Reprieve for REITs as risk-free yields fall
Insider Asia
Written by Insider Asia
Wednesday, 07 May 2014 10:15
UNIT prices for real estate investment trusts (REIT) are enjoying a rebound of sorts in recent months, recovering from 52-week lows. This may be attributed to the rather unexpected drop in yields on risk-free government bonds.
With the US economy widely expected to gain traction, many investors have been factoring in the imminence of higher interest rates. Indeed, government bond yields have been inching higher through much of the second half of 2013.
Contrary to expectations, however, having briefly crossed the 3% threshold at the start of the year, yields for the global benchmark 10-year US Treasury notes have instead fallen back to around 2.6% currently. Similarly, yields on the 10-year Malaysian government securities (MGS) have also fallen, now hovering around 4% down from as high as 4.3% earlier this year.
Lower risk-free yields have led to a mild recovery in interests in REITs, which are high yielding investing alternatives. For the five largest listed REITs on Bursa Malaysia — by total assets and market capitalisation — prices have rebounded by 5% for IGB REIT to as much as 21% for Axis REIT (Table 1).
Where does that leave investors in REITs now?
The five largest REITs listed on Bursa currently offer net yields estimated at 5.5% to 5.6%, on average, for 2014/15. That is roughly 1.5% above prevailing risk-free MGS yields (this yield spread is the so-called risk premium for investors).
With corporate earnings growth continuing to underwhelm, so far, and equity valuations at the higher end of long-term historical averages, investors may be tempted to stay invested in REITs — if only for their dependable income stream.
The risks of investing in REITs, though, may not be as low as advertised — and investors may not be adequately compensated for taking on these risks at prevailing prices.
The current average yield spread of 1.5% — the buffer against rising risk-free yield — is quite low from a historical perspective. As a comparison, a sampling of the larger REITs listed in neighbouring Singapore currently have a yield spread of about 4.25%, on average.
When, not if, risk-free bonds yields resume their upward trend, REITs could very easily see their recent price gains wiped out — and quite likely more, depending on how fast interest rates are rising.
The reprieve is likely to be temporary
The current upswing in bond prices — and corresponding drop in yields — is due, at least in part, to a flight to safety on escalating tension in Ukraine. It is uncertain how long this situation will last but fears will eventually wane.
Also, economic data for the US economy has been somewhat mixed. First quarter of 2014 (1Q14) gross domestic product growth for the world’s largest economy was an anaemic 0.1%, though this was attributed to bad weather. Importantly, inflation remains modest, giving the US Federal Reserve more leeway on keeping short-term rates near zero.
But the US economy is gaining traction and so will inflation expectations. Thus, higher interest rate is inevitable — even if the timing is still up for debate.
Indeed, most market observers are expecting risk-free bond yields to end the year on a higher note while the majority currently believe short-term rates will start rising by mid-2015.
Income growth may be too tepid to match rising risk-free yields
REITs may be ill equipped to generate sufficient distributable income growth to keep pace with rising risk-free yields, at least in the near to medium term.
High property prices remain the key obstacle to income growth through yield accretive acquisitions. There was no notable new acquisition for listed REITs last year and so far this year, save for Quill Capita Trust, which saw the emergence of Malaysian Resources Corp Bhd as its largest shareholder following the injection of Platinum Sentral into the trust.
If such conditions persist, this will leave REITs with just organic growth — through asset enhancement initiatives (AEI) and rental increase — amid operating cost inflation. Higher interest rates will also raise borrowing costs for REITs going forward.
Insider Asia 1
Retail REITs are still enjoying double-digit rental reversion, for now. Looking ahead, there will be emerging pressures, in terms of rental rates and occupancy, with more retail space coming into the market — although well-located and popular malls should be less affected.
We also do not discount a deeper negative impact from the slowdown in domestic consumption. Industry statistics indicate retail sales growth in the country fell well below expectations in 2013, at just 4.5%, slowing noticeably in the second half of the year.
Retail sales growth estimate for 1Q14, at 4.8%, was also well below the 7.5% registered in 1Q13 as rising cost of living hit consumer spending power. In view of the ongoing subsidy rationalisation and implementation of the goods and services tax next April, price inflation is not expected to subside anytime soon.
Table 2 underscores the modest earnings growth for most of the largest REITs in 1Q14 — which could slow further over the coming quarters.
Of note, IGB REIT saw strong double-digit growth in 1Q14, boosted by a major rental cycle for over half of total net lettable area at The Gardens Mall in 3Q13. (Rental rates at The Gardens Mall are still below those of the adjacent Mid Valley Megamall.) As such, its pace of growth too is likely to taper off in the second half of this year and going into 2015. Furthermore, the trust is not seen to make any new acquisition in the next two to three years.
Table 3 highlights prevailing valuations and net yields for the largest REITs. Axis REIT appears the most expensive in terms of price-to-book value, at 1.6 times. On the other hand, it may also be among the most likely to make fresh acquisitions this year, which should help income growth — distribution per unit in 1Q14 was flat, excluding the 0.8 sen per unit distribution from disposal of asset (to be paid over three quarters).
Source: http://www.theedgemalaysia.com/insider-asia/288346-reprieve-for-reits-as-risk-free-yields-fall.html
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Note: This report is brought to you by Asia Analytica Sdn Bhd, a licensed investment adviser. Please exercise your own judgment or seek professional advice for your specific investment needs. We are not responsible for your investment decisions. Our shareholders, directors and employees may have positions in any of the stocks mentioned.
This article first appeared in The Edge Financial Daily, on May 7, 2014.