The REIT model works well in an environment where interest rates are low and the economy is booming, both for the REIT sponsors as well as investors. The value proposition to the REIT sponsors is that they are able monetize their developments and get the cash flow to fund new projects. For the investors, they get to receive regular dividend payouts akin to a fixed income instrument, and yet enjoy the upside potential of the share price.
Not too long ago, the foremost objective of REIT managers is to grow the portfolio size so that they can deliver increasing dividends to the investors. The issue then is the lack of acquisition opportunities. Fast-forward to today’s credit crisis, only a few REIT managers talk about acquisitions despite valuations being lower now. Ability to secure financing is the topmost worry.
In the last quarter, the REIT sector has been plagued by refinancing risk although some of the managers have proved otherwise as they secured new fundings. We believe that in the coming quarters, the market will be taking into consideration the sustainability of revenue and possible tenant defaults.
DPU maintenance or DPU erosion We believe the fundamentals supporting the entire landscape have turned 180 degree. REIT model works best when cost of funds is low and cash flow generated from rentals provides a steady and recurring dividend to investors. Today we are facing the opposite; high cost of funds and potential shock to rental income.
Commercial rents are softening According to the URA statistics, 4Q08 rental index of commercial property in the central area declined 6.5% from the previous quarter.
In our last sector update published in November 08, we presented a historical analysis and postulated the index to fall at least 30% from its peak. If history can be a guide, we should be looking at a trough reading of 145, which is 25% away from the current reading of 193. Vacancy is now at 9.3% as compared to the trough reading of 6.8% at 4Q07. The highest level recorded was during the SARS period in 2003 whereby vacancy was 19.0%.
Industrial rents tend to be more stable as the leases are longer Although industrial rents display much less volatility, we can observe that rents have softened in 4Q08, its first real decline since 2004.
Retail and hospitality Retail sales index fell two consecutive months from Sep 2008 to Nov 2008. Excluding motor vehicles, the index started its decline since Aug 2008 and on a YoY basis, retail sales declined by 3.4%. Excluding motor vehicles, sales declined by 2.2%. Although collection from tourist receipt set a new record in 2008 at $14.8 billion, the trends are not very optimistic. Our argument is that if tenants’ businesses are affected in this recession, landlords will not have it easy, even if leases are signed and locked-in. REIT managers will then have an even tougher job of preventing falling DPU.
Report Card We use a simple metric to see how the various REITs have performed in their stated objective of increasing DPU. We compile the gross revenue and DPU for the most recent announced quarter and compare the percentage variances on a YoY and QoQ basis. We expect percentage changes in revenue to affect DPU in the same proportion. Any deviation demonstrates the REIT managers’ efficiency. We caution that our compilation is not a be all and end all guide, as individual REIT will have its own merits.
From the above, six REITs have registered falling DPU over the year while seven have registered falling DPU over the quarter. The sectoral performance confirms our last view (see REIT update report in Nov 08), where hospitality sector seems to be the most affected, with both QoQ revenue and DPU registering negative growth and healthcare continues to be the most resilient.
We expect rental income to face increasing pressure as businesses implement cost containment measures. DPU will in turn be subjected to a double whammy from higher borrowing costs and management fees. In conclusion, we expect to see more DPU erosion in the coming quarters.
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