Capital management is likely to be front and centre of REIT managers’ focus this year. For instance, Digital Core REIT, which was listed in December last year at 88 US cents ($1.22), promptly rose to a high of US$1.20 in the wake of its IPO. However, its unit price is down to 85 US cents as at June 14, below its IPO price. Its capital management was found wanting by investors.
Following the IPO, all Digital Core REIT’s debt was floating, and the manager only announced it had fixed just 50% of its US$550 million of debt, including an undrawn revolving facility of US$250 million, during a business update on April 21. At present, 50% of Digital Core REIT’s debt is still floating at a time when the US Federal Reserve looks set to accelerate the pace of rate hikes.
Yet, most market observers and analysts remain somewhat sanguine about the impact of rising interest rates on S-REITs. Perhaps investors should pay particular attention to JP Morgan’s clarion call for caution, and its recommendation to underweight some of the REITs under its coverage.
It bears repeating that interest rates impact S-REITs in three main ways: rising risk-free rates will impact REITs’ unit prices as distribution yields expand to maintain their yield spread; interest rates will raise financing costs for REITs and pressurise distributions; interest rates indirectly affect capitalisation rates and discount rates which are used to value properties.
“The fastest pace of Fed rate hikes in 28 years makes select S-REITs with higher floating rates and gearing vulnerable to disappointment. We believe FY2023 distributable income will be most impacted for Suntec REIT (–8% for every 100 bps rise in rates), Keppel REIT (–5%), CDL Hospitality Trusts (CDLHT, –4.1%), and Far East Hospitality Trust (FEHT, –4%),” a recent JP Morgan report points out.
JP Morgan warns investors to expect “significant pain ahead” as floating rates “float” upwards by between 80 bps to 200 bps in the remaining quarters of this year compared to 1Q2022. “Higher rates upon refinancing and higher floating rates are the two avenues in which REITs are exposed to interest rate risk,” JP Morgan says.
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REIT managers which have paid attention to capital management and ensure that debt expiries are staggered with ideally 20% of debt due for refinancing annually, and with a high portion of fixed-rate debt, are likely to weather the rising rate environment better than REITs which have a high portion of floating rates.
In general, Suntec REIT, CDLHT, FEHT, Frasers Centrepoint Trust (FCT) and Keppel REIT are the handful of REITs that have 30% to 40% of their debt on floating rates. Interestingly, Keppel REIT and FCT have taken steps in the past six months to arrange for a larger portion of fixed-rate debt.
Suntec REIT was known to be at risk, which is why it often traded at a steeper discount to its net asset value than other office REITs.
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Suntec REIT and Keppel REIT are likely to see an 8.5% and 4.6% decline respectively in distributable income for every 100 bps rise in floating rates, JP Morgan estimates. Furthermore, Suntec REIT is likely to be disproportionately impacted due to its higher gearing of 43.6% compared to the S-REIT average of 37%.
Unfortunately, rate hikes will outpace office rental growth expectations. “We anticipate that office REITs such as Suntec REIT and Keppel REIT would see the rise in interest costs outstripping the impact of higher rents, largely due to the immediate pass-through of higher floating rates, as opposed to a reversion over a typical three-year office rental cycle,” JP Morgan says, adding that a 10% rise in office rents is needed to offset every 100 bps hike in rates, but with a two to three years’ lag.
No wonder JP Morgan has an underweight for Suntec REIT and neutral weightings for Keppel REIT and CDLHT.
