Taking stock of yield spreads
QE tapering is drawing near and with it, rising long bond yields and falling S-REIT prices. S-REITs trade at the long-term average spread of 396bp over the 10-year SGS yield. This would be attractive in a normal cycle but not now. We expect SREITs’ repricing to continue.
For value hunters, this is not the time to be aggressive. We maintain our Neutral call. A strong management, solid financials, AEI growth prospects and valuation buffer remain our stock selection criteria. AREIT stands out in this regard and remains our top pick. SUN is also an Outperform as its 0.7x P/BV valuation and 6.3% FY14 yield are hard to ignore. The sector’s re-rating catalyst is the stabilisation of interest rates.
The SG10Y yield is on the rise again (269bp currently) after coming off the previous high of 277bp in Jun 2013. This sparked an 8% correction in S-REITs in the past month, back to the levels seen when we released our last report (‘Nailing down interest rate effect’ on 26 Jun 2013)
What We Think
We believe that the time is not yet ripe to be bullish on the sector. S-REITs’ FY14 yields are now at a c.396bp spread over the 10-year SGS yield, which is still within the historical average range. In a normal cycle, this would be attractive but not in the current rapidly rising interest rate environment. Assuming that the historical average spread is maintained and the 10-year SGS yield rises to its 10-year high of 360bp (+90bp from now), we estimate that S-REITs will have 12% downside from their current share prices. The market may lower yield spread expectations despite the high bond yields but this will only happen if the rate of change in interest rates stabilises- not now. On the positive side, average S-REIT yield spread in the last 10 years was 420bp (+20bp from now) during periods of rising interest rates (close to current levels). At this juncture, we think it prudent to factor in an additional 50bp buffer for yield expansion, before revisiting the sector. This implies 7% equity downside, backed by 6.7% FY14 DPU yield. The sector trades at 1x P/BV, below its historical average of 1.2x.
What You Should Do
We maintain our Neutral rating with AREIT and SUN as our top picks.
Taking stock of yield spreads
The 10-year Singapore Government Bond (SG10Y) yield has risen by 25bp in a week to 269bp but it is still below the previous high of 277bp in Jun 2013. The S-REITs’ yield spreads narrowed to c.360bp in Jul as bond yields contracted, but have bounced back to 396bp. This is the level reached when we last issued an update on the sector (‘Nailing down interest rate effect’ on 26 Jun 2013). Taking stock of yield spreads and valuations at the moment, we reiterate our view that the time is not yet ripe to adopt an aggressive investment stance on the sector.
1) Yield spreads remain at the long-term average. While S-REIT share prices corrected 8% in the past month, the average yield spread of 396bp is still within the historical average range. In a normal cycle, this would be attractive but not in the current rapidly rising interest rate environment. The average FY14 DPU yield of 6.7% is right smack at the sector’s historical average.
2) It’s not where rates are at, but rather, when will they stabilize and at what levels. Assuming that the historical average spread is maintained and the SG10Y rises to its 10-year high of 360bp (+90bp from current level), we estimate that the share prices of S-REIT will have 12% downside from current prices, theoretically. The market may lower yield spread expectations despite the high bond yields, but this will only happen if the rate of change in interest rates stabilises. This is unlikely to happen in the near-term. On the positive side, our analysis shows that S-REIT yield spreads in the last 10 years averaged 420bp (+20bp from current levels) during periods of rising interest rates. This is not far from current levels.
3) P/BV valuations at historical mean as well. The sector trades at 1x P/BV, below its historical average of 1.2x. Unsurprisingly, defensive sectors such as industrial and retail trade at a premium over the office and hospitality sectors. At the moment, none of the sub-sectors trade significantly below their historical means.
We expect the S-REIT sector to stay in the repricing phase until there is clearer evidence of rate stabilisation. In the meantime, we continue to advocate a selective approach and maintain our Neutral sector rating. A strong management, solid financials, AEI growth prospects and valuation buffer remain our stock selection criteria. We highlight our top pick AREIT and SUN as our preferred stocks in the S-REIT sector. CCT and CMT remain Neutrals.
AREIT (Outperform, TP: S$2.49) AREIT trades at 1.1x FY14 P/BV, at 1 s.d. below its historical average, with an FY14 DPU yield of 7% or 410bp spread over the SG10Y.
We expect steady DPU growth from positive rental reversions and past investments coming onstream. Current market rents are 9-35% higher than its passing rents due for renewal in FY13-14, pointing to a sustained double-digit positive rental reversions. Past developments and asset enhancement should also bear fruit in FY13, potentially boosting DPU growth in FY14. Its asset leverage of 28% (or 30% after factoring in committed investments) is one of the lowest in the sector, with a staggered debt maturity profile.
SUN (Outperform, TP: S$1.68). SUN trades at 0.7x FY14 P/BV, the cheapest in the S-REIT sector, with an FY14 DPU yield of 6.3%. We believe that its ability turn the retail scene at Suntec City around will be the wildcard catalyst for the stock’s re-rating. The Suntec City performance has been promising so far. Phase 1 of AEI at Suntec City Mall achieved an average passing rent of S$13.09 per sq ft, which is well on track to meeting SUN’s 10.1% ROI target. All eyes will be on the execution of Phase 2 and 3 of the AEIs. At current valuations, we believe that the market has priced in the potential negatives from rising borrowing costs but accorded limited value to the AEI at Suntec City Mall.