Saturday, April 6, 2019

S-REITs 1Q19 Review



It's been an exhilarating quarter for those who kept the faith after a terrible 2018 and held onto their REITs this quarter. As explained in a prior post, falling bond yields globally have been the fuel behind the sharp S-REIT rally. The rally had little to do with the underlying fundamentals of the sector, and more of global institutional flows hunting for yield as bond yields plunged. 

Yield curve Inversion

With much ado over the US bond yield curve inversion, what does this mean for REITs? Should we sell all and run for the hills? Well, historically we know that it has been a reliable indicator of an impending recession. However, in many instances in the past, stock markets rallied on for as far as a couple of years. In the prior cycle, the 3m/10y inversion first occurred in January 2006 but the S&P 500 would run up by another 21%, before peaking in October 2007, a good 20 months later.

Looking at the current state of the global economic environment, I would interpret the yield curve inversion as an amber light, rather than a red light. It is a warning that we are entering the final phase of the business cycle, and just that. The end draws nigh, but markets are not about to fall off the cliff tomorrow. Furthermore, my view is that major central banks have become very proactive following the previous crisis.

Previously, they were more reluctant to bail out banks, which ultimately led to Lehman Brothers failing and turning a recession into a full fledged financial crisis. Taking the lessons of the previous crisis, major central banks have been very vigilant and have been acting very swiftly to support the economy with any early signs of weakness. These factors should keep markets well supported for the foreseeable future. 

Stars

Mapletree REITs have been stellar performers this year, on the back of institutional flows into the sector. The dividend yield spread above Capitaland has narrowed considerably.

REITs with Chinese assets have performed very well, which is to be expected given the various stimulus measures taken by the government to support the economy. Of the top 5 performers, 3 are with high or total exposure to Chinese assets (Sasseur REIT, Capitaland Retail China Trust and Mapletree North Asia Commercial Trust). Chinese assets have rallied this year as the government has eased banking lending standards, reduced the effective income tax and started spending on infrastructure projects. This has eased fears of an imminent recession and will support the REITs with Chinese assets, as described in my earlier post. Should a trade deal with the US be reached, this will be an additional cherry on top for the sector.

Laggards

Industrials as a sector continue to underperform as recession fears and falling rents act as headwinds. I would avoid this sector until the demand-supply dynamics of industrial space turns positive. This could be a couple of years away as excess supply has to be fully absorbed. However, if a global recession hits by then, this timeline could be further delayed.

Notably, the two REITs linked to Lippo Karawaci (First REIT and Lippo Malls Retail Trust) have underperformed the sector despite their relatively high yields. Their ties to troubled parent Lippo Karawaci has weighed on their performance. First REIT is one of the worst performers as the market realized that it is less of a healthcare play than initially perceived. This is because >80% rental income from the underlying hospitals were paid directly by Lippo Karawaci, rather than from the operator of the hospitals, PT Siloam International Hospitals Tbk.

This essentially means that REIT unitholders are subject to Lippo Karawaci’s cash flow generation ability, which has been dismal over the last few years. This risk is clearly quite different from that of a hospital operator, which First REIT was painted to be. Also, the rental payments have become more burdensome for Lippo Karawaci due to the currency mismatch, given that the IDR has depreciated very considerably against the SGD since its IPO in 2007.

Where do we go from here?

Bond yields have started to rise after the sharp drop in 1Q19. This implies that the rally for the S-REIT sector is largely done here, although the correction should be a mild one. I do not expect REITs to fall back to the levels we saw in 2018, though I would certainly welcome a sell-off as a golden opportunity to accumulate good quality REITs. Aside from that, I am still bullish on REITs with Chinese assets, which remain cheap against its historical yields.


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