Irrational signals from yield spread as REITs stay under pressure
Interest rates affect S-REITs in three main ways. Firstly, the yield spread impacts pricing. As a hybrid between a yield instrument and equity, the immediate sensitivity of S-REITs to risk-free rates is through the yield spread between the S-REITs’ historic yields and the yield on 10-year Singapore Government Securities (see Chart 1). Secondly, interest rates affect interest cost, the highest expense item for S-REITs. Given that most S-REITs have announced aggregate leverage levels of more than 30%, with heavyweight REITs such as CapitaLand Integrated Commercial Trust’s aggregate leverage rising above 40%, interest costs going into 2024 are unlikely to fall.
Thirdly, the impact is on valuations as risk-free rates and policy rates have an indirect impact on discount rates which are used to assess assets of REITs in a discounted cash flow model. The higher the discount rate, the lower the capital value, unless these higher discount rates are offset by higher cash flow levels and rents. This has happened for hospitality and lodging assets. The rents of office REITs have been resilient and that too has kept valuations stable in Singapore.
The fourth impact is indirect. Interest rates affect the economy and if “higher for longer” causes an economic slowdown, that will affect the outlook for rents, demand for space and retail spending, among others.
In terms of yield spreads, in the past 10 years, S-REITs traded at a mean spread of around 3.1% as shown in Chart 1. In times of stress — the most recent of which was in 2020 during the global Covid lockdowns — the yield spread surged to 5.2%. The rationale for monitoring yield spread is that as riskfree rates rise, the yield of REITs expands such that the yield spread remains more or less stable. Hence, during rising interest rate cycles, the equity prices of S-REITs tend to fall to compensate for their DPU yield expansion. As at Oct 31, the yield spread stood at just 2.6%.
If the yield spread expands to 3.1% or higher, which is the mean, REIT price levels may have further to fall.
“The previous behaviour of S-REITs and their yield spread is based on a more benign rate environment. The market is trying to understand if the current level of risk-free rates is permanent, or whether the Fed will cut rates eventually. It’s a question of the market viewing the current phase as transitory. The rapid increase in rates during the last two years has no precedence, and that may make the yield spread comparison less than ideal,” an analyst explains. “If the Fed pivots or even clearly signals a pause, risk-free rates will taper off immediately,” he adds.
The Federal Reserve’s decision not to raise rates on Nov 1 during its latest Federal Open Market Committee, may not provide the S-REITs with the reprieve it needs as yield spreads move to their mean.
Market watchers may recall that, over the years, REITs were encouraged to expand overseas for growth because of Singapore’s
limited size. This year, expansion and growth are anathema to investors. As a case in point, CapitaLand Ascott Trust’s (CLAS) $530.8 million acquisition in London, Dublin and Jakarta, coupled with equity fundraising (EFR), caused its security price to tumble from $1.12 to a low of 84 cents before rebounding. CLAS remains below the EFR price of around $1.02.
Elsewhere, Keppel DC REIT took a tumble because investors were not excited about its acquisition strategy and the master lessee of its Guangzhou data centres. On the other hand, Suntec REIT, Mapletree Logistics Trust and Mapletree Industrial Trust have been relatively stable following their results as their managers have articulated asset sales as part of the strategy to rejuvenate their portfolios, or in the case of Suntec REIT, to reduce debt.
Our big REIT table below shows a divergence between the performance of REITs with a preponderance of Singapore assets and those with foreign assets. The table shows that REITs with 100% of overseas assets performed more poorly than REITs which had some local assets. In particular, DPU yields of REITs with US assets are trading at distressed levels, with Prime US REIT at 52% and Keppel Pacific Oak US REIT at 27%.
“The market is implying, and certainly there is a likelihood, with rates moving so fast they may breach 50% gearing,” the analyst says of the two US office REITs.
On a positive note, analysts were pleased to note that ESRLOGOS REIT (E-LOG) is making use of its share buyback programme. E-LOG bought 3 million units on Oct 27 and a further 1 million units on Oct 30. The REIT is authorised to buy back 719.9 million units in a year and has 7.68 billion units in issue.
E-LOG is the third S-REIT which has bought back its units, the others being Keppel REIT and Digital Core REIT.
As analysts, investors and market watchers see it, buying back units when they are trading at discounts to NAV is accretive. This means at least some REITs are doing something that investors like.