Path to prosperity: REITs

With the announcement of LREIT's results a few weeks back, all retail REITs with exposure to SG retail have announced their results. Similar to the previous article, the focus will be broadly on the performance and outlook for these REITs and I will highlight some catalysts to look out for. Didn't have the time to write FCT, so will leave that out for now.

Lendlease REIT (LREIT)

Lendlease REIT reported year-on-year increases in financial metrics like Revenue, NPI and Distributable Income however I think these are quite difficult to analyze as the 1HFY20 figure was annualized and pro-rated since LREIT only listed halfway through that half. Focusing on operational performance would be more valuable. About 60% of its NPI for the half-year was from 313 Somerset and this is its only asset in Singapore. The other asset is an office property in Milan that is master leased so there would not be much variations to explain.

Occupancy remained high at 98.7% at 313 despite the Covid-19 pandemic. With the phase 3 reopening, 313 reported a 19.5% qoq improvement in tenant sales and a 12.4% improvement in footfall. This represents 75/60% of pre-Covid levels respectively. This trend was similar across other REITs where tenant sales have improved more than footfall. I think this could be due to deliveries for sub-urban malls and also larger ticket sizes from Singaporeans as borders remain closed.

LREIT highlighted that it is focused on maintaining occupancy levels and help tenants stay viable; my read through for this is that there could be rental abatements or reliefs given and reversions could be less positive than before. Nonetheless, some (albeit lower) income is better than no income.

A key catalyst for LREIT is definitely more acquisitions; currently, it only has 2 fully-owned properties and a small stake in ARIF3 (which owns JEM). The Sponsor has cleverly structured the REIT to be global and commercial such that the range of potential acquisitions is quite wide. In the near-term I expect there to be acquisitions from the sponsor overseas and a gradual increase in the stake in ARIF3 and perhaps even new stakes in PPP (Parkway Parade) and PLQ.

SPH REIT

SPHREIT was the first to report its results in mid-Jan and is largely underpinned by Paragon (74% of revenue). Paragon suffered a 12.9% decline in revenue while Clementi Mall declined less at 6.6%. This is understandable as prime retail malls (especially luxury ones like Paragon) would suffer more from the dearth of tourists. Clementi Mall, as a suburban mall beside Clementi MRT, would have been less impacted as office workers work from home and patronize their nearby mall.

Year-on-Year Footfall and Tenant Sales trends (Source: SPHREIT)

Looking at the graphic from SPHREIT's presentation, tenant sales held up very well at Clementi Mall while Paragon still remained resilient. Footfall for Paragon actually held up more than Clementi Mall. A few possible reasons for this.

i) Clementi Mall was affected by capacity restrictions. For those who have been to Clementi Mall pre-Covid, you would remember how packed the place used to be. There was barely enough space to walk more than 5 steps in a straight line. Safe distancing measures could have limited the number of people allowed inside the various shops.

ii) The affluent are less impacted by Covid-19. Those buying luxury goods at Paragon's high-end shops like Balenciaga and Prada would probably continue buying during the pandemic due to their high level of financial resources. Luxury items also hold their value well.

In terms of catalysts, investors can look out for:

a) recovery from Covid-19 and opening of borders

b) acquisition of assets from the sponsor, in particular Seletar Mall, which has been talked about for the longest time

Starhill Global REIT (SGREIT)

SGREIT continued to retain income as it only distributed 0.14 Scts out of the 0.35 Scts it retained. This could be an indication of where it sees the recovery of retail. I think the REIT could be worried about its exposure in Malaysia (13.4% of NPI) as the country remains in lockdown and also the lack of tourists in Singapore for its prime retail malls (Ngee Ann City and Wisma Atria). Of note would be the Re-Align Framework where qualifying tenants can renegotiate or terminate their leases without penalties.

In terms of capital management, apart from issuing $100m of perpetuals at 3.85%, SGREIT managed to refinance $500m of debts and also had a DRP programme in place. This means investors should take their 35.8% gearing with a pinch of salt since it does not include perpetuals and also investors need to account for the small dilution from DRP in future quarters.

An upcoming acquisition to look out for is the acquisition of Isetan's stake of Wisma Atria. This could have been the reason why SGREIT raised perps. However we understand that the yields for retail malls are still low (4-5%) and hence it may be challenging for SGREIT to acquire the property accretively. Furthermore, the remaining lease on Wisma is only 40yrs.

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Over the past few weeks, S-REITs have been announcing their results for the quarter ended 31 Dec 2020. Out of the few sectors (Retail, Office, Industrial and Hospitality), REITs with exposure to the Singapore office market have finished announcing their results. The article will broadly summarize what the key takeaways have been for me and also highlight some of the catalysts that investors in such REITs can look out for. Most of these REITs have non-SG Office exposure too but the focus will be on SG Office since that is the key exposure (apart from CICT).

Suntec REIT

In previous years, SUN had a significant portion of distribution that was capital in nature; this was absent in FY20. However, it seems like there was guidance from management during the briefing that such capital distributions could be used to keep DPU stable in FY21 as SUN recovers from the retail and conventions (~13% of NPI) fall out.

Most of the decline in portfolio valuation (-1.8%) was driven by the mall and convention space. Suntec City office, ORQ and MBFC declined by 1.2/0.6/0.8% respectively. Not too worrying as I think valuers imputed weaker reversions in the near term.

On the office front, SUN guided that there would be continued pressure on rents as companies turn cost-conscious. The pace of renewals was also expected to slow as downsizing was expected. Only about 20-30% of the workforce has returned to their offices. Nonetheless, SUN expects positive rental reversions to continue especially driven by the UBS lease at ORQ which seems to have been done at <$8.50 according to JPMorgan. This can explain the divergence in occupancies and rents seen in the chart below. Typically we would have expected higher occupancies and lower rents as landlords try to fill up their space in a downturn.

As for growth and catalysts, 2021 would see the absence of rental reliefs and full contribution from:

21 Harris Sydney acquired in Apr 20
477 Collins St Melbourne completed in Aug 20
Nova Properties UK acquired in Dec 20
9 Penang Rd Singapore

On the flipside, DPU is expected to be impacted by negative reversions at its mall and convention centre and overhang from its high gearing of 44.3% and low ICR of 2.6x (in 2022 REITs would need ICR of >2.5x to have a gearing of >45%). Analysts are forecasting a DPU yield of around 5.3-5.8% on the back of ~10-15% growth for FY21.

Suntec City Office Committed Occupancy and Passing Rents (Source: Suntec REIT)

Keppel REIT

KREIT had a 2.7% yoy improvement in DPU due to contributions from T Tower and Victoria Police Centre but offset by rental reliefs and divestment of Bugis Junction Towers. Looking ahead, analysts expect DPU yield to be around 5.0% DPU growth will be driven by:

Victoria Police Centre (2H20 onwards)
Pinnacle Office Park (Dec 20 onwards)
Keppel Bay Tower (2Q 21 onwards)

KREIT highlighted that most of its new leasing was from Banking & Finance (36.5%) and Real Estate (34.2%) which doesn't seem entirely in line with news reports of tech companies being the largest new demand sector. The TMT sector contributed 13.5% to KREIT's new leasing demand but 34% to Suntec's new leasing demand. So maybe OFC just doesn't attract tech as much as Suntec City office if we ignore the overseas assets. Nonetheless, management continues to expect positive rental reversions as expiring rents ($9.76 in 2021 and $10.26 in 2022) are still lower than new signing rents ($11.02).

Valuations declined by 1.6/1.8/1.1% for OFC, MBFC and ORQ respectively. Diving into the numbers, I am intrigued by the MBFC and ORQ ones as the declines are more than that of what Suntec experienced for their stake in MBFC and ORQ. Putting them beside one another so that readers can compare. Not sure if I missed anything important that could explain this difference.

Suntec Valuations (Source: Suntec REIT)

KREIT Valuations (Source: Keppel REIT)

During the briefing, management guided that it was continuing to look for acquisitions in Australia and Korea and could scale back unit buybacks to conserve capital. It seems there is also potential for KREIT to partner with its Sponsor to redevelop Keppel Towers. Not very sure if gearing of 39.0% (post acquisition of Keppel Bay Towers) is a concern considering KREIT also has pseudo-debt in the form of perpetual which could increase debt by 10% so maybe around 43% gearing if we include it.

OUE Commercial REIT

OUECT is the only one in the office REIT space that continues to have a retention of distributable income. 11m of distributable income was retained, 6m of which was for working capital for their hospitality segment. This is understandable as hospitality continues to be badly hit and they are also looking at closing Mandarin Orchard for a rebranding to Hilton.

Like Suntec and KREIT, OUECT experienced positive rental reversions for its SG office spaces and expects such positive reversions to continue albeit at a slower pace as committed rents were still above expiring rents. Management highlighted that there could be transitional vacancies as leases expire but overall should still be fairly stable. The largest tenant, Bank of America also recently renewed their lease at OUE Bayfront and would remove an overhang.

Following the divestment of 50% of OUE Bayfront, DPU could be weaker yoy due to the income vacuum. There would also be lower hospitality revenue once MOS is shut for rebranding. Based on disclosures, it seems like the proceeds from divestment could be used to pay down debt (41.2% now but 34.5% if paid down) or distributed to unitholders. To me this is not positive as it indicates a lack of capital recycling opportunities from the REIT and also not conducive for DPU. It is giving up 3.6% yield (using cap rate as a proxy for yield) to save on 3.0% cost of debt resulting in a net loss of 0.6% income on the capital. OUECT already doesn't have the best reputation due to its dilutive fund raising a few years back and also Sponsor that is linked to the Riady family that has backed First REIT and LMIRT.

I think it will continue to trade at a discount to its peers due to i) reputation of sponsor and ii) exposure to hospitality. On a trailing 12M basis, it trades at around 6.2% yield, while its peers are trading at sub 6% yields.

CICT

Finally, the to the largest REIT in Singapore, CICT. Took >2hrs to read through the slides and listen to the webcast. Since the work has already been done, I will also touch on retail a little.

For Office, leasing momentum has picked up over the past few quarters as tenants have a clearer picture of what a post-Covid-19 world will look like. 86% of new demand was from financial services. This also underscores the idea that financial services will still demand high quality offices more than tech firms which can go to business parks or city fringe.

Looking at the graph below from CICT, we can tell that market rents have passed their peak in late 2019 and are gradually going on a downtrend. While I do not expect the trough of rents to fall below $9.00 psf, I think the decline will be long drawn as office landlords are still reporting positive reversions from lower base rents entered into during the upcycle.

Market Rents across time (Source: CICT)

On retail there were a few key concerns by analysts. 1) Is the worst over? 2) Tourism impact for tenant sales 3) Reversions and 4) New retail. It appears that the worst is over and we would not go back to 2Q2020. Tourists used to account for maybe about 20%+ of tenant sales for downtown malls. Reversions would still be negative going forward to support tenants and ensure that there is a good mix of tenants conducive for shoppers.

For DPU growth, it would be driven by the completion of:

CapitaSpring (2H21)
Lot One AEI (2H21)
21 Collyer Quay (4Q21)
6 Battery Road (4Q21)

This could be offset by additional AEIs that the REIT Manager undertakes during the year as well as divestments. From the sound of it, I'm not sure if JCube could be divested as it seems like it doesn't really have a strong value proposition when trying to compete against JEM and Westgate which are attached to the MRT and have everything.

Summary

Overall I think that office REITs' growth has to be driven by inorganic growth as there is little room for organic growth. Organic growth will be held back by tenants giving up space and negotiating shorter leases. On the flip side, shorter leases could be positive if the cycle bottoms out soon as that would give landlords more negotiating power if leases end on an upcycle. From a tenant perspective, it really doesn't make sense to be leasing the same amount of space when you only can have a maximum of 50% of your workforce back. I think the shift will be to co-working concepts that allow companies to do a core+flex strategy to optimize rental costs. With greater prevalence of co-working, that could also imply lower rents for landlords since co-working operators take up large volumes of space.

As most office REITs have gearing of >40% (KREIT is 39%), there is also a small 'risk' of equity fund raising to bring this down. I think what could be prudent for REITs to do is to do a fund raising together with an acquisition and 'over-raise' a bit to bring down gearing. So on a net basis the acquisition is less accretive than it could have been but still accretive to DPU.

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As the world experiences an uneven recovery from the Covid-19 virus, investors continued to pile into markets driving the S&P and NASDAQ indices to all-time highs. The divergence between reality and stock markets have been explained by some as the lack of any viable alternatives for return as interest rates have plummeted.

On the S-REITs front, industrial REITs have continued their outperformance while hospitality and retail continue to lag. In this article, I will explore some general concerns investors have regarding REITs in order to provide readers with more tools to evaluate REITs.

1. Have equity valuations fully accounted for real estate valuations?

In my opinion, the short answer is 'No' as most valuations would have been done at the last year-end, generally being Dec 2019. In Dec 2019, Covid-19 was still in its nascent stages and valuers were unlikely to have factored in the profound changes that the pandemic has brought about. As cashflow and growth are inputs of certain valuation methods, I think the decline in both would lead to lower valuations when assets get revalued soon.

An example of this valuation decline from book value would be OUE Limited's sale of US Bank Tower for US$430m vs its book value of US$650m (~1/3 lower!). Additionally, I do believe that asset owners are holding back on conducting asset revaluations as this could have a negative impact on loan covenants (Ie. fall in asset value leading to higher LTVs).

2. Could leverage limits be breached?

Leading on from my previous point, this is certainly true as valuations decline. The key concern about breaching leverage limits would be the implications on capital structure. If a REIT is close to breaching the limits, it is more likely to embark on equity fundraising (possibly dilutive). This could be why we are seeing smaller premiums (or larger discounts) attributed to REITs with >40% gearing like ESR REIT and ARA Logos Trust. From a pure property investment standpoint, a 40% LTV is not actually something to be very worried about as private funds do not have such limits and tend to go over 50% LTV. However, being a REIT comes with this trade-off of extra regulations.

For investors with a longer memory, S-REITs undertook extremely dilutive equity fundraisings during the GFC period headlined by blue-chip names like Mapletree Logistics Trust and Capitaland Commercial Trust. That exercise caused a crash in REIT stock prices; the crash was a short-term one and REITs subsequently had a strong run until 2019.

3. When will things go back to normal?

Due to the difficulty in quickly testing for Covid-19, I believe that a return to the old norm will come only when a fast test and a vaccine are found. As earlier mentioned, different REIT subsectors have had different impacts from Covid-19. Subsectors like data centres and logistics are strong beneficiaries from the shift to a virtual economy and stay-at-home nature that comes with Covid-19. Others like hotels have been decimated while the future of retail and office are still up in the air.

For both office and retail, I believe that the longer the pandemic lasts, the more people would be accustomed to flexible working and online shopping respectively. Covid-19 has accelerated nascent trends and this may not be reversible. On the flip side, we have also been seeing office workers pining to return to office as work-from-home arrangements have caused additional stress. Shoppers have also been craving the full sensory engagement that comes with seeing and touching items.

As for hospitality, while it is a short term mega loser, I do think that in the long run, it will recover more than office and retail, especially leisure travel. Corporate travel could be somewhat hampered by greater adoption of virtual conferencing but leisure travel is something I believe society is itching to go back to. Of the top 5 oldest business that have been around since before 1300, 4 of them are hotels. This further emphasizes the intrinsic need that humans have for exploration and discovery.

Conclusion

While the market continues to power on, I do think that the Covid-19 situation has shown the importance of having a strong balance sheet and survivability. These are characteristics that are present in most REITs as they have strict gearing limits and have cashflows backed by assets. When the time comes, I believe REITs will come back in favour.

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Ascendas REIT announced their results about 2 weeks ago and reported a 3.7% growth in distributable income but a 10.8% yoy decline in 1H20 DPU. Broadly speaking results were seen as positive despite the Covid-19 pandemic raging on in other sectors. Positive rental reversions, especially in business parks, were encouraging and gearing of 36.1% continues to provide AREIT with a healthy debt headroom for acquisitions. In this article, I would like to focus on key points brought up during the analyst briefing that investors may have missed if they merely looked at the announcements on SGX.

AREIT 1H20 results highlights (Source: AREIT)

1. Positive reversions in the face of weakening outlook not weird at all

At first glance, it seems weird that AREIT could report +4.0% positive rental reversions in Singapore and +4.3% for the total portfolio despite the weakening outlook. However, management has revealed that a number of these discussions had already started taking place before Covid-19 hit and that properties were also under-rented relative to market. The positive reversions represent a mark-to-market of expiring rents rather than an actual growth in market rents.

In particular, the management highlighted business parks as a bright spot with multiple instances of 20%+ reversions. The specific example given was that of an international bank renewing its lease at Changi Business Park for >20% reversion on a new 3-year lease for the same space (no reduction or expansion in space). CEO also highlighted that this was a positive read-through for the business park segment.

For the rest of FY20, the management has guided for mildly positive rental reversions but cautioned that this was not indicative of the direction that the market was moving in. A better gauge could be looking at occupancies instead.

AREIT rental reversions (Source: AREIT)

2. Logistics demand more transient in nature

Much has been said of the new-found stability and strength of logistics tenants that support e-commerce and Covid-19 related stockpiling. However, during the analyst briefing, AREIT did not believe that those 2 would drive the logistics sector much higher.

Firstly, Covid-19 related stockpiling appears to be done on leases <1 year. Therefore, should the pandemic subside, landlords could see a decline in demand for such spaces. In the short term, we can probably see an improvement in rents from such short leases as they tend to be higher than leases with longer commitments. Such short leases also did not really have an impact on rental reversions as reversions only account for renewal leases >12 months.

Next, while e-commerce has been doing well, it does not make up the bulk of leasing demand for logistics spaces. Instead, AREIT CEO mentioned multiple times that logistics demand in Singapore is driven by contract manufacturing and ~80% of it serves international markets. Therefore, the key catalyst for logistics would be whether Singapore can continue to attract contract manufacturers here and if product demand remains at current levels.

Generally, excluding the transient demand from Covid stockpiling, the management said that the new take up is weaker and occupancy could trend down in the near future.

3. Acquisitions and AEIs, while delayed, continue to be on the cards

It should come as no surprise that AREIT is reporting delays in the estimated completion dates for its AEIs and redevelopments due to the outbreak at the foreign worker dormitories. Nonetheless, asset enhancement plans continue to be on track and AREIT also announced 3 new AEIs (2 in Australia 1 in Singapore).

There were also questions on potential acquisitions from the sponsor in Singapore and also overseas. Due to the sensitive nature of such transactions, management could only give very broad motherhood statements; they continue to be interested and have conversations with the sponsor and are doing what they can to unlock opportunities. Deals are coming back and it seems like we may see an overseas one before anything local; anyway, AREIT already did 25% of Galaxis earlier this year.

In terms of strategy, AREIT maintains that it would focus on sectors that drive economic growth like tech and bio-med. In the UK they continue to like logistics and business parks. They also continue to monitor opportunities in data centres. AREIT has a sizeable exposure to data centres from an absolute GFA perspective, however it does not pop out as much due to AREIT's size. Singtel (one of their top 10 tenants) leases data centre space from AREIT. From a pricing standpoint, the management highlighted that lower interest costs also improved the holding power of sellers and hence AREIT is not really seeing any 'Covid-pricing' yet.

AREIT AEIs in progress (Source: AREIT)

4. DPU decline despite no retention and outlook

One analyst asked about a decline in DPU to around 3.6cts per qtr vs 4.0cts per quarter in 2019. This appeared odd given that AREIT did not retain any income and that the US acquisition in 2019 was supposed to be DPU accretive (+0.7%). To this question, the management highlighted that there were certain one-off distributions in 2019 like the rollover adjustment that contributed to about 0.25cts of distribution. 2020 results also had to account for rental reliefs given to tenants due to Covid-19 and also declines in occupancies leading to lower operational results.

Looking ahead, one area that AREIT is poised to reap some savings is on interest cost. AREIT has some perps coming up on their reset date and whichever option it chooses to take (reset, refinance, issue bonds), AREIT is confident that there will be interest cost savings. Apart from this, most of the outlook really depends on how the Covid-19 virus progresses.

In comparison to its Capitaland peers, AREIT has outperformed and even hit above $3.50 last week. Due to this, and the fall-off of CMT, AREIT remains the largest and most liquid REIT in Singapore. Trading at ~1.6x P/B and 4.3% FY20F yield, AREIT is in a good position to continue its growth via acquisition strategy. On the flip side, its size also means that acquisitions won't really move the needle much and AREIT does have to make portfolio-size acquisitions to continue its growth trajectory.

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Ascott announced its results earlier today and it wasn't pretty. Ascott had earlier set out profit guidance that distributable income could drop between 55-65% and DPU could decline by 65-75% for 1H2020. Looking at the actual results, the guidance was fairly accurate as DI declined by 56% while DPU dropped by 69%.

I believe the decline would have been even worse if Ascott had compared it on a same-store basis since there was the merger between Ascott and Ascendas Hospitality that would have boosted the distributable income. During 1H2020, 21 of Ascott's properties were temporarily closed due to the pandemic. Since then, 12 properties have reopened and 7 more are scheduled to reopen in 3Q20.

Operationally, we also saw the benefit of having master leases or management contracts with minimum rents. From a gross profit standpoint, management contracts experienced the worst decline of -61% while master leases actually grew 51%, although partially contributed by the Ascendas merger.

Ascott financial performance of various segments (Source: Ascott)

Ascott has further highlighted that it has a highly diversified set of revenue streams from a geographical perspective and this could help with the recovery. As mentioned in a previous article, exposure to non-Singapore countries allows Ascott to ride on the push for domestic tourism compared to its SG-focused peers. The higher APAC exposure also allows it to ride on the strong response to Covid that APAC countries have had relative to Europe and the US.

Ascott gross profit contribution by country (Source: Ascott)

I expect Ascott's hotel-focused peers to be even worse off as serviced residences tend to have a more stable occupancy due to longer stays. Additionally, in its largest country, Japan, Ascott actually has residential properties that it is renting out, which provides further stability to income.

At its current price of 90cents, Ascott provides an annualized yield of 2.3% (taking 1.05Scts multiplied by 2). In reality, the yield could be around 2.5% assuming Ascott pays out the amounts retained. At such low yields, I do not believe that investing in Ascott shares provide good risk-return ratio. In fact, investing in their perpetuals might be a better choice since it has seniority over common shares and provides a higher yield at 3.07%.

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Yesterday both Keppel DC REIT (KDCREIT) and Mapletree Industrial Trust (MINT) released their results for the quarter ending Jun2020. Both REITs have performed strongly after their end-Mar lows due to their exposure to data centres. MINT has performed more strongly even though it only has a 32% exposure (by AUM) to data centres vs KDCREIT's 100% exposure. I think this could be due to the more visible growth pipeline of MINT from its sponsor's stakes in the US data centres and also redevelopment opportunities at its existing non-DC assets.

KDCREIT Results

KDCREIT reported a 1H2020 DPU of 4.375 Scts which as a 13.6% improvement yoy. This was due to new acquisitions of SGP4 and DC1 in 2019 as well as the latest acquisition of Kelsterbach DC in May 20. Based on the 1H2020 closing price of $2.54, this represents a 3.44% annualised distribution yield. As all of KDCREIT's tenants are in the data centre business, they were not subject to any shutdowns and hence did not require any rental reliefs/support from KDCREIT. KDCREIT was thus able to payout 100% of its distributable income.

KDCREIT Results (Source: KDCREIT)

MINT Results

For MINT, it reported a 1QFY20/21 DPU of 2.87 Scts which was 7.4% lower yoy due to rental rebates extended to tenants due to Covid-19 as well as holding back tax-exempt income of S$7.1m to mitigate the impact of mandated rental reliefs. According to MINT, if such income was not withheld, DPU would have been 3.19 Scts, representing a 0.09 Scts increase yoy. The amount held back was about 10% of its 70.6m distributable income.

Breakdown of sub-asset classes by AUM (Source: MINT)

In my opinion, MINT continues to be held back by its legacy portfolio of flatted factories and older business parks as shown in the negative rental reversions as well as lower new rents achieved during the period. However, investors could possibly see this as 'land bank' to be redeveloped into more future-ready assets. Given MINT's management's strong execution track record, there could certainly be more redevelopment opportunities like 30A Kallang Place and Kolam Ayer.

MINT Rental Rates (Source: MINT)

It is hard to overstate the attractiveness of the data centre asset class during the Covid-19 period where businesses have been forced to digitize and people have been working from home. More importantly from a real estate perspective, data centre leases tend to be long (KDCREIT's WALE of 7.4 years) and provide a steady stream of income so long as service level agreements are met.

At their current trading levels, it appears that both KDCREIT and MINT are in a virtuous cycle as their trading yields (3-4%) are much lower than data centre cap rates (5-7%). This would allow them to make accretive acquisitions even with a greater proportion of equity funding. In turn, this growth potential can further drive up the share price and make it even easier for either to make accretive acquisitions.

Investor optimism has certainly showed up in their strong price growth and I believe that investors are pricing in additional acquisitions. Therein lies a certain amount of risk if the REITs are unable to find assets to acquire and meet investor expectations.

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Today in addition to Keppel REIT releasing results, CCT also released the minutes of their AGM. Both events can help give investors an insight into what has happened in the office market and what we can expect going forward. This article will attempt to summarize some of the key points from the two releases.

1. Slower leasing and a shift to renewals

The pace of leasing has been slower as marketing and property visits have been postponed. CCT also mentioned that it has seen more renewals coming in as tenants want to minimize capital expenditure. Both CCT and KREIT cited that their high tenant quality was important in keeping occupancies high and allowing them to collect rents on time. There have also been no significant requests to downsize.

During this period, CCT highlighted flex space operators as being more affected as their members defer or waive memberships. This is usually highlighted as the downsize of flex space operators as they incur long term rent expenses but with short term membership revenues. On the bright side (for CCT), the WeWork lease at 21 Collyer Quay remains on track and there has been no indication of a withdrawal.

2. Earnings to weaken due to rental reliefs and higher expenses

KREIT cited rental reliefs as a reason for weaker property income. Zooming out a little, we expect NPI margins to compress due to higher cleaning and digitizing expenses incurred by office landlords in making their properties suitable for a return to work. While this is somewhat already expected, the investing community is still waiting on more specific guidance on how much earnings would weaken (similar to what the hospitality players have disclosed recently).

In their outlook statements, both KREIT and CCT mentioned that the impact is still hard to assess and they would continue to be prudent in distributions.

3. Demand down but supply is also lower

As generally known, demand for office space follows economic cycles and it is up to developers and urban planners to manage the supply of office space. While demand is expected to decline, Covid-19 has also resulted in construction and renovation works being pushed back and thus reducing new supply in the next few years. Furthermore, developers could also take the coming few years of weak demand to undertake redevelopments and asset enhancements at their properties. Examples of this are AXA Tower and Keppel Tower.

Overall while the impact from Covid is still limited to the first-degree impact from rental reliefs, I think that we can see higher vacancies and even negative rental reversions in the coming years as leases expire. Office demand will not collapse as fast as hospitality and landlords generally remain fairly positive about the long term potential of office. The slide below from Keppel REIT sums the discussion up quite aptly.

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SPHREIT released its 3QFY20 Business Update this evening. This comes after it shifted to half-yearly reporting; the link to the presentation can be found here. Would like to highlight a few things to take note of:

1. DPU continues to be low but may not be because of a low payout ratio

SPHREIT declared a DPU of 0.5 Scts for the quarter representing an increase over 0.3 Scts declared in the last quarter. However, it did not disclose its distributable income hence we are unable to accurately calculate what the current payout ratio is. If we take last quarter's results, this represents a payout ratio of 33%, up from 20% previously.

In all likelihood, 3Q distributable income would have been significantly worse off than 2Q as the quarter covered Mar-May which were the months which felt the most impact from Covid-related mall closures. Additionally, SPHREIT also announced that they were giving rental waivers for tenants. Therefore, the reduced DI would mean that payout ratio is probably more than 33%.

2. Gulf in prime and suburban not as big

My original thesis was that prime district malls in Orchard//City area like Paragon would suffer substantially more than suburban retail due to the target audience. Apart from having a bigger residential catchment, suburban malls typically tend to have a larger proportion of 'essential' tenants like supermarkets and F&B. Whereas prime district malls tend to have a larger percentage of high fashion and targets discretionary and tourist spend. Therefore I expected suburban malls to be substantially more resilient.

Looking at the visitor traffic figures, Paragon experienced a 58% decline in traffic while Clementi Mall's traffic declined 53%. Would have thought that the difference would be much bigger. My guess would probably be that pre-Covid Paragon was not overcrowded whereas Clementi Mall is frequently packed to the brim. Hence with a higher base there was much more room for traffic to fall at Clementi Mall.

SPH REIT Footfall (Source: SPH REIT)

3. Occupancy remains high but what about rental reversion?

SPHREIT reported a committed occupancy of 98.8% across its malls in Singapore and Australia. Importantly, its 2 largest revenue contributors had occupancies of >99%! I think this is impressive as it probably implies only 1-2 shop lots are vacant. Going forward both Paragon and Clementi Mall have 28%/22% of lease renewals in FY21 and this will be a critical point to watch as leases do take time to expire. I also note that SPHREIT did not disclose its rental reversions in the presentation pack. We are therefore unsure if the high occupancies are a function of cutting rents.

In the down-cycle that is coming, I believe that landlords will do well to shore up occupancy even if it is at the expense of rental rates. Unlike rental rates, occupancy is binary, either you are getting income from that shop lot or you are not. However, do hope that the REITs can be transparent in sharing such figures so that unitholders are well-informed.

SPHREIT Occupancy (Source: SPHREIT)

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Following the private placement by MINT to acquire the remaining 60% of its first US Data Centre portfolio, other REITs with strong balance sheets made moves recently.

Ascendas REIT

AREIT announced the acquisition of a yet-to-be-built logistics property in Sydney today (1 Jul 2020) for A$23.5m. The property will be developed by the Vendor and completed by 2Q2021. In the press release, AREIT mentioned that it managed to acquire the property at an almost 20% discount to its 'as if complete' valuation and this implies a 1st year NPI yield of 6.2%/5.8% pre and post-transaction costs.

With a huge portfolio across Singapore, Australia and the UK, this acquisition barely moves the needle although AREIT says it is accretive to DPU. To unitholders, the REIT is also taking on development risk as the property is uncompleted and does not have a tenant. To mitigate this risk slightly, the Vendor is providing a 9.5months rental guarantee.

REITs taking buying uncompleted assets or taking part in development means that their capital is tied up but not generating any income for unitholders (ie. not so efficient). However, as this acquisition is small, I do not think that there will be any noticeable impact on AREIT. Additionally, this method allows AREIT to gradually build up its portfolio accretively as they are unlikely to get good yields on completed (and fully tenanted) assets. The acquisition is expected to be fully funded by debt or internal resources hence the ability to get yield accretion.

Google Map View of the acquisition (Source: Google)

Frasers Centrepoint Trust

The more sizeable acquisition was made by FCT's acquisition of an additional 12% interest in the PGIM ARF Fund for S$197.2m. This brings its interest in the fund to 36.89% from 24.82%. As a recap, the PGIM ARF Fund contains 5 retail malls and 1 office property in Singapore and 1 retail mall in Malaysia. Ever since FCT and its parent, FPL, started buying stakes in the Fund, their intention was always to absorb these malls into FCT eventually.

According to FCT, this transaction will be DPU accretive on a pro-forma basis by +0.13%. The transaction will be fully debt-funded and would cause gearing to rise from 32.9% to 36.2% on a pro-forma basis.

I like the transaction as it continues FCT's push to eventually own the entire Fund. The properties are all sub-urban retail which plays nicely into the Covid-19 resilience theme vis-a-vis prime district malls. Looks like FCT will continue to make bite-sized acquisitions of stakes in the Fund going forward.

As mentioned in my previous post, I like the growth pipeline for FCT. Other than the PGIM ARF fund, it also has additional stakes in Waterway Point and Northpoint City that it can acquire going forward. A possible benefit of acquiring 100% of PGIM ARF is that FCT could then do away with the Fund structure and have these assets directly under FCT. This would save unitholders one level of fees; currently, I believe that unitholders are being charged fund management fees by PGIM ARF and REIT manager fees from FCT for every dollar that the PGIM assets generate.

Both the AREIT and FCT transactions again emphasize the importance of having a strong balance sheet. For AREIT, it is large enough that bite-sized transactions can still be done without making too much of an impact on its balance sheet. While for FCT, it had always maintained one of the lowest gearing ratios historically, which allowed it to take advantage of opportunities when they arise.

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Frasers Centrepoint Trust (‘FCT’) is a REIT that owns and operates 7 suburban malls in Singapore. FCT generates rental income from its malls that have a total of 1.4m sqft of net lettable area. The REIT is sponsored by Frasers Property Limited, which develops and manages a wide range of properties globally. While its share price has somewhat recovered, I think there is room for more premium than what the market currently accords to it. FCT continues to offer investors good value due to:

1. Visible pipeline for acquisition growth

FCT currently holds a 25% stake in PGIM ARF fund, which has 5 suburban malls with a total of ~1.0m sqft of retail space under the AsiaMalls brand. Its parent, Frasers Property (‘FPL’), holds 65% while the remainder is held by third parties. As part of a possible capital recycling strategy by FPL, the 65% stake could be divested to FCT given that the characteristics (type of malls and tenant mix) of the PGIM ARF assets are very similar to the type of malls FCT currently holds.

Apart from acquisitions of stakes in the PGIM ARF fund, there is also the potential for FCT to increase its stake in Waterway Point, in which it currently holds 40%. The stake in Waterway Point was acquired in 2019 and this could go up once the mall stabilizes; Waterway Point is currently still within its first 2-3 renewal cycles which tend to be periods of stabilization in terms of tenant mix and footfall. Similarly, FCT could also acquire Northpoint City South Wing; FCT currently owns Northpoint City North Wing. Northpoint was reopened in 2017 after extensive asset enhancement works and is also yet to fully stabilize according to FCT.

2. Dominant malls in regions with low floorspace per capita in Singapore

FCT’s 2 biggest revenue contributors, Causeway Point and Northpoint City North Wing, have dominant positions in the Northern part of Singapore. The Northern part of Singapore is also the region which has the lowest shopping mall floor space per capita according to a Cistri report in Aug 2019. This implies that both malls have an excellent catchment of residents and have less competition compared to other regions.

Floor space per capita (Source: Cistri)

3. Suburban retail to remain resilient amidst Covid

Suburban retail malls differ from their prime district counterparts in terms of tenant mix, with a higher proportion of tenants being in essential goods and services (ie. Supermarkets and F&B outlets). In the latest retail sales figures released by Singstat, Supermarkets and Convenience Stores were the only 2 categories that registered yoy and mom growth.

FCT is well-exposed to these sectors as shown in its portfolio trade mix where about 50% of its gross rental income is derived from F&B, Household and Supermarket tenants. The coming Covid-19 induced recession also plays to the value proposition of suburban malls, which is to have products that have accessible pricing relative to prime district malls. With consumers tightening their purse-strings, the search for value items could divert spending towards suburban malls.

FCT portfolio trade mix (Source: FCT)

Key risks

1) Business impact from Covid-19. An extended virus scare could negatively impact FCT’s tenants and could potentially lead to negative rental reversions and lower occupancy going forward. This could also negatively impact property valuations and cause P/B to rise in subsequent years.

2) Concentration risk. FCT’s top 2 malls, Causeway Point and Northpoint, contribute 75% of its Net Property Income. Any decline in population in the Northern part of Singapore or new malls built in the area could negatively impact footfall in the 2 malls.

3) Large tenant non-renewals. About 14% of FCT’s total gross rental income is up for renewal in FY20 and non-renewals, especially for anchor tenants, could imply a period of reduced rent even if a replacement tenant is found due to the time required for fitout works.

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Path to prosperity

Lendlease REIT (LREIT)

SPH REIT

Starhill Global REIT (SGREIT)

Suntec REIT

Keppel REIT

OUE Commercial REIT

CICT

Summary

1. Have equity valuations fully accounted for real estate valuations?

2. Could leverage limits be breached?

3. When will things go back to normal?

Conclusion

1. Positive reversions in the face of weakening outlook not weird at all

2. Logistics demand more transient in nature

3. Acquisitions and AEIs, while delayed, continue to be on the cards

4. DPU decline despite no retention and outlook

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