Silver linings in Reits

We prefer S-Reits with growth potential, higher proportion of fixed rate borrowings and healthy balance sheet.

Industrial Reits - This is our preferred sector due to the long weighted average lease expiry (WALE), inbuilt rent escalation and diversified portfolio, all of which will help to enhance income resilience which is crucial under the current macro-environment. Their high exposure to structural growth and ability to acquire, supported by healthy gearing and availability of assets, help to drive distribution per unit (DPU) growth and offset potential increase in operating expenses. The Reits have been acquiring actively in the past one to two years and this will help them to ride through potential income downside better than their peers in other sub-sectors.

Office Reits - Office demand should remain healthy due to reopening of the economy from the pandemic while rents would be supported by the tight supply which will help to buffer the rising costs. However, some Reits within the sector would see a meaningful impact from the rising interest rates and there is also risk of recession which will affect the demand for offices.

Retail Reits - The retail Reits have benefited from the initial reopening and tenant sales have generally recovered near/above pre-Covid levels. Hence, further upside could be limited, even as international borders reopen and travel resumes. Given the weaker economic outlook, retail landlords may also find it more challenging to pass on the higher electricity expenses to consumers.

Hospitality Reits - Hospitality Reits have seen strong recovery in revenue per available room (RevPAR) and they could reprice room rates frequently to adjust for inflation. However, this has already been priced in while the looming recession outlook could mean the strong recovery beyond the initial rebound may taper off quickly.

Rising interest costs and electricity expenses are some of the more pertinent risks. In view of that, we have a lower preference for Reits with high gearing and/or high proportion of floating rate debts. In addition to higher interest expenses, high gearing also reduces the ability to make accretive acquisitions and thus inorganic growth. Reits such as overseas Reits which are trading at high DPU yields may also find it difficult to make accretive acquisitions. The majority of the Reits did not experience the full impact of higher electricity cost due to hedges. More of the impact could be felt in 2023 as hedge contracts roll off. This is, however, a smaller concern as most Reits could pass on the higher costs to tenants as leases get renewed and service charges are raised. We are also cautious on Reits which are trading at low DPU yields which may make it more susceptible to share price impact due to narrower yield spread.

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Carmen Lee, Head, OCBC Investment Research

The average yield for the Singapore government bond is about 2 per cent in the last 10 years, while the average annual distribution per unit (DPU) yield on S-Reits has been around 6 per cent. The differential of around 4 per cent has now narrowed to about 2.7 per cent as rates move higher.

Taking into account dividend yield and share price performance, the Straits Times Index (STI) provided an average annual return of about 4.5 per cent in the last 10 years. For S-Reits, the 10-year average return was an average of 6.9 per cent. Over a longer term, the average return on S-Reits has been better than the broader STI stocks.

For the near to medium term, the market environment is still uncertain, largely due to elevated inflation, expensive energy costs and higher interest rates. Wide currency fluctuations could also impact S-Reits as several Reits derive part of their incomes in foreign currencies. Among S-Reits, the only sub-sector that has posted gains this year is hospitality Reits, which benefited from the reopening of several economies as pandemic concerns eased, a strong reversal from 2020.

With the high-rate environment as the base case, our preference is for Reits with prudent capital management and manageable leverage. Our picks include Ascendas Reit, CapitaLand Integrated Commercial Trust, Frasers Centrepoint Trust, Mapletree Industrial Trust and Mapletree Logistics Trust.

While a global slowdown will impact almost all sectors, hospitality, office and retail Reits could be more impacted than industrial (which typically have longer leases), healthcare or data centre Reits.

For retail Reits, higher e-commerce adoption has raised concerns about the longer-term outlook for retail sales and rentals. Most retail Reits are taking active steps to mitigate this.

Industrial Reits are currently well supported by resilient manufacturing trends. Based on statistics from JTC, the price index and rent index of all industrial space in Singapore increased by 1.5 per cent quarter on quarter (qoq) in Q2 2022, the 7th consecutive quarter of growth. However, supply pressures remain high for the industrial sub-sector in Singapore. An average annual supply of 1.2 million square metres (sq m) of industrial space is expected from 2022 to 2025, compared to an average annual supply and demand of 0.7 million sq m over the past 3 years.

Office Reits in Singapore are currently enjoying a healthy upward trajectory in rents, with Grade A and Grade B Core CBD office rentals climbing 3.2 and 3.8 per cent qoq, respectively, both of which were an acceleration from Q1 2022.

Overall, with the US Federal Reserve likely to hike rates in November and December 2022, we believe a near-term pullback in share prices of S-Reits remains possible. We would look to accumulate quality names, especially the bigger market capitalisation and well diversified Reits with good and growing annual distribution, in such a scenario.

Derek Tan, Head of Property Research (Singapore), DBS Bank

With recession increasingly seen as a base-case scenario, we see investors turning towards more defensive positioning in terms of their allocation strategy. Instruments like S-Reits offer resiliency given their attractive and growing yields, but the opportunity cost for investing in S-Reits is getting greater given higher returns offered by alternative yield products and fixed deposits. Still, we believe that S-Reits will come off strong especially when the sector continues to see stable growth rates in dividends ranging from 3 per cent to 30 per cent in 2023, depending on the sub-sectors. Most real estate sectors are in a "landlord's market" meaning that landlords continue to have the upper hand in their leasing negotiations but that could change with the onset of a recession (if it comes). As such, we prefer to invest in sectors that can offer resiliency in returns and yields in a low-growth or recessionary environment. We believe that suburban retail and logistics are attractive given the structural growth trends driving demand growth in these sectors.

The suburban retail space is one that we particularly like, mainly due to a pivot towards a hybrid working environment, meaning that more employees will spend an increasing part of the work week from home and thus consumption trends in suburban malls are expected to change, going forward. Tenant sales have exceeded pre-Covid levels but rents have yet to catch up.

In logistics, we see a multitude of factors driving demand for logistics space with companies now taking more warehouse space due to companies' shift towards "just-in-case" from a "just-in-time" inventory management strategy. It has also been proven in the past crisis that the logistics sector is most resilient in a downturn.

We believe these are the most salient risks. Interest rate risk: The Fed's more than hawkish stance in the last FOMC meeting means a repricing of interest rate risk for the sector. With more spikes ahead if inflation remains stubbornly high, this is a key overhang for the sector heading into 2023. The impact will be more visible for Reits that have difficulty in raising revenues, where interest rate spikes will eat into distributions.

Asset values risk: S-Reits generally have kept gearing below 40 per cent over time, but we note a slight increase in the past few years as MAS raised the upper gearing limit to 50 per cent with S-Reits gearing up to fund acquisitions. While there is an increasing headroom available for S-Reits to acquire, investors will likely shy away from S-Reits which are geared to the upper end of the peer range. This is because of their higher debt burden and interest obligations which will have a bigger impact in a more subdued growth environment.