The impact of risk-free rates on trading yields

“For REITs, we value the assets with a discounted cash flow (DCF),” EngKwok points out. Discount rates are benchmarked against prevailing interest rates.

Because REITs are “pure property play” where 90% of distributable income is distributed, they should ideally be trading at their capitalisation rates and, as a consequence, their NAVs. Capitalisation rates are derived from the portfolio’s net property income (NPI) compared to its capital value. But this is not likely to be the case because of a myriad of factors including asset quality, jurisdiction, management quality, sponsor strength and, often, liquidity. Impact of rising rates on unit prices

The most significant impact on a REIT’s unit price is the risk-free rate because REITs take their pricing off of the risk-free rate. According to an SGX Research note in February, the average yield spread (difference between risk-free rate and sector dividend yield) of S-REITs over the past 10 years is around 400 basis points (bps).

Since the start of 2022, the yield on 10-year Singapore Government Securities (SGS) has risen by around 114 bps to 2.84%. In the same period, though, REITs’ DPU yields, on average, have risen by around 30–35 bps. Based on The Edge Singapore’s “big” REIT table, the average yield of all the REITs including those with overseas assets is around 6.3%. The yield on 10-year SGS, the local riskfree rate is around 2.84%. Hence the yield spread is around 360 bps.

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The US Federal Reserve has become increasingly hawkish, raising the US Federal Funds Rate (FFR) by 75bps since December 2021. The Fed has communicated that it is likely to raise the FFR till it reaches the 3%– 3.5% range. The nature of the S-REIT market has evolved such that REITs with mainly Singapore assets trade at premiums to NAV because their risk-premium or spread as measured against the yield on 10-year SGS tends to be more compressed, not just because of a modest local risk-free rate (of 2.84% plus or minus) as at June 6, but also because of the Lion City’s triple-A sovereign rating, rule of law and regulatory framework.

Year to date, REITs’ unit prices have stayed remarkably resilient in the face of both the FFR hikes and quantitative tightening (QT). The Fed is likely to drain more than US$1 trillion ($1.38 trillion) of liquidity from the system in the next 12 months. These two events are likely to drive risk-free rates in both the US and Singapore higher, possibly to 3% and more. Inevitably, S-REITs’ DPU yields are likely to expand to maintain their yield spread of 360–400 bps. To maintain this yield spread, the average S-REIT DPU yields are likely to expand to the 6.6% to 7% range.

Indonesian risk-free rates

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Bank Indonesia sets Indonesian policy rates. In the past, factors that have affected Indonesian rates have depended on the value of the rupiah, inflation, Indonesia’s current account surplus or deficit, and reserves. On June 6, the rupiah traded at IDR14,423 to US$1, and the 10-year bond yield stood at 7.067%. Bank Indonesia says inflation remains low and under control. Indonesia’s annual inflation rate rose to 3.55% in May from 3.47% a month ago. Hence, the Indonesian economy appears remarkably resilient in the face of global inflation, war and famine.

“Bank Indonesia will continue to strengthen coordination with the Government and other relevant authorities to revive economic growth amid escalating external pressures while optimising the policy mix strategy to maintain the macroeconomic and financial system stability and sustain economic recovery momentum,” Bank Indonesia says in a statement on May 24.

LMIRT owns 29 retail malls in Indonesia and trades at around 6.6% because its DPU in FY2021 was 0.35 cents. To compensate, LMIRT’s P/ NAV is 0.53 times. When compared with Indonesia’s risk-free rate LMIRT is trading at a negative yield spread. To get to a positive yield spread, LMIRT’s yield would need to expand to more than 7.1%. To trade at a normal yield spread, LMIRT’s yield should expand from 7.06% to 11%. This has happened before and could well recur. LMIRT’s price does not need to collapse further from its current 5.3 cents. Once the pandemic is over, the Indonesian economy normalises, and the population starts to frequent LMIRT’s malls, LMIRT’s DPU should be able to rise. That could go some way to expanding its yield and its yield spread.

First REIT, which has more than 70% of its asset base in Indonesia, is trading at a positive yield spread. First REIT’s trading yield is around 10%, giving a yield spread of around 300 bps which is more aligned with theoretical yield spreads for Indonesia. First REIT owns 16 assets in Indonesia, mainly hospitals, 12 nursing homes in Japan and three in Singapore.

DPU growth, sound assets, property and capital management

Whatever the case, the lowest yields are for REITs that have mainly Singapore assets, strong sponsors, sound property managers and especially in a climate of rising interest rates, managers with strong capital management abilities. In addition, different asset classes command different costs of capital because their capitalisation rates are likely to differ.

At present, the REIT with the lowest yield is PLIfe REIT because its assets are three hospitals in Singapore and some 40-plus nursing homes in Japan. Although the yield on 10-year Japanese Government Bonds (JGB) has risen significantly to 0.24%, it is low compared to risk-free rates in other developed economies. Hence, PLife REIT trades at a DPU yield of around (and often below) 3%.

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In general, investors still prefer REITs with Singapore assets or at least assets in jurisdictions where laws, regulations and sovereign ratings are similar to Singapore such as Australia. Oftentimes, when REITs with only Singapore assets expand to jurisdictions outside of Singapore and Australia, their cost of equity rises.

A case in point is the merger of Mapletree Commercial Trust (MCT) and Mapletree North Asia Commercial Trust (MNACT). MCT has only Singapore assets while MNACT has properties in Hong Kong, China, Japan and South Korea. Last November before the merger announcement on Dec 31, 2021, MCT was trading at around 4.6% and at 1.2 times NAV. With the merger moving towards completion, MCT’s yield has expanded to 5.3% and it is trading at or near its pro forma NAV of $1.81. This is despite China’s risk-free rate falling to around 2.83%, which is similar to developed markets such as Singapore and the US.

The pure-play Chinese REITs are trading at higher yields of 7.5% for CapitaLand China Trust (CLCT) to 8.6% for Sasseur REIT; and more than 10% for EC World REIT. The spread between China’s risk-free rate and CLCT’s yield is more than 4%.

CapitaLand Integrated Commercial Trust (CICT) is trading at a historic DPU yield of around 4.7% to 4.8%. However, based on 2H2021 actual DPU, its annualised DPU yield is higher at around 5.2%. Frasers Centrepoint Trust (FCT), with only Singapore assets, is trading at an annualised DPU yield of 5.3%. These lower yields are useful should these REITs aim to grow DPU via acquisitions. As an example, CICT was able to acquire Australian office properties on an accretive basis because of its lower trading yield. It is likely to complete the acquisition of an integrated development, 101 Miller Street and Greenwood Plaza, comprising premium-grade office and retail, this quarter. The asset’s 1H2021 pro forma NPI yield is 4.9% but its passing NPI yield, which implies NPI yield based on passing or market rents, is 5.6%.

The acquisition is 2.8% accretive based on a loan-to-value of approximately 50% for the acquisitions and the balance from a combination of net sales proceeds from the sale of 50% of One George Street and a placement made on Dec 8. All in, CICT announced the acquisition of more than A$1 billion ($990 million) of mainly office properties in Australia in the past six months and CapitaSky.

“Unitholders want income growth, and the job of the REIT manager is to grow income because growing income will translate into growth in DPU,” says Tony Tan, CEO of CICT’s manager.

In an earlier interview, Kevin Chow, CEO of Lendlease Global Commercial REIT’s (LREIT) manager, says, “We are trying to produce stable DPU returns, DPU accretion and value preservation to investors.” LREIT completed the acquisition of the iconic suburban mall Jem this year which cost more than $2 billion, paid for with a combination of equity, perpetual securities and debt. Chow believes that keeping LREIT’s buildings environmentally sustainable and green, and utility costs low will lower expenses, preserve valuations and make the buildings more attractive to tenants.

To make acquisitions accretive, REIT managers have to be mindful of the combination of debt and equity. Hence, the lower the cost of equity, the more accretive an acquisition can be. In the near term, REITs that made sizeable acquisitions in the past 12– 18 months may decide to take a break from continued acquisitions given the rising cost of both debt and equity. These REITs could include CICT, LREIT, MCT which will soon be renamed Mapletree Pan Asia Commercial Trust, Mapletree Industrial Trust, Mapletree Logistics Trust, and possibly the US-based S-REITs.