How low can Reits go?

It has been a strange year where investors piled into certain stocks for their bond-like yields, while trading bonds for stock-like gains.

But with US long-term yields rising sharply when Donald Trump was elected US President, it is worth asking whether a paradigm shift has occurred.

A unified Republican government is more likely to push through inflation-boosting policies, be it a giant infrastructure-related stimulus bill to help the white working classes that voted Mr Trump, or protectionist policies that will likely raise the cost of goods sold.

The rise in interest rates will have tremendous implications for all asset prices, especially that of utilities stocks, low-growth consumer staples stocks, and real estate investment trusts (Reits).

How can one value Reits in the new landscape?

Today's feature will introduce a quick and dirty valuation method to value Reits as if they were bonds.

This is an admittedly simplistic method.

But we will apply it to blue-chip Reits such as CapitaLand Mall Trust (CMT), CapitaLand Commercial Trust (CCT) and Ascendas Reit to see what prices they might trade at.

Equities are bonds, and bonds are equities

A bond valuation method is suitable to value Reits because these vehicles have both bond and equity-like characteristics.

Reits are holding companies for properties which deliver investors a steady rental income.

The steady income mimics a fixed bond coupon.

But Reits also have the flexibility to make improvements to their properties to boost rental income.

They can also buy or sell properties, with the opportunity to make investors capital gains.

If an economic calamity strikes and tenants vacate the buildings the Reit owns, income will drop.

The variability of income is thus an equity-like characteristic.

Other than Reits, utility stocks, telcos and consumer staples companies all provide a steady stream of income.

These companies sell goods and services which people need regardless of the economic cycle.

When companies provide a bond-like stream of income, investors tend to value them like bonds.

This means these companies are hyper-sensitive to short-term and long-term interest rate expectations.

Prices will fluctuate according to whether the US Federal Reserve is going to raise rates, which in turn depends on what people think inflation will be in the next year.

More relevant for today's piece, Reit prices are also affected by long-term bond yields because the same Reit investor also has the competing option of investing in the long-term bond.

How interest rates affect prices

To see how interest rate expectations affect Reit prices, let us first use an example from the bond universe.

Imagine someone comes to you with a fantastic deal.

A very stable blue chip company needs to borrow money, and it is promising to return the money in 10 years, with a coupon of 3 per cent a year.

You say, the bank pays me nothing, so why not? And you subscribe to the bond offering.

Now, the company might be a very stable blue chip firm, but you are still taking a little bit of risk.

How much more risk are you taking?

We usually compare the 3 per cent yield with what you would otherwise get from a bond of equivalent tenure that is effectively risk-free.

The comparison is typically with the yield of a government bond. Government bonds are usually risk-free, but not always.

But let's assume the 10-year government bond is yielding 2 per cent.

If the blue chip company's new bond issue you bought yields 3 per cent, we say that the spread of the bond is 100 basis points (bps), or one percentage point.

Spreads measure the extra risk investors are willing to take in buying a bond relative to a risk-free instrument of equivalent tenure.

If spreads rise for this particular blue chip company bond from 100 bps to 200 bps, this means investors are getting nervous.

If the risk-free yield remains at 2 per cent, investors are only willing to pay for this bond if they can be paid 4 per cent a year.

Similarly, declining spreads signal improving confidence about a company and its prospects.

Let's say you agree to buy S$100,000 worth of this blue chip company bond, and you are getting a stream of S$3,000 a year, or a yield of 3 per cent.

The 10-year government bond yield is at 2 per cent, and spreads are thus at 100 bps.

Rate shock

What happens if right after you bought the bond, the 10-year risk-free government bond yield surges from 2 per cent to 5 per cent?

Previously, you could get S$2,000 a year for 10 years by investing your S$100,000 in the government's 10-year bond.

The blue chip company bond offers S$3,000 a year, which was attractive. But now, the 10-year government bond yield is at 5 per cent.

This means you can get S$5,000 a year risk-free.

Imagine you are a new investor looking at this now-dated blue chip bond issue.

Would you still buy it to get S$3,000 a year? Of course not.

The government bond will be more attractive.

What yield does the blue chip company bond need to give you before you are willing to buy it?

Perhaps 6 per cent. Maybe you are willing to pay the same spread of 100 bps over the risk-free government bond.

But perhaps circumstances have changed, and the blue chip company is looking a bit shaky due to macroeconomic developments.

You are now demanding a higher spread of 200 bps. So at 200 bps above 5 per cent, you are only willing to pay 7 per cent for the company bond.

But the bond can still only offer you S$3,000 a year in coupon payments. It can't magically give you more.

So bond prices will have to adjust to the yield investors are willing to pay.

At the new price, you will demand a yield to maturity of 7 per cent, by getting S$3,000 a year for 10 years, followed by the original S$100,000 you lent to the company.

What price are you willing to pay for this deal such that you can still get a 7 per cent yield with coupons reinvested at the same rate?

We won't go into the calculations today, but if there is a yield shock like that, the price of the bond will fall from S$100,000 to around S$72,000 - a 28 per cent drop.

Applying bond valuation to Reits

What happens if Reits are priced like bonds, then, with their yields compared to the risk-free, 10-year government bond yield?

What would be the fair value of Reits if the 10-year yield rises?

To get the answer, we first do away with complicated bond price calculations.

We just imagine distributions from a Reit as an annuity that lasts forever.

This is a reasonable assumption because leases on some Reit properties might expire only in our children's lifetimes.

For example, the 99-year lease on Tampines Mall owned by CMT only runs out in 2091, or 75 years from now. Plaza Singapura is freehold.

And the Westgate lease runs out in the year 2110.

What happens when leases are near expiry is anybody's guess, for now.

There's no point factoring in potential lease renewal payments or redevelopment costs so far into the future.

These costs could be much smaller when converted into today's dollars.

Separately, we also assume zero dilution, such that increases in the Reit's units are balanced out by increases in distributions.

Valuing a perpetual annuity is simple.

You just need a number for distributions, and the required interest rate.

If CMT is distributing 11 cents a year, how much are you willing to pay for it if you are happy with a 5 per cent yield? The answer is S$0.11 / 0.05 = S$2.20.

But what yield should we use to value CMT looking ahead?

I downloaded seven years of data from Bloomberg of CMT's distribution yields, calculated weekly based on its price.

Yields have been as low as 4.4 per cent, and as high as 6.1 per cent.

CMT's yields are on the high side relative to history now, but this fact alone does not mean anything without knowing what the spreads to the 10-year government bond are.

In bond valuation, yields don't matter as much as spreads. You always have to compare what yields are like relative to the equivalent risk-free rate.

For example, a 6 per cent yield for CMT might seem cheap, but if you can already get 5 per cent risk-free from the government, a 6 per cent yield for CMT with a spread of just 100 bps is not worth it.

By contrast, a 4 per cent yield might not be expensive to pay for CMT when risk-free government yields are 1 per cent.

The spread is a juicier 300 bps.

To see what CMT's current and historical spreads are, I downloaded data on the Singapore 10-year bond.

Yields on the risk-free bond were as low as 1.3 per cent in 2012 and as high as 2.9 per cent last year.

To get CMT's spread, I then subtracted, for every week in the last seven years, the government bond's yield from the Reit's yield.

For CMT, spreads fluctuated between 220 bps and 450 bps, with the average around 320 bps.

As at Nov 11, spreads were at around 350 bps.

Spreads had hit a high at the beginning of 2012.

That was the time when Europe was grappling with its debt crisis and when government bond yields hit lows in the course of the year.

Higher spreads, just like higher yields, do not mean the Reit is definitely cheap.

It might just suggest the market is pricing in slower potential growth.

Similarly, lower spreads, like lower yields, do not mean the Reit is expensive but could just mean the market is pricing in income increases.

Either way, now we are armed with historical data on yields and spreads.

If you believe in mean reversion, or the idea that highs and lows will correct themselves over time, you will be ready to estimate a fair value yield for CMT.

Figuring out a value

Last week, the Singapore 10-year bond yield shot up from under 2 per cent pre-election, to 2.35 per cent by Friday.

Assuming yields will move to 2.5 per cent - near a 10-year historical average - and spreads remain the same at 350 bps as of Nov 11, our fair value yield, all things being the same, will already rise from 5.5 per cent to 6 per cent.

This means that for CMT, its justified price will drop almost 10 per cent from S$2 a unit to S$1.83 a unit.

What if you think that by the end of next year, we will have a 10-year yield of 3 per cent or more?

Assuming distribution per unit (DPU) stays at 11 cents and spreads stay the same at 350 bps, which is slightly higher than the average range, we are already looking at a justified yield of 6.5 per cent, and a fair value of S$1.69.

If we think DPUs will drop due to a slower economy, say by 5 per cent, and if spreads rise to CMT's historical high of 450 bps, its fair value will be just S$1.40.

Thus some of Singapore's most stable Reits might have downsides of 10 to 20 per cent from a mere rise in yields.

If spreads rise as well ("widen" in the jargon), and DPUs drop, the downsides could be more.

As at last Friday's close, the Reits we examined had already adjusted downwards to close to their fair values, assuming that their spreads are at historical averages as seen in the table, and assuming the 10-year bond yields 2.5 per cent.

Ascendas Reit was undervalued at the beginning of the week according to this framework and it has bounced up accordingly. Frasers Centrepoint Trust still has a little bit more downside.

Other factors that affect Reit valuations

Of course, Reits are not valued in such a simplistic fashion.

Analysts examine the drivers behind distributable income, such as sponsor pipeline of properties, general demand and supply factors, debt structure, sector-specific risks, recent property transaction prices, and population growth projections.

Some Reits naturally trade at higher spreads than others.

Reits with shorter-lease industrial properties exposed to the business cycle, such as Ascendas, are considered riskier compared to Reits with long-lease properties catering to retail consumption like CMT.

Ascendas spreads have always been higher than CMT spreads by a historical average of 120 bps.

Meanwhile, CMT has typically been more dearly valued compared to smaller fellow mall owner Frasers Centrepoint Trust (FCT), with spreads averaging 60bps lower.

The price to book ratio is often used as a guide to value Reits, but the measure has its flaws.

Reits don't necessarily have justified values at one time book.

Book values are derived using consultants who adjust the figures every year depending on the economic outlook.

These values are vulnerable to big fluctuations in an economic crisis.

More importantly, investors need to predict how fast rental income can grow, depending on economic conditions and management skill.

If there is substantial growth in the pipeline, the Reit might look expensive but is actually cheap. It will trade at a higher price to book multiple, a lower yield and lower spreads. The reverse is true.

To sum up, investors in Reits have to consider a wide variety of factors before deciding whether a Reit is overvalued or undervalued.

The bond valuation technique described above is just for investors to make a relatively quick calculation to see what is being priced into the Reit's yield relative to a risk-free bond, or relative to other riskier bonds.

Investors still have to make their own judgements about what spread is justified given the circumstances.

With spreads in mind, they can better cut through the valuation fog and make informed purchases.


This article was first published on November 21, 2016.
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