Why Singapore REITs might be worth a look

TL;DR

• For investors looking for dividend income, Singapore REITs (S-REITs) might be worth a look after their recent sell-off on interest rate concerns.
• REITs dividend distributions might be buffered from high proportion of borrowing locked in at fixed rates.
• An improving economic outlook also allow REITs in the retail, hospitality and office markets to earn higher rental incomes.
• Historically, REITs were able to generate positive returns even in a rising interest rate environment. This is especially when the S-REIT dividend yield is higher than the dividend yield of government bonds and the Singapore market.
• When deciding which REIT to own, investors can screen for 1) positive fundamentals driving improving rent prospects 2) lowest gearing and higher proportion of debt fixed 3) attractive dividend yield.

What happened?

Holders of Singapore REITs seeking to earn some dividend income are naturally concerned about their performance during periods of rising interest rates. This is especially with the US Fed expected to start hiking rates in the upcoming March meeting.

Indeed, the S-REITs have underperformed the broader market with the FTSE ST REIT index down by close to 3% in January 2022. While they have performed slightly better than US-REITs and the broader US market, the returns are in stark contrast to the Singapore index which was up 4% in January.

What does this mean?

To evaluate if the selldown in Singapore REITs is justified, we look at a few areas in which the higher interest rates could potentially affect them, including:

1) How borrowing costs could increase

2) How dividends could be reduced

3) How valuation could be impacted

1) How borrowing costs could increase

REITs rely on borrowing to finance the purchase of assets that are managed by them. For example, when Lendlease REIT recently bought its remaining stake in Jem for S$2.08bn, close to half of the cost of purchase would be financed from borrowing.

An increase in interest rates could lead to higher borrowing costs for the REITs, leading to potentially lower dividend payouts to investors. This has been one of the key reasons REITs have fallen in value amid rising interest rate expectations.

The mitigating factors that could help to cushion the interest rate increases include:

a) Most of existing borrowing are based on fixed interest rates: Singapore REITs have secured close to 70% of their borrowing in fixed rates. This helps to further cushion the interest rate increases, as they will not have to pay higher interest for most of existing borrowing until they expire.

b) REITs may have existing borrowing they can tap: For example, the weighted average debt expiry profile of Singapore REITs is more than three years. This means that any increase in interest rates today will take more than three years to have a full impact on distributions.

From the two factors mentioned above, it is estimated that a 100 bps increase in interest rates will likely only cut dividend distributions in 2022 by 3-4%. Based on the expected dividend yield of the FTSE STI REIT index of 6%, this means that even if the interest rate increases do come through and lead to lower dividend payout, investors might still be able to get a dividend yield of close to 5.8%.

2) Higher rental income can help to offset cost increases

While the higher interest payments might be negative for dividend payouts, REITs can try to offset the impact by generating higher rental income from their property assets. Here, an improving economic outlook is positive on the ability of REITs to earn a higher rental income.

– Retail: If you have been to a retail mall recently, you would have noticed the crowds even as the Omicron variant has led to higher number of Covid-19 cases in Singapore. As a whole, retail sales rose by 6.7% YoY in December 2021, and are expected to rise further this year as Singapore moves towards treating Covid-19 as endemic. This could help to improve occupancy of retail malls and allow landlords to raise their rents.

– Commercial: Likewise, as work-from-home is no longer the default, we have seen more people going back into offices. This could lead to better rental prospects for landlords of office buildings.

– Hospitality: Have you taken your first overseas vacation in years with the growing number of Vaccinated Travel Lane (VTL) flights available? It does appear that travel is making a comeback, and this would be positive for the occupancy and room-rates for hotel owners.

3) Dividend yield compared to government bond yield

Four rate hikes? Five rate hikes? Or seven rate hikes? Much of the focus amongst investors in recent months has been on the pace of the Fed interest rate increase, especially with soaring inflation.

Higher yields on the government bonds could be seen as a negative for how Singapore REITs may be valued. This is because they might not be seen as offering as attractive a dividend yield relative to safer assets such as government bonds.  

For example, the expected dividend yield for the Singapore S-REIT index is now at about 6.0%. On the other hand, the 10-year yield of the Singapore government bond is at about 2.0%. This means that someone holding on to a basket of Singapore REITs would earn a higher yield of about 400bps compared to someone holding on to a safe asset like the Singapore government bond.

This is quite similar to the average premium someone would expect to earn from holding the Singapore-REITs compared to the Singapore government bond over the past 10 years.

What could cause this change? The 10-year bond yield would have to go up higher compared to where it is currently. With the market already expecting five rate hikes by the Fed in 2022, the pace of interest rate increases has to be much faster for investors to decide that it might no longer be attractive to be holding on to the REITs.

Singapore REITs also offer a higher dividend yield compared to the Singapore market index measured by the STI. The dividend yield of the FTSE ST REIT index is now at 4.5%, higher than the STI index dividend yield of 3.1%.

What would Beansprout do?

1) What happened in previous episodes of Fed rate hikes

To understand if Singapore REITs can withstand higher interest rates, we look at past episodes of interest rate increases by the US Fed to see how they performed back then.

Looking back at the rate hike cycle in 2004, the FTSE REIT Index was able to generate a total return of 25.8% between the first hike in June 2004 to the last hike in 2006.

In the 2015-18 rate hike cycle, the FTSE REIT index was able to generate a total return of 11.9% between the first hike in December 2015 and the second hike in December 2016.

This would suggest that Singapore REITs can still generate a positive return in a rising interest rate environment.

2) Picking the right REIT

As we discussed earlier, the REITs that could do better in a rising interest rate environment are the ones where:

a) Borrowing costs might be least impacted,

b) Are able to improve on rental income,

c) Valuation already factor in higher interest rates.

Hence, the REITs that might be best positioned could be the ones with:

a) Lowest gearing and higher proportion of debt fixed

b) Have positive fundamentals to be able to drive higher rental reversions

c) Have an attractive dividend yield spread relative to the government bond yields

For investors interested to find out more the Singapore REITs, do check out our article on Singapore ETFs. For investors who are looking for individual REITs to own, the above pointers might be a good starting point to help you decide!