- Inflation pressures to cut profitability across most real estate classes, warehouses least impacted
- Renewal of utility and maintenance contracts are key pressure points on margins in 2H22
- Sensitivity analysis of a 100% hike in utilities: 10% hike in maintenance implies a 5%-7% drop in distributions
- Growth over yield; add MLT to top picks
Inflation pressures cut into profitability. Persistently high inflation rates due to global supply disruptions coupled with the ongoing geopolitical tensions have driven oil prices above US$100 per barrel. In Singapore, businesses are faced with higher energy costs (utilities, petrol) and labour costs. Landlords are also not spared, as utility and maintenance costs are expected to hike when these contracts are rolled over in 2H22-2023. While some of these cost pressures may be temporary, they add to the challenges that landlords need to manage, amidst the prospect of rising funding costs.
What if utility costs double? We understand that most S-REITs as landlords will have to incur operational costs in maintaining the common areas (i.e., the walking spaces within the malls, lift lobbies for office buildings, common areas in industrial properties) which account for c.5% to 40% of the overall GFA. While some of these costs can be defrayed through service charges, landlords will still have to bear some of the burden going forward. Based on our estimates, utilities and maintenance take up c.2% and c.5% of revenues, respectively, but this may vary, depending on the real estate subsector. Assuming a doubling of utility costs, a 10% hike in maintenance costs, we see a potential c.1% to 4% erosion to net property income (“NPI”) margins, translating to an estimated c.2% to c.7% decline in distributions. In our scenario analysis, we have not accounted for scenarios where selected landlords have running contracts that last beyond FY22.
Who is most shielded and where should investors hide? The warehouse sector (mainly ambient warehouses) is the most shielded from the rise in operational costs, given their efficient footprint, and we see the least downside to earnings. Overall, even with these rising cost pressures, we estimate that the sector can still deliver a growth of 7.4% (vs. 8.0% before), with sector yields still attractive at c.6.0%. Our strategy is to stick with “growth sectors”, given their ability to deliver higher DPUs despite these costs pressures. In addition, we have added MLT to our top eight names.