Industrial REITs – Possible downside risks ahead
(Downgrade to NEUTRAL)
Further improvement in performance
Industrial REITs continued to reap the fruits from their past acquisitions and positive reversion in rental rates. In 2Q13, the subsector delivered a 7.9% YoY rise in aggregate NPI to S$302.1m and a 4.2% rise in DPU to 16.07 S cents, relatively consistent with the growth rates achieved in 1Q. We note that AIMS AMP Capital Industrial REIT (AAREIT) and Ascendas REIT (A-REIT) have raised equity via private placement over the Mar-Apr period. This has resulted in the DPU growth at the respective REITs to be relatively mute over the quarter.
Firm operational performance
Operationally, the performance has remained sound, with the overall subsector occupancy rate improving by 30bps QoQ to 97.7%. This is despite the fact that occupancy rates at several industrial REITs’ properties were affected due to the conversion from single-user assets to multi-tenanted buildings, ongoing asset enhancement initiatives (AEIs) and non-renewal of tenants. As at 30 Jun, the weighted average lease to expiry (WALE) stood steady at 3.3 years, compared to 3.4 years in 1Q.
Enhanced financial position
Aggregate leverage has also improved sequentially in 2Q13 to 32.3%, largely driven by the substantial improvement in gearing ratio by AAREIT following its placement of new units. In addition, financing costs within the industrial REIT subsector fell by 10bps QoQ to 3.3% due to significantly lower interest rates of 1.9% achieved by Mapletree Logistics Trust (MLT), thanks to new interest rate swaps and fixed rates notes entered into during the quarter to replace the expiring interest rate hedges. Consequently, the subsector interest coverage ratio improved from 5.6x in 1Q to 6.1x.
Active hedging policy to contain interest costs
To allay concerns on the negative impact of rising interest rates, industrial REITs have been steadfast in locking the interest rates on their existing borrowings (as high as 100% in the case of AAREIT and Sabana REIT). The average debt term to maturity, on the other hand, maintained fairly healthy at 2.8 years (3.0 years in previous quarter), with ~S$330m or 5.5% of subsector borrowings due to mature in 2013. This is comfortable in our view given that the REIT managers still have access to several funding alternatives. As at 30 Jun, Cambridge Industrial Trust (CREIT) has the lowest debt duration as ~S$310m (64.3%) of its loan facilities will mature in 2014. However, management revealed that it is already in advanced discussion with banks to refinance the debts. Should CREIT conclude its refinancing needs in the coming quarter, its debt maturity profile is likely to improve
Turning cautious on industrial REITs
Looking ahead, however, we are turning increasingly cautious on the industrial REIT space despite the continued firm results and strong financial standing of the REITs. One of the reasons is the moderating trend in the industrial property rentals in Singapore. According to URA REALIS, the multi-user factory rental index continued to show signs of weakness, with the sequential growth rate in 2Q13 at 0.1% as opposed to 0.4% growth seen in 1Q. In addition, the warehouse rental index experienced a dip of 2.4% QoQ, continuing its decline of 0.2% in 4Q12.
Broad increase in vacancy rates
The net completions within the factory, warehouse and business park spaces have also been exceeding the net absorptions for 2012 and 1H13. This has pushed the 2Q13 vacancy rates for the factory and warehouse markets up to 7.6% and 7.2%, respectively, from 6.9% and 7.1% in 4Q12. The vacancy rate for business park segment, we note, was maintained at a relatively high level of 19.1% in 2Q13.
Upward revision in rents upon renewal to moderate
Property consultant CBRE said in its 2Q13 Real Estate market report that most factory tenants are maintaining a wait-and-see approach on their expansion and relocation plans in spite of the potential recovery in demand from the manufacturing sector, and believes that factory rents may face downward pressures going forward due to a significant supply of factory space (43.94m sqft from 2H13 to 2016, or 13.2% of current stock) and alternative options available. Within the warehouse space, CBRE anticipates some upside in rents amid the current limited supply and positive demand for logistics, transportation and storage sector. However, as a total warehouse space of 16.33m sqft (20.3% of total stock) is expected to come online over the 2H13-2016 period, we believe that the upward growth, if any, would likely be modest. Lastly, CBRE projects that a total supply of 6.42m sqft (42.7% of current stock, but 48% already pre-committed) of business park space will be delivered to the market over the same period, and the business park rents are likely to increase in the short term amid continued healthy demand and decentralization by some office occupants. As such, we are maintaining our view that the industrial property rents, on the whole, will remain stable in 2013, while rents in 2014 may be flat to slightly downside biased. This implies that the rental reversions at some of the industrial REITs’ properties, while still positive now, may gradually taper off going into 2014.
Investment activity to be relatively muted
Singapore warehouse and factory prices have also been experiencing steady growth after bottoming out in 3Q09, and have just reached their historical highs in 1Q13. We believe that industrial REITs will continue to face difficulties in acquiring industrial properties that are yield-accretive, especially in a potentially rising interest rate environment. Furthermore, the Singapore government has also imposed a few cooling measures, such as the seller’s stamp duty and upfront land premium, in the past year, which may cause the industrial REITs to be more selective on their acquisition targets. As a result, the investment activity in the local scene and DPU growth may possibly be relatively muted in the upcoming year.
Tipping point for capital values?
A check on the recent industrial property price trend has revealed some indications of a market fatigue. While this may mean that it might be less onerous for industrial REITs to justify an acquisition going forward, we are concerned about the impact of a higher interest cost and an expansion in the cap rates on the industrial property capital values. Specifically, if the existing assets in industrial REITs’ portfolios were to encounter negative asset revaluations, the book value and debt headroom of the REITs will also trend lower. This may in turn lead to lower valuations and financial flexibility for industrial REITs.
Downgrade to NEUTRAL
In any case, the industrial REIT subsector has enjoyed a good run since we first ascribed an Overweight view in end 2011, growing by a considerable 47.4% to-date. In the recent sell-down of interest-rate sensitive stocks (including S-REITs) in anticipation of the Fed’s tapering actions, we note that the industrial landlords have also outperformed the S-REITs sector in terms of total returns, reflecting their resilient nature and recent improvements in the local economy. Going forward, however, we believe there are downside risks to rentals and capital values, and industrial REITs may be impacted as a result. While more industrial REITs are turning to AEIs and (re)developments to grow their income, we are of the view that the pace of growth may moderate in 2014. In light of this, we now downgrade the industrial REIT subsector from Overweight to NEUTRAL. Nevertheless, we retain Cache Logistics Trust [BUY, FV: S$1.30] as our preferred pick for the industrial subsector, due to its strong earnings visibility, robust financial position and attractive yield.
Publish date: 09/09/13