stream for unitholders through long leases and bluechip tenant base.’

Separately, Suntec Reit issued two announcements in quick succession, following its third-quarter earnings announcement, which saw distribution per unit of 2.533 cents, up 1.2 per cent year on year.

The first, its divestment of Chijmes for $177 million, was well-received by analysts. DBS Group Research noted that the divestment was a ‘small but nice surprise’, given that ‘while the property performance has been consistent, in our view it may not be a good fit to Suntec Reit’s current portfolio’.

News of the $410 million asset enhancement initiative (AEI) – $230 million for Suntec City Mall and $180 million for Suntec Convention Centre – on the other hand, met with mixed reactions.

While some analysts said that the AEI was necessary to keep Suntec City relevant, others argued that the resultant gearing might be too high. According to Standard Chartered, the Reit’s gearing could rise to some 42 per cent upon completion of the project, although it qualified that this was likely to be mitigated by the gradual nature of the expenditure.

‘We continue to think that Suntec Reit could sell assets to raise equity to reduce its gearing. Strata office spaces in Suntec Office Towers could be sold, or Park Mall could be divested. If (it) manages to sell Park Mall at 20 per cent above current book value of $338 million, gearing could fall to approximately 38.5 per cent.

‘However, this could still seem high as the Reit’s gearing could rise to some 47 per cent if office capital values fall 25 per cent as we forecast.’

Over in the industrial sector, Credit Suisse warned that perception of industrial Reits’ defensiveness, due to its longer lease tenures is misplaced, citing high industrial rents, and Singapore’s high exposure to the United States and European economies.

Industrial rents have not only surpassed pre-subprime crisis peaks but are at 10-year highs, said Credit Suisse.

‘We expect flat to low single-digit growth for factory rents driven by high occupancy, and business park rents to moderate from hereon due to the oncoming supply pressure (including new supply of decentralised office space).’

Standard Chartered, in a report released mid-October, agreed with the prognosis, citing high supply and falling office rents as key contributors to falling business park rents.

‘We expect business park rents to fall from the current $3.60 psf per month to $3 psf per month by end-2012E and $2.50 psf per month by end-2013E. This implies a 30 per cent decline over the next two years, ie back to 2007-levels.’

Standard Chartered had earlier cut prime office rents forecast by 25 per cent, due to low leasing activity and expectations of slower growth in 2012. The slower demand for office space is expected to spill over to business parks, suppressing tenants’ willingness to pay for higher rents, it said.

In the retail sector, analysts were generally optimistic on Frasers Centrepoint Trust. UOB Kay Hian expects Causeway Point to be the key growth driver in 2012, seeing as how it recorded strong rental reversions of 9-22 per cent in FY11, and is on track to reach 22 per cent NPI growth post-AEI.

While the acquisition of Bedok Point diversifies FCT’s portfolio, UOB also noted that there was room for improvement, particularly in the areas of the unoccupied space in the basement, and lack of strong anchor tenants.

It maintained a ‘buy’ call, with an unchanged target price of $1.75.

1H11 performance round-up

Industrial REITs – stability from positive reversion and longer lease structures. The three industrial REITs under our coverage reported 1HCY11 results which were largely within our expectations. Some of the common themes we noted were 1) contribution from new acquisitions, 2) continued high occupancy rates, and 3) positive rental reversions. Ascendas REIT (A-REIT), Cache Logistics (Cache) and Mapletree Logistics Trust (MLT) had annualised implied yield of 6.2%, 9.0% and 7.7%, respectively, based on their latest reported quarterly DPU and last closing prices. As at 30 Jun 2011, both A-REIT’s and Cache’s leverage was below 30% (28.7% and 28.5% respectively), while MLT’s gearing of 40.6% was within management’s medium-term target range of 40%-50%. In light of possible headwinds from the current macroeconomic uncertainty, the relatively longer lease structures of industrial REITs could provide some level of stability to unitholders. Our preferred pick in this space is Cache [BUY, fair value: S$1.06] at a relatively attractive FY11E yield of 8.5%.

Office REITs – prefer Grade A exposure. The 1H11 performance of office REITS under coverage (CCT, FCOT and Suntec) were largely in line with expectations. Overall, occupancy rates stayed healthy (CCT: 97.7%, FCOT: 97.6%, Suntec: 99.1%), while we expect negative rental reversions to continue in 2H11 with inflection points ahead in FY12. As of end Jun11, leverage levels remained below long-term targets (CCT: 26.9%, FCOT: 37.1%, Suntec: 38.5%), though we expect CCT and Suntec to gear up further with the Market Street office project and an increased stake in Suntec Singapore, respectively. We continue to prefer CCT for its exposure to domestic Grade A space which is likely to enjoy continued tailwinds underpinned by a flight to quality office space and an increasing rental spread between Singapore and Hong Kong. Maintain BUY on CCT with fair value estimate of S$1.67.

Retail REITs – Orchard supply to ease ahead. CapitaMall Trust (CMT), Frasers Centrepoint Trust (FCT), Starhill Global REIT (Starhill) reported 2Q11 results that were within expectations. In this space, we prefer Orchard retail exposure over suburban malls with the supply of Orchard retail space expected to ease into FY12. We continue to see managers carry out asset enhancement works – CMT (The Atrium, Junction 8), FCT (Causeway Point) and Starhill (Wisma Atria) – which would be the main driver for performance uplifts ahead, in our view. We prefer Starhill for its Orchard retail exposure (Wisma Atria and Ngee Ann City). Maintain BUY with fair value estimate of S$0.70.