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S-Reits and its investment opportunities

Apart from offering a high dividend yield of 6.5% currently, it also offers a stable yield that will keep growing


WHEN planning for the golden years, it is important to ensure that one's retirement nest egg is able to support one's ideal retirement lifestyle. In practical terms, that means putting the retirement funds to work, to make the funds last longer than it would otherwise. This also means that the retirement stash has to weather inflation, which can significantly erode the real value of the funds.

Inflation has averaged 2.8 per cent over the past decade. Therefore, it is important to protect one's retirement nest egg through investments that yield enough income to keep up with inflation. In addition, this income should be stable, with regular payouts, which can serve as additional income to supplement the retirement funds.

Attractive options

With these considerations in mind, Singapore real estate investment trusts (S-Reits) stand out as an attractive option for investors looking to stretch their retirement dollars. Apart from offering a high distribution (or dividend) yield of 6.5 per cent currently, S-Reits also offer a stable yield that is expected to continue growing.

Regular payouts are an added benefit: S-Reits have either quarterly or semi-annual distribution policies. S-Reits also allow investors to invest in a professionally managed portfolio of income producing real estate, indirectly allowing them to reap the rental income and growth in value of the underlying commercial properties that most investors would not otherwise have access to and without the hassle of having to manage the properties themselves. In addition, as S-Reits are traded in the equity market, it offers liquidity that one might not get as a landlord.

Encouraging results

As an equity class, while prices may fluctuate according to changes in market sentiment, share price performance of S-Reits have been encouraging as over the past two years, the FSTREI Index (a Reit Index which measures the price performance of S-Reits) has outperformed both the STI (Straits Times Index) and the FSTREH (Real Estate Developers Index) by 3 per cent and 10 per cent respectively.

S-Reits have also proven their mettle in the recent equity market volatility by falling only 5 per cent, in comparison to the 12 per cent and 20 per cent fall in the STI and FSTREH.

This relative out-performance, in our view, can be attributed to S-Reits' good income visibility, stability and their prospective high distribution yields. Current S-Reits yields of 6.5 per cent are attractive. Spreads of 5 per cent against the ten-year Singapore government bond which presently is at 1.6 per cent, is also higher than its historical average.

This is also higher than other yield benchmarks such as the Central Provident Fund (CPF) ordinary and special account interest rates of 2.5 per cent and 4.0 per cent respectively.

Adding to the appeal of S-Reits are tax regulations that make it mandatory for S-Reits to distribute 90 per cent or more of their taxable income to shareholders as dividends annually. This ensures a stable and regular income flow for investors. In actual practice, most S-Reits have maintained a 100 per cent payout ratio record. Moreover, the dividends are tax-free in the hands of individuals.

Hedge Instrument

S-Reits offer relatively strong income visibility for investors as their distributions are backed by rental income earned as landlords. S-Reits tend to derive rental income through the ownership of a portfolio of properties and having individual tenants each contributing to a small percentage of total portfolio earnings, thus further diversifying its income.

In fact, faced with a positive rental outlook, S-Reits are expected to continue growing its yields at an average rate of 5.2 per cent in 2011, which is above inflation rate, highlighting S-Reits' effectiveness as an inflation hedge instrument.

To complement their underlying portfolio growth, growing dividend yields are complemented by S-Reits ability to acquire assets that contribute to distributions over time. In this respect, we saw S-Reits being active in acquiring properties to expand their portfolios and this behaviour is a major contributor to the sector's earnings' growth potential.

Properties acquired are primarily in the Asia-Pacific region, and they range from commercial assets to logistic properties and retail malls. We also note that there have been more offshore acquisitions in the Asia Pacific region as S-Reits look to jurisdictions that offer higher asset yields, which is positive as apart from offering higher earnings growth, these overseas acquisitions also help to diversify their portfolio concentration in Singapore.

Underpinning the S-Reit sector's stability is a robust regulatory framework set by the Singapore authorities that emphasises transparency and financial prudence. S-Reits' balance sheets remain robust and hovers at a current financial leverage average of 34 per cent, which is low and compares favourably against the average longer term optimal gearing target of between 40-45 per cent. (S-Reits are able to leverage up to a high of 60 per cent if they have obtained a credit rating from any one of the credit rating agencies, if not leverage ratio will be subjected to a limit of 35 per cent).

The current prudent balance sheet position allows S-Reits to pursue acquisition opportunities or development projects in order to grow their portfolios through taking on further debt.

However, we believe that S-Reit managers, in complementing their growth strategy, will endeavour to continue to manage their capital wisely, apart from just utilising their debt headroom for acquisitions. They will also periodically tap the equity market for additional capital. This strategy in our view is a boon for income investors who are looking for a stable and regular source of income in the long term.

Hospitality, retail

Amongst the various S-Reit sectors, hospitality and retail Reits are expected to perform better than the rest.

We believe that rental growth stemming from exposures in the hospitality and retail sectors (with average distribution growths of 11 per cent and 6 per cent respectively) offer the highest earnings upside given their positive outlook after the opening of the two integrated resorts.

We continue to expect strong demand for rooms stemming from sustained record visitor arrivals in the coming months. As such, hotel earnings should continue to see upside. We also see retail Reits enjoying the spillover effect from the buoyant tourism outlook.

This comes on top of the current positive consumer sentiment, and should inevitably spur higher retail spending in the coming months.

In terms of stability, the outlook for industrial S-Reits remains one of the more stable ones amongst the various sectors owing to a larger proportion of longer-termed lease expiries from tenants who typically rent an entire industrial property (known as master lessee) or those who take larger spaces.

Looking ahead, we expect industrial landlords to enjoy a slight up-tick in earnings and distributions from expected positive rental reversions on the back of a healthy demand for industrial space, coupled with high tenant retention and high average occupancies at their properties.

Office Reits

Commercial office Reits should enjoy positive recent news flow of robust Grade A rental outlook as they look towards narrowing the spread between expiring and re-contracted leases, with newly completed buildings also seeing high take-up rates and those in the pipeline also reporting healthy pre-commitment rate and positive net absorption in 1H11.

However, we are less sanguine about its prospects in the nearer term as earnings recovery in office Reits would only be felt from 2012 onwards as they are currently renewing rents signed in the previous peak in 2007-2008.

What are the potential drawbacks? On the back of current market volatility, S-Reits unit share prices might fall to changes in market sentiment, but we have noted that while share prices have fallen recently, performance continue to remain more resilient compared to the STI and FSTREH.

In addition, rising interest rates might lead to higher interest costs and cut into the profits of S-Reits, however we believe that this risk is likely to be mitigated in the shorter term as S-Reit managers have taken the prudent step in locking in a majority of their loans into fixed-rated debt, thus any impact on rising interest costs is not likely to be excessive in our view.

In summary, we believe that S-Reits, with their high yields, stable income growth and regular dividends coupled with its effectiveness as an inflation hedge, is an attractive investment class that one should have as part of a retirement portfolio.

By Derek Tan
Analyst
DBS Vickers Securities