Global market watchers are waiting for signals from the US Federal Reserve Board on prospects of a rate cut in the Federal Funds Rate but Fed officials appear ambivalent to indicate any rate cut.
The three local banks have tempered expectations and are expecting two rate cuts by the Federal Reserve as a “base” case scenario, which is in the absence of further inflationary data and a high-for-longer scenario. “We are currently forecasting two rate cuts, so we will get some tailwinds compared to our previous guidance, probably by $100 million,” says Piyush Gupta, group CEO of DBS Group Holdings, on May 2 during a results briefing.
Additionally, market strategists are also expecting the 10-year US bond yields to stay high for longer. The chart of the US and Singapore 10-year bond yields shows that despite their divergence in absolute levels since late 2022, their trends are similar. After rising from their 2021 lows, risk-free rates may have reached a plateau of sorts since October last year, at elevated levels.
Impact of interest rates on S-REITs
In general, firmer rates tend to benefit banks and softer rates benefit REITs. REITs rely on debt (particularly low-cost debt) to raise their yields. Debt is almost always cheaper than equity. The average distribution per unit (DPU) yield of S-REITs (excluding business and infrastructure trusts but including stapled securities) is around 7.6% on a historic basis, and 6.7% based on current-year projections of DPU. For most Singapore-focused REITs, the average cost of debt remains below 4%.
In terms of actual y-o-y DPU declines for FY2022/2023 versus FY2023/2024 complied by The Edge Singapore, office was down 36% distorted by the US office REITs; retail was down 19%, distorted by BHG Retail REIT BMGU Bmgu and Lippo Mall Indonesia Retail Trust, industrial was 7% lower, and hospitality 20% higher.
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Interest rates affect REITs in three main ways. First off, unit prices are impacted through the yield spread, which is the difference between DPU yield and risk-free rates. The rising rate cycle has impacted unit prices adversely. To maintain the yield spread, unit prices of REITs have to drop unless DPU rises sufficiently to offset the spread.
Secondly, higher interest rates affect DPU negatively. S-REITs’ largest expense is interest expense. Even if the absolute level of debt does not rise during an interest rate hike cycle, the cost of that debt rises. Hence DPUs have been falling. Based on a table of current DPUs versus historic DPUs compiled by UOB Kay Hian, DPUs are likely to decline for most REIT sectors.
Some of the DPU data is distorted by Manulife US REIT (MUST), Prime US REIT OXMU and Keppel Pacific Oak US REIT (KORE). MUST and KORE have halted DPU till 2025 and later. Prime has cut its DPU drastically. This caused the office sector to register the largest DPU declines, down 11% y-o-y. The rest of the sectors recorded DPU declines of 2% to 4%.
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Vijay Natarajan, vice-president of real estate and REITs equity research, RHB, says: “We expect interest costs for the S-REIT sector to peak by the end of FY2024 and slowly start tapering next year. The majority of the S-REITs have seen the bulk of higher interest expenses flow through their financials since FY2023, with the full impact of higher expenses to be in numbers by FY2025.”
His estimates are based on his current assumptions of one rate cut this year, followed by a few rate cuts next year. “The peaking of the interest rate cycle in our view will coincide with the bottoming out of DPU and capital value decline for the sector, and a recovery is anticipated next year.”
Capital and portfolio management
The capital values of REITs are affected by a myriad of factors, of which interest rates, (and by association discount rates) are just one factor, but arguably the most important consideration. Discount rates are derived from risk-free rates and risk premiums. The latter is often obtained from the estimated rate of return less the risk-free rate. Discount rates are important because they are used in discounted cash flow (DCF) projections of properties’ valuation.
Fitch Ratings says portfolio valuation and capital management are two key considerations in their ratings for REITs.
“A portfolio of highly liquid and well-located properties in mature markets with strong investor and lender appetite underpins REITs’ business profiles, supporting steady cash flow and capital access through the cycle. Asset scale is also important in our portfolio analysis, as larger issuers have greater bargaining power with tenants,” Fitch says.
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Because of its importance in valuation, the quality of rental income is of high importance. “Rental income risk is measured by portfolio occupancy, record of lease renewals, well-spread lease expiries that mitigate the impact of a downturn on cash flow, and low tenant concentration or credit risk,” Fitch says.
Fitch’s analysis of a REIT’s financial structure is anchored by ebitda net leverage, with net debt to property value and unencumbered asset coverage as secondary considerations. Ebitda net leverage is an objective measure, as it is largely independent of fluctuations in property valuations, which are subjective and prone to volatility. Additionally, the Singapore regulators have added a further layer to S-REITs’ financial reporting, requiring them to report their interest coverage ratios including the use of hybrids such as perpetual securities.
Liquidity, in terms of availability of credit, including that of undrawn revolving credit facilities, is also an important rating factor, Fitch adds.
Stresses remain for REITs
Following the announcement of S-REIT results and business updates for the first quarter of this year, JP Morgan says the results were mixed with five REITs in its coverage reporting above expectations, six in line and four below.
“Interest costs and forex headwinds continue to weigh, with S- REITs reporting DPU showing y-o-y declines (except for Mapletree Industrial Trust ME8U ). Cost-of-debt guidance is being revised higher and many REITs are still facing a 5% to 64% increase in borrowing costs over the next 2-3 years which continue to pose a headwind to DPU,” JP Morgan says.
Interestingly, JP Morgan has upgraded Frasers Centrepoint Trust J69U to “overweight” as a result of its portfolio, which is suburban and 100% Singapore-based. FCT, being a rare pure-play Singapore REIT, is not impacted by the strength of the Singapore dollar versus other currencies. Forex losses were one of the reasons DPU and valuations have declined for several S-REITs. Furthermore, suburban retail is a resilient asset class as evidenced by the performance of FCT’s portfolio through the pandemic.
For the REIT sector in general, Natarajan awaits a signal from the Fed. “The key catalyst for S-REITs remains the commencement of the rate cycle by central banks (and the Fed in particular), which will provide the affirmation investors are currently waiting for to reallocate capital. The rate cuts should have an immediate impact in terms of lowering of risk-free rates and other high-yield fixed income opportunities in the market, enhancing yield spreads for the sector and making it more attractive,” he explains.
Banks’ asset-liability management
For banks, the largest contributions to earnings are their net interest income, a result of the difference between asset yields and costs of liabilities such as deposits. In the face of tepid loan growth, analysts are focusing on how the banks are positioning their securities portfolio, including high-quality liquid assets which are part of regulatory requirements.
As Gupta explained on May 2, of the bank’s total fixed-rate assets of $184 billion, $16 billion was repriced in 1QFY2024, $11 billion in 2QFY2024 while $13 billion each will be repriced in 3QFY2024 and 4QFY2024.
“The bulk of the duration we put on was between two-to-three-year tenors and gives us a decent two-percentage-point lift in yields for our fixed-rate assets,” Gupta says. “All this repricing gives us incremental yield. On the other hand, the headwinds on net interest margins (NIM) come from potential rate cuts and Casa (current account savings account) repricing,” he elaborates.
However, deposit costs may keep edging up as rates stay high, he suggests. “When you put the headwinds and tailwinds together, our modelling suggests that we will see a marginal decline in NIM from last year’s exit level. For next year, if you assume that there is no change to the rate outlook, I think the trajectory will probably be similar to this year,” Gupta acknowledges.
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What the analysts say
In a roundup following the local banks’ 1QFY2024 business updates for the first three months of the year, Maybank banking analyst Thilan Wikramasinghe has a clear preference for DBS, which is his only buy recommendation among the three banks.
In addition to net interest income being supported by two instead of five rate-cut scenarios, Wikramasinghe points out that DBS’s management has locked in yields “by parking liquidity in mid-tenor instruments. This should give better NIM visibility towards 2025, even if interest rates fall.”
Additionally, despite paying out higher dividends this year compared to 2023, DBS has the potential to pay more “given its strong capital levels”. With strong execution and additional yield upside, the Maybank report has a target of $38.87.
Citi is also positive on DBS. “We see upside risks for net interest income driven by better liquidity management and capital management into treasury markets interest-earnings assets,” Citi says. As an addendum, the Citi report points out that the 1QFY2024 EPS of $1.02 implies a dividend of 54 cents per quarter assuming a 52% payout ratio “which reinforces management’s intention to raise DPS by 24 cents a year”.
Bloomberg Intelligence points out that United Overseas Bank U11 ’s speedy integration of Citigroup’s retail business in Malaysia, Thailand, Vietnam and Indonesia “will extend its Southeast Asian footprint and boost its deposit base, loan book as well as wealth business”. In its 1QFY2024 business updates, UOB announced that its deposits had grown by 4% y-o-y and 1% q-o-q to $388 billion, with low-cost Casa rising to 50.6% compared to 48.9% in 4QFY2023 and 47.9% in 1QFY2023.
Maybank’s Wikramasinghe says Oversea-Chinese Banking Corp’s 1QFY2024 earnings were ahead of Maybank’s and the Street’s expectations on stronger trading, insurance and fees. “Net interest income is also holding up. Higher for longer interest rates and the execution of the One Group strategy should allow ROEs to land on the higher end of guidance,” he says.
On the other hand, Wikramasinghe believes the transaction to acquire the Great Eastern shares OCBC does not own “has limited synergistic value. Plus, there are risks the offer price may have to be raised to close the deal,” he adds. “We believe the $1.4 billion of capital is better utilised by returning to OCBC shareholders.”
In an update to clients on May 27, Goldman Sachs has a buy recommendation on OCBC. Analyst Melissa Kuang believes that the offer for Great Eastern can help to optimise OCBC’s balance sheet because of Great Easterns excess capital which can be streamed up to OCBC and possibly its shareholders.
Whatever the case, investors may opt to stay with banks in the near term. “We believe investors will continue to prefer banks over S-REITs in the near term amid current interest rate volatility and uncertainty surrounding rate cuts. However, we expect investor preference to shift in favour of S-REITs later this year (by 4Q2024), with the beginning of the normalisation of the rate cycle,” Natarajan says.
