Friday, October 11, 2013

Real estate investment trusts: QE taper prospect undermines outlook, but analysts see pockets of opportunity

Real estate investment trusts: QE taper prospect undermines outlook, but analysts see pockets of opportunity
Written by Goola Warden  
Monday, 07 October 2013 16:26

The FTSE REIT Index jumped 22 points to 748 on Sept 19, the day after the US Federal Reserve said it would continue with its quantitative easing policy. Since then, the index has eased to 733 as at Oct 1. That’s 5% higher than the low of 697 reached on Aug 29. However, it’s still a long way from its peak of 890 in May, before the Fed sparked a broad sell-off by indicating it would soon begin tapering its US$85-billiona- month bond-buying programme. (See QE tapering weighting down valuations table.)

Analysts say it is only a matter of time before the US Fed begins tapering, though. And, in the meantime, yields on everything from bonds to stocks could face upward pressure from their compressed position just over a month ago. “While our economists still believe that the start of tapering may be resolved by year-end… they can’t rule out a lengthier debate dragging into next year,” notes a recent report from Citi. The report adds that forecasters are anticipating a fed funds rate of 1% by late-2015, rising to 2% by 2016, from almost zero currently.

The asset class most closely aligned with the shifting expectations of US Fed action is US Treasury bonds. The yield on 10-year US Treasuries has fallen 15 basis points in the past one month to 2.63% currently. It started the year at 1.75%, which was also the low of the year, and reached a high of 2.99% in September. The yields on Singapore Government Securities have mirrored this trend, as Singapore uses its exchange rate rather than interest rates to keep inflation in check. The 10-year SGS is currently yielding about 2.35%, lower than the high of 2.77% reached in late August, but much higher than the yield of 1.34% at the start of the year, which was also the year’s low.

This is weighing on the market valuations on REITs in a number of ways. REITs have a risk-return profile that ranks somewhere between stocks and bonds. Designed to delivering a significant portion of their total return through cash payouts, their market valuations fluctuate with yields on government bonds. “S-REITs trade at around a 396bps spread over the 10-year Singapore government bonds,” notes Donald Chua, an analyst at CIMB.

In an environment of falling interest rates, their yield spread versus government bonds tends to tighten, as investors reach for higher yields by piling into these instruments. Conversely, when the market is anticipating higher interest rates, the yield spread versus government bonds often widens. “Investors should be mindful that S-REITs typically do not perform well in a climate of interest-rate uncertainty,” Chua warns. “We think that it is not where rates are at, but rather when they will stabilise and at what levels.”

Moreover, higher interest rates aren’t good for the market valuations of real estate, the underlying assets of REITs. In fact, some analysts fear that property prices may have been pushed to a level where a correction is inevitable once the US Fed pulls back on its quantitative easing policy. “With Singapore rentals and asset prices of most segments at an all-time high, it is hard to pin down further growth trajectory that is not liquidity-driven or credit-fuelled,” says Ong Kian Lin, an analyst at Maybank Kim Eng, in a recent report.

In addition, REITs have boosted their yields, leveraging up their balance sheets with relatively cheap debt in the past decade. That potentially leaves them vulnerable to the higher cost of debt in the future. According to Moody’s, the 13 REITs it has rated are relatively over the next 12 months because more than half of their outstanding debt is tied to fixed interest rates. The REITs have a weighted average debt maturity profile of more than two years, and only 18% of their total debt will come due over the next 18 months, a recent Moody’s report states.

Yet, some REITs are in a better position than others. By Moody’s calculations, Frasers Centrepoint Trust and Saizen REIT are the most insulated from rising interest rates. FCT has 94% of its total debt on fixed-rate terms, and 10% due for refinancing over the next 18 months. Saizen REIT has 85% of its debt on fixed-rate terms, and its earliest refinancing is in February 2018.

On the other hand, Frasers Commercial Trust and Suntec REIT are the most exposed to the risk of higher debt costs, according to Moody’s. FCOT has 51% of its debt tied to fixed interest rates, and 36% of its total debt due for refinancing over the next 18 months. Suntec has 60% of its total debt on fixed-rate terms, and 28% or $774 million of its total debt due for refinancing in the next 13 months.

Ironically, REITs with the lowest average cost of debt now are likely to suffer most when they refinance their debt in the future. According to Moody’s, among the most sensitive to higher debt costs are Mapletree Greater China Commercial Trust, Keppel REIT and Mapletree Commercial Trust. All three would suffer a more than 10% decline in interest coverage ratios in the event interest rates rose by 25bps, the rating agency says. These three REITs also happen to have relatively high debt-to-asset ratios of close to 40%.

Against this backdrop, Maybank Kim Eng is advising investors to give REITs a wide berth, with an “underweight” rating for the whole sector. “S-REITs are currently trading... with a yield spread of 402bps (above the historic average of 380bps). While spreads appear attractive, we think that a recalibration is necessary in the next nine to 12 months to put rentals and property prices on a more sustainable path,” Ong of Maybank Kim Eng writes in his report.

On the other hand, Chua of CIMB points out that S-REITs are, on average, trading at about their book values, and offer forward yields of 6.3% for 2014. These are within the historical average, he says, “not cheap but also not expensive”. Hence, he is advising investors to simply stay “neutral” on the sector.

He does, however, say that Ascendas REIT and Suntec REIT are attractively priced. Suntec REIT, in particular, is trading at a 26% discount to its book value, which is a higher discount compared with other REITs in the office and retail sectors. REITs in the retail sector are generally trading at a premium to book value.

Meanwhile, some analysts say there is opportunity to be seized in the office property sector. According to DTZ, this sector showed clear signs of recovery in 3Q2013. “Stronger net absorption q-o-q resulted in a tighter office space environment where landlords were able to increase their asking rents,” DTZ notes in its quarterly update.

DTZ estimates that 65% of office space to be completed between now and end-2014 is suburban. “Within the CBD, the only major completion expected is CapitaGreen, which will add approximately 0.7 million sq ft of office space in 2014,” DTZ says. CapitaGreen is 40%-owned by CapitaCommercial Trust. The trust has a call option to acquire the remaining 60% from CapitaLand and Mitsubishi Estate Asia.

Separately, on Sept 24, CCT said it had refinanced $450 million of loan facilities by extending their maturity dates to 2018 to 2020. “We see this as a positive move for CCT, which will significantly extend the average maturity of its debt portfolio,” says OCBC Investment Research in a report that rates the trust as a “buy” with a price target of $1.61.

CCT is also Deutsche Bank’s preferred pick. “CCT (5.5% FY2014E yield) offers an attractive 0.84 times price to book and exposure to the office sector, which has the highest beta on GDP growth,” Deutsche Bank says.

Deutsche Bank also has “buy” recommendations on Ascendas REIT and Mapletree Industrial Trust. Ascendas REIT has a large, well-diversified portfolio, conservative balance sheet and positive rental reversions, according to Deutsche Bank, while Mapletree Industrial Trust has an attractive forward yield of 7.1%.

Chua of CIMB, however, reckons it’s safer to stick with developers with diversified portfolios such as UOL Group, Capitaland and Global Logistic Properties.

Publish date: 07/10/13

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