Singapore-listed REITs are enduring a “red-hot summer”, say DBS Group Research analysts Derek Tan and Dale Lai, as the extended period of high interest rates spell continued distribution per unit (DPU) erosion until 2024.
“While we remain constructive on S-REITs as we approach the end of the rate hike cycle, we believe that all are not totally ‘out of the woods’ yet, as near-term funding costs are likely to remain elevated over an extended period before entering a period of normalisation from 2H2024,” write Tan and Lai in a July 12 note.
This means that S-REITs will still feel the erosion of distributions as average portfolio interest rates inch higher in 2024. The analysts have forecast FY2024 DPU growth of 2.0%, but -1.0% without hospitality names, bringing an overall FY2024 DPU yield of 6.3%, or a spread of 3.3% against Singapore 10-year bonds.
In a slow growth and high interest rate environment, DBS maintains a “conservative stance” of preferring resilient subsectors, such as industrial and retail. Top picks include CapitaLand Ascendas REIT (CLAR), Mapletree Logistics Trust (MLT), Frasers Centrepoint Trust (FCT), Mapletree Pan Asia Commercial Trust (MPACT) and Lendlease Global Commercial REIT (LREIT).
Tan and Lai have “buy” calls on these S-REITs, with target prices of $3.40 for CLAR, $1.88 for MLT, $2.60 for FCT, $2.00 for MPACT and $1.00 for LREIT.
In addition, Tan and Lai like hotel S-REITs like CapitaLand Ascott Trust (CLAS) for its leverage in the “robust”, medium-term China reopening story. The DBS analysts have a “buy” call and target price of $1.30 on CLAS.
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Where will it cut the deepest?
Tan and Lai have priced in a “through cycle” portfolio debt costs hike of 1.2% in their models and believe this to be sufficient for now.
This reflects DBS’s assumptions of a 100 basis points (bps) cuts to US Fed funds rate come 2024.
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That said, a bear case scenario of a prolonged period of high interest rates till the end of 2024 would potentially drive portfolio debt costs up by another 30 bps or a 4.0% cut to Tan and Lai’s estimates, which they have yet to price in.
“This cut would be more keenly felt in the US office, China Retail S-REITs and selected commercial (selected office + retail S-REITs). We expect that the industrial and hotel S-REITs should remain most resilient as they enjoy stronger portfolio cash flows to compensate for the higher interest rates burden,” they add.
Based on this sensitivity analysis, Tan and Lai believe there could be some adjustments to estimates for the retail and hospitality subsectors. “But we are maintaining our estimates for now, given our conservative ebitda growth numbers [of] 4.0% for retail and 11.0% for hotels.”
Look at underlying cash flow growth
Refinancing costs will continue inching higher, but the peak increase in rates is likely over, says Tan and Lai.
“Overall borrowing costs will continue to inch higher as we head further into 2023 and 2024 as the cheaper cost of debt that was secured back in 2020-2021 gets marked to the market. Based on our estimates, overall S-REITs’ cost of debt has risen by 1.1% y-o-y to 3.4% as of 1Q2023 and should continue to inch higher as we head into 2023-2024,” they add.
This is because of the higher base rates where the three-month SORA and swap rates are generally 250-300 bps higher compared to the rates in 2021.
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The S-REITs are projected to deliver a two-year CAGR of 0.4%. Without hospitality names, the CAGR drops to -3.2%.
The decline is mainly in FY2023, with a spike in interest rates eroding part of the growth in property cash flows, thus resulting in a slight increase in overall distributions, note Tan and Lai. “We have assumed overall ebitda growth of 3% in FY2024, ranging from -1% to +1% in FY2024F, mainly from the continued positive leasing spreads, which allow S-REITs to continue capturing the overall growth in portfolio cash flows.”
Where will interest coverage ratios land?
With the assumed higher interest rate obligations, Tan and Lai’s forecast interest coverage ratios (ICRs) are generally lower than levels seen in 1Q2023, despite ebitda growth of 4.0% that “somewhat helps” alleviate the interest burden for most S-REITs.
“Overall, we will see ICR declining from an average of 4.6x (ranging from 2.6x to 9.4x) to a range of 4.0x,” they write.
In scenarios where there is “no growth” or a 10% decline in ebitda when compared against assumed FY2024 interest rates, Tan and Lai expect to see average ICRs declining to 3.6x, although office S-REITs’ ICR ratios could decline to 2.4x-2.5x, which is close to the MAS’s guidelines of 2.5x.
“While we understand that most S-REITs remain bank covenants, the potential drop in ICR ratios towards 2.5x will mean lower flexibility for the S-REITs,” they add.
How should investors be positioned?
Investors have generally stayed cautious when it comes to S-REITs, with the sector underperforming the Straits Times Index (STI) in May and June.
With a rate pause on June 14, the Fed signalled two more rate hikes between July and September, which has been repriced into expectations.
That said, Tan and Lai maintain their stance that S-REITs will see some respite upon a pause in rate hikes with a more meaningful rally in share prices due to expectations of a trajectory towards more normalised interest rates.
In a slow growth and high interest rate environment, the DBS analysts maintain our conservative stance of preferring resilient sub-sectors that they believe offer a good mix of growth and earnings visibility with minimal negative surprises on the interest rate front.
“We believe that the focus will then move towards the impact of a recession, and we believe that suburban retail and industrial names offer better relative DPU resilience with a capacity for upside surprises,” they note.
“We are also not taking our eyes off the hospitality subsector, which remains a dark horse that can surprise on the upside once China’s reopening trajectory regains momentum. In this space, we like CLAS for its more global footprint and attractive yields,” they add.
As at 1.30pm, units in CLAR are trading 1 cent higher, or 0.36% up, at $2.81; while units in MLT are trading 2 cents higher, or 1.18% up, at $1.72; and units in FCT are trading 1 cent lower, or 0.45% down, at $2.19.
Also at 1.30pm, units in MPACT are trading 1 cent higher, or 0.60% down, at $1.68; while units in LREIT and CLAS are both trading flat at 67.5 cents and $1.12 respectively.
