Held on Oct 29, The Edge Singapore’s forum titled Industrial REITs in the New Economy — sponsored by ESR-LOGOS REIT (E-LOG) — may have answered questions about why the two data centre REITs have fallen so much this year. The speakers were Adrian Chui, CEO of ESR-LOGOS REIT’s manager, Tan Teck Leng, deputy chief investment officer at Phillip Capital Management and Wong Xian Yang, head of research at Cushman & Wakefield.
Chui, who manages some $5.5 billion in assets under management, mainly in Singapore but increasingly in Australia and recently in Japan, articulated how important it is for his REIT to stay future-ready. As at Sept 30, E-LOG’s New Economy assets stood at more than 62%.
As Singapore moves into the mid-21st century, the New Economy focus is likely to be increasingly on digitalisation, tech, medtech, life science and sustainability. Future-ready portfolios are those whose properties support digitalisation, and various aspects of science and technology with green, sustainable buildings.
So far this year, industrial rents have been resilient, as evidenced by E-LOG’s double-digit rental reversions announced for its 3QFY2022 business updates. “The current tight supply in Singapore is driving outperformance, especially for New Economy assets,” says Cushman & Wakefield’s Wong. “[Year-to-date] prime logistics rental growth increased by 6% y-o-y, and this is one of the fastest rental growth rates over the last 10 years where rental increases were about 1% to 2% per annum.”
On average, he attributes low vacancy rates of 5% in prime logistics to the pandemic, which delayed new construction. In addition, because of tight office supply, city fringe business parks are a credible alternative. Older stock tends to have much higher vacancy rates, while newly built amenitised business parks have much higher occupancies. “Specs do matter for business parks,” he adds. Other sectors that are experiencing continued growth are high-tech factories, he indicates.
Based on feedback from Cushman & Wakefield, sustainable buildings are likely to be a demand driver. “There is strong demand from occupiers for green and sustainable buildings. In future, you could see a wave of capex because this will continue to drive higher rents, and sustainable buildings are still a minority in the market,” Wong says.
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The challenge, of course, is a land policy in Singapore, where industrial land has short land tenure. Industrialists want land costs to remain low, so JTC — which controls industrial land supply — has lowered land tenure from 30+30 years to 30 years and now to 20 years.
No surprise, then, for E-LOG, assets that undergo asset enhancement initiatives (AEI) or redevelopment will be those on long land tenures with excess, unutilised GFA. One of these is 7002 Ang Mo Kio Avenue 5. The land was the car park area for 7000 Ang Mo Kio Avenue 5. 7002 Ang Mo Kio will be a high-tech building with extra generators and a higher-than-normal power supply.
“Singapore is well positioned to benefit from the electronics sector, biomedical manufacturing, precision engineering, digitalisation and related sectors, and life science,” Wong adds.
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The speakers at the Industrial REITs in the New Economy forum, held on Oct 29. From left are Adrian Chui, CEO of E-LOG's manager, Tan Teck Leng, deputy CIO, Phillip Capital Fund Management and Wong Xian Yang, head of research at Cushman & Wakefield / Photo: Albert Chua of The Edge Singapore
Not without risk
Yet, New Economy assets, including data centres and logistics properties, are not without risk. Phillip Capital’s Tan, in his presentation, highlighted three risks on the horizon, one of which is already being played out on the Singapore Exchange.
Keppel DC REIT and Digital Core REIT are down 28% and 56% year-to-date. Compare that with Mapletree Industrial Trust (down 18% this year) and CapitaLand Ascendas REIT (CLAR), down about 10% this year. All four REITs hold data centres, but Keppel DC REIT and Digital Core REIT own only data centres. At the same time, 54% of Mapletree Industrial Trust’s portfolio comprises data centres, and 9% of CLAR’s portfolio comprises data centres.
“Until now, a lot of the hyperscalers such as the big technology companies, Alphabet (Google’s owner), Amazon, Facebook, the likes, have been customers of data centres, which are held by data centre REITs. These REITs service third-party customers. Increasingly, customers have been developing their own data centres and housing their needs inside the data centres they built for themselves. Customers become competitors, and this becomes an issue for data centre REITs,” Tan explains. Indeed, Google has a data centre built in Jurong.
Then, take Amazon Web Services (AWS), Amazon’s cloud and hyper-scale subsidiary. “As a proportion, the portion of data centres leased from third parties versus those that AWS owns is going down,” Tan says as a case in point. He adds that data centre REITs with long weighted average lease expiries (WALE) and quality tenants will be able to mitigate some of these pressures.
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E-commerce demand slips
A second challenge is in the form of e-commerce falling from Covid-19 highs. For Singapore, e-commerce sales as a portion of total retail sales have eased from 24% of total retail sales during the pandemic to somewhere between 12% to 15% of retail sales in recent months. Even then, that may still imply “a fair bit of runway going forward”, Tan says, pointing to the importance of e-commerce to logistics properties.
Logistics properties lend themselves to a wide variety of businesses, not just e-commerce for online shoppers. These include retail supermarket demand for everyday items such as toothpaste, shower gels, medicines, mobile phones and laptops, and food and drinks.
“Technology and e-commerce people tend to think that e-commerce is B2C (business-to-consumer). E-commerce includes B2B (business-to-business). For instance, cold storage facilities are B2B because you need the cold storage warehouse to distribute your fresh produce,” Chui says.
E-LOG owns ALOG Cold Centre and 6 Chin Bee Road, master-leased to Sharikat Logistics for food logistics. E-LOG also owns DHL Supply Chain Advanced Regional Centre on 1 Greenwich Drive, a largely robotic-operated, temperature-controlled logistics property servicing the chip industry. Pharmaceuticals must be stored in temperature-controlled logistics facilities, with some items, such as vaccines requiring ultra-low temperatures.
Industrial REITs still resilient
Tan’s third risk is the risk of recession. He points out that industrial REITs are the least volatile in the universe. Usually, the most volatile are hospitality trusts — as has been the experience over the past three years. Office REITs are also somewhat cyclical, moving in tandem with the business cycle. Retail REITs, especially those with suburban malls, tend to be resilient as they depend on necessity shopping and domestic demand.
The most resilient sector is industrial REITs, including on the valuation front. “For the private markets, stock for sale is quite limited because owners may not want to sell when the asset is getting double-digit rental increases,” Wong says. However, there are some bite-sized transactions done in industrial space.
The benefit to valuers is the sales comparable. “Transactions tend to tell investors as well as the banks that the V of the LTV (loan-to-value) is real,” Chui adds.
Capitalisation rates have remained mostly the same despite interest rates rising. While discount rates are a tad higher, cash flow has also been higher for industrial REITs due to rising rents. Hence, based on the income capitalisation and discounted cash flow methods, valuations have stayed mostly the same.
To keep distributions per unit (DPU) stable, REIT managers need to look at their debt expiry profile against their lease expiry profiles, Chui says. “Let’s say 10% of the debt expires in the next 12 months, but you have a lease expiry of 30%; you should be okay because the rental reversions will more than offset your debt expiries.”
Operating costs are also rising with higher utility costs. And if interest costs double, the rental reversions may only offset 75% or 80% of the expected cost increase. “That’s probably why most REITs with capital reserves from property sales will start to take out some of the capital reserves and top up the remaining 25 to 30% [of DPU],” Chui says, referring to DPU top-ups that are done during times of stress, such as the “circuit breaker” during the depths of Covid-19.
“For those of us who have saved money from selling assets at a premium to book, we will pay out the capital gains in the short term to manage the impact of the increase in costs,” Chui adds. In July, E-LOG divested 49 Pandan Loop at a 15.1% premium and 2 Jalan Kilang Barat at a 21.7% premium to book.
Waiting for rates to peak
The hope for investors and REIT managers is that the peak of the rate hike cycle will likely materialise in 1Q2023 or 2Q2023. “We have had one whole year of interest rate rises. Investors and analysts expect rates to reach a plateau by the first half of next year,” Chui says. When rates peak, REITs are likely to rally as one of the REITs’ valuation metrics is the yield spread between DPU yield and risk-free rates.
Although DPU yields, on average for S-REITs, are now around 7% to 8% and look attractive, on a relative basis, the yield spread has compressed. This yield spread is the DPU yield minus the risk-free yield of the 10-year bond. Tan attributes the compression to the sharp rise in government bond yields.
Tan says yields on the 10-year Singapore Government Securities (SGS) have risen by more than 2% in the past year from 1.3% to 3.5%, while DPU yields have only gone up by 1%. “On a relative comparison, therefore, REITs become less attractive, and that’s also a key reason why REITs, in terms of their unit prices, have gone down as well over the past year or so.”
Chui attributes the decline in REITs’ unit prices to a fear premium. “This fear premium can only subside when rates peak, and that’s when people see the inflexion point coming.”
