The maturity of Singapore’s S-REIT sector is evidenced by its yields and price-to-net-asset-value (P/NAV) ratios. Inevitably, investors, particularly global investors, prefer Singapore portfolios. REITs with mainly Singapore portfolios tend to trade at a premium. CapitaLand Integrated Commercial Trust, ParkwayLife REIT and Keppel DC REIT are trading at sub-5% yields, a sign of their popularity with institutional investors.
REITs are effectively a hybrid between equity and bonds. With that, interest rates affect REITs in three main ways. First off, REITs’ unit prices are directly affected by the spread between the distribution per unit (DPU) yield and the risk-free rate.
The higher the risk-free rate, the higher the DPU yield needs to be to maintain the yield spread. As a result, during periods of rising interest rates, REITs’ unit prices are likely to underperform the benchmark index. For the market as a whole, interest rates impact the cost of capital and weighted average cost of capital (WACC).
Simply put, WACC is the “minimum return a company must earn on its investments to avoid losing shareholder value.” WACC is the blended cost of borrowing (debt) and of raising capital from shareholders (equity). If a company earns more than its WACC, it is creating value; if it earns less, it is destroying value. WACC, expressed as a percentage, is used as a hurdle rate in investment decisions and as the discount rate in valuation models such as discounted cash flow (DCF).
Secondly, REITs can offer higher yields due to the debt they carry. Hence, REITs’ DPU are affected by the cost of debt. Interest costs are usually the REITs’ highest expense. The higher the interest expense, the lower the DPU. Of course, DPU is impacted by other issues. Chief among these is the quality of the assets, the REIT manager, the property manager, and the way the portfolio is managed.
Interest rates indirectly affect discount rates used to value investment properties via DCF, as well as the outlook for rents and occupancy. Hence, interest rates indirectly affect the capital value of investment properties.
In The Edge Singapore’s Big REIT Table, the largest, most liquid REITs tend to have a lower cost of capital than smaller REITs. Liquidity is perhaps the main reason for REITs’ penchant to grow. Other factors also affect the cost of capital. Among these, REITs with overseas assets in unfamiliar markets are likely to trade at higher yields.
In sum, interest rate trends are likely to be an important driver of S-REITs’ total returns.
