The advantage of the external manager model

REITs are able to escape higher labour costs because of the external manager model, but are impacted by higher interest rates

For most corporates, labour is a large cost - in some cases the largest cost. This is the big advantage of the S-REIT’s external manager model. REITs are passive vehicles holding property to pass through rental income after utility and interest expenses.

If a REIT manager needs more property management fees or manager’s management fees, it has to ask for unitholder permission in an EGM which in turn requires an opinion by the indepdent financial adviser. The proxy advisors may also chip in at some point.

The Edge Singapore has written extensively on fees and the external manager model and S-REITs sidestepping higher labour costs looks like a plus during inflationary phases.

Whatever the case, S-REITs can’t run away from higher costs comprising interest expense and utility costs. During results following 1Q2022, some REIT managers indicated that electricity costs could rise by two or three times. At any rate, electricity costs are lower than interest cost, which is often the highest cost for a REIT. Hence there is an outsize focus on interest expense. The attention on interest expense has also brought into sharp focus the overall capital management strategy of a REIT - such as floating rates versus fixed rates, and debt expiry timetable.

REIT selldown

On July 5, the S-REITs were sold down, in particular CapitaLand Integrated Commercial Trust. In 1H2022, CICT was one of the top five performers, after the hospitality trusts which rallied following the privatisation offer for Frasers Hospitality Trust, so some profit taking was inevitable.

Interestingly, in 1H2022, according to Bloomberg data, the FTSE REIT Index (-5.02%) and iEdge REIT Index (-6.05%) have underperformed the Straits Times Index (+0.69%). However the S-REITs have outperformed the Hang Seng Index (-6.57%) and the S&P 500 Inndex (-20%).

“Singapore REITs have significantly outperformed the broader Singapore market YTD, which we attribute to market optimism around recovery plays. However, we think that ignores dividend and valuation impact from rising interest rates and higher inflation. We turn more bearish on the sector,” says Morgan Stanley in a recent update.

Morgan Stanley blames the impact of rising interest rates, higher leverage, lower acquisition led growth and higher electricity prices.

“As real estate landlords, REITs are typically viewed as good buffers against inflation, with the ability to raise rents to offset costs increase. However, REIT Managers are experiencing near-term difficulties in passing on rapidly rising electricity costs to their tenants, and we see this eroding near-term dividend growth,” Morgan Stanley adds.

Interest rate impact

On June 30, analysts at Fundsupermart delved deeper into the impact of interest rates on capitalisation rates and the yield spread.

“Higher interest rates also tend to decrease the value of properties held by REITs, which are measured based on techniques including the discounted cash flow method and the capitalisation method,” says the June 30 report. “The capitalisation method is essentially dependent on the capitalisation rate, which corresponds to an investor’s required rate of return less the expected growth of the property. Rising interest rates would push the required rate of return up, hence increasing the cap rate.”

The Edge Singapore has written about the impact of rising risk free rates such as the yield on 10 year SGS on the yield spread and REITs’ unit prices.

Despite these underminings, there are some silver linings. The May 2022 retail sales figure was a blowout - up some 22% excluding vehicles. “Year-to-date, retail sales grew by 9.6%. Barring the re-emergence of fresh Covid-related risks in Singapore and around the region (leading to re-imposition of social and travel restrictions, which is not our base case), we now expect retail sales to expand by 9.0% in 2022 (from previous forecast of 6%) as base effects are likely to continue to uplift retail sales growth prints in the coming months,” says UOB Economic Research.

DBS Group Research is particularly upbeat about the hospitality sector as China has announced a gradual relaxation of border controls. “Asia is the single largest revenue contributor to our hotel S-REITs, at around 42% to 100% of revenue exposure, which are set to benefit from China’s news on outbound travel relaxation,” DBS says.

In the meantime, investors should keep a hawk’s eye on the US Federal Reserve for any hint of the interest rate cycle peaking, because that would be the trigger for a REIT rally.

 

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