E. Industrial REITs: Downside risks lurking
Firm 3Q13 results, with some positive surprises
Industrial REITs continued to turn in a firm set of results in 3Q13, as they still benefit from higher rents and contribution from completed acquisitions and development projects. There were some positive surprises for the quarter, with two (Ascendas REIT or A-REIT and Soilbuild REIT) out of four industrial landlords under our coverage performing above expectations due to stronger-than-expected rental income and better cost containment.
However, subsector DPU growth was rather modest at 4.3%, partially impacted by divestments and a larger unit base following the private placements and implementation of Distribution Reinvestment Plans (DRPs) by several industrial REITs during the year. AIMS AMP Capital Industrial REIT (AAREIT) was the clear winner for the quarter, raking up a 10.0% YoY growth in DPU post development of Phases 1 and 2 of 20 Gul Way. Only Mapletree Logistics Trust (MLT) saw a slight dip in NPI YoY due to a weaker JPY. But as MLT’s income streams from Japan properties are substantially hedged, its DPU also grew by a robust 6.4% YoY.
Subsector occupancy saw a marked decline
Leasing activity has stayed healthy for the quarter, with positive rental reversions ranging from 7.9% to 26.7% being achieved by some of the industrial REITs. This is higher than the respective reversions registered by some of the landlords in the previous quarter. However, subsector portfolio occupancy encountered a marked sequential decline of 2.9ppt to 94.8%, due to the inclusion of newly-completed developments and acquisitions, conversion of single-user assets into multi-tenanted buildings, and non-renewal of certain tenants. Looking ahead, A-REIT has guided that occupancy rates in some of its portfolio properties may deteriorate due to non-renewal of tenants, while MLT and Sabana REIT will be converting some of their master leases/single-use assets into multi-tenancies. At the same time, several industrial properties will be commencing asset enhancement initiatives (AEIs) and redevelopment projects. As such, we believe portfolio occupancies at some of the REITs may continue to face downward pressures, though may not be as pronounced as compared to those experienced in 3Q13 due to the filling up of leases at the newly completed investments.
Aggregate leverage expected to increase
As at 30 Sep, the subsector aggregate leverage stood at 31.4%. This represents the third consecutive quarter of improvement in the financial position of the industrial REITs. We note that Cambridge Industrial Trust (CREIT) was the chief driver, which saw its gearing ratio fall from 35.8% in end-Jun to 27.9%, as it divested 63 Hillview Avenue and two other non-core assets and utilized S$108.0m in divestment proceeds to repay part of its S$208.0m club term loan due 1H14. However, we expect the industrial subsector aggregate leverage to inch up again going forward, as a few REITs have yet to complete their announced acquisitions or have announced acquisitions after the quarter end. Nevertheless, given that three REITs (Cache Logistics Trust or CACHE, CREIT and Sabana REIT) may still post asset revaluation gains at the close of their financial years for 2013, we expect the increase in gearing to be slightly cushioned. To-date, the industrial REITs that have yet to complete their proposed investments are:
1) AAREIT – Proposed acquisition of 49.0% indirect interest in Optus Centre Macquarie Park in Australia for A$184.4m (~S$215.0m) on 25 Nov. As it will be fully funded by debt, aggregate leverage is expected to hit 37.7% from 25.2% in 3Q13.
2) CREIT – Expected to complete acquisition of 30 Teban Gardens in 4Q13. The purchase consideration was S$41.0m.
Debt profile continues to strengthen
Average all-in financing costs also improved by ~10bps QoQ to 3.2% in 3Q13. We understand that this is due to fair value losses of loans, reduction in borrowings and renewal/refinancing of loans and hedging instruments at more favourable terms. As a result, subsector interest coverage ratio also saw an uplift to 6.3x from 6.1x in previous quarter. Weighted average debt term to maturity for the industrial REIT subsector, on the other hand, was extended to 2.9 years from 2.8 years in 2Q. In our view, industrial REITs remain one of the most active REITs in managing their capital structure and related risks, possibly due to lessons learnt from the 2009 credit crunch. With the exception of A-REIT, all industrial REITs have at least 70.0% of their existing borrowings hedged into fixed rates, thereby limiting their exposure to a potential interest rate hike. Nonetheless, as A-REIT refinances S$395m term loans maturing in May 2014, we believe its debt duration and interest rate hedging level will also improve as well.
Keeping our cautious stance
Looking into 2014, however, we are keeping our cautious view on the industrial REIT subsector. While industrial REITs have been performing well thus far, we remain concerned on the outlook of the local industrial market. The rental market has essentially been on an uptrend since the trough in 3Q09, according to the rental indices published by URA REALIS. In 3Q13, the multiple-user factory rental index again registered a 4.4% QoQ gain, after seeing some tentative signs of fatigue in the previous quarters. In addition, median rent climbed to S$2.20 psf pm from S$2.11 psf pm in 2Q. Within the multiple-user warehouse space, the index also saw a rebound of 4.6% QoQ, while median rent similarly picked up from S$1.98 psf pm in 2Q to S$2.07 psf pm. This marks the highest peaks for both the factory and warehouse median rents historically.
Factory rents may suffer in near term
We are skeptical of the sustainability of the growth momentum in the factory and warehouse rental market. While several datapoints suggest a recovery in the manufacturing sector in Singapore (manufacturing output grew 8.0% in Oct; PMI showed continued expansion in Nov), leasing activity for factory space has tapered, according to property consultant CBRE. Moreover, some factory buildings faced increased pressures to backfill significant spaces vacated by tenants due to relocation. From 2013-2016, we note that 43.66m sqft (13.0% of total factory space) of factory space is also expected to complete, which may potentially add burden to the already lackluster factory market. Hence, we believe that rents in the factory market may face downward pressures in the short term.
Warehouse rents may see modest increase
Demand within the warehouse market, on a more positive note, has remained relatively healthy as existing tenants continue to seek more storage space amid the current tight supply. CBRE said that demand from retail and the transport & storage sectors have also helped to prop up demand, and expects the overall demand to stay healthy over the next 6-12 months on the back of increased production and growth in ecommerce. Hence, CBRE believes that warehouse rents could see further upside over the period. However, as a sizeable 18.13m sqft (22.4% of total warehouse stock) of warehouse supply is projected to come online from 2013-2016, we maintain our view that the upward growth, if any, would likely be modest. Note that the warehouse sector is the only submarket that witnessed net absorption exceeding net completion for 9M13, and decline in vacancy rate as compared to 4Q12.
Business park rents poised for further upside
The bright spot in the industrial market, in our view, lies in the business park segment. Demand for business park space has held steady in 3Q13 as it continued to draw interest from sectors such as the biomedical and electronic industries. Higher rents in newer properties were also achieved, and this has led to overall growth in business park rents (1.9% QoQ rise in CBRE’s Fringe of Central Area basket to S$5.40 psf pm and 1.3% QoQ rise in Rest of Island basket to S$3.85 psf pm). According to CBRE, new quality assets continued to gain market preference, resulting in robust pre-commitments for new developments ahead of their completions. CBRE estimates that the total business park space by the end of 2013 will be 17.55m sqft, and that 1.21m sqft (6.9% of current stock) and 2.02m sqft (11.5%) of future supply will be delivered to the market in 2014 and 2015 respectively. Notably, at least 75.0% of the future pipeline supply has already secured occupancy. As such, CBRE believes that the prospect for the business park market is likely to remain positive in the short to medium term, with potential upside in the rents over the next 6-12 months.
Overall industrial rental growth may be muted in 2014
In view of the various submarket outlooks, we thus maintain our view that the industrial property rents, on the whole, will remain stable in 2013, while rents in 2014 may likely be flat to slightly downside biased. This is because the softer factory market constitutes the majority (~77.5%) of the total current industrial market space in Singapore. Should this pan out according to our expectations, the rental reversions at some of the industrial REITs’ properties, while still positive now, may gradually taper off going into 2014.
Increasingly difficult to find yield-accretive properties
Apart from a potential moderating rental trend, we also highlight again the possibility that industrial REITs may continue to face difficulties in acquiring industrial properties that are yield-accretive. Singapore warehouse and factory prices have been experiencing steady growth after bottoming out in 3Q09, and have recently witnessed yet another set of record highs in 3Q13. This has resulted in the compression of cap rates, as rental rates have not been able to keep pace with the increase in property prices. Furthermore, the Singapore government has been imposing a number of cooling measures, such as the seller’s stamp duty, upfront land premium and total debt servicing ratio (TDSR) framework, over the year. Just last week, JTC Corporation also announced that industrialists and third-party facility providers such as REITs who own industrial properties on JTC-leased sites will be required to hold these properties for a long period before they may sell them. All these developments serve to dampen the market sentiment and transaction activity in our view, as industrial REITs are likely 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.
Maintain NEUTRAL on industrial REIT subsector
While we have correctly projected that REITs with overseas mandates/strong sponsors or smaller asset sizes may still be successful in acquisitions, we believe that REITs with overseas exposure may have to contend with potentially higher risks or costs relating to hedging. With the potential reduction of the stimulus programme by US Federal Reserve and accompanying hike in cost of debt funding, earnings accretion may also be eroded, while the existing portfolio assets may be susceptible to devaluation amid a possible expansion in cap rates (arising from rise in interest rates). Nevertheless, more industrial REITs are turning to asset enhancement initiatives (AEIs) and (re)developments to grow their income, and this should help to cushion the moderating growth trend. In light of this, we are maintaining our NEUTRAL stance on the industrial REIT subsector. We choose A-REIT [BUY, S$2.45 FV] and CACHE [BUY, S$1.30 FV] as our preferred picks for the subsector due to their strong earnings visibility, robust financial position and compelling yields.