28th Jan 2014
A SCALE back of the US Federal Reserve’s bond-buying programme and the possibility of rising interest rates have reversed investor sentiment on real estate investment trusts (REIT), sending prices tumbling. Going ahead however, as yields begin to rise, there could be some decent buying opportunities emerging in the sector for investors willing to take a longer view.
With yields in excess of 6% for some mall REITs and 7% for office REITs, there is only a small opportunity cost from holding REITs while taking a medium-term view. At the same time, there is room for upside through capital gains.
“I believe that REIT yields are currently very attractive and many are trading at or close to their IPO yields. It’s a great time to buy. REIT’s are a long-hold stock and the yields are compelling for the long-term investor at this time,” says Malaysian REIT Manager Association chairman Stewart LaBrooy, who is also CEO of Axis REIT.
He pins the poor performance of REITs in the past few months on a selldown by foreign funds as the US and Europe recover and offer better returns. At the same time, local funds and institutions have also been trimming their positions.
“REITs are starting to look cheap but we still do not like REITs at the moment given the trend of rising interest rates. [Malaysia’s] interest rates may not have begun to move, but REIT yields have been rising in tandem with government bond yields. At 6% yields, it is not quite attractive yet,” says Eastspring Investment Bhd chief investment officer Yvonne Tan.
In terms of yields, REITs are trading at quite a broad spectrum (see table). While some are looking a little expensive, Axis REIT looks quite cheap trading at 6.64% yield at last Thursday’s close of RM2.83. In comparison, it was trading at yields as low as 4.76% mid-2013.
Likewise, the yields of CapitaMalls Malaysia Trust (CMMT) and Sunway REIT are substantially lower than the sub-5% they were commanding last year.
There are three things to consider when investing in REITS — bond yields, earnings and risk appetite in the market.
Firstly, REIT yields trade at a spread to Malaysian Government Securities (MGS) yields that have been on the rise, closely tracking US bond yields. Ten-year MGS yields closed at 4.13% last Thursday, up from 3.5% a year ago.
However, the spread between REIT and MGS yields has also been widening. This means that REIT yields have increased more than MGS yields.
For example, Axis REIT’s yields have gone from a premium of 132 basis points (bps) over MGS yields to a 244 bps premium in the past six months.
There are concerns that a hike in the overnight policy rate (OPR) by Bank Negara Malaysia from the current 3% could push bond yields higher and in turn, make REIT yields look less attractive. RAM Holdings chief economist Yeah Kim Leng expects a 25 to 50 bps hike in the OPR in the second half of the year.
“How soon and how much the OPR is increased would depend on growth being sustained over 5% and inflation exceeding 3.5%,” notes Yeah.
However, industry observers point out that Bank Negara Malaysia will have to tread carefully when raising interest rates as it will eat into household incomes at a time of rising inflation. Even if the OPR is raised by the full 50 bps, MGS yields are unlikely to exceed 4.5% this year as the hikes have largely been priced in.
Arguably, yields (see table) are not quite at rock-bottom levels yet and REIT share prices are facing downward pressure in the short term. Investors should keep a close eye on that downward trend, as it could offer buying opportunities. After all, for some of these REITs, how much higher can yields get?
Tan points out that once yields begin to hit the 7% to 7.5% level, REITs will begin to look attractive again and funds will begin accumulating. Using that as a floor, the downside on the investment can be estimated.
On the other hand, a rebound in yields to 5% for retail REITs and 6% for office and commercial REITs will easily generate double-digit capital gains (see table).
This is on the assumption that earnings and therefore dividends remain unchanged this year. To put that in perspective, retail REITS were booking healthy rental growth upwards of 5% last year. This year however, will be much more challenging for REIT earnings.
On one hand, there is a surge of office and retail space coming into the market. At the same time, REITs will have to grapple with higher costs. Office space has already been in oversupply for awhile, hence the higher yields for office REITs.
CB Richard Ellis data estimates 9.8% and 11.3% growth in retail space in the Klang Valley for 2014 and 2015, respectively. Notably, most of the new supply will be in Selangor as opposed to Kuala Lumpur.
“The influx of new space will impact upon existing centres, and poorer performing centres will increasingly compete for the same tenants and shoppers. Better centres with defensible positions such as KLCC, Pavilion KL and Mid-Valley should continue to perform well,” says CBRE director Nabeel Hussain, who expects occupancy rates in such malls to remain at over 90%.
However, he notes that rental growth will come under pressure.
“Average rents will probably see minimal growth, possibly less than inflation, but the better centres, especially those with lower bases should continue to enjoy healthy rental growth,” he says.
Rising costs could also weigh on REIT earnings, with higher electricity prices and the possibility of assessment rate hikes in Kuala Lumpur. “There is no denying that costs for operating buildings will increase — electricity is one of the big ticket items, Assessments will also play a part. In the end these will translate into higher rents for tenants and add to the inflation that we are trying to avoid. Owners will have to put into place strategies to save energy and reduce waste, But in the short term, there will be an impact,” says LaBrooy.
Assessment rates were supposed to be increased at the beginning of the year but this was stalled due to protests from residents. The current rate of 12% of annual rental for commercial properties hasn’t been revised in 21 years, and there are reports that Kuala Lumpur City Hall could look to double it.
According to a report by Kenanga Research, some of the REITs that will be hardest hit by the hike will be KLCC REIT, which has a 100% exposure to properties in Kuala Lumpur and CMMT through Sungei Wang Plaza, which makes up 26% of its net property income.
While rising costs are a concern, most of the well-located retail REITs should be able to pass on the bulk of the costs to their tenants, note analysts. Nabeel, however, is more concerned about a decline in consumer spending affecting the retail REITs.
That said, if consumer spending is on the decline, it does not bode well for many other sectors as well as the wider economy. If demand slows down amid the inflationary pressures, it could create lots of earnings volatility for the growth stocks.
It may not happen in the near term, but if sentiment deteriorates going ahead as it did in 2011 and 2012, there will be a rebalancing towards stable dividend paying assets like REITs that may enjoy a rerating.
This article first appeared in The Edge Malaysia Weekly, on January 20, 2014.
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