• Keep OVERWEIGHT; Top Picks: CapitaLand Ascendas REIT, Keppel REIT, AIMS APAC REIT, and CDL Hospitality Trust. The pushback in expectations of interest rate cuts has tamed down our earlier optimism of a sector recovery in 2H24. With only a single rate cut expected at end-2024, we believe recovery is now only likely by end-4Q, with the sector expected to be rangebound till then. Current sector valuation remains attractive with room for more upside potential compared to downside over the medium term.

• Key factors driving persistent S-REITs weakness is the continued high interest rate environment. Since rate hikes started in 2022, S-REITs has fallen c.27% in absolute terms, one of the steepest since inception. Reason being the sharp spike in interest rates caused a surge in ultra-low financing costs that S-REITs enjoyed during the past decade. This has resulted in lower distributions, coupled with asset value decline from cap rate expansions (especially overseas markets) as investors demanded higher acquisition yields to offset the rising cost of capital. Rising interest rates also resulted in a host of other higher yielding options available in the market, ie high quality corporate bonds, treasury bills, and fixed deposits narrowing yield differential, resulting in a significant capital shift.

• What will drive a potential sector recovery? As we near the tail-end of current interest rate upcycle, we see a reversal of the aforementioned factors driving capital flows back to the sector. RHB Economics expects one rate cut by the US Federal Reserve in 4Q with more on the cards next year. While interest rates are unlikely to go back to pre-pandemic levels, a normalisation of rates by 100-200bps lower in the medium term could provide 30-50% upside to the sector. On the positive side, GDP growth is expected to be more than double that of last year. This should aid in continued better operational performance and topline growth, with a peak in interest cost pressures anticipated by end of the year. Currently, S-REITs offer an average yield of c.7%, with a yield spread of c.360bps over 10-year government bond yields – higher vs global major REIT markets ie the US, UK, Japan, and Australia.

• Prefer large-cap industrial and office REITs with modest gearing and strong sponsor backing as market awaits greater clarity on interest rate path. Industrial S-REITs still have the most defensive characteristics with favourable demand supply dynamics and stable cash flow while office SREITs remain the most attractive in terms of valuation amid undue investor concerns over the sector. In the near term, hospitality S-REITs too offer good upside potential from continued strong tourism recovery in Singapore.

• Key catalysts and risks. Catalysts: Earlier-than-expected interest rate cuts and a decline in long-term interest rate expectations, coupled with resilient economic growth. Key risks are stagflation scenario with persistent high rates and weakening growth, as well as severe global recession.

Source: RHB Securities Research - 26 Jun 2024