Source : Business Times - 16 Jul 2008
REAL estate investment trusts (Reits), once an investors’ darling, are feeling the heat of the credit crunch and the expected rise in bond yields.
A number of analysts have downgraded the sector on concern over the funds’ ability to secure future financing, whether through the structured debt or equity markets or through asset sales.
A rise in bond yields, widely expected thanks to rising inflation, will raise the risk free rate which is used to value the securities, pulling the fair value prices lower.
Yields of about 20 Reits have risen to an average of nearly 8 per cent on forecasted 2008 distributions, based on consensus estimates captured by Bloomberg. That offers a spread of about 4.6 percentage points over the 10-year Singapore government bond yield, which currently stands at about 3.379 per cent.
While that sounds very attractive, yields do not tell the full story. A source who declines to be named points to ‘macro’ risks, including that of valuation.
‘There is a risk of slowing demand for office and industrial space, so there is a possibility of (more) downgrades over the next few months. It’s all very fluid and we need to be very conscious of the macro risks.’
He adds: ‘There has been a rapid decline in the amount of (property) transactions in the physical market . . . If the asset price drops, you are dealing with a portfolio whose value is at risk.’
In a July report, Merrill Lynch said that it was cutting its price targets for Reits by about 16 per cent. It also reduced distribution per unit estimates by 5.3 per cent for fiscal year 2009 and 6.4 per cent for FY2010. ‘While valuations are undemanding by historical standards we believe the availability and cost of debt and equity continue to present challenges for the S-Reit sector. We remain cautious on the medium-term outlook for the sector which is highly reliant on capital markets for growth and is sensitive to interest rate movements.’
In Merrill’s analysis, the average debt expiry profiles for the Reits is about 2.6 years, which is half that of developed markets. This suggests earnings would suffer a hit as early as 2009, as expiring debt is rolled over at higher rates. It expects the average cost of debt to rise from 3.6 per cent currently to 4.9 per cent in 2010.
In its valuation assumptions, Merrill has raised its cost of debt and risk free rates by more than 100 basis points to 5.5 and 5.4 per cent, respectively. It has, however, a ‘buy’ rating on a number of Reits, including Macquarie Prime, Capitamall, Capitacommercial Trust and Ascott Residential.
Rating agency Moody’s sounded a warning bell on Reits in May when it gave a negative rating outlook for Reits over the next 12 to 18 months, due to concern over ’short-term refinancing risks’, among other factors. The sector, it said, retains little cash and tends to use a relatively high proportion of short-dated bank facilities instead of committed long-term funds. They often do not have committed facilities in place for capital expenditure or acquisitions, said Moody’s.
This type of funding structure ‘can introduce elements of instability and uncertainty into the capital structure of those S-Reits with a lot of short- term debt, which is unusual for investment grade issuers’.
Moody’s pointed out that in the past, S-Reits did not spend enough time cultivating strong bank relationships as they had easy access to equity and CMBS (collateralised mortgage-backed securities) funding.
Moody’s senior analyst Kathleen Lee and her team wrote that they had talked to banks on their appetite for lending to the S-Reit sector. ‘Our impression from these discussions is that funding remains available, but that the banks have become more selective about borrowers, the maturity of such lending and the price charged.’ In the first quarter, the team reckons that banks raised their pricing by 50 to 100 basis points for short term loans and refinancing.
On a more positive note, a Deutsche Bank July 1 report by strategist Gregory Lui and analyst Elaine Khoo points out that valuations look attractive at a 6.8 per cent forecast 2008 yield and 18 per cent discount to net tangible assets.
The report said that Reits have retreated by about 35 per cent from mid-2007 despite a less volatile business model. At the time of writing the sector was traded at a 321 basis point spread over the nominal 10-year government bond yield, which then stood at 3.9 per cent. On a real yield basis, the spread was even more attractive at more than 11 per cent. Three-quarters of the funds were trading below book NTA, and up to 50 per cent discount.
Inflation, in any case, is expected to feed through to rental costs, say the analysts. ‘Current supply/demand pricing dynamics . . . suggest that the industrial and retail sectors are better positioned to pass on inflation. Industrial rents are only starting to recover from a low base and are still 26 per cent below peak levels, while both the manufacturing and services sectors have continued to expand over the past 10 years.’
Industrial rents trended upwards at a 15-16 per cent annualised rent this year. Retail rents could also benefit from inflation as a larger proportion of leases now include a step-up component, said the report.
Mr Lui and Ms Khoo wrote that borrowing rates are set to rise, based on the swap offer rate which has risen by 30-143 basis points. ‘The Reits by and large have exercised prudent interest rate risk management and have more than 75 per cent of total debt fixed or hedged, which also means that the impact of higher rates will be moderated.’ They added that for most Reits, balance sheets are generally robust with gearing ‘below or at optimal levels’.
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