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Some office and retail S-REITs could rebound, but expect a 'fear of recession' ahead: DBS

Jovi Ho
·6-min read

“Despite reopening plays doing well year-to-date, up 10%, we believe the hospitality and office sectors will continue to shine.”

Higher inflationary pressures and interest rates have been the key bugbears for Singapore REITs (S-REITs) in the first half of the year. DBS Group Research analysts see brighter days ahead as S-REIT managers have taken steps to mitigate these pressures.

“With real estate fundamentals for most sectors remaining firmly in landlords’ favour in 2H2022, we believe these impacts are factored in, with improved clarity in the overall SREITs’ distribution per unit (DPU) growth profile of 6.0% over FY2022-2024,” write DBS Group Research analysts Derek Tan, Rachel Tan, Dale Lai and Geraldine Wong.

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With S-REITs now offering a FY2023 yield spread of 3.5%, DBS believes that stocks offering superior growth will continue to outperform.

In an Aug 25 note, the DBS analysts name Keppel REIT and Capitaland Integrated Commercial Trust as their office picks; while Frasers Centrepoint Trust and Lendlease Global Commercial REIT have been named as the analysts’ retail picks.

They also highlight “selected growth names” in hotels, such as Ascott Residence Trust and CDL Hospitality Trusts; and from the industrial sector, Mapletree Industrial Trust and Frasers Logistics & Commercial Trust.

Numbers have improved in 1H2022

According to DBS, S-REITs’ overall financial metrics have improved in 1HF2022 compared to 4Q2021, with S-REITs maintaining a well staggered debt profile (WADE), limiting expiry to below 20% a year, thus reducing concentration risks.

“Most S-REITs have already refinanced their loans that will be expiring in FY2022. For REITs with debt remaining to be refinanced this year, their debt mainly consists of loans that will only expire at the end of FY2022, and for which they have mostly received in-principle agreements with their lenders for refinancing,” writes DBS.

Only seven S-REITs have more than 30% of loans due to expire in FY2022 and FY2023. “Over the next two years, S-REITs have an average of some 23% of their loans due for refinancing.”

The seven REITS could be subject to a more significant increase in their financing costs, due to the current rising interest rate environment, says DBS. Among them, the China focused S-REITs, such as Sasseur REIT and EC World REIT, have 100% of their debt expiring by mid-2023, but DBS understands “plans are underway’ to refinance these ahead of expiry.

DBS thinks S-REITs’ gearing remains healthy. “As compared to December 2021, the average gearing of S-REITs only inched up 50 basis points (bps) to some 37.9% in June 2022. Retail and industrial REITs had the overall lowest gearing of 35.0% and 36.2% respectively, while the office and US office REITs had the highest gearing of 39.7%.”

Previously, the hospitality sector reported gearing of above 40%, as there were write-offs in its portfolio when the Covid-19 pandemic struck. With borders now gradually reopening and hotel revenue per available room (RevPAR) recovering and exceeding pre-pandemic levels, hospitality REITs have seen their portfolio valuations improve, and the sector’s average gearing stands at 37.3% currently, writes DBS.

Borrowing costs up

S-REITs are keeping overall interest costs in check, up 10 bps to 2.4%, and a high hedge ratio of some 75%, shielding themselves from a substantial part of interest rate impacts.

While DBS economists expect SORA rates to inch higher till end-2023, driving higher refinancing rates, they believe the impact is largely priced in. “In our models, we have assumed that sector average interest rates rise to 3.0% by FY2024, 50 bps higher than current levels), providing ample buffers, in our view.”

In anticipation of higher financing costs in a rising interest rate environment, DBS priced in higher interest rates to earnings projections. “In our estimates, we have assumed that the borrowing costs for S-REITs would average 2.7% by year-end, as compared to the current cost of debt of 2.5%. Our assumed borrowing costs have priced in a 100bps effective cost of debt, which we believe to be comfortable.”

The effects of higher refinancing costs will be felt in the coming years.

Assuming a 100 bps increase on refinanced debt, DBS says S-REITs could potentially see a 20 bps increase in their overall cost of borrowings. “This implies a potential downside of 2.2% to FY2023 DPU on average. Once again, S-REITs with a higher proportion of debt that will be expiring over the next two years will be more susceptible to higher refinancing costs.”

According to DBS, the likes of Sasseur REIT, OUE Commercial REIT and Ascott Residence Trust could potentially see a 5% downside risk to FY2023 DPU with a 100 bps increase on loans that will be refinanced.

Margin pressure cooling off

The high energy prices and cost pressures have resulted in higher utility expenses and maintenance expenses for S-REITs.

That said, margin pressure is cooling off, says DBS. “While we saw a dip in operating margins in 1H2022 by 1-4 percentage points (ppt) compared to 4Q2021, we see a gradual rebound in 2H2022. Oil prices have eased off in 3Q2022 and we see any further pressure on margins to be dissipating.”

Throughout 1H2022, S-REIT managers have renewed their utility contracts and are planning to raise service charges in upcoming renewals, which will come in handy to compensate for the cost impact felt by landlords, writes DBS.

Among the sectors, warehouse and industrial S-REITs are least impacted compared to the office, retail and hospitality sectors, says DBS. “But impact is mitigated by the ability to raise rents or room rates.”

Share price rebounds

With risk abating for the sector in 2H2022, DBS remains confident that the S-REITs are able to deliver a 6.0% CAGR in DPU over FY2022-2023, led by the hospitality and commercial (office and retail) sectors, mainly due to stronger organic growth prospects.

Based on DBS’s estimates, S-REITs are trading at an FY2022 and FY2023 yield of 6.0% and 6.3% respectively. From a forward perspective, with 10-year yields at 2.7%, forward FY2023 yield spreads could expand to 3.7%, above the S-REITs’ historical mean, says DBS.

While the S-REITs are not spared in the rising interest rate environment, they can still outperform in instances when the yield curve flattens, such as if a fear of recession sets in. DBS thinks this could happen in 2H2022-2023. “As such, despite the reopening plays having already done well year-to-date, up 10%, we believe that the hospitality and office sectors will continue to shine on the back of improving fundamentals.

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