Singapore Reits, Rising interest rates and the Pandemic

This is not a new topic. In fact, when I think of Sg Reits in general, this appears to be a perennial matter on my mind. What is perhaps significant and new now, is the context. However, the conclusion will probably be the same. That could be the eventual conclusion, but there are a few key points I like to highlight. Things after all have evolved, and the Reits sector with the pandemic context as a whole has evolved (I try not to use the word ‘changed’).

For the beginning part of the article, I will be quoting many articles found online. This first part of the post is rather long. Subsequently I raised a few questions for all of us to ponder. So you can skip the first and go to the second part.

Before we move on, I just want to highlight that there are many things I like about Reits eg. their relatively high tax free dividend yield, stable assets backing the counters, not as volatile in terms of price movement. These are after all general statements. There are of course exceptions such as Eagle Hospitality Trust, Sabana Reit, First Reit, etc. Then again, ultimately no Reit investment is risk free.

Eagle Hospitality Trust stuck in limbo after unitholders vote against change of manager (read here)

Is it time for Sabana Reit to be euthanised? (read here)

First Reit FY2020 DPU down 51.7% to 4.15 S cents (read here)

1) Rising Interest Rates and Reits

In many way, I view owning Reits very close to owning an investment property, while excluding the headaches of dealing with tenants, agents, etc. In addition, it is pretty close to a bond like investment, with quarterly or semi annual dividend payouts.

So naturally many people would compare Reits to bonds and are concerned about yield, and how the rising yield (or interest rates) affect the dividend yield of Reits.

S-Reit investors need not fear rising rates (read here)

How Higher Interest Rates Impact REITs (read here)

I think the above 2 articles are good in explaining the matter. Let me summarise some of the key points below, while adding some other points from other sources.

To quote the second article: “Over the past decade, interest rates have fallen to historically low levels. This has created a challenging environment for income investors who previously enjoyed healthy, low-risk returns from money market funds, CDs, and Treasury bonds. In fact, since the darkest days of the financial crisis, many yield-starved investors have been forced to search elsewhere for their income needs, driving up demand for bond alternatives such as REITs.”

The below shows the U.S. 10 Year Treasury yield chart dating back to 1962. As you can see, yield peaked around 1981 and since then has been trending down. Today it is around 1.69% (at the time of writing).

Interest rates have never been this low for this long, making many of the academic studies about rising rates potentially less relevant.

To quote Howard Marks in his latest memo:

“Through bond buying, the Federal Reserve grew its portfolio by $2.7 trillion, or roughly 55%, and the U.S. Treasury funded roughly $4 trillion in grants and loans.

Unlike the credit crunches that accompanied many past crises, capital flowed like water. High yield bond issuance for the year was $450 billion, up 57% from 2019 and well above the prior record set in 2013. Investment grade debt issuance totaled $1.9 trillion, up a similar 58% from 2019 and also ahead of the previous record, set in 2017.

Rising economic confidence and the increasing pace of economic development and growth, even if it comes with inflationary pressures can be good for REITs.

After the Fed cut its federal funds rate target to between zero and 0.25%, bond prices rose as bond yields fell in parallel. At year-end, the average A-rated bond yielded just 1.52%, and the average yield on high yield bonds (ex. energy) was just below 4%.”

As mentioned by Howard Marks, the Fed targets the federal fund rates to be between zero and 0.25%.

So how will it impact the 10-year interest rate? No much perhaps.

As mentioned, in the article below: “In contrast, the interest rate on a 10-year Treasury bond does not appear to move as closely with the fed funds rate. While there appears to be some co-movement, the 10-year interest rate appears to follow its own declining path.“

How Might Increases in the Fed Funds Rate Impact Other Interest Rates? (read here)

In fact, we have recently seen a spike in the U.S. 10 Year Treasury yield. Treasury bond yields (or rates) are tracked by investors for many reasons. The yields are paid by the U.S. government as interest for borrowing money via selling the bond.

The 10-year Treasury yield is closely watched as an indicator of broader investor confidence. This is because Treasury bills, notes, and bonds carry the full backing of the U.S. government, they are viewed as the safest investment. The 10-year is used as a proxy for many other important financial matters, such as mortgage rates.

When confidence is high, prices for the 10-year drop, and yields rise. This is because investors feel they can find higher-returning investments elsewhere and do not feel they need to play it safe. But when confidence is low, bond prices rise and yields fall, as there is more demand for this safe investment. This confidence factor is also felt outside of the U.S.

So why does the yield rate or more specifically interest rates matter to Reits?

To quote this article:

“There are two reasons why interest rates matter to REITs, and both have to do with the underlying business model of this high-yield industry.

1) REITs exist so that the companies that own the properties can avoid paying corporate taxes as long as they distribute 90% of taxable income as unqualified dividends.

This means that REITs aren’t able to retain much of their earnings or adjusted funds from operations (AFFO – similar to free cash flow for a REIT).

Thus, in order to grow, REITs need to raise external debt and equity capital from investors. As a result, higher interest rates increase a REIT’s cost of debt and make it incrementally harder to achieve profitable growth. That’s especially true because REITs frequently use secondary offerings (i.e. they sell new shares) to raise growth capital…..

However, when interest rates rise, bonds, including risk-free Treasury bonds, decline in value, causing their yield to rise. REITs compete for new capital with bonds, as well as savings accounts, money market funds, and CDs. Some investors who own REITs today might be inclined to sell their shares if rates rise because they can now achieve similar but less risky yields elsewhere.

2) To put it another way, because REITs are often seen as bond alternatives, higher interest rates could mean decreased demand for REIT shares, causing a REIT’s yield to rise. While that’s great for dividend investors looking for new places to put money to work, it can also be a problem for the REIT’s long-term growth prospects.

That’s because the higher a REIT’s valuation (i.e. share price), the less new shares it takes to raise growth capital.
In other words, the less dilution to existing investors is needed in order to continue growing a REIT’s AFFO, and thus its dividend.

Think of it this way. Suppose a REIT currently yields 5%, and management is able to buy new properties at a capitalization rate (annual net income / purchase price) of 7%. Even if the REIT has to raise 100% of the capital to buy a property by selling new shares, then AFFO per share will still increase, and so will the dividend.
And if the REIT buys the property with a 50/50 mix of equity and debt (with an interest rate of 4%), then the amount that AFFO per share increases is even more due to less dilution and an even lower weighted average cost of capital, or WACC.
However, if interest rates increased to 6% and a REIT’s shares fell enough to raise its dividend yield to 8%, then suddenly the ability to buy that property with 100% equity capital disappears.

The 8% yield a REIT would have to pay on its newly issued shares is more than the 7% capitalization rate it earns on its property, destroying shareholder value.
In other words, the REIT’s cost of capital has risen high enough to not make the deal accretive.
REITs essentially have an optimal growth sweet spot, in terms of their yield. If shares are too expensive, then the yield is too low for investors to earn the income they need.
But if shares are too cheap for too long (due to higher interest rates, for example), then the REIT gets cut off from growth capital and can’t expand its property portfolio and dividend.”

So as what I mentioned earlier, many people compare Reits to bonds. The rise in the bond yield stems from fears over inflation escalating as the economy recovers amid huge fiscal stimulus and ultra loose monetary policy. In Singapore, the 10 year government bond yield has also been rising (see below). The Singapore 10 Years Government Bond has a 1.715% yield (last update 3 Apr 2021 10:15 GMT+0).

So yes, a rising interest rate might (a) push investors to safer investments (eg. bonds) that offer similar yield and (b) with the shift away from Reits, share prices drop and their dividend yield increase, reducing the ability for Reits to access growth capital and expand its property portfolio and dividend.

Ok these are not new worries. Remember we already have a prolonged period of dropping rates and low interest rates / U.S. 10 Year Treasury yield.

As with all investments, everything is relative. The attractive of the relatively risky assets like Sg Reits are often compared to other safer investments in Singapore.

S-Reits generally trade at a decent spread to the 10 year government bond yield, typically in excess of 250 basis points.

At the point of writing:

1) Lion-Phillip S-REIT ETF currently has a dividend yield of 4.29%;

2) NikkoAM-StraitsTrading Asia Ex Japan REIT ETF currently has a dividend yield 5.04%;

3) Phillip SGX APAC Dividend Leaders REIT ETF currently has a dividend yield of 3.27%.

And as mentioned earlier, the Singapore 10 Years Government Bond has a 1.715% yield. So items 1 and 2 show that there is a spread of in excess of 250 basis points (or 2.5%).

By the way, for item 3 (Phillip SGX APAC Dividend Leaders REIT ETF), most of the REITs in this ETF are concentrated in Australia, followed by Singapore, Hong Kong, and Thailand. So technically it is not very representative of Singapore Reits (as compared to items 1 and 2).

REIT ETFs: The Ultimate Singaporean Guide to Investing in ‘Em (read here)

Savings in CPF accounts pay an interest rates of 2.5% (OA) per annum or more.

The April issue of the Singapore Savings Bonds provide a yield of 1.15% per annum over a 10 year period.

The oversubscribed Astrea VI Class A-1 bonds issued by an entity of Temasek Holdings Azalea Asset Management offer a yield of 3% per annum assuming they are called after 5 years.

So with the above mentioned taken into consideration, the price / yield of Sg Reits in general appears acceptable.

S-Reit investors need not fear rising rates (read here)

As per the article above, the conclusion is that with rising economic confidence and pace of economic growth, even if that comes with inflationary pressures and rising yield of long dated government bonds, this is not bad for Sg Reits. With incremental demand for real estate that stem from growing business growing and consumer spending increasing, the income of business and households will rise and tenants of Reits can afford higher rents. Retail and hospitality Reits stand to gain the most from further opening of economies and borders.

This conclusion is not new when the matter of increasing interest rates is mentioned. Way before the pandemic happen.

To be honest, I do not totally disagree with this argument, and as I have Reits in my portfolio, I do hope this is right.

2) Questions moving forward. The key word is “Unprecedented”

This is where it gets interesting.

There are a few questions on my mind, and we have to consider these questions together, not individually.

Let’s go back to the Singapore 10Y Bond Yield chart (see below). This time, let us go back further, to 1998. As you can see, the yield has been in a very consistent long term trend – which is down. This is also similar to the U.S. 10 Year Treasury yield chart – a long down trend since 1981.

The first listed Reit in the Singapore stock market is CapitaMall Trust (now CapitaLand Integrated Commercial Trust), which was listed on 17 July 2002.

So historically speaking, Singapore listed Reits have always been trading within this long term downtrend yield period (macro trend speaking). The macro yield trend did not change.

Howard Marks raised a few interesting questions in his latest memo titled “2020 in Review”. Yes, beyond the unprecedented flow of cash in the system, the loose fiscal and monetary policies environment we are in:

Question 1: The biggest risk of all is the possibility of rising interest rates. Rates have declined quite steadily for the last 40 years. This has been a huge tailwind for investors, since a declining-rate environment lowers the demanded returns on assets, making for higher asset prices. The linkage between falling interest rates and rising asset valuations is a good part of the reason why p/e ratios on stocks are above average and bond yields are the lowest we’ve ever seen (which is the same as saying bond prices are the highest).

But the downtrend in rates is over (if we can believe the Fed’s assurance that it won’t take nominal rates into negative territory). Thus, while interest rates can rise from here – implying higher demanded returns on everything and thus lower asset prices – they can’t decline. This creates a negatively asymmetrical proposition.

Question 2: The Fed says rates will be low for years to come, but are there limitations on its ability to make that happen?

Question 3: Can the Fed keep rates artificially low forever? On longer-maturity bonds? And what about inflation? Can the 10-year Treasury note still yield 1.40% if inflation reaches 3%?

Since Howard Marks like to talk about odds, think of it this way, looking at the yield charts (be it U.S. 10 Year Treasury yield chart or Singapore 10Y Bond Yield chart), we have been in a really long period of downtrend. Yes, there is a possibility that we may go into negative interest rate zone, but that is a very low possibility (and seems to create more problems than good, looking at past precedents in other countries eg. Japan). What is the odd of that? I think it is rather low in the long term.

We are likely moving towards an inflexion point.

So that leaves us with basically 2 scenarios:

1) Scenario 1: A change in trend, eg, rising rates.

2) Scenario 2: A long period of stable rates or range bound rates.

Or put in another way, Scenario 1: Upwards, Scenario 2: Sideways.

As per the first part of the post, conclusion is that rising rates in the context of a growing economic condition is not exactly bad for Reits.

How Higher Interest Rates Impact REITs (read here)

In the US listed Reits context, the above article was able to show how US listed Reits perform historically in times of higher interest rates.

To quote: “The chart below, courtesy of REIT.com, plots the 12-month return of REITson the y-axis, and the change in the 10-year Treasury yield on the x-axis from 1992 through 2017. The blue dots represent periods when REITs earned a positive total return during each of those periods. The red dots signal that REITs lost money.

While an investment in REITs made money in 87% of rising rate periods observed, it is clear that REITs have been positively and negatively correlated with interest rates during different periods of time, indicating that there are other factors influencing their returns.”

However, there are also further questions. If in the context of rising rates or stagnant rates, there is another issue of structural change in the business of Reits. Basically, the 2 key “unprecedented events”.

No. 1: Unprecedented long term up trend (or sideway trend) for interest rates for Singapore listed Reits.

No. 2: Unprecedented structural change in business for many of the Reits tenants.

For No. 2 (yes that is the second spanner thrown), technically we are still not out of the woods from the pandemic. There are companies still practising a work from home system. In addition, travelling between countries is still affected. However, there are nonetheless discussions that there will be permanent changes to how people work, live and play in the future. There is no going back to pre-Covid situations.

A growing list of major firms, such as Facebook, Google, Twitter, Mastercard and Shopify, are now planning a permanent shift to remote working even after dangers of COVID-19 fade and cities lift shutdowns.

Business wise, in the supply chain, there will be a change from just in time model to just in case model. For the hospitality sectors there will also be changes.

For the retail sector, even prior to the pandemic, it is already facing pressure from e-commerce. The pandemic just hasten the change. In 2020, we saw the closure of Singapore’s Robinsons department store, ending an era dating back 162 years.

StanChart unveils permanent move to flexible working from 2021 (read here)

Microsoft is letting more employees work from home permanently (read here)

Goodbye office: Is the future of work in our homes? (read here)

EVERY COMPANY GOING REMOTE PERMANENTLY: MAR 20, 2021 UPDATE (read here)

Moving from Just in Time to Just in Case (read here)

Singapore’s Robinsons department store to shut down after 162 years (read here)

The world wide lock-downs, the large scale shift from office to work from home made possible by the advancement in technology, to the way people socialise, live, work, play, etc are in many ways unprecedented.

As a retail investor, I like to be able to forecast, to extrapolate into the future, while looking at the past. It is easier to do so when I do not have ‘unprecedented’ situations. However, for many retail investors, how fast rates will rise or the future direction of interest rates are beyond their control. In addition, as mentioned earlier, the interest rate on a 10-year Treasury bond does not appear to move as closely with the fed funds rate. So am wondering how will the Fed be able to keep rates artificially low forever.

Many investors are spooked by what they cannot foresee or control, nor have any historical references.

Inflation fears hit markets as Fed sticks with low-rate policy (read here)

In Gist

When we combine these 3 items together, Singapore Reits, Rising interest rates and the Pandemic, many questions arise.

Yes the economy will pick up after the pandemic, but will Reits prosper as well? Or will they be left behind?

There are not many pure play Reits listed in Singapore. Eg. Reits that are purely office, retail, industrial etc. Yes there are, but many of the bigger capitalised Reits have their fingers in different sectors. On another note, some sectors are more impacted by the structural changes (if they do become permanent). eg. Office or hospitality or retail sector. So in a way, many of the diversified Reits will be somehow impacted, unless they managed to off load or adapt in time.

In addition, Reits as mentioned earlier, pay out 90% of their profits, and essentially have an optimal growth sweet spot, in terms of their yield. So if yield rise and they cannot find ways to grow either by asset enhancement or addition of better assets, it is just a continuous downward spiral, while investors look for safer better yielding alternative investments. Are the Reit managers able to find that sweet spot in this environment?

Asset enhancement in the context of rising material prices (fast inflation + rising interest & mortgage rates) and disrupted supply chains is also not going to be cheap. And how willing will landlords be, to be the first to experiment and break through, without government incentives? Or rather what is the likelihood that the notion be approved by shareholders, who may be more ‘short-sighted’ retirees who are more concerned about the next dividend payout amount and date than the long term prospect of the Reit itself. This is not the fast paced disruptive tech start-up sectors we are talking about.

How experienced will Singapore Reits managers be in addressing the unprecedented situations?

I do not think it will be a dead end, and businesses / Reits will evolve and adapt. Nevertheless there are big question marks. However, knowing these few questions is probably the first step in tackling them.

Most people do not get rich by trading in and out of Reits, or holding Reits for very short period of time. It is typically through long holding periods, through the accumulation of dividends and capital appreciation that investors profit. So most retail investors will have to ride the long term trends, whichever they might be.

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