SINGAPORE (Dec 20): The FTSE ST Real Estate Investment Trust Index is up 23.5% this year, buoyed by three interest rate cuts by the US Federal Reserve. The Straits Times Index by contrast is up only 8.8% year-to-date. This year, the US Federal Funds Rate declined from the 2.25% to 2.75% range down to 1.5% to 1.75% as at end-Oct, when the Fed announced its final rate cut for the year.
Interest rates affect REITs in three ways. REIT yields are directly affected by the 10-year bond yield, with S-REITs trading at around 3.5% to 4% above yields of 10-year Singapore Government Securities. REIT distributions are affected by cost of debt, hence a higher cost of debt depresses distributions. Interest rates affect property valuations. Discount rates used in discounted cash flow models which in turn are used for valuing investment properties.
In general then, rising interest rates pressure REITs in three ways, and falling or low interest rates provide a tailwind for REITs’ unit prices, distributions and valuations.
The question is: where are interest rates heading in 2020? “We expect REITs to remain in favour in 1H20 aided by persistent low interest rates and favourable demand-supply outlook,” says RHB Research in a Dec 10 update.
DBS Research expects the yield curve to steepen by 25bps in 2020 and 2021, bringing 10-year yields to 2.25%. “As S-REITs are typically priced off 10-year bonds, we see comfort that current yield spreads of 3.7% can be maintained given similar pace of DPU growth,” a DBS Research report dated Dec 18 says.
DBS maybe right in expecting higher interest rates for the 10-year bonds. Yields on Singapore’s 10-year SGS have rebounded very mildly, from their lows of 1.64% in Oct to 1.72% as at Dec 18.
Yields on the US 10-year treasuries have risen by more, from 1.46% in Sept to 1.92% on Dec 18. While this is a far cry from the more than 3% yields on US 10-year treasuries last year, the rise in the yield is more dramatic.
“In determining the timing and size of future adjustments to the target range for the federal funds rate, the [Federal Open Market] Committee will assess realised and expected economic conditions relative to its maximum employment objective and its symmetric 2% inflation objective,” the Fed had said in a Dec 11 announcement. The annual inflation rate for the US is 2.1% for the 12 months ended November 2019, compared to 1.8% previously, according to U.S. Labour Department data published December 11, 2019. In addition, the US is at full employment currently.
No one is expecting US inflation to pick up from here. If it does, the 10-year US treasury yield would rise further, putting upward pressure on 10-year SGS yields which have been far more stable than that US 10-year treasury yields (See chart 1).
The US yield curve (spread between the yields on 2-year and 10-year treasuries) which been on a downward trend appears to have rebounded (see chart 2). A rebound by the yield curve indicates a better outlook for the economy.
The S-REIT yield spread (see chart 3) is near a 10-year low, which may limit its potential to fall further. Falling yield spreads are caused in large part by REIT yield compression and vice-versa for yield expansion. Analysts are clearly not anticipating expansion caused by falling REIT unit prices. Instead, they expect REIT distributions per unit to rise.
“We see potential upside in growth momentum if the S-REITs continue to acquire or tap their sponsors for acquisitions, which are not priced in at this moment,” DBS says.
RHB Research concedes that valuations are high as yield spreads are close to their long term lows. However, on a global basis, S-REIT yield spreads are among the highest globally. “With the global interest rate outlook still remaining dovish, ample liquidity and uncertain market conditions, we believe interest in yield instruments are unlikely to see a sharp correction,” RHB Research says.
