On the face of it, S-REITs (Singapore REITs) are a clear beneficiary of lower interest rates, while banks are likely to face challenges given that net interest margins (NIM) are likely to compress, pressuring their net interest income (NII). In 1HFY2024 ended June, NII contributed 64% to DBS Group Holdings’ total income, 67% to Oversea-Chinese Banking Corporation’s (OCBC) total income and 68% to United Overseas Bank U11 ’s (UOB) total income.
Their relationship with interest rates is more complicated. The fundamental difference between banks and REITs is their capital structure. The structure affects their payout ratios and vice-versa. The local banks pay out around 50% of their patmi. S-REITs must pay out 90% of their distributable income for tax transparency. This requirement means a REIT with Singapore properties is not taxed on its distributable income, and most unitholders are not taxed.
Retaining 50% of net profit, coupled with years of retained earnings, inevitably places the local banks in a stronger position than S-REITs with no retained earnings. It is an over-generalisation to infer that banks’ earnings are likely to be adversely affected by a decline in interest rates, as banks have levers they can pull to mitigate the expected decline in their NIMs.
The most-messaged lever is lengthening the duration of the local banks’ securities portfolio. “The banks have been building up the book on high-quality government securities and T-bill deposits — DBS and UOB more notably — in anticipation of the US Federal Reserve’s rate cuts. As a result, they have managed to lock in attractive rates for reasonably long durations of over two years,” says CLSA in a report following the banks’ results briefings last month. “Hence, the sensitivity of NIMs to falling rates is expected to be lower. DBS, in particular, indicates that every
–1 basis point (bp) change in rates affects NII by $4 million by its estimate. In contrast, in the past, the impact would have been about $18 million.”
Meanwhile, RHB Singapore analysts say: “In anticipation of the rate cut cycle, recall that Singapore banks have been taking steps to protect NII by hedging and adding duration and fixed rate assets to their portfolios. Consequently, NII sensitivity is now lower versus the start of the rate hike cycle.”
See also: Changes in ICR, leverage to come into effect immediately, with additional disclosures in March
Based on the recent briefings, Singapore’s banks guided for NII sensitivity of $4 million to $5 million change a year (per basis point), or 3% and 7% a year impact to profit before tax for DBS and UOB respectively, for a 100bps change in rates, RHB notes.
On the valuation front, banks are often valued based on the Gordon Growth Model. The formula to calculate a bank’s implied price-to-book takes the ratio of its return on equity (ROE) minus the long-term growth rate divided by the cost of capital minus the long-term growth rate. The formula is part of the reason why banks are focused on ROE, as the higher ROE — and a lower cost of capital — are likely to lead to higher share prices.
Hence, since the US Federal Reserve cut interest rates by 50bps on Sept 18, DBS, OCBC and UOB have rallied by 4.2%, 2.3% and 2.4%, respectively, as at Sept 23.
See also: IREIT signs 20-year lease contract with UK hotel chain, Premier Inn, in Berlin Campus
Plenty of capital, allowances, overlays
The local banks have plenty of capital to cushion a decline in interest rates. As a case in point, banks set aside ample general allowances as they take on more loans.
The banks’ support comes in multiple forms: robust capital structures; the Basel Accords, which impose specific capital and liquidity requirements on banks; the Monetary Authority of Singapore’s (MAS) supervisory role; and the keenness of the local banks to maintain their AA credit rating. These are additional guardrails around their capital structures and their asset-liability management strategies. These include sufficient liquidity to withstand a 30-day bank run.
In addition to onerous expected credit loss (ECL) recognition of impairment and macroeconomic variable models that local banks subject their portfolios to because of International Financial Reporting Standards (IFRS 9), they set aside additional allowances known as management overlays.
The additional adjustments are for unexpected risks caused by climate change or a sudden black swan event (such as Covid-19). This “post-model” adjustment management overlays above amounts stipulated by their models of macroeconomic variables (MEV) are substantial. DBS’s overlay is more than $2 billion, UOB’s is between $1.4 billion to $1.5 billion and OCBC’s overlay is around $1 billion.
These allowances and overlays arm the local banks with additional buffers to withstand price shocks, including sudden declines in interest rates.
The S-REITs are in a very different position, with relatively weaker capital structures compared to banks, which is why many of them lean on their sponsors if they are required to recapitalise or seek additional funding in the event of restructuring and acquisition growth.
To stay ahead of Singapore and the region’s corporate and economic trends, click here for Latest Section
Triple whammy
The less robust capital structures of REITs are through no fault of their own, as they must pay out most of their cash income. As a result, REITs tend to rely on debt to raise or lower their distribution per unit (DPU).
During the rising interest rate cycle, REITs were hit by a triple whammy. First, the yield spread is based on the risk-free rate, and this affects unit prices directly and immediately. When risk-free rates fall, the DPU yield falls, and unit prices rise.
Secondly, interest rates affect DPU. The higher interest expense causes DPU to fall if net property income (NPI) cannot rise sufficiently to offset this increase in interest expense.
Finally, interest rates affect discount and capitalisation rates indirectly, and these rates are used to calculate capital value. These three impacts do not immediately reverse, although they may reverse eventually.
The office-focused Manulife US REIT (MUST) faced these problems in recent years. The Fed started raising rates in March 2022, just a quarter after MUST acquired three properties, funded through loans and proceeds from a private placement. The Edge Singapore noted in a report that same month that the REIT’s DPU and occupancy rates had been at a standstill.
Higher discount rates, terminal capitalisation rates and low occupancy pushed MUST’s portfolio valuation down 14.6% h-o-h to US$1.63 billion as at June 30, 2023. With the drop, MUST’s aggregate leverage rose, breaching a 50% regulatory limit and reclassifying the REIT’s loans as current liabilities. The REIT then declared at its 1HFY2023 results in August that it would halt its half-yearly distributions, which is still in effect today.
Debt maturity
REIT managers have also been scrutinised for how they plan to ride out the cycles of rate hikes and cuts. MUST’s weighted average interest rate at June 30, 2022 was 2.97%. A year later, this had spiked to 4.10%. As at June 30 this year, the figure was 4.58%.
Around 80% of MUST’s debt is hedged, and its new policy is to keep 50%–80% of debt hedged on the expectation of interest rate cuts, management said at its latest results briefing.
As at June 30, MUST’s debt profile looks lumpy, with US$130.7 million ($168 million), or 14.9%, of debt due next year — specifically, in May and August 2025. It then has US$203.9 million worth of debt due in 2026. The weighted average debt maturity is 3.0 years as at June 30, and 80.2% of total loans are either on fixed rates or hedged.
Under the REIT’s master restructuring agreement, all loan maturities of existing facilities have been extended by one year, and financial covenants have been temporarily relaxed until Dec 31, 2025, or when the early reinstatement conditions are achieved, whichever is earlier.
The conditions are for MUST’s consolidated total liabilities to consolidated deposited properties to be no more than 45%; or for MUST’s consolidated total liabilities to consolidated deposited properties to be more than 45% but not more than 50%, while interest coverage ratio is more than 2.5 times and there are no potential events of default continuing for at least one financial quarter.
Meanwhile, Prime US REIT OXMU ’s weighted average interest rate was 3.1% at June 30, 2022, 3.9% at mid-2023 and 4.1% at mid-2024. The manager entered into a US$550 million credit facility agreement on Aug 9, set to mature in July 2026 with a one-year extension option.
According to the CEO of the manager, the overall cost of borrowings at the current benchmark rate will be “below 5%” this year. “And next year, it will be at [the] 5% handle,” says Rahul Rana. As at Aug 13, US$330 million of borrowings remain hedged till mid-2026 via interest rate swaps.
Assuming that Prime US REIT will use the net divestment proceeds from the sale of One Town Center and post-refinancing with the US$550 million credit facilities — both of which have been completed — the REIT’s weighted average term to maturity is 3.3 years. On a pro-forma basis, 67% of the REIT’s total debt is either on a fixed rate or hedged. According to its 1HFY2024 presentation slides, Prime US REIT has US$70 million due in 2026, $475 million due in 2027 and $105 million due in 2029.
According to a Sept 24 corporate presentation by Prime US REIT, it would take about 12 to 18 months for the REIT to achieve more than 90% occupancy rate from the current average of 85%. As at June 30, occupancy was at 83.9%.
The manager also says there will be no further divestments, and Prime US REIT may look at acquiring distressed properties when interest rates drop further. The REIT’s portfolio will be revalued as interest rates fall, adds the manager.
Unlike US office S-REIT peers MUST and Keppel Pacific Oak US REIT (KORE), Prime US REIT has not halted distributions. It announced a DPU of 0.18 US cents in 1HFY2024, equating to 10% of distributable income for the period.
According to the manager, DPU will slowly resume over the next 18 to 24 months. The REIT is in cash preservation mode as potential new tenants want to see a strong balance sheet before they sign up, adds the manager.
Over at KORE, income available for distribution in 1HFY2024 was US$23.8 million, 8.8% lower y-o-y. According to the manager, the drop was mainly due to higher financing costs from rising interest rates.
KORE’s year-to-date, all-in average interest rate for borrowings, including upfront debt-related transaction costs, was 4.47%. Excluding upfront debt-related transaction costs, KORE’s year-to-date average interest rate, as at June 30, was 4.36%.
As at July 31, all of KORE’s borrowings are US dollar-denominated and 100% unsecured. 69.0% of KORE’s loans have been hedged with floating-to-fixed interest rate swaps, which the manager says reduces near-term exposure to rising interest rates.
As at June 30, an eighth (12.4%) of KORE’s US$607.2 million of total external loans are due in 4Q2024, while a quarter (25.5%) are due in 2025, 6.6% are due in 2026, 24.0% are due in 2027, and 31.5% are due in 2028.
KORE entered into new loan facilities in July, refinancing and extending its loans due in 2024 and 2025. Pro-forma, KORE faces a smaller immediate debt expiry, with just 14% of loans due in 4Q2024 and 2025. A quarter (25.5%) of KORE’s total external debt is due in 2026.
REITs that stand to gain
On the interest expense front, REITs with the lowest fixed rates and the lowest average debt to maturity are likely to benefit as rates fall.
In a report dated Sept 23, Krishna Guha, analyst at Maybank Research, says: “Based on disclosures as of June, Suntec REIT, CDL Hospitality Trusts J85 (CDLHT), Keppel REIT, OUE REIT TS0U and Far East Hospitality Trust Q5T (FEHT) have the highest DPU sensitivity to rate cuts. On average, distribution rises by 3.4% for every 50bps rate cut.”
FEHT has the lowest fixed rate debt with 36%, followed by CDLHT with 52% and Suntec REIT with 54%. OUE REIT’s fixed rate debt as at end-June was 61%. “If rate cuts are further front-loaded without sacrificing growth, distribution growth for the S-REITs may kick in early,” Guha says.
Jonathan Koh, analyst at UOB Kay Hian Research, says in a report dated Sept 23 that investors should turn their attention towards laggard S-REITs that have underperformed their faster-running blue-chip peers.
“We zoom in on S-REITs that have underperformed the FTSE ST All-Share REIT Index by a double-digit quantum. The underperformance for the hospitality sector is unjustified as Mpox is unlikely to be as disruptive as the Covid-19 pandemic. Visitor arrivals have picked up recently and expanded 17% y-o-y to 1.5 million in August, accounting for 89% of pre-pandemic levels. CapitaLand Ascott Trust HMN has underperformed the FTSE REIT Index by 4.1% in 3Q2024, followed by CDLHT and FEHT, which both underperformed by 10%,” Koh says in his report.
Outside of hospitality, Digital Core REIT has underperformed the FTSE REIT Index by 5.3%, while Keppel DC REIT has outperformed the index by 7.9%, Koh adds.
Normalisation
The yield curve normalised on Sept 6, ahead of the Fed’s rate cut. Furthermore, the Fed’s dot plot indicated that a further 50bps cut this year would not be unexpected, and the target based on the 19 “dots” announced on Sept 18 points to a Federal funds rate of 4.4% by the end of this year, declining to 3.4% in 2025 and 2.9% by the end of 2026.
Despite the downward trend, both RHB and JPMorgan believe that DBS is well-positioned during this cycle.
“DBS has delivered one of the best bank turnarounds in the last decade, in our view, as technology-led changes across the franchise led to improvements in growth, efficiency and ROE. The bank’s digital strength is driving gains in market share, wealth management as well as underwriting, which had previously seen challenges at the bank,” says JPMorgan in a report dated just before the Sept 18 rate cut announcement.
“Low-single-digit loan growth and benign asset quality is further helping capital generation. It appears that the bank started competing for mortgages late last year in a bid to lengthen duration of the loan book, which limits NIM in the near term but reduces rate-sensitivity of NIM over the next few years; hence providing visibility to capital generation,” JP Morgan observes.
The main risk with the local banks is their commercial real estate (CRE) exposure, particularly in Hong Kong. DBS’s CRE exposure to Hong Kong is $18 billion. UOB does not break out Hong Kong CRE specifically, but 1% of its loans is to developers in Greater China, based on its 1HFY2024 ended June 30 presentation. OCBC’s total exposure to CRE is 11% of total loans, which stood at $305 billion as at June 30. Of this, two-thirds are in its key markets of Singapore, Malaysia, Indonesia and Greater China, with the remainder largely in developed markets.
“Any indication of a pick-up in non-performing loan formation would be a catalyst for de-rating. Yet, if [DBS] is able to manage asset quality well over the course of 2024–2025, the stock would continue to re-rate,” JP Morgan says.
Citi is negative on DBS and reiterated its sell recommendation on Sept 25, with a target of $31.90 as the most optimistic earnings estimates have been factored in the bank’s “2027 wealth ambitions”.
RHB says it has left its earnings forecasts unchanged at this juncture, and expects the banks’ patmi to rise by 6% y-o-y for FY2024. DBS’s management has articulated that it continues to defend its $10 billion patmi recorded in FY2023.
However, FY2025 could be a different story. “We expect FY2025 patmi to stay flat, mainly as NIM compresses and there is a moderation in non-interest income growth. Upside risks to earnings include better-than-expected loan growth, robust wealth activities and treasury flows, and lower-than-expected credit costs,” RHB says.
See also:
