AP-REITs: A return to fundamentals

2022 was a challenging year for all asset classes, but the fundamentals of Asia-Pacific real estate investment trusts (AP REITs) remained resilient despite the risk-off environment. This was evidenced by their earnings and guidance. In addition, asset values remained buoyant, driven by healthy rental growth and growth in distribution following the cessation of rental relief measures.

In the new year, we believe that investors will shift their attention to the underlying fundamentals of AP REITs as the period of interest-rate volatility that dented overall REIT performance in 2022 comes to an end and rates begin to stabilize. In turn, this should pave the path for a more normalized market environment.

From an asset-class perspective, investors should remember that dividend returns are a central feature of the REIT asset class—when markets decline, dividends help compensate for any price losses. Crucially, regardless of the market environment over the past decade, dividend return has remained positive. As such, when markets move higher, dividends augment total return.

2022: higher rates amid inflationary pressures

Worries about the impact of higher rates and energy costs on asset values and the asset class’s profitability more or less defined a challenging 2022. This translated into market uncertainty about the ability of these asset managers to maintain their distributions to investors.

As interest rates rose over the year, investor concerns persisted on potentially lower asset values due to rising cap rates; however, we felt the level of drawdown priced into AP REITs due to higher rates wasn’t indicative of their underlying operational performance.

In addition, reopening tailwinds in Asia provided some ballast for the asset class, but these are expected to fade (except for Hong Kong SAR and Mainland China) heading into 2023.

From a geographic perspective:

• Australian REITs tend to be more sensitive to movements in 10-year bond yields than other major REIT markets. The first half of 2022 made this dynamic clear: Yields on the Australian 10-year government bond started at 1.67% and reached a peak of 4.20% by mid-June. The rapid and largely unanticipated increase in rates, which reflected the Reserve Bank of Australia’s aggressive monetary stance, weighed on the REITs sector—the region’s weakest performer through the first half of 2022.
• Hong Kong REITs were affected by negative investor sentiment toward Mainland China for most of the year. Despite the continued loosening of COVID-19 measures at the local level, financial distress in the country’s property sector and the closure of the China-Hong Kong border spilled over into related sectors, including REITs.
• Singapore REITs were the relative outperformer in Asia-Pacific despite broader concerns about the asset class. Singapore REITs benefited from the reopening of the economy, leading to expectations of a recovery in the retail and hospitality sectors on the back of a rise in convention and exhibition activity. Notwithstanding renewed optimism stemming from the post-COVID-19 economic recovery, macro concerns outweighed operationally positive data points.

Central bank policy still a factor in 2023—but largely priced in

Moving into 2023, the U.S. Federal Reserve is likely to gradually reduce the quantum of rate hikes and should pause as inflationary pressures decelerate; however, the risk of persistent sticky inflation and lower growth in the United States (and elsewhere) still exists, particularly in the second half of the year. Any potential easing in global inflation and labor markets (i.e., wage pressure) could offer central banks more room to balance their goal of supporting growth versus tamping down inflation.

Although the impact of higher rates and energy costs should still be felt in 2023, the impact has been well communicated by corporates.

Indeed, as interest-rate volatility starts to normalize, it may provide a better environment for risk assets, including REITs. As such, we believe the incremental impact of higher rates on interest costs should subside and investors can focus more on AP REITs’ operational performance and underlying fundamentals.

Operating fundamentals should drive performance in 2023

We currently don’t see balance sheet or liquidity risk as key risks for AP REITs given healthy levels of leverage and, more importantly, their ability to service debt. Data shows that current interest coverage ratios (ICR) for key Singapore REITs are well above the typical minimum threshold (i.e., adjusted earnings before interest, tax, depreciation, and amortization are at least two times the required interest payments).

Even if we were to factor in the possibility of higher interest rates, refinancing risks are staggered over a few years. In addition, rising net property income could also help to mitigate the overall impact of higher rates on ICR.¹

Further, rental reversions are likely to be positive in the industrial, hospitality, and retail sectors in 2023. Given high occupancy and the continued demand in e-commerce and logistics warehousing, we could see continued positive rental reversions, which should help to partially mitigate the effect of cap-rate expansion on asset values.

Finally, we also expect dividend growth to continue. Despite recent downward revisions in analyst expectations on the back of some of the aforementioned challenges, there remains expectations for distribution-per-unit growth (the amount of dividends an investor receives for every unit of REIT held) to be maintained through 2024.

2023 sector outlook: Positive on industrials and retail over offices

We’re more constructive on industrials and retail than offices in 2023.

• In Hong Kong in the retail space, neighborhood malls have generally outperformed during times of economic uncertainty given their nondiscretionary nature. The upward adjustment for minimum wage in 2023 should also provide support. In Singapore, the continued recovery in tourist arrivals should continue to drive an increase in traffic and revenue for malls. The strong rebound in tenant sales has brought down occupancy cost to healthy levels, which allows for more room for potential upside to rental rates.
• Industrials should continue to perform. High occupancy and amplified demand for e-commerce and third-party logistics warehousing should continue into the new year. Longer weighted average lease expiries should provide some cushion to cash flows with more visible rental income.
• We believe that offices should face a challenging year across the region. In Australia, the segment is suffering from a slower-than-expected return to the workplace. Hong Kong should experience a muted recovery with significant supply coming online in 2022–2023. Singapore could see a slowdown in leasing demand and slower pace of rental growth.

Conclusion

After a difficult 2022, investors in AP REITs should likely look at the asset class’s robust underlying fundamentals in the new year, which we consider as core earnings and cashflow strength, strong capital management, and quality real estate which generally provides greater resilience to rental rates during times of economic uncertainty—all factors which provide support to sustainable dividend payouts.

1 Manulife Investment Management analysis and company reports.