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Valuation enigma for properties, REITs and banks

Goola Warden
Goola Warden • 10 min read
Valuation enigma for properties, REITs and banks
Despite peak, higher rates are likely to pressure valuations, gearing and ICR for REITs as banks escape worst write downs
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The decline in investment property valuations of local developers and S-REITs is unlikely to impact banks’ balance sheets to date, analysts have indicated. However, the net profit and NAVs of the developers and S-REITs are likely to be impacted.

On Oct 12, 2023, Frasers Property TQ5 -

(FPL) announced that it expected fair value losses on a portion of its portfolio of investment properties, primarily its commercial properties in the UK and industrial and logistics properties in Europe. The caveat was that the fair value losses were non-cash in nature and arose mainly due to higher capitalisation rates.

As it turns out, FPL’s attributable profit fell by 81% in its FY2023 to $173.1 million, for the 12 months to Sept 30. The fair value change and gain on disposal of investment properties was a negative $446.17 million in FY2023, with a negative $441.75 million recorded in FPL’s 2HFY2023. The valuation decline also led to a decline in NAV to $2.52 as at Sept 30, 2023, compared to $2.64 a year ago.

Since then, CapitaLand Investment (CLI) and City Developments (CDL) have announced similar impacts on their earnings. On Dec 8, 2023, CLI said that it expects “to report a significant decrease in total patmi for FY2023 as compared to the previous financial year”. In FY2022, CLI’s patmi was $861 million. Whether CLI suffers an 80% decline in patmi remains to be seen. CLI has stressed that its operating profit remains stable.

Due the rate cycle, divestments and forming new funds to raise AUM has been somewhat challenging. In his New Year message, Lee Chee Koon, group CEO of CLI, says: “This is my sixth New Year message as CEO of CapitaLand/CapitaLand Investment, and I have found that this year’s message has been by far the most challenging I have had to write. CLI announced a profit warning to caution investors that there will be asset valuation losses for FY2023 across various markets that we are operating in. Even though these losses may be non-cash in nature, they will still impact CLI’s full-year results. This is despite the fact that our underlying operating performance continues to be resilient and our business units continue to position strongly for the future. Our operating profit also remains strong, driven by our fee income.”

Analysts have suggested that CDL’s patmi could follow a similar trajectory to FPL’s. In FY2022, CDL announced big gains from the sale of Millennium Hilton Seoul and the restructuring of its ownership in CDL Hospitality Trusts J85 -

. Hence, CDL may have more room to manoeuvre.

See also: Paragon REIT to divest The Rail Mall for $78.5 mil

Officially, analysts have been a lot less negative for CLI and CDL. The Bloomberg consensus is for a net profit of $798 million for CLI in FY2023, a modest decline from FY2022’s $861 million. Analysts are forecasting a net profit of $328.5 million for CDL, given the absence of the FY2022 gains.

The problem with valuations

A report dated Jan 5 by OCBC Credit Research highlights the issues with valuations in a high interest rate environment. Some of the problems associated with rising interest rates — which arguably have ended — were crystallised by Manulife US REIT (MUST).

See also: Sabana Industrial REIT prices $100 mil 4.15% sustainability-linked bonds due 2029

Back in 2022, MUST’s manager had expressed it was exploring funding and strategic options. That included reports of a divestment strategy. By end-2022, MUST’s portfolio experienced declines. Between end-2021 when the portfolio was valued at US$2.184 billion as an investment portfolio, and US$1.41 billion ($1.88 billion) at end-2023, including the sale of one property for US$33.5 million in April last year, the portfolio has fallen by 33.8%. This could be partly due to properties in the portfolio being held for sale as expressed by MUST’s manager during 2023.

“In deriving a valuation, we think valuers will consider that S-REITs primarily hold their property assets for generating income rather than for property trading and additionally there have been limited investment sales transactions. As such, we think valuers have held off from fully marking down the value of properties owned by S-REITs to levels which we think buyers are demanding in the current environment,” states OCBC Credit Research in its Jan 5 report.

Interestingly, despite the sharp erosion of property values in MUST’s portfolio, the valuations of Keppel Pacific Oak US REIT and Prime US REIT OXMU -

have not moved by the same magnitude.

“We think valuations, even those conducted by independent valuers, may be less reliable in accurately reflecting the current pricing an owner is likely to obtain in the investment sales market, when compared to the recent past,” the Jan 5 report adds.

“While this may be less of an issue for S-REITs where the properties are mainly for cash flow generation, it could pose challenges for S-REITs facing credit stress and needing to monetise their properties,” OCBC Credit Research says.

Uncertainty over property valuation also complicates an external financing process. In the case of equity capital providers, the equity valuation of an S-REIT is highly correlated to value of the underlying properties while debt capital providers may be concerned over collateral value, the OCBC report explains.

Interest rates and valuations

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Although interest rates may have reached a plateau, the markdown in valuations is a result of the interest rate cycle and still-elevated rates. As a result, valuers and property owners including S-REITs will have to contend with elevated discount rates in their DCFs (discounted cash flow) valuations.

To take a step back, and as explained by OCBC Credit Research, higher interest rates affect asset values in a few ways. They increase cost of funding for buyers, limiting the buyer pool, as experienced by MUST. In 3Q2022, it was reported that an attempt to divest a property did not materialise because interest rates rose swiftly.

Sometimes, property yields are lower than the cost of funding. For example, look no further than the Singapore office sector. The yields on Grade-A Singapore offices are below 4%, at around 3.75%. Three-month Sora is still above 3.7%, excluding the spread that borrowers have to pay.

Traditionally, properties are valued by three main valuation methods. Property sales are used to provide the “comparable” method. Property sales can also be translated into capitalisation rates based on the net property income or net operating income as a percentage of capital value. With higher risk-free rates, discount rates used in DCF valuations would also need to increase to offset the higher risk. DCF valuations use operating cash flow, and rely on assumptions of rents and costs including funding costs.

Separately, OCBC Credit Research points out that asset coverage ratio provides a level of protection available to creditors in the event of credit stress. “In our view, S-REITs financial risk is relatively high as S-REITs structurally lack internal liquidity while debt levels are high relative to earnings with gross debt-to-ebitda ratio of around 9.0x.”

The upshot of all this is that S-REITs and their sponsors are likely to report declines in the valuations where those with properties in the UK, Australia and US are more vulnerable than in Singapore. “We expect some asset corrosion when S-REITs disclose their property valuation as at end-2023, though not the full impact. Given the high uncertainty surrounding asset values, we think a more conservative approach is to also assess an indicative floor price to cater for stressed case scenarios,” OCBC Credit Research says.

S-REITs aggregate leverage to creep up

As property values fall, and because S-REITs have no retained earnings or other offsets in their capital structure, their aggregate leverage is likely to rise.

The Monetary Authority of Singapore (MAS), following feedback from the REIT sector and REITAS (REIT Association of Singapore) during the pandemic and earlier, raised the gearing ceiling in 2020 from 45% to 50%. In 2021, MAS introduced a floor of 2.5x for the interest coverage ratio (ICR) as a determinant for leverage. That is, with ICR at 2.5x or higher, REITs had the flexibility to raise their aggregate leverage above 45%.

These relaxations in aggregate leverage did not really serve S-REITs well. In Europe, the UK and US, the rise in interest rates and the subsequent declines in property valuations caused those S-REITs to either sell properties, or, in the case of Elite Commercial REIT, to raise equity and sell properties.

S-REITs with predominantly Singapore assets may have weathered this rate cycle better and could benefit as rates plateau and ease in 2H2024. Even then, CapitaLand Integrated Commercial Trust C38U -

’s aggregate leverage is above 40%, and given rising cost of debt in 2023 and this year, its ICR would inevitably decline in the absence of rental increases.

“On an overall basis, S-REITs we track on average have a reported aggregate leverage of 37.9% as at end-September 2023. Assuming debt stays constant and asset value falls by 10%, reported aggregate leverage will be pushed upwards to 42% and on a 15% decline, this goes to 45%,” OCBC Credit Research estimates.

As such, a 20% decline in asset value would raise aggregate leverage to 47%, and so on. “In the rare cases so far where the 45% cap had been exceeded, this has typically been a temporary situation, with S-REITs quickly taking action to lower their reported aggregate leverage.”

Impact on banks

According to Bloomberg Intelligence, losses in OCBC’s and UOB’s loans in the commercial real estate (CRE) sector seem manageable, despite high interest rates and growth worries.

“Based on a foundation internal-ratings approach in line with Basel rules, the average probability of default (PD) for OCBC’s and UOB’s income-producing real estate (IPRE) loans have risen only modestly since 2020. This is due to the banks’ tight risk controls and the fact they do not finance riskier, volatile CRE loans,” says Rena Kwok, credit analyst at Bloomberg Intelligence.

“Most of Singapore banks’ CRE exposure is to their home city, where fundamentals are healthy, and well-rated customers with strong sponsors. They have a low average loan-to-value of 40%– 60% for their overall CRE exposure,” she adds.

The analysts at OCBC Credit Research concur and also indicate that most of the lending by Singapore banks is to Singapore properties. Kwok points out that in 2Q2023, the PD of UOB’s and OCBC’s IPRE exposure rose to 2% and 2.08% respectively, with OCBC stating it had a default in its CRE book arising from the US in its 1HFY2023 results briefing. However, its overall CRE book remains good.

In a recent Jan 7 update, JP Morgan says asset quality metrics for Singapore banks look resilient currently. Although most of the local banks’ portfolio is in SGD, SGD rates are linked to US dollar rates because of Singapore’s exchange rate policy. In addition, around 19% to 26% of Singapore banks’ balance sheets are dollar-denominated.

“One risk that is evolving is related to Hong Kong real estate (3%–7% of loans based on disclosures),” JP Morgan says. “Most of the outcome on their non-performing loans [NPL] will depend on growth metrics, as well as the rates environment.”

All in, the low NPL formation coupled with continued net profits accreting to capital generation, local banks are likely to remain dividend plays — with balance sheets that are possibly stronger than the S-REITs’.

Elsewhere, even though Goldman Sachs has downgraded UOB from “buy” to “neutral” and DBS from “neutral” to “sell”, it says credit costs are likely to remain benign. Instead, UOB is downgraded because earnings could “come under pressure when rate cuts start with little room versus peers to raise dividends given tight CET1 ratio compared to management’s comfort level to support share price”. DBS is downgraded more because of rich valuations and its net interest margin sensitivity to potential rate cuts.

The irony for banks is that potentially lower interest rates in the latter part of 2024 would support investment property valuations, but pressure the banks’ own net interest income

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