In his recent memo, legendary investor Howard Marks noted that today’s macro-environment could be the third “Sea Change” that he has witnessed over his 53-year-long career. He is referring to a transformational, long-term reversion from a highly stimulated, positive and "easy" money environment to the tightening, high-interest rate environment we experience today [Source]. 

REITs, which are typically relatively leveraged, are one of the obvious casualties of this “Sea Change”. So, what does this mean for S-REITs, the crown jewel of the Singapore stock market?  

1. Why are REITs so loved in Singapore? 

Firstly, S-REITs distribute dividends regularly on a quarterly or semi-annual basis. Why? They must distribute at least 90% of their taxable income to enjoy tax exemptions from IRAS. This tax concession also leads to higher yields. 

Secondly, a low capital outlay is required to gain access to a professionally managed, diversified portfolio of quality real assets with high liquidity compared to purchasing a single property. 

Thirdly, S-REITs are essentially a collection of real estate-based assets yielding rental income. Do I have to remind you that Singaporeans have a longstanding love affair with real estate? A funny story my 82-year-old grandmother once told me. If a stock drops to zero, you get nothing back. If a property drops to zero, at least you have a piece of tangible land. Not a fully accurate statement, but you get the point. 

However, given that we can now yield risk free interest rates via fixed deposit or T-Bills at roughly 4%, it raises the following questions:

1. Is the risk-reward of owning S-REITs now still compelling? 
2. If so, are there bright spots that are being underappreciated by the market? 

2. The elephant in the room: Interest rate hikes ‍

2.1. Current interest rate environment

As seen in the chart above, interest rate seems to be going down, especially with US inflation on a consistent decline. However, experts like Howard Marks have been opining that we are highly unlikely to revert to the prior 4-decade run of low-interest rates that propelled much risk-taking.

2.2. How does interest rate hike impact S-REITs? 

There are 2 key implications for S-REITs: 

1. Like how you would finance your own home, REITs typically take on a relatively large debt. Higher interest rates thus translate to higher interest expenses and hence lower bottom-line figures. In particular, we are looking at a lower amount available for distribution and hence, a lower Distribution per Unit (DPU).  
2. REITs typically grow inorganically through capital recycling and Mergers & Acquisitions (M&A). With sky-high interest rates, this may make potential M&A transactions extremely expensive and thus difficult to close. This might hence stifle the REIT’s ability to grow. 

2.3. Can S-REITs adapt to this new economic landscape?

S-REITs that can adapt will have the following attributes: 

One: Ability to weather interest rate hikes (i.e., lower sensitivity to increase in interest rates) 

1. Lower gearing/leverage ratios (i.e., less debt in their balance sheet) 
2. Higher interest coverage ratio (i.e., earning comfortably enough to pay off interest expense) 

Two: Relatively lower cost of debt 

1. Higher proportion of fixed debt vs floating debt 
2. Longer duration fixed debt, to delay refinancing at a higher interest rate  
3. Better financial health and is thus able to demand lower financing cost 

In the above table, I have noted down the debt profile of 13 notable S-REITs (out of 42) that are more popular in the investing community (i.e., more analyst coverage, larger and with more prestigious sponsors). S-REITs with more greens are in more favourable positions and can adapt better in the high interest rate environment than S-REITs with more reds. 

With this in mind, we can broadly classify my S-REITs list above into 3 buckets: 

In particular, Frasers Logistics & Commercial Trust has a relatively low leverage ratio of 27.4% coupled with a high interest coverage ratio and low cost of debt. A 150bps increase in cost of debt (i.e., 1.6% to 3.1% will only result in a -3% in DPU. Even with a further 150bps increase, which is close to the consensus Fed terminal rate of 5%, we will likely only see a c.6% drop in DPU.

Key Takeaway: Investors should be selective when investing in S-REITs. There are some S-REITs with evidence of high financial prudence and are likely to be able to service their debts easily even with worsening credit situations. Perhaps, these are the bright spots that are currently being unfairly washed away by the wave of pessimism towards REITs.

3. Compelling enough valuation? 

Broadly, REITs can be valued through (1) distribution yield-based approach or (2) underlying asset value/NAV approach.

3.1.  Distribution yield-based approach 

Investors typically compare distribution yield (forward and historical) with (i) a peer group and (ii) the yield spread over risk-free rate (i.e. fixed deposit/T-Bill). The yield spread will reflect the risk premium that the market is willing to give investors to take on the additional risks associated (e.g. safety and growth potential) with a REIT. Obviously, the higher the yield spread, the better. However, a low yield spread might not necessarily be a bad thing. It could also mean that there is high growth expectation priced in by the market that could be realized. 

Note: If I were analysing a single, specific REIT, I would also conduct a dividend discount model. It is similar to a discounted cashflow model, forecasting operational metrics to arrive at a bottom-line distribution figure, which is then discounted by the cost of equity to arrive at the stock price. Thereafter, calculate yield by dividing forecasted forward distribution per unit by the derived stock price.

Note: S-REITs like CapitaLand India Trust and CapitaLand China Trust may appear to have high yield spread. However, a fairer comparison would be to use India and China risk-free rates to derive the yield spread rather than a Singapore risk-free rate. 

Key Takeaway: Personally, I will only focus my research on S-REITs with at least 2% yield spread. However, it is ultimately up to you to decide the appropriate yield spread at which you are comfortable with the risk-reward of owning a specific REIT. This is done by holistically evaluating the REIT’s (i) historical performance (ii) growth potential (iii) safety in terms of leverage (iv) sponsor strength and reputation and (v) size and liquidity.

3.2. Underlying asset value/NAV approach 

The NAV is the value of all the assets of a REIT minus the liabilities. This approach follows the logic that the valuation of a REIT should not stray too far away from the value of its underlying assets. 

Fortunately for S-REITs, our central bank require S-REITs to have properties valued at least once per year by a professional valuer. Hence, unlike the US where properties are carried at original cost minus depreciation, NAV numbers reported by S-REITs better reflect market value. Nevertheless, I would caution against using these numbers at face value when doing in-depth research into specific REITs. Many times, appraisals tend to overvalue properties during up cycles and undervalue them during down cycles as if recessions go on forever.

In the table above, I have indicated the P/NAV of the same list of 13 S-REITs as above. In addition, I have input the street consensus target price (many brokers tend to use a 50-50 weight on yield based and NAV based approach) and the implied potential upside from the target price. 

Key Takeaway: S-REITs with more “greens” in the table above) are more likely to be fairly or undervalued. Personally, I would focus on S-REITs with at least P/NAV < 1 and with a consensus target price higher than the price it is currently trading at.

4. Concluding thoughts and going forward

A quick look into debt position and valuations across S-REITs can help us to narrow down the possible underappreciated bright spots.

Our initial screening solely looking at debt position and valuations suggest that we focus on our research into Frasers Logistics & Commercial Trust and Frasers Centrepoint Trust. 

Obviously, there are a host of other factors to consider when conducting in-depth fundamental analysis following the initial screen. 

This includes (not exhaustive): 

1. Quality of assets: Being a price setter in today’s high inflation environment can help the REIT pass on rising cost (e.g. higher utility bills, need to provide rental rebates, etc.) to tenants and thus protect the REIT’s earning power. 
2. Management track record: Is management able to consistently create value via (i) acquiring synergistic assets and (ii) divesting underperforming assets at attractive prices and (iii) making sound commercial decision to enhance earnings (e.g. AEI, etc.) 
3. Strength of sponsor: Reputation and track record of sponsor can provide assurance. 
4. Macro trends on underlying asset: Presence of macro tailwinds to ride on? Demand and supply situation of the type of asset. 
5. Corporate governance: Is the REIT manager behaving responsibly in the long-term interest of unitholders? 

Do let us know if you are interested in a deep dive into a particular S-REIT!

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