Why buy Singapore office, retail assets for yields below borrowing costs?

Sep 18, 2023

OVER the past 18 months, much attention in Singapore and globally has focused on the rise in interest rates.

The US Federal Reserve started hiking interest rates in mid-March 2022 to combat rising inflation. Commercial property in the US has felt the pain of higher interest rates. Capitalisation rates used to value various buildings expanded, causing massive falls in values.

The capitalisation rate captures the annual return an investor expects from an investment. In the income capitalisation method used to value properties, a property’s value may be derived by dividing the assumed net property income (NPI) by its capitalisation rate.

A victim of higher capitalisation rates hurting property values is Manulife US Real Estate Investment Trust. The Singapore-listed trust, which owns various US office buildings, abandoned paying out distributions for H1 2023.

Yet, the capitalisation rates used to value many office and retail properties here have held remarkably stable.

Take two Grade A office buildings in the Central Business District that Keppel Reit owns.

The capitalisation rates for Ocean Financial Centre and One Raffles Quay were 3.4 per cent and 3.5 per cent respectively as at end-June 2023, unchanged from end-December 2022. Ocean Financial Centre’s capitalisation rate was 3.5 per cent for end-June 2022 and end-December 2021, while One Raffles Quay’s capitalisation rate was 3.5 per cent for end-June 2022 and 3.45 per cent for end-December 2021.

The capitalisation rate used to value mega mall VivoCity, which is owned by Mapletree Pan Asia Commercial Trust, was 4.6 per cent as at end-March 2023 and end-March 2022.

Property values are highly sensitive to the capitalisation rates used. A property with NPI of S$50 million is worth S$1.43 billion using a capitalisation rate of 3.5 per cent. Applying capitalisation rates of 4 per cent and 4.5 per cent, valuation falls by 12.5 per cent to S$1.25 billion and 22.2 per cent to S$1.11 billion, respectively.

Declining property values hurt asset owners. Loan covenants may be breached, thereby creating refinancing problems. Also, the overall gearing limits of listed property trusts could bust the mandatory limit.

Nonetheless, one can defend the stability in capitalisation rates used to value Singapore properties despite rising interest rates. Some big-ticket property deals are being done at prices that exceed latest valuation.

Changi City Point

In late August, Frasers Centrepoint Trust announced the proposed sale of Changi City Point, a mall with around 208,453 square feet of net lettable area. The divestment consideration of S$338 million is 4 per cent above the end-July valuation of S$325 million. Using financial year 2022’s NPI, the NPI yield based on the divestment consideration is 4.31 per cent. FCT stands to book an estimated net gain of S$10.9 million from this proposed sale.

The proposed divestment will strengthen FCT’s financial position. The trust’s manager plans to use sale proceeds to repay loans with higher interest rates of possibly over 5 per cent per annum. Post the proposed sale, FCT’s aggregate leverage reduces from 40.2 per cent to 37.1 per cent, and average costs of borrowings fall from 3.7 per cent to 3.6 per cent per annum.

Moreover, Changi City Point’s remaining land lease of over 45 years is shorter than that of other Singapore malls in FCT’s portfolio. Property values will run down as land lease outstanding reduces, and malls with fewer years of land lease left might find greater difficulty in securing buyers.

However, one may wonder why a party wants to buy Changi City Point at a yield which may be below the borrowing cost.

Property investment is far less attractive when interest rates are high. In the not too distant past, one might have borrowed at 2.5 per cent per annum. If a property’s NPI yield is 4.31 per cent and the purchase is funded 50:50 by debt and equity, the NPI yield on equity post leverage gets bumped up to 6.12 per cent. On the other hand, when debt costs 4.5 per cent, the NPI yield on equity post leverage becomes 4.12 per cent.

Buying rationale

Nonetheless, there are reasons to buy office and retail properties here at yields that are at or below borrowing costs.

First, a buyer using cash could be fine with receiving a relatively low single-digit NPI yield, especially if he expects NPI to rise. Demand for Singapore office buildings is supported by knowledge workers from diverse sectors spending much time working out of physical offices. Meanwhile, malls draw support from residents who continue to enjoy patronising malls as well as rising numbers of international visitors.

Second, a buyer can justify using some debt to fund an office or retail asset purchase even when using debt may lower the initial return on equity (ROE). Subsequent income growth can lead to NPI yield on purchase price exceeding borrowing cost. In short, potential future uplift in NPI and capital value may more than compensate for the hit to initial ROE from taking on debt to fund a property buy.

Third, some properties offer scope to carry out asset enhancements, which can substantially boost NPI. Several listed property trusts here have consistently undertaken asset enhancements that generate positive returns on investment. Also, some properties have redevelopment potential. Moreover, asset repositioning plus active tenant management can help optimise NPI of many malls.

Fourth, interest rates may not rise much more and could possibly decline as early as some time in 2024. A buyer who uses debt to buy a property today could be looking at lower debt costs and hence higher ROE going forward. Crucially, should interest rates soften, buying appetite for big-ticket properties will improve. As more buyers chase assets, property values could be bid up. Ultimately, a buyer of a chunky property today will make strong capital gains if interest rates adjust materially downwards.

Selling properties at good prices to boost an entity’s financial position is sensible in the prevailing high interest-rate environment. A party with cash and borrowing capacity available is well-positioned to snare opportunistic buys.

Still, there are sound reasons for lowly-geared long-term focused buyers to make non-distressed office and retail property buys at skinny entry yields in a stable Singapore market, where such properties are often tightly held.