On Aug 26, The Edge Singapore’s REITs Investment Forum titled “REITs in a high interest rate environment”, sponsored by ESR-LOGOS REIT (E-LOG), brought together three speakers who are experts in their respective fields — Adrian Chui, CEO and executive director of E-LOG’s manager; Wong Xian Yang, head of research at Cushman & Wakefield; and Krishna Guha, vice-president at Maybank Research.
Despite being a Saturday, the auditorium was full. The question-and-answer session was also lively, with a question on E-LOG’s capital-raising. Interestingly, 25% of the questions were on Manulife US REIT (MUST).
On the broader property market, Wong in his briefing showed how popular residential property remains with local investors and home buyers. For residential property investors, properties near good schools are easier to rent.
“[A popular choice] is the tenant market for properties catering to students near education institutes such as NUS and NTU,” Wong says.
Elsewhere, industrial and retail rental trends are divergent. “The pandemic has helped industrial rents and prices are still going up despite supply. While office property isn’t as robust as industrial, there is a flight to quality,” Wong notes. To-date, Grade-A office rents have not fallen.
Wong also explained the various ways landlords can raise property yields. One of them could be a change in use, such as for shophouses.
For investment properties, this would be through asset enhancement. S-REITs’ asset enhancement initiatives or AEIs range from extensive renovations to redevelopments to increase their return on investments (ROIs). Chui adds that these can be in the range of 7% to 8%.
Rising costs affecting valuations, gearing
Since the start of 2022, and exacerbated by the war in Ukraine, costs such as utility costs and interest costs have been top of mind for both REIT managers and investors. For one thing, the speed and acceleration in the rise in the Federal Funds Rate from near zero to 5.5% have been unprecedented. Interest rates may have been higher, but they have never risen so fast and so high before.
Chui took the bull by the horns and addressed the issue of costs head-on. In the past, pre-2022, the focus was always about the topline, and DPU (distribution per unit) growth, Chui recalls.
“In the last 12 months, a lot more attention was focused on costs, with inflation resulting in rising interest rates,” he notes.
For a REIT, revenues come from its leases, which for most tenants are fixed for a two- to three-year period. In some cases, master leases and anchors run for a longer period.
For instance, E-LOG signed a couple of leases, including NTS Components Singapore for a 15-year lease with fixed annual rent escalation at 21B Senoko Loop. E-LOG has announced a redevelopment for which it has a non-binding head of agreement signed with a master tenant for 20+5 years with built-in annual rental escalations and negotiations are currently underway.
“The rental reversion depends on your lease expiry profile. If you have market rents rising by 10% to 20% a year, but no leases expiring in that year, you can’t capture that upside,” Chui says. On the other hand, interest costs and expenses “can totally flip us to the other side”, he indicates. This is because they go up almost immediately and affect the REIT’s bottomline — and DPU.
“The first example of that which made everybody sit up was utility costs back in late 2021 and early 2022. Because of the Ukraine-Russia war, energy costs spiked up,” Chui says. This caused REIT managers of all the S-REITs with local properties — retail, industrial, office and data centres — to warn unitholders that costs were rising. At the same time, the interest rate hike cycle took off.
Since the first few months of 2022, REIT managers started to pass higher utility costs on to their tenants. Master leases are usually on a triple-net basis, where the tenant bears the costs of property expenses.
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Keeping gearing low
The US Federal Reserve has said that the pace of rate hikes from now on would be data-dependent. “The biggest elephant in the room is actually rising interest costs. In the past 18 months, the Fed has raised rates 11 times from a low of 0.1% to 5.5%,” Chui notes.
Rising and high interest rates affect REITs in three main ways, Chui elaborates. The most visible for investors is DPU, which would fall if rental growth is slower than the pace of interest cost increase.
Higher rates also affect net asset value because of its impact on valuation. The third factor is aggregate leverage. If valuations fall, aggregate leverage rises, Chui reasons.
To sidestep valuation decline and lower gearing, E-LOG raised $630 million this year through an equity fund raising, and sale of older properties with low land leases. Of the $630 million, $290 million is earmarked for a redevelopment.
“The amount is for a redevelopment of an existing asset into a cold storage facility,” Chui says. The rest of the capital raised will be used to settle debt maturities, taking E-LOG’s gearing to around 32%–33%.
Guha, in his presentation, explained why REITs — as a financial instrument — are affected by higher interest rates. REITs finance property portfolios partially through debt, including bonds and other capital instruments, he indicates.
“If interest rates rise, naturally their cost rises,” he says. “If everything else is constant, the net income you get from your properties is affected,” Guha continues. “The other side of things is discounting. If you discount the cash flow from the properties with a higher discount rate, that affects valuation,” he adds.
Under discounted cash flow (DCF) valuations, cash flows based on current and future rents are used, and discounted to a net present value. Discount rates are related to policy interest rates, and if rates rise, discount rates usually rise in tandem.
“The offset from the discount rate is from an increase in rents. Therefore, [speaking] to growth and how you enhance the yield of the property [matters],” Guha says.
Outlook for REITs’ unit prices
In his research, Guha shows that the growth rate for REITs is not as high as other sectors. Moreover, as rates rise, that impacts the bond proxies. REITs are a hybrid, a yield instrument that sits somewhere between bonds and equities. Bonds fall when rates rise.
“There is an opportunity cost for REITs. When their yields are at 5% [to 7%], instead of taking on the [risk] of [unit price], you could have just put the monies in fixed deposits or US corporate bonds.”
Guha says that inflation is likely to persist, so rates may not fall any time soon. “If the commentary on Jackson Hole is anything to go by, the prevailing thinking is that inflation is going to be sticky,” he adds.
The yield spread between S-REIT yields and the yields on 10-year Singapore Government Securities — which is the risk-free rate — is at the low end of a 13-year range at 323 basis points, Guha indicates.
Generally, yield spreads tend to expand when interest rates rise because S-REITs are a lot riskier than risk-free rates, and thus have to compensate for this risk by offering higher yields.
Guha says there may be a couple of reasons why the yield spread is tight. “In Singapore, supply is tightly controlled, and the second reason is the market backdrop. Not all people who invest in equity can invest in the bond market,” he observes.
The majority of bonds in Singapore is for accredited investors, and the bond market is relatively illiquid compared to equities. “It is really sector illiquidity which is driving this kind of difference in the yield spread.”
On the other hand, S-REITs with US assets are trading at a much higher yield spread than S-REITs with a preponderance of Singapore assets.
The problem with US office
Because of the many questions on MUST, Wong addressed the differences between the Singapore and US office markets. MUST’s aggregate leverage is above the regulatory ceiling because of a significant decline in its US office portfolio.
“In Singapore, valuations are still stable. The main reason is because return-to-office in Singapore has been quite encouraging. We estimate it to be around 78%. The other advantage is Singapore’s small size, and the ease at which office workers commute to work,” Wong says.
“It’s easier to get people back to the office and that has kept occupancies high. Singapore office vacancy rates are less than 5%.” Wong adds that Singapore is the gateway to a fast-growing region.
The US is geographically large. During the pandemic, the population may have moved back to areas where costs are lower.
For instance, it is a lot cheaper to eat at home; the commute is longer in the US, and with higher energy costs, transport is more expensive post-pandemic. With actual vacancy at around 40% to 50%, and tenants downsizing, valuations are affected.
In addition, in Singapore, tenants usually pay for their own fit-outs and renovations. In the US, landlords finance tenant incentives (TI) and capex. When rates were low, there was no issue. But with the cost of debt at 5.5% or more in the US, the cost of keeping a building up to date is increasingly challenging.
Guha is looking beyond the current low occupancy rates of US offices. The new data points to no new major supply. “That’s not rocket science. If the banks don’t finance, there are no new buildings. In some cases, the conversion of those officers [to other uses] has also started to take some supply off,” he adds.
The Fed indicated that the bank loans supporting office assets are a very small slice of their loan book. These loans could be a part of a Troubled Asset Relief Programme type of structure if needed. “There is some light at the end of the tunnel,” Guha says.
Sponsor support crucial
The entire US office S-REITs issue in Singapore has shown that sponsors are needed to support their REITs. No single entity is able to hold more than 9.8% of S-REITs with US office assets and this limits sponsor support. This, coupled with the issues faced by US office properties on occupancies and valuation, has caused S-REITs with US office assets to trade at distressed levels.
S-REITs with mainly Singapore assets continue to trade at respectable yields. Chui puts this down partly to sponsor support.
“Sponsors of REITs play an important role. They support the REITs with a quality asset pipeline, and financial support in times of growth and during bad times. Thirdly, sponsors support the REITs in managing the assets. If we go overseas, I can lean on our sponsor’s on the ground presence in those markets,” Chui says