Part of the weakness may have been due to a price correction after the year-end window dressing activities. But sentiment was primarily affected by souring sentiment for global equities.
Bellwether indices in key global markets are mostly down for the year-to-date, led by sharp losses in emerging markets.
Stronger growth expectations in the US and the Federal Reserve’s gradual pullback on its bond-buying programme are prompting fund flows back to the country, mainly from emerging countries — from both bond and equity markets. Countries that are worst affected by the outflow of foreign capital are those with weak underlying economic fundamentals and political uncertainties.
Against this backdrop of renewed uncertainties, it may be tempting for investors to go on the defensive, again — specifically for companies with resilient earnings and high dividend yields. A sector that comes to mind will be real estate investment trusts (REITs).
After all, the sector had fared very well previously in the chase for yields, before mid-2013 when the US Fed started hinting at tapering.
Prices for REITs have fallen quite a bit since mid-2013
Recall that we questioned the sustainability of low-risk premiums for REITs back in mid-2013 when net yield fell as low as 4.7%, on average, for larger retail-focused REITs — Sunway REIT, Pavilion REIT, CapitaMall Malaysia Trust and IGB REIT.
Axis REIT, the only industrial-focused REIT on the local bourse, had a net yield of approximately 4.4%.
This implied a historically low yield spread ranging between 0.9% and 1.2% against the then risk-free Malaysian government securities (MGS) yield of about 3.5%.
Commercial-focused yields stayed comparatively higher at roughly 6.5%, on average, due to their perceived greater risks on expectations of persistent oversupply in the market.
Since then, REITs have fared poorly as expectations for rising interest rates gained traction.
Unit prices for four large retail-focused REITs have since lost between 17% and 30% of their values at the peak. Meanwhile, the unit price for Axis REIT was down by as much as 33% from the high of RM4.18 before recovering some lost ground in recent days. Losses for the commercial REITs were more modest by comparison, averaging about 8%, due to their relatively higher yields to start with.
The drop in unit prices means that net yields have rebounded — yields are inversely correlated to price movements — to roughly 5.7% for the retail REITs and 6.4% for Axis. The latter includes an estimated one-off 2.37 sen per unit distribution from asset disposal gain this year. Net yield in 2015 is expected to drop back to about 5.9%.
The question is has prices fallen — and yields risen — sufficiently to make REITs more attractive now?
But yield spreads are still comparatively low
Of note, whilst REIT yields have rebounded, so have risk-free returns. Yields on the benchmark 10-year MGS now stand at just under 4.2%, a sharp rise from an average of about 3.5% in the first half of 2013 (1H13).
Thus, compared against prevailing MGS yields, the risk premium for retail REITs is averaging roughly 1.5%, while Axis and the commercial REITs have a yield spread of about 2.2% on average.
Although the yield spread has widened somewhat from that in mid-2013, this buffer does not seem attractive by most yardsticks — especially if interest rates continue to rise, as is current expectations. Indeed, recent statements from central banks around the world suggest that the era of low interest rate is, by and large, over.
Local bank lending and deposit rates are expected to start rising by 2H14. If true, this will cause the yield spread to narrow again — likely leading to another round of downward re-pricing for REITs.
Earnings growth expected to be modest
Positively, earnings for REITs are still expected to be quite resilient but growth may well slow going forward.
One of the key drivers for growth is the acquisition of yield accretive assets. This avenue, however, has been limited — in fact, no fresh acquisition was completed in the whole of 2013 — due to high property prices. Rental rates have not kept pace, which translates into unattractive returns. Unless property prices fall, new acquisitions will likely be sparse in the near to medium term.
This leaves organic growth, mainly through rental reversion. Last year, retail-focused REITs were still enjoying strong rental reversion, particularly for malls with prime locations such as Pavilion KL Mall and Sunway Pyramid Mall. Both reported rental reversion of around 15% for leases renewed last year. CMMT enjoyed an average 7.5% rental reversion for its portfolio of four malls, while Axis REIT saw an average rental hike of about 8% in 2013.
Going forward, the outlook is more cautious. The quantum of rental hikes will likely be tempered by a broad slowdown in domestic consumption, as wages lag rising cost of living, as well as greater competition from new retail and office space.
For instance, revenue growth for commercial REITs such as Quill Capita Trust was negative last year as rental increases for some properties were offset by lower occupancy in others.
Earnings growth will also be dampened by rising operating costs, due to higher electricity tariffs and assessment rates. Interest expense will increase as borrowings are gradually rolled over, although the near-term impact will be limited. On balance, investors should weigh prevailing expected returns from REITs against these risks.
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 February 10, 2014.
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