By Tay Hock Meng
With a rising interest rate environment comes the dilemma among investors when it comes to choosing between property developers or real estate investment trusts (REITs) counters. The recent buoyancy in new home sales and news headlines about potential home price appreciation (HPA) have warranted some attention among real estate type stocks, be it developers or Reits stocks. What would be the impacts of rising interest rates and debt levels on these two sectors?
Downtrend In Developer and Reits Indices Amidst Higher Interest Rates
Source: Phillip Securities Pte Ltd (16 October 2018)
The one-year chart depicts the overlaps of two indices, the FTSE ST Real Estate Holding and Development Index (blue colour), and the FTSE ST Real Estate Investment Trust (brown colour). As there are not many interest proxy indices available in the open public markets, I have chosen the iShares Asia High Yield S$ Exchange Traded Fund (ETF) (SGX:QL3) as a proxy for corporate interest rates which is depicted on the chart shown above in green colour.
One of the reasons for choosing iShares Asia High Yield S$ ETF is its closest approximation to corporate high yield issuers, and the sensitivity of high yield debt in a rising interest rate environment.
As one might note, both the FTSE ST Real Estate Holding and Development Index (FTSE ST REHDI), and the FTSE ST Reit indices are trending downwards, whereas the iShares Asia High Yield ETF bucked the trend and is about to trend above the FTSE ST Reit index. The combination of rising interest rates and investors’ risk aversions might have negatively impacted both the real estate developer stocks and the Reits. Moreover, with the introduction of the property cooling measures on 05 July, it might have hurt the real estate developer stocks badly as the sector suffered severe corrections in the range of 5 to 15 percent in a single session when markets reopened on 06 July.
Another reason that might explain the downtrend of both the real estate development and Reits indices is the widening yield spreads which resulted in a shift of investors’ preference towards higher yielding corporate debt issues where interest rates are pegged to a base rate plus a yield differential. The shift in investors’ preferences does result in monies being diverted to high yield debt instruments, and away from equities such as developer stocks, Reits and other high dividend yielding counters.
Highly-geared Developers And Reits Face Higher Risks
Despite the negative impacts of higher interest rates on developer and Reits stocks, we might want to be selective about our stock picks in both sectors. For Reits, the sector is tightly regulated by a strict gearing ratio of 45 percent as measured by the total debt to total assets ratio. The 45 percent gearing ratio is mandated by the Monetary Authority of Singapore (MAS).
According to figures obtained from Reitdata.com, one of the highest gearing levels among the Singapore Reit (S-Reit) universe during the month of October 2018 is Soilbuild Business Space Reit which has a 40.60 percent gearing level and a Distribution Per Unit (DPU) yield of 9.621 percent. With the relatively higher gearing level, investors might want to continue monitoring the capital expenditure plans, and fund-raising methods undertaken by management. This is to ensure that the management is mindful about not exceeding the mandatory debt limit and to protect the interests of the unitholders.
Recently, Soilbuild Business Space Reit has gone to the capital markets to raise funds through a $65 million perpetual debt. According to a 21 September 2018 Business Times report, the Reit counter managed to attract one of the single largest investments worth S$30 million from its largest controlling shareholder, Lim Chap Huat who held a 9.096 percent stake in the counter before the purchase.
For developer stocks, they do not face any mandatory gearing level. However, the negative impacts of higher interest rates cannot be ruled out considering that several smaller developers have closed shops due to the inability to manage its debt levels. According to a Singapore Business Review (SBR) article dated 12 March 2018, Singapore developers’ debt as a share of total assets rose from 33.8 percent in 2010 to 35.6 percent in 2018, and interest coverage ratio fell from 10.6 percent in 2010 to 3.7 percent in 2016.
Should Investors Resist Any Moves Into Developer and Reits?
The combination of higher interest rates and higher gearing levels of stocks in both the real estate and Reits sector do pose some concerns, and investors are advised to conduct thorough due diligence before they make their final selections. However, we do not think that the rising interest rate environment will pose a severe dampening effect on investors’ sentiments towards both sectors. Contrary to some investors’ misconceptions that higher interest rates will pose dangers to their investment portfolios, we think that it is more important to examine the ability, and the capacity to handle higher interest rates which are the two largest challenges posed on both sectors. If corporations are able to juggle both higher interest rates, and debt levels, the overall market confidence towards stocks in both sectors will eventually be positive.
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