Investment summary
Higher inflationary pressures have raised concerns on the impact of margins on the S-REITs sector. We believe mitigating factors include i) S-REITs engaging in bulk purchase of electricity, especially for those REITs which have larger sponsors, ii) passthrough of higher utility costs to tenants in the form of higher service charges, iii) tighter cost controls and use of automation and technology to reduce manpower costs such as security contracts, iv) lease structures which have annual rental escalations, direct CPI-linked indexation and/or periodic market rent reviews which would help to buffer the increase in cost inflation. From 2005 to 2021, there was a meaningful positive correlation between the YoY change in the Singapore CPI and corresponding YoY changes in both the Singapore property price and rental indices. Our findings show that the residential and industrial sub-sectors have the highest correlation between CPI changes and growth in their respective capital values and rents, while the retail sub-sector has the lowest correlation.
Given persistent inflationary pressures, interest rates are poised to increase further as major central banks are likely to raise their benchmark rates this year. Although this could result in higher borrowing costs ahead, we believe the S-REITs under our coverage have continued to be prudent on their capital management. The average gearing ratio stood at 37.4%, as at 31 Dec 2021, while 74.4% of their borrowings are fixed/hedged, which would mitigate the expected increase in borrowing costs ahead.
During the major rate hike cycles from 2004 to 2006 and 2015 to 2018, we note that the S-REITs sector delivered positive share price return from the start of the first hike to the start of the first rate cut, although there was volatility seen, especially in 2018. The FTSE Straits Times REIT Index is trading at a forward yield spread of 389 bps (as at 28 Feb 2022). This is 0.4 standard deviations below the 10-year average of 411 bps, but in-line with the 5-year mean (389 bps). Current yield spread is higher as compared to the start of 2020 (pre-pandemic), and also the period from the start of 2018 to mid-Oct 2018. We continue to recommend a barbell strategy in terms of sector positioning, focusing on the higher quality large cap names with strong sponsor support amid an uncertain macroeconomic and geopolitical environment. Our preferred picks for our basket of reopening/recovery plays comprise Ascott Residence Trust (ART) [BUY; FV: SGD1.22] and CapitaLand Integrated Commercial Trust (CICT SP) [BUY; FV: SGD2.44]. On the other hand, S-REITs we like with exposure to new economy assets which we believe are more resilient and defensive over the longer run are Ascendas REIT (AREIT SP) [BUY; FV: SGD3.63], Frasers Logistics & Commercial Trust (FLT SP) [FV: SGD1.66] and Mapletree Industrial Trust (MINT SP) [FV: SGD3.30].
• Real estate offers some form of inflation hedge; prudent capital management to mitigate interest
rate increases
• S-REITs sector delivered positive returns during last two rate hike cycles in 2004-2006 and 2015-2018,
though volatility was seen
• Preferred picks: ART SP, CICT SP, AREIT SP, FLT SP and MINT SP