S-REITs & Impact of U.S. Federal Funds Rate Increase
1. U.S. Federal Reserve Interest Rate Hike
Since 2015, the U.S. Federal Reserve has embarked on a series of interest rate hikes as a means to control inflation and prevent its economy from overheating. With recent unemployment and inflation rates data in the U.S. mostly in line with market consensus estimates, it is widely expected that the Central Bank of U.S. will be raising the Federal interest rates further in 2018, which will likely impact the real estate and REITs markets profoundly.
2. Impact of Rising U.S. Interest Rates on S-REITs
The U.S. Federal Funds rate and Singapore Interbank Offered Rate (SIBOR) have a direct relationship. When U.S. interest rates rises, funds flow back to the U.S. in search for higher yield, reducing liquidity in the Singapore banking system. Since the Singapore central bank does not use interest rate as a lever in its monetary policy, Singapore is a price-taker, and SIBOR historically tracks the movement of the U.S. federal funds rate.
How does SIBOR affect S-REITs? S-REITs are generally sensitive to interest rate risks. As SIBOR increases, the future dividends received from S-REITs would be discounted at a higher rate, and hence be worth less at present value. Concurrently, risk-free government bonds become more attractive, since the coupon rate, which is tied to the risk-free rate and hence SIBOR, has increased. Therefore, for REITs to continue staying attractive, prices would generally have to fall in order to increase their yield vis-à-vis other income producing instruments.
S-REITs also take on large amounts of debt to finance their property acquisitions. With increased SIBOR, borrowing costs increase vis-a-vis the same amount of debt. REITs will find it more expensive to refinance their loans as well as take new loans to acquire new properties. Given that REITs generally tend to have a low cash surplus as they distribute most of their income to investors, more expensive borrowing costs will reduce their ability to make future acquisitions. This may impact their future pipeline of developmental properties unless managers take appropriate measures to face rising borrowing costs.
3. Historical S-REITs Performance during Interest Rate Hikes
The common perception is that a rising interest rate environment is negative for REITs. The US Federal Reserve has embarked on its latest rate hike cycle, with December 2015 seeing the first rate hike since 2006 as seen in Figure 1.
Nevertheless, investors can still potentially benefit from an allocation to REITs in a rising interest rate environment. Figure 2 illustrates how the FTSE Straits Times REIT Index and the FTSE Straits Times Index performed against the changes in the 10-year Singapore Government Bond yield, for the period between December 2014 and August 2017.
Figure 3 below shows that for 3 out of 7 time periods (May 09 – May 10, Nov 10 – Feb 11, Jan 15 – Sep 15), S-REITs actually outperformed the broader Singapore equity index. These are also periods in which the interest rates increased on a relatively more gradual basis. Hence, it is not with certainty that S-REITs will underperform in a rising interest rate environment.
Moreover, in the year-to-date October 2017, the SGX S-REIT Index has generated a 15.5% price return and 21.2% total return (inclusive of dividends), compared to the benchmark STI’s 15.6% price return and 19.0% total return while Singapore’s 3-month SIBOR has gained 16.2% in the same period. Figure 4 illustrates that the performance of the SGX S-REIT Index surpassed the benchmark STI in August 2017 on the back of positive sentiment in the Singapore property market.
4. Summary of Impact on S-REITs
Interest rate increases might also bring benefits to REITs. Rate increases are often associated with improving economic growth, which indirectly boosts S-REITs’ earnings. As the economic outlook improves, rental income, vacancy rates and other key operating metrics important to the S-REIT’s cash flows also tend to improve. Furthermore, for S-REITs, the income (i.e. dividends) is not fixed as compared to bonds whereby investors receive fixed coupon payments. Therefore, dividends pay-out may rise in tandem with improvements in economic fundamentals. Interest rate hikes may be indirectly associated with higher S-REITs earnings, which may help to offset increased borrowing costs. While S-REITs are sensitive to rising interest rates, managers have a say in navigating the different interest rate environments, depending on the amount of leverage taken on by the S-REIT amongst other factors.
In summary, there are various sector- and stock-specific factors at play when analyzing the potential of S-REITs as well as other catalysts that could potentially allow the S-REIT to perform against the broader market in spite of a rising interest rates environment.
