Valuation of REITs in an interest-hiked environment

Forecast about half a year ago

In 2022, we have seen the Fed (Singapore has basically no fiscal sovereignty despite SIBOR, SG rates will follow Fed rates) constantly hiking interest rates to combat inflation. Undoubtedly, REITs would be one of the hardest-hit sectors of the market due to its nature of mainly relying on borrowings to fund their assets, and its dividend/distribution yield being directly impacted by interest expenses.

In order to assess the damages, I have, around the end of 2022, attempted to forecast distributions of a random REIT I own - Lendlease Global Commercial REIT or SGX:JYEU.

While the assumptions were sound, the valuations returned abysmal results, and the DCF model doesn't seem to make sense.

Assuming Interest costs of 3.5% starting 2023, for the next 5 years, then resume to current average weighted avg cost of debt. 1.69% is also used instead of actual cost of debt, 59% debt is fixed.

Given the current treasury rates, discount rate of 5% seems reasonable, but that would put us at a fair value of $0.377, far from $0.66 as of writing. Other assumptions returned even worse valuations of $0.113 and $0.339, so what gives? We will have to thus depend on latest figures to try extrapolating better.

With data 3 Months later

For starters, there are definitely positives that aren't taken into account during valuation for conservative purposes. They are positive rental reversion (aka increasing rental income) and refinancing. However, I am not exactly sure how impactful are these on paper as increase in interest costs could significantly outweigh rental increments.

For example, the 6 months ending 31 Dec 2022 (in S$ thousands)

(1H FY2023 Financial Statements from Website)

Gross Revenue - 101,733

Finance costs - (23,586)

Total Loans and Borrowings stood at (1,424,950).

A 1% increase in financing costs would increase expense by $14,249.5, while a 1% increase in Revenue only increases it by $1,017.33.

The Amount available for distribution to Unitholders is $56,030, which means an interest cost increase of ~4% would entirely wipe distributions available.

While there might be some mitigation that management can do to withstand the high interest environment, from the time I did the valuations in the Sheet here (last Q figures) till the latest numbers available - 31 Mar 2023 - nothing significant seemed to have occurred.

Weighted average cost of debt (I am just going to call this WACC since in REITs there's almost no cost of equity) has increased by 0.16% within a quarter, and this is with approximately 60% of their debt already being fixed. This means that if nothing is fixed, WACC would increase by 0.4% that quarter.

We can also see that the debt maturity also fell from 2.6y to 2.3y, hinting that more or less no refinancing was made to extend these low-ish interest rates.

From 31 Dec 2022 to 31 Mar 2023, fed interest rates increased from 4.1% to 4.65%. It is currently 5.25% as of May 2023. Hence it shouldn't be too far-fetched to linearly project a similar increase in Q2 2023 data, which would be something like:

	31 Mar 2023	30 June 2023
Borrowings (status quo)	1454.4	1454.4
Gearing (status quo)	39.3%	39.3%
Weighted average debt maturity	2.3 years	2 years
WACC	2.51% pa	2.67%
Interest coverage ratio	4.6 times	3.7 times

We can probably verify how accurate is this forecast soon, since it's already June. But anyway, a further increase of 0.16% in WACC would increase interest expense by S$2.3million, which is about 1% of revenue (full year ~$203m revenue)

The latest distribution - 1 Jul 2022 to 31 Dec 2022 SGD2.45 Cents (7.4% yield) - comes from distributable income of $56.03m. The increased interest expense/decreased income would result it being S$54.88m or 2.4 cents (7.27% yield).

Still pretty good, but the future is extremely uncertain, especially after the current 2 years average debt maturity. It won't be unreasonable to assume a 4% interest rate environment sometime in the future. This increase of 1.5% WACC would add S$21.81m interest expense, and distributable income would be S$34.22m - 1.496c - 4.5% yield.

Current valuations

Of course, share prices would not be able to keep propped with such low yields, and assuming it drops to maintain a 7% yield, it would equate a share price of 0.427 cents, a 34% downside to the current 0.66 cents.

I believe reality would probably be somewhere in-between the scenario above and the present situation, but odds are it won't be better.

With current yields, it is not attractive to buy more at the moment as I don't foresee many upsides. But I also wouldn't sell because there is a decent probability that it will continue to return in the 6-7% yield zone. The underlying assets are solid and not going anywhere anytime soon, with prospects of profitability returning should interest rates drop.

Regarding REITs, at the moment I would prefer to buy something more stable with a higher margin of safety. An example is the Daiwa House Logistics Trust, who seem to have outstanding capital management presently (mainly because borrowings are in JPY):

Capital Management DHLT’s borrowings as at 31 December 2022 were fully denominated in JPY, which provided a natural hedge as the value of the properties is denominated in JPY. The all-in weighted average borrowing cost is 0.99% per annum (including upfront fee), and 100% of the borrowings are on fixed rate basis, therefore the current outstanding borrowings of DHLT are not exposed to the risk of rising interest rate. Aggregate Page 3 of 6 leverage as at 31 December 2022 remained at a prudent level of 35.9% as at 31 December 2022, and there are no refinancing requirements until November 2024. 

and about a 10% yield.

Or else, buy banks.