REITs and rates have a love-hate relationship. What is clear, however, is that the rate tightening cycle has begun. The US Federal Reserve (Fed) has already articulated at least three rate hikes — possibly even four — in the Fed Funds Rate this year.
Risk free rates, which are the 10-year US Treasury yields and yields of 10-year Singapore Government Securities locally, are rising as evidenced by the chart below. Against this background of rising rates, the FTSE ST REIT Index — something of an outperformer in 2021 — is falling as per the chart below.
Rising interest rates — which are usually felt through bond yields first — are being blamed on inflationary pressures.
“The plunge in global government bond prices at the start of this year underscores the new market regime. The trigger was the Fed indicating a faster-than-expected policy normalisation, including speeding up the timeline for letting its bond portfolio shrink. Markets quickly priced in faster and more rate hikes this year against a backdrop of 40-year high inflation and a tight labour market,” note BlackRock strategists in a Jan 19 update.
Could the Fed raise rates sooner — starting in say, March — and more aggressively than expected? The Blackrock strategists believe the sum total of expected rate hikes remains low, because of a historically muted Fed response to inflation. “Instead, the yield spike tells us that investors are less willing to pay a safety premium for bonds,” the report adds. “Expectations for the future fed funds rate have risen only modestly in the last six weeks, whereas 10-year Treasury yields have shot up. The driver is an increase in the term premium, the extra compensation investors demand for the risk of holding government bonds at historically low yield levels.”
The Fed has adopted new policies that let inflation run a little hot to make up for below-target inflation in the past, and has now met its target. The Fed and other central banks may be prepared to live with some inflation. This is because today’s inflation is not the usual demand-pull inflation but is triggered by pandemic-induced supply constraints.
See also: CICT's manager proposes to acquire ION Orchard at $1.85 billion, subject to EGM
Impact of rates on REIT yields and unit prices
Unlike the banks — which are a proxy play for rising interest rates — REITs do not usually outperform when bond yields rise. This is because REITs are priced off risk-free rates with a yield spread. Sometimes, investors may wonder why certain REITs are unable to get their DPU (distribution per unit) yields more compressed (in good times). That is because investors are pricing them off different risk-free rates, and of course the quality of the manager, and alignment with the sponsor also impact cost of capital.
According to a January report by the Singapore Exchange (SGX) research arm, the average yield spread over 10 years is 3.99%. The current 10-year SGS yield is at 1.84% and the 10- year Treasuries yield is at 1.87%. Compare this to levels in July and August last year where the yields for both 10-year SGS and 10-year Treasuries hovered between 1.2% and 1.4% (see chart) while the FTSE ST REIT Index was at around 900 compared to its current level of 827.
See also: CICT's manager proposes to acquire ION Orchard at $1.85 billion, subject to EGM
A secondary impact of rising rates is the relationship between discount rates which are used for valuations, and policy rates. Policy rates, and risk-free rates could also impact capitalisation rates, which are used for valuation by the income capitalisation method. As a result, rising interest rates generally cause valuations including capital values of properties to fall when they are valued by discounted cash flow methods.
For property valuations to remain stable, or to rise, the cash flow of the asset needs to rise such that it offsets higher discount rates.
Similarly, REITs — which have made accretive acquisitions in 2021 — may experience an uplift in DPU such that the DPU yield maintains the yield spread without REIT unit prices falling. Last year, around 20 S-REITs and business trusts made around 51 acquisitions valued at around $12.6 billion, according to data in the SGX report.
The Edge Singapore also compiled a list known as Bankers’ Best Friends which takes a light-hearted look at how much equity S-REITs raise in a given year. In 2021, S-REITs raised around $5.33 billion, including perpetual securities (this excludes the $250 million of perps which were called).
Can accretive acquisitions outpace the yield expansion?
How could investors play rising interest rates with REITs? REITs which raised equity and/or perpetual securities in 2021, to acquire assets which are accretive to their various metrics such as DPU and/or net asset value, should stay relatively resilient, and defensive, if they have most of their debt on fixed rates. Practically all the REITs that made acquisitions claimed theirs were accretive, although a handful had help from income support.
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The accretion to DPU does not imply that their yields won’t expand to maintain their yield spread against the risk-free rates, but they have a better chance of yields rising from growth rather than from a decline in unit price.
The largest bunch of acquisitions was done by Mapletree Logistics Trust (MLT), which announced the acquisition of $1.85 billion of assets in 2021. It recently held an extraordinary general meeting (EGM) on Jan 13, to approve the acquisition of $1.014 billion of assets in China and Vietnam from its sponsor Mapletree Investments. While the accretion from some of the assets includes income support, the impact on DPU is likely for MLT’s FY2023 which would be the 12 months to March 31, 2023.
Mapletree Industrial Trust (MINT) acquired $1.78 billion of data centres in the US, and this may have a more meaningful impact on its DPU as MINT has assets under management (AUM) of $8.5 billion compared to MLT’s $10.7 billion as at Sept 30.
While CapitaLand Integrated Commercial Trust (CICT) only made a modest acquisition of $740 million in 2021, CapitaSpring, which is the tallest building in Singapore (along with Republic Plaza and UOB Plaza 1), has opened for business. CICT owns 45% of CapitaSpring and has a call option to acquire the remaining 55%. Elsewhere, asset enhancement initiatives for Six Battery Road and 21 Collyer Quay are largely done, and new tenants have moved into 20 Collyer Quay.
The most direct impact of rising interest rates would be on distributable income as interest expense is the largest expense item for any S-REIT. CICT has an average term to maturity of 4.1 years, with 84% of its debt on fixed rates. That means that rising interest rates would have a limited impact on DPU. CICT will announce FY2021 results on Jan 28.
Frasers Centrepoint Trust (FCT) has a resilient portfolio, and a relatively low aggregate leverage of 33.3%. However, only 56% of its debt is hedged to fixed interest rates as at Sept 30, 2021, although this is higher than the 54% level as at March 31, 2021. FCT will announce its latest business updates on Jan 26.
Suntec REIT acquired an office in London for the equivalent $667 million, partly financed with Singapore dollar perpetual securities. While this keeps the income and accretion to DPU stable, only 57% of its debt is fixed. In addition, Suntec REIT’s aggregate leverage — excluding its perpetual securities — stood at 44.3% as at Sept 30, and its interest coverage ratio (ICR) was at 2.7 times.
From Jan 1 this year, REITs have to announce their ICRs. Only REITs with ICRs of above 2.5 times can have a higher aggregate leverage of above 45%. If ICR falls below 2.5 times, aggregate leverage is capped at 45%. Suntec REIT announces its FY2021 results on Jan 26 and it is likely to announce higher valuations for its properties given that its capital management metrics are — for want of a better word — borderline.
In June last year, Lendlease Global Commercial REIT (LREIT) announced it acquired a 28.05% stake in Jem for $337.3 million, funded partly by $200 million 4.2% perpetual securities and partly by debt. The acquisition is likely to move the needle for LREIT as its portfolio was valued at $1.4 billion prior to the acquisition. LREIT’s aggregate leverage — excluding the perps — was 34.3% as at Sept 30. LREIT has no refinancing till FY2023, which starts on July 1.
Firmer greenback
An interesting impact of inflation and rising interest rates is a strong greenback. “Markets priced in four Fed hikes and wiped out the US dollar’s losses for the year. DXY appreciated 0.5% to 95.75 from a nine basis points (BPS) increase in the US Treasury 10-year yield to 1.874%, its highest pre-Covid-19 level since January 2020,” note DBS Group Research rate strategist Duncan Tan and senior FX strategist Philip Wee.
The heaviest US Dollar Index (DXY) component — the Euro — depreciated the most, followed by the British pound and Swiss franc. The two DBS strategists are expecting a rate hike to be announced at the Bank of England meeting on Feb 3.
The four US dollar S-REITs are likely to be buffeted by rising 10-year Treasury yields on the one hand, and supported by a firmer US dollar compared to the Singapore dollar on the other.
The largest acquisition in 2021 was done by Prime REIT in June-July last year, of US$245.5 million of properties in San Diego and Boca Raton, compared to its portfolio of US$1.67 billion. Prime REIT does not have any debt coming due till FY2023 (it has a December year-end). As at June 30, 2021, 66% of its debt was fixed, a further 20% was floating rates which were fixed through a swap, and the rest were on floating rates.
Manulife US REIT (MUST) acquired US$201.6 million of properties in December 2021, which are likely to boost DPU by 2.8% on a pro forma basis. MUST is interesting in that as at June 30, 98% of its debt was fixed, suggesting a tiny impact of rising interest rates on its income, despite a gearing of around 42%. Since MUST was among the weakest US S-REITs last year, it could well be this year’s dark horse among the US S-REITs.
Photo credit: CapitaSpring tops out by CICT
