Singapore Property - Stability Trumps Growth in 2017
Prefer strong recurring income: CCT, KREIT, UOL
- With another challenging year ahead for the physical market, we struggle to turn more positive on property counters despite cheap valuations. In this risk-averse environment, we position defensively at the lower end of the risk spectrum and prefer exposure to stable platforms over trading portfolios. Hence, our preference for Office REITs over Developers.
- We like CCT and KREIT for their attractive valuations, strong WALE and low lease expiry in the near term. While we retain a cautious view on Developers, we see trading opportunities within the sector.
- Developers with a large base of recurring income and a less risky development profile could outperform. UOL is our top developer pick.
Risk appetite remains low => REITs over Developers
Office REITs: Position ahead of the bottom
- S-REITs trade at attractive yield spreads of 3.9ppt over the 10Y government bond yields even after the recent pick up in risk free rates. This is well above the low of 2.9ppt and marginally wider than the average of 3.6ppt over the past three years.
- Valuations of Office REITs look attractive when compared to transactions in the physical market. Their implied cap rates of 4.1-4.9% look generous against the low-3% cap rates for transactions in the physical market.
- Aggressive bids seen at the Central Boulevard land tender imply that replacement cost for a new office building is high and office REITs look cheap trading at a significant 13-22% discount to the underlying values of their Singapore office assets.
- CCT and KREIT are our preferred sector picks as they are well-placed to ride through the storm with their strong WALEs and low lease expiry profiles in the near term.
Small exposure to rate hike; Yield remains attractive
- We believe muted unit prices for office REITs over the past month suggests that the market has ignored an important fundamental event in the office sector – aggressive land bids for Central Boulevard. Instead, the market has focused on macro events with the successful campaign of Donald Trump taking centre stage.
- We acknowledge that increasing odds of a rate hike at the December US Federal Reserve meeting and the recent pick up in Singapore Government Bond Yields has lowered the attractiveness of yield sensitive sectors, such as REITs. Nonetheless, we note that yield spreads remain attractive relative to history and see this pull back for office REITs as a buying opportunity.
- Probability of a rate hike in the upcoming US Federal Reserve meeting on 14 Dec has increased significantly in recent months. The impending rate hike and upwards pressure on the USD has led to a spike in bond yields recently. 10 year bond yields on the Singapore Government Securities (SGS) rose by almost 50bps over the past month to 2.4%. This led to a recent sell off in rate sensitive sectors, such as REITs. While negative, we opine that REITs remain attractive as:
- Yield spreads remain attractive. The 3.9ppt yield spread between S-REITs and the 10-year bond yields remain attractive. This is wider than the average spreads of 3.6ppt over the past three years.
- Interest rate hike manageable. As highlighted in our previous note, office REITs have fairly small exposure to an increase in borrowing costs. CCT/KREIT/Suntec REIT fixed 80%/74%/60% of their borrowings and have just 5%/0%/3% of debt due for refinancing in 2017. Furthermore, 3MSOR has moved by much smaller magnitude than bond yields.
Office REITs trading below replacement cost
- We also see strong downside support with office REITs now trading below replacement cost of its underlying assets.
- High land cost for commercial site. Aggressive bids submitted for the land parcel at Central Boulevard illustrates the elevated land costs in the market with the SGD1,689 psf GFA top bid submitted by IOI Properties (IOIPG MK, Not Rated) a record high. Our calculations suggest that the developer will need the value for the office component to reach SGD2,800 psf NLA in order to breakeven on this project. In order to achieve a decent 10% margin to compensate for the risk and effort, office prices will need to hit close to SGD3,200 psf. Hence, the strong bid price suggests that replacement costs for office buildings in Singapore are high and should lend support to capital values of office properties.
- Implied value of office assets. With office REITs trading at c.0.8x P/BV, we believe the market has priced in significant discounts to the underlying value of their office assets. Our calculations suggest that the market has assigned a discount of 13-22% to the market value of their Singapore office assets, which we think is excessive. The implied market value of their offices of SGD1,800 to SGD2,200 psf is below the replacement cost of a new office building that is inferred from the high prices for Central Boulevard. Implied cap rates of 4.1-4.9% also look generous against the tight cap rates of office buildings transacted in the market.
Demand for office buildings could close NAV gaps
- Media reports suggest that at least three deals are currently under discussion. The Business Times reported 12 Nov that China Life Insurance and Haitong Securities were doing due diligence on a half stake in One George Street, a wholly-owned building by CCT, with pricing in excess of SGD2,500 psf. This is at least 10% above the SGD2,264 psf valuation on its books. Assuming a sale at SGD2,500 psf, the deal would imply an NPI yield of 3.4%.
- Apart from this deal, BlackRock was reported to be exploring the sale of Asia Square Tower 2 and Alpha Investment Partners looks set to sell its half-stake in Capital Square to ARA Asset Management.
- With strong investment demand for office buildings, office REITs can immediately create shareholder value by capitalizing on this trend to sell fringe assets. Given the mismatch between the physical market and REIT prices, we believe any asset sales in the market today could drive unit prices up and close the NAV gaps.
Developers: Stability trumps growth
- All developers will not meet their cost of capital in the year ahead and the market is rightly bearish in pricing them below book. Operating environment remains challenging as intense competition for land could weigh on margins.
- In this environment, we believe developers with stable streams of recurring income and good development earnings visibility could outperform. CAPL and UOL scores best on this. UOL replaces CAPL as our top sector pick as persistent concern over potential headwinds in China property could weigh on stock performance in the year ahead.
Compare cost of capital vs returns
- Our forecasts suggest that all Singapore developers will not meet their cost of capital in the year ahead.
- We expect large cap stocks - CAPL, UOL and CDL – to generate the smallest ROE and ROIC spread in 2017, while returns for mid-cap developers - Wing Tai and Ho Bee – should remain significantly below their cost of capital.
- In order to capture relative stock performance, we compare P/BV vs ROE to screen for developers that can generate decent returns amidst the market headwinds. UOL is in a favourable quadrant with relatively low P/BV and decent ROE. While Ho Bee and Wing Tai are amongst the cheapest stocks in our universe, we believe they are unlikely to perform given their thin earnings base and lackluster ROE profile.
Developers with large recurring income base to outperform
- Returns from taking on new development projects may be low as intense competition will continue to keep land cost elevated. Risk-reward for new residential projects remains unfavourable as cooling measures will limit velocity of sales and the system of penalties for missing sell-by dates heightens the risk of cost overruns. Hence, developers highly dependent on trading income may struggle to generate a decent risk-adjusted return for shareholders.
- Furthermore, with risk appetite remaining low, we expect the market to favour developers with large recurring income streams as investors seek safety along the lower end of the property risk spectrum. CAPL and UOL scores best on this.
Fine-tuning TP; Ratings unchanged
- We align our target discount framework across the sector and assign a consistent 20% discount (from 15-20%) across Singapore property assets. This should sufficiently compensate for downside risks in asset prices in the year ahead.
- We factor in discount rates of 25-50% for overseas projects to reflect our qualitative assessment of execution risks and apply no discounts to market price or target price of listed entities. A notable change in this note is the higher target discount of 25% (from 15%) that is applied to CapitaLand’s China portfolio as persistent concern over potential headwinds for China property could weigh on stock performance in the year ahead.
Two pair trades to capture relative performance
- We advocate two pair trades to capture relative performance in 2017.
 UOL > CDL.
- While CDL could generate positive total return in the year ahead on undemanding valuations, we expect UOL to outperform given the former’s larger residential exposure. Historically, CDL tends to underperform whenever the residential outlook is tough.
- Furthermore, UOL has a bigger recurring income base and trades at a larger discount to its underlying assets than CDL.
 KREIT > Suntec REIT.
- While both REITs trade at a relatively similar discount to their underlying office assets, we see KREIT outperforming Suntec REIT as there is bigger downside risk for the latter with more office leases up for renewal and potential for further weakness in retail rents.
Demand-supply mismatch in the physical market
- We expect almost every property asset class to remain oversupplied in 2017. Occupier market remains weak as population growth and job creation slows.
- Residential: We see limited downside to home prices, but expect sales volumes to stay weak as we doubt cooling measures will be lifted anytime soon. Land sold over the past year seems to point to a rebound in home prices in 2018. Downside risk from policy tightening.
- Office: Grade A office rents should continue to fall, albeit at a slower pace. However, capital values should hold firm on tight transactional cap rates and high replacement cost of office properties. Therefore, a full sector rerating may not materialize until fundamentals improve.