Cai Jin

Financials favoured over Reits

Higher interest rates, tepid economy outlook are just a few investment challenges for Reits

If there is one trend worth highlighting about trading stocks in the past two months, it is the divergence between the performance of bank stocks and those in the real estate investment trust (Reit) sector.

Reits have been one of the most popular investments in recent years, thanks to their mouth-watering yields which beat the next-to-zero returns offered on bank deposits hands down.

But in the past two months, they have markedly underperformed the market, with the FTSE ST Real Estate Investment Trusts Index falling by as much as 8.6 per cent in that period. Since the start of the year, however, they have been able to recover some of their losses.

In contrast, financial stocks have been on a roll. Since October, the FTSE ST Financials Index has risen by about 6 per cent. What is even more incredible is the performance of bank counters. DBS Group Holdings has surged 18.5 per cent, United Overseas Bank has jumped 11.5 per cent while OCBC Bank has powered ahead by 7.5 per cent.

The big contrast between the performance in the two sectors is also reflected in the way in which fund managers have been moving money in and out of them.

In October, the monthly fund-flow data produced by the Singapore Exchange showed that institutional investors were net sellers in both Reits and bank stocks.

CIMB noted that based on URA indexes, retail rents fell 7 per cent in the first nine months of last year. Even so, some Reits such as Mapletree Commercial Trust's VivoCity (above) and Fraser Centrepoint Trust's Causeway Point still managed to experience "positive rental reversions" because of their active property management. ST FILE PHOTO

But in the following month, they had a big change of heart. While they continued to pull a net $299.8 million out of Reits, they turned into big buyers of banks, pouring a net $1 billion into them.

Last month, fund managers appeared to have made use of the market rally to continue to lighten up on their portfolio. While they continued to favour bank stocks, buying a net $135.9 million during the period, they sold a net $322.2 million worth of Reits.

In short, one conclusion that can be drawn from the data is that fund managers are bullish on banks but bearish on Reits. Why is this so?

One observation worth flagging is that while Reits benefit in a low interest-rate environment, banks get a boost from higher interest rates.

But the election of Mr Donald Trump as US president has built up expectations that the US central bank will accelerate its pace in hiking interest rates, given the tycoon's campaign promises of fiscal stimulus and tax reforms which spurred hopes of economic growth and rising inflation.

As if to confirm this view, soon after the Trump victory, the Federal Reserve raised interest rates for the first time in a year. It also lifted its outlook for the US economy and flagged that it could raise interest rates three times this year.

And given how closely interest rates here track the US', the upshot is that borrowing costs here may rise as well.

This may prove to be bearish for Reits, as the spread enjoyed by their generous dividend payouts over deposit rates narrows. Higher interest-rate costs will also make it more expensive for Reits to finance their projects.

As credit ratings agency Moody's noted in a report last month, Reits here are exposed to refinancing risks and mismatches in funding that arises from using relatively short-term debt to fund the real estate assets which they purchase.

For banks, however, higher interest rates would give a boost to their bottom lines as the net interest margin - the difference between the amount which banks earn in interest from borrowers and the amount they pay out to savers - goes up.

Now that the dust has settled on the US presidential election and investors have taken the various market movements since then in their stride, it is worth asking whether this preference for bank stocks and disdain for Reits will continue.

For one thing, interest-rate movements will continue to play a big role in shaping how the market prices Reits and banks.

But investors may also have to consider the challenges facing businesses here.

In the case of banks, this will require keeping a watchful eye on their exposure to the troubled oil and gas sector and whether there is a need to make further bad debt provisions which would dent their bottom lines.

However, it is the Reit sector which may be more difficult to assess, given the tepid outlook for Singapore's economy and the pall this has cast on consumer spending.

So far, one big worry dogging Reits is the impact rising interest rates will have on the heavy debt burden shouldered by the sector.

CIMB Research noted that as of the first nine months last year, the Reit sector had a total debt of $43.8 billion, with an average debt maturity of four years and total assets under management of $115.3 billion.

One perennial worry dogging Reits during the global financial crisis was their ability to roll over their debts if there was a credit crunch. But that may not be a concern for now, as only about $3.8 billion of Reits' borrowings is up for refinancing this year.

Indeed, the bigger worry may be the impact of the slower economic outlook on rents.

CIMB noted that based on Urban Redevelopment Authority indexes, retail rents fell 7 per cent in the first nine months of last year. Even so, some Reits such as Mapletree Commercial Trust's VivoCity and Fraser Centrepoint Trust's Causeway Point still managed to experience "positive rental reversions" because of their active property management.

The question is whether such a happy state of affairs will continue if the economic outlook does not brighten.

Rising occupancy costs - which can account for as much as 22 per cent of a retailer's expenses - have been a constant source of grief whenever leases are up for renewal. And this is likely to stiffen the resistance by retailers against any attempts to raise their rentals, even as they cope with the likelihood of a further slowdown in retail sales and rising competition from e-commerce sales.

Additionally, there may be a spike in vacancy rates. CIMB noted that a supply of 1.2 million to 1.8 million sq ft of retail space may come on stream this year. But demand has averaged only about 700,000 sq ft a year since 2011.

The only redeeming grace is that some Reits, especially those in the office sector, are trading at discounts to recent physical transactions in the market. In valuation terms, that makes them look cheap, as compared with the break-even costs of owning a new office building.

That said, some investors invest in Reits for their ability to deliver a dependable dividend and not for capital gains. Hence, even if Reits are trading at discounts to prices in the physical market, that may not necessarily increase their investment appeal.

Fund managers were net sellers of Reits in 10 out of the 12 months last year. Given the economic uncertainties ahead, that may prove to be a trend that will be difficult to reverse.

A version of this article appeared in the print edition of The Straits Times on January 16, 2017, with the headline 'Financials favoured over Reits '. Subscribe