With the rise in interest rates through 2022 likely to continue into the first half of 2023, albeit at a slower pace, we discuss how Singapore-listed REITs or S-REITs, as a key Singapore-dollar credit-issuing sector, are contending with this new normal.
While the market is still pricing in a rate cut in mid-2023, the US Federal Reserve (Fed) terminal rate range is between 5% and 5.25%, indicating the tussle between what the market thinks and what the Fed thinks is still an ongoing issue.
At OCBC Credit Research, we track 21 S-REITs which are Singapore-dollar credit issuers. These S-REITs represent around 75% of the total S-REIT market cap. While we have turned more cautious over the credit profile of the S-REITs we track over the next 12 months, the credit deterioration is starting from a manageable base. We consider the bulk of these 21 S-REITs to be high-grade or more “crossover”.
How do higher interest rates affect S-REITs?
Like other property-holding entities, one of the main ways higher interest rates affect S-REITs is through the impact on property valuation. There are two main methods of property valuation, one by discounting a future cash flow stream and analysing the valuation of similar properties, including from actual sales activity.
Under the discounted cash flow method, benchmark interest rates are a component of the discount rate, and, all things equal, the property value would fall when interest rates increase. For S-REITs who buy properties in part using leverage, properties owned are a crucial determinant of credit strength.
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As such, a fall in property valuation means that a smaller asset base supports debt. The rise in interest rates has resulted in the depreciation of a range of currencies against the Singapore dollar through 2022, corroding the value of overseas assets when translated into the Singapore dollar, the reporting currency for many S-REITs. Already, two S-REITs that own overseas assets have guided the market. They reported that the aggregate leverage ratio (simplistically total debt over total assets) is set to rise.
However, given that the rise in interest rates in this environment is mainly due to inflationary pressures, even if rental income is also increasing fast, the net effect in practice may still be a neutral-to-positive impact on property value. According to URA data, office space in buildings located in core business areas in the Downtown Core and Orchard Planning Area that are relatively modern or recently refurbished, command relatively high rentals and have large floor plate sizes and gross floor area, saw rental growth of 6.9% in the fourth quarter of 2022 (based on lease commencement) versus the fourth quarter of 2021.
Among S-REITs which have announced their updates for the quarter that ended Dec 31, 2022, a number have reported an increase in property valuation for their Singapore properties. However, we expect the pace of rental growth to fall in 2023 with impending macroeconomic headwinds and a reduction in demand from technology tenants.
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Overall, reported aggregate leverage will likely increase in 2023 from possible revaluation losses. However, in our view, these are more likely to be “mark-to-market” losses, where we expect S-REITs we track to be more inclined to hold onto assets rather than be forced sellers.
Structurally, S-REIT managers see value in scaling up, which indicates a preference to hold properties visà-vis cash, especially if there are no good opportunities to recycle capital. Based on our analysis of debt maturity profiles as at Sept 30, 2022, the S-REITs we track to face a maximum of 23% of total debt coming due in 2023, while the median REIT only has 12% of total debt coming due. Despite a higher cost to refinance, there is little to suggest that S-REITs will face difficulties in financing this year. 2024 will be a higher-risk year for a handful of REITs, given a higher proportion of debt coming due.
The rise in interest rates has resulted in a downward adjustment of S-REIT equity prices. The iEdge S-REIT index had fallen 12% year-on-year on a total return basis in 2022. In our view, equity investors buy REIT units mainly as dividend seekers and stable income growth, where REIT equity dividend yields are typically compared against income-generating financial assets. As previously covered in The Edge Singapore, when benchmark rates rise, this makes the REIT equity less appealing on a relative basis, and REIT equity prices will tend to fall. In addition, the higher benchmark interest rate has pushed up the cost of debt both in the bank debt and credit market. The current environment has made it harder for S-REITs to make acquisitions on an accretive basis for their equity holders.
Higher interest rates also mean thinner interest coverage ratios, and we have started to see this among the S-REITs we track. S-REITs with a low proportion of fixed debt or a lack of hedges would face a more significant impact from higher interest rates. In 2023, we expect large-cap investment-grade S-REITs to see limited credit rating headroom, discouraging S-REITs from using debt for acquisitions or pursuing mergers and acquisitions activities. On Jan 26, Frasers Property and its sponsored REIT, Frasers Centrepoint Trust (FCT), jointly announced the proposed acquisition of a 50% interest in NEX shopping mall at Serangoon.
It is notable in our view that FCT is starting from a low reported aggregate leverage of 33.9% as at Dec 31, 2022, lower than its S-REIT peers, while a REIT listed in Hongkong is buying Jurong Point and Swing By @ Thomson Plaza. Individual variances tend to be more prominent among mid-cap REITs. Despite being primarily unrated by international rating agencies, their credit profiles suggest they are “crossover” issuers. These S-REITs are typically smaller in scale, and some rely on perpetuals in their capital structure. We expect “crossover” S-REITs to see reported aggregate leverage rise above 40% while the adjusted interest coverage ratio (including perpetual distribution in the denominator) may go below 3.0 times. This is, though, still higher than the 1.5 times set as financial covenants, where applicable.
REIT yields bonds and perpetuals broadly look fair
Despite our more cautious outlook for S-REIT credit profiles this year, the repricing in S-REIT credit through the second half of 2022 means that S-REIT bonds and perpetuals are trading at yield levels that have not been seen in a long time. Recent developments in inflation data suggesting that we have gone past the peak in US inflation may also bode well for yielding assets such as S-REITs.
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In our view, new issuances in the first half of 2023 from S-REITs will be mainly from refinancing needs ($1 billion of bullet bonds issued by S-REITs are due to mature in 2023) as a likely lack of acquisitions among S-REITs will limit new funding required.
Mercatus Co-operative, a non-REIT high-grade corporate selling critical commercial space assets, has sought bondholders’ consent to early redemption, which may result in money seeking to be redeployed into other bullet bonds.
We expect a tighter supply to support secondary market prices for Singdollar credit in the year’s first half. We think high-grade bullet bonds issued by high-grade REITs are broadly trading fair, with a yield to maturities at 4% or more. Despite the higher credit risk profile, we think “crossover” bullets provide a compelling risk-return, with ask yields reaching as high as 5%.
Perpetuals issued by S-REITs do not tend to come with step-up margins, although reset dates generally coincide with first call dates. S-REITs can structure perpetuals with step-up margins, but in practice, it is not advantageous for them to do so. We think issuers are prioritising upfront cost savings over reputational risks in this current environment and would decide on calling a perpetual only if it is more cost-efficient for them to do so. Despite the elevated risks of non-call at the first call, distribution rates are more likely to be reset higher in a rising rate environment, even if the perpetual is not called.
Since the downward repricing in the second half of 2022, S-REIT perpetuals are trading at an ask yield-to-perpetuity of 5.5% to 6% and, in our view, looks interesting relative to equity dividend yields.
Ezien Hoo, Andrew Wong, Wong Hong Wei and Chin Meng Tee are credit research analysts with OCBC Bank’s global treasury research & strategy
