This is just not a good time for REITs and the reason is the yield spread. The immediate impact of inflation and rising interest rates isn’t on the valuation or operating costs, or cost of debt - although managing cost of debt is probably a major KPI among REIT managers. It is the impact of the yield spread. As pointed out by SGX Research, the average yield spread between S-REIT distribution per unit (DPU) yield and risk-free rates as measured by the yield on the 10-year Singapore Government Securities is 3.99%. In order to maintain the yield spread, DPU yields have to rise, or REIT unit prices have to fall.
“In the US historically, when you see inflation and interest rates up, you see REITs getting hit on stock prices. But eventually people see that rents are picking up and propertes are doing well, but initially there is a bit of a price shock,” observes David Snyder, CEO of Keppel Pacific Oak US REIT's manager.
On Jan 25-26, the Federal Open Market Committee (FOMC) was as visibly hawkish as the US Federal Reserve board signalled clearly that the first policy rate hike will take place in the upcoming Mar 15-16 FOMC. No surprise then that economists are increasingly rounding on the Kokomo policy option - where the Fed is likely to raise rates - fast. In addition, the Fed’s asset purchase program (QE) tapering will be further reduced in Feb 2022 and be completed by early March this year, before the March FOMC.
QE tapering does not directly affect interest rates, but it impacts the yield on the 10-year US Treasuries, the all-important US risk-free rate. REIT pricing is affected by its relationship with risk-free rates. Hence, the more hawkish the Fed gets, and the quicker the tapering, the sharper the REITs’ prices moves to get to the necessary DPU yield to maintain the yield spread. (DPUs can rise but an S-REIT sector rebound is likely to be a secondary result.)
Take Keppel DC REIT (KDC REIT). Its unit prices has been in a declining trend for a year. Initially, analysts put it down to the impending IPO of Digital Core REIT. Prices continued to decline after the IPO. Operationally, based on a briefing by Keppel DC REIT on Jan 24, metrics appear to be normal.
In 2HFY2022, DPU grew by 2.8% y-o-y to 4.927 cents. This is despite declines in gross revenue and net property income (NPI) in 2HFY2022. The revenue decline of 4% to $139.5 million and NPI decline of 4.3% to $124.3 million were caused by an upward non-cash straight-lining adjustment and rental support drop-off in Singapore. These declines were only partially offset by contributions from acquisitions and AEIs. For FY2021, KDC REIT’s NPI and DPU rose by 1.6% and 7.4% to $248.2 million and 9.851 cents respectively.
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Other metrics were fair - with occupancy up marginally q-o-q to 98.3% in 4QFY2021, WALE remaining long-ish, at 4.9% by gross rental income, and rent reversions were stable. Neither Anthea Lee, CEO of KDC REIT’s manager, nor Andrew Lee, the manager’s CFO provided details of rental reversions, or capitalisation rates.
However, KDC REIT recorded a revaluation gain of $151.4 million due to better occupancy and tighter capitalisation rates which boosted the value of its Singapore and Australian properties. For instance DC1 in Singapore was valued at $273 million as at Dec 31, 2021, compared with $212 million at the same time in 2020. In Australia, Gore Hill was valued at A$230 million as at Dec 31, 2021, compared to A$208.5 million as at Dec 31, 2020. The revaluation gains boosted NAV by 12.6% to $1.34.
Some 74% of KDC REIT’s debt is on fixed rates, and its remaining floating debt is dominated in Euros. Cost of debt as at end-2021 was just 1.6%. Foreign-sourced distributions are hedged to 1H2023 to mitigate the impact of currency fluctuations.
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Despite these underpinnings, KDC REIT’s unit price is at a one year low. This is because analysts and the investing community are starting to ascribe higher cost of capital to KDC REIT.
Elsewhere, on Jan 27, HSBC downgraded its recommendation for Mapletree Industrial Trust (MINT) to a hold recommendation. HSBC cited limited room for further compression in capitalisation rates, and the narrowing gaps between industrial asset yields and cost of funding.
The rationale behind the downgrade is tied to interest rates and the impact they have on capitalisation rates, property yields and cost of debt and equity. In addition to debt costs, the relationship between interest rates and discount rates may cause the weighted average cost of equity (WACC) to rise. As a result, the accretion to DPU is likely to be lower than during a low and falling interest rate environment.
Other than higher cost of capital, inflation is also leading to higher costs for expenses such as utilities and power. Of course MINT’s data centres are mainly core and shell which are on triple net leases where the tenant pays for infrastructure and costs associated with the data centre such as utilities, power and other property related fees.
The first expiries from MINT’s US data centre portfolio will materialise in the 12 months to Mar 31, 2023 (MINT’s FY2023). “An upcoming lease expiry in FY2023 will test management’s capability of active portfolio management overseas,” HSBC observes. A larger expiry in the US data centre portfolio materialises in the 12 months to Mar 31, 2024.
For all its challenges, MINT delivered its seventh consecutive quarter of DPU growth following the onset of the pandemic, with DPU rising 6.4% y-o-y, and 0.6% q-o-q to 3.47 cents for the three months to Dec 31, 2021. MINT’s gross revenue and NPI in 3QFY2022 increased 31.3% and 24.1% y-o-y to $162.4 million and $122.7 million respectively. The increases were underpinned by contributions from the acquisitions made in 2021, of a portfolio of 29 data centres in the US and a data centre in Richmond, Virginia.
