SINGAPORE (July 9): Real estate investment trusts as measured by the FTSE ST Real Estate Investment Trust Index have fallen by 6.6% since the start of the year despite a rise in the yield of 10-year Singapore Government Securities — from 2% at the start of the year to around 2.5% currently. A strengthening US dollar is likely to exert upward pressure on the Singapore Interbank Offered Rate (Sibor) and the Swap Offer Rate (SOR) and these will continue to have an indirect effect on the 10-year SGS yield, which some market observers expect to rise towards the 2.8% to 2.9% range.

Unit prices of REITs are based on a yield spread, which is the difference between their historic and forward yields versus the risk-free rate. With risk-free rates rising, some focus has fallen on the outlook for REITs given their interest-rate sensitivities.

“If you look at a 15-year average [yield spread], it is typically 3.7% to 3.8%. Just on the basis of the average spread versus current spread of 3.6% to 3.7%, it’s not a good time to bottom-fish across the sector. On the other hand, REITs are also not going to see a significant selloff given the flattening yield curve,” says Brandon Lee, an analyst at JPMorgan (see Charts 1 and 2). 

In his view, the more interesting relationship is the trend of REIT prices compared with that of the yield curve. “Generally, a flattening yield curve tends to benefit REITs, no matter which countries you look at — the US, Japan, UK, Australia or Singapore. There is a 75% correlation,” Lee says. The yield curve has not flattened yet, but when it does, REITs could outperform the market, just as economic growth slows. Flattening yield curves are a sign of slowing GDP growth. 

JPMorgan’s economists are more hawkish than the consensus for rate hikes. “We’re looking at four hikes this year and four next year,” Lee says. The consensus forecast is for three hikes this year, and economists are expecting some slowdown in growth if the trade war between the US on the one hand, and the EU, China, Canada and others on the other, exacerbates.

Are we moving into a scenario similar to that in 2008 or 2009 when interest rates rose sharply and capital values fell? Lee does not think so. The big difference between now and then is the heightened gearing levels of REITs at the time, of 40%, Lee says. The REITs also issued a lot of commercial mortgage-backed securities that were quite dangerous to balance sheets, he adds.

Ten years on, gearing is averaging between 35% and 36%, and most REITs’ debt instruments are plain vanilla bonds or bank loans. A couple of REITs have issued convertible bonds, and a number have issued perpetual securities. Still, as interest rates rise, this is likely to have a negative impact on distribution per unit unless DPU growth can outpace the impact of the former. (See “Office REITs DPU growth to offset cap rate expansion”)

REIT managers lobby for higher gearing ceiling 

Ironically, just as analysts and investors are concerned about the cost of debt, REIT managers are lobbying the regulator for higher gearing levels. The current regulatory limit is 45% and perpetual securities are treated as equity. Interestingly, rating agencies do not consider all perpetual securities as equity. 

“REITs are constrained by the 45% gearing limit, which is making them increasingly uncompetitive as they grow their portfolios because they have to compete with other capital holders that don’t have this constraint, such as private equity and REITs in other jurisdictions. [The latter] are able to compete on an uneven footing to acquire the same asset,” says Andrew Lim, CFO of CapitaLand, on the sidelines of the REIT Association of Singapore’s inaugural REIT Conference on July 3. Lim is the current president of Reitas. “This is beyond the fundamentals of the asset, the ­REIT’s mandate and strategy. It’s not even a level playing field.” 

Increasingly, REITs are acquiring assets overseas and REIT managers have articulated that they are increasingly disadvantaged as they come up against private funds that do not have this constraint. According to Jerry Koh, deputy managing partner at Allen & Gledhill and secretary of Reitas, Australian, US and Japanese REITs do not have gearing limits. 

The average gearing for these jurisdictions is 40% to 50%, Koh says. “Because most of the REITs want a buffer, the average leverage is around [35% to 36%] for the S-REITs. We could go up to 50% to give a bit more debt headroom. Leverage would then go up to 40% to 41%. There is still sufficient loan-to-value [buffer] for investors,” he elaborates. 

Koh points out that although mature markets do not stipulate a gearing limit, there is a natural ceiling of 50%. “The market is allowing these REIT managers to balance the risk and return of these [overseas] REITs. They are finding the level themselves.” 

Lim, too, believes that market discipline is the fastest and most efficient way to let REIT managers know where the gearing limit is. “REIT managers, equity investors, banks and ratings agencies all come together and through demand and supply, will send a message out on how much debt is too much,” he says. If you have an accommodative cycle, you can get a bit more aggressive. When the cycle turns, you have to shift with that, Lim continues. The market mechanism works such that weaker REITs fall away — by being acquired or merged — and the stronger ones become stronger, he says. 

Oftentimes, for S-REITs, it is not so much the gearing ratio that determines a REIT’s valuation, but the strength of the sponsor. For instance, the REITs with the lowest yield, and hence the lowest cost of capital, are likely to have developer sponsors such as CapitaLand, Mapletree Investments and Frasers ­Property (see Table 1). 

Koh argues that a higher gearing limit would encourage more REITs to list on the Singapore Exchange. “A good, strong pipeline of IPO aspirants is screaming for higher leverage. A lot of sponsors are from overseas now and we face enormous challenges. Most REITs will IPO with a gearing ratio of 35% and it’s a real strain to get to an attractive yield for investors.”

Moreover, while gearing levels can impact a REIT’s rating, some investors may prefer a more aggressive level of gearing anyway so that yields are higher. This is especially so in the event of an acquisition, market observers say. Equity is more expensive than debt, and if an acquisition is made using debt, it could keep the weighted average cost of capital lower and raise return on equity. The acquisition is more likely to be accretive when debt is used and unitholders would not get diluted.

Stock and property impact from rates  

The interest rate hike cycle has started to translate into a higher cost of debt for REITs. But, Lee of JPMorgan points out that the higher debt cost is very moderate compared with the number of times the US Federal Reserve has raised its fed funds rate. “If you look at the mortgage rates, it’s only [in] the last couple of months [that] the banks have increased them by 30 basis points to 50 basis points.” Borrowing costs for REITs have risen 10bps to 30bps since Dec 31 (see Table 1). Quoted rates by banks for REITs have also been 20bps to 30bps higher, Lee adds.

Rising interest rates affect capital values indirectly. According to research done by some portfolio managers, there is a rough correlation between capitalisation rates and interest rates. A recent report by JPMorgan says a 10bps to 20bps rise in 10-year SGS yields translates into cap rates of 3.8% to 3.9% for office property, compared with a cap rate of 3.6% in 2017. 

However, this expansion — which would lead to a decline in office valuations — can be compensated by rising rents and ample liquidity. “Even if you’re predicting an expansion in office cap rates, the improved rents should more than offset the expansion in cap rates,” Lee says.  

Still, office properties are being transacted at historically low capitalisation rates: ­CapitaLand Commercial Trust announced the sale of Twenty Anson at a capitalisation rate of just 2.7%.

Capital raisings curtail REITs’ upside 

In Lee’s view, one of the reasons REITs have fallen this year is because of a spate of fundraising. In the first half of this year, REITs issued around $2.1 billion in fundraising exercises (see Table 2), 70% of the amount raised in 2017. 

“Demand for this fundraising has been quite strong, but it’s also a reason why Singapore ­REITs have not done as well as their global peers YTD. A number of REITs have been issuing [new units] at a 3% to 5% discount to their adjusted VWAP [volume-weighted ­average price] unit price, with a total of $2.1 billion raised YTD versus $3.1 billion in full-year 2017, and prices have reflected this. Therefore, investors are wondering who is going to raise equity in the second half,” Lee says. 

On June 29, Mapletree Commercial Trust announced it had upsized its multi-currency medium-term note programme from $1 billion to $3 billion. OCBC Credit Research points out that the move could be a prelude to an acquisition, which could include Mapletree Business City Phase II. This property comprises 1.2 million sq ft and has an estimated value of $1.31 billion. 

Mapletree Logistcs Trust is acquiring five modern, ramp-up logistics properties in Singapore for $778.3 million in a sale-and-leaseback deal from CWT International, a subsidiary of HNA Group. HNA’s chairman, Wang Jian fell to his death on July 3 while in France. Funding for the acquisition is likely to be proceeds from equity fundraising, potential divestments and debt, MLT’s manager says.