The latest CPI inflation data was released, and it was good. One day after, the Fed announced that they were not raising the interest rate this month in favor of waiting for more data to account for the full impact of their policy so far. This ‘temporary pause’ is historic because the Fed has consistently raised the benchmark interest rate in the past ten consecutive FOMC meetings. With inflation cooling down and the first rate pause this month, the prospect of reaching the tail-end of this rate hike cycle is becoming more apparent.
The most interest-rate-sensitive assets should benefit from this development. US growth stocks have been performing very well this year, with Nasdaq rebounding 32%. But on the other hand, REITs, another rate-sensitive asset class, still have not performed too well. Let’s look at whether the terminal interest rate is coming and whether this is the time to invest in Singapore REITs.
Latest Inflation Data
The latest data shows inflation rose 4% YoY, the lowest in two years. The previous month’s inflation was still at 4.9% YoY. Core inflation was 5.3% YoY, down from 5.5% YoY last month.
From the chart above, we can see that the disinflationary process is currently in progress. No, we have not won the inflation battle yet, but we are on the right track.
Latest Fed Interest Rate Update and Projection
The Fed decided to pause the rate hike this month temporarily. This is in line with the market expectation. During the speech afterward, the Fed chair, Jerome Powell, mentioned that they wanted to wait for more data to see the full impact of their policies so far. This is historic because this is the first rate pause after ten consecutive rate hikes!
While this sounds good, there is a bit of a surprise in the FOMC projection data. Although the Fed paused this month, the consensus projected terminal interest rate actually increased to 5.6% (up from 5.3% projected in last month’s FOMC). The Fed also expected the 2024 interest rate to be at 4.6% (up from 4.3% projected in last month’s FOMC).
Stickier-than-expected inflation data likely contribute to these higher projected rates. With the US economy and labor market much more robust than expected, cooling down inflation may take longer. The Fed revised up the US economic growth to 1% this year, 1.1% next year, and 1.8% in 2025.
Is The Fed Too Slow to React?
If inflation is already cooling down, why does the Fed still want to keep raising interest rates? Based on their projection, we are still due for another two 25bps rate hikes this year. Core PCE inflation, the Fed’s preferred inflation measure, shows a similar downward trend.
If we know that inflation is going down and that economic data is usually lagging, shouldn’t the Fed stop the hike already? The data reflected today is not only because of the last month’s rate hike; it is the impact of all the rate hikes in the past several months. Yes, the economic data is, unfortunately, lagging.
The Fed’s Dual Mandates
The Fed has two mandates: maximum employment and price stability. For the first mandate of maximum employment, the Fed has done a decent job. The labor market has been remarkably resilient so far this year. However, the Fed has done a terrible job with the second mandate, price stability. They are now trying to correct their mistake by ensuring inflation is under control. And from their hawkish posture, it looks like they will do whatever it takes to get inflation into their long-term target rate of ~2%.
Possible Scenarios
If the Fed pauses too early when inflation has not been controlled, it will likely pick up again, making it even more challenging to tame. However, if the Fed pauses too late (or overtighten), the inflation will go down at the cost of hard-landing in the economy (recession). Given the two choices, they will likely prefer the overtightening risk to ensure once and for all that they win the inflation battle. If the economy enters a recession, they already have a tool to deal with this: quantitative easing.
In the case of a soft landing, we can see that the interest rate may stay elevated longer, just like the Fed’s projection going into 2024. However, if something breaks in the economy, the Fed may pivot much earlier, and rates may go down much faster than projected. Which scenarios will play out is hard to predict, but we can see that the interest rate seems to be peaking soon.
What about REITs?
Because of leverage, REIT is an asset class susceptible to interest rate volatility. Singapore REITs have had a ‘free fall’ since the Fed started its rate hike cycle. Now that inflation seems to be on the right track, with the Fed finally paused for the first time, the silver lining that the investors have been waiting for may start to show up.
Where Are We with Singapore REITs?
As we can see from the chart above, the S-REITs have not been performing too well. Since 2021, the market has been on a steady decline, with the current price being roughly at the level seen during the peak of COVID fear and lockdown!
But to be fair, most Singapore REITs managers and investors have yet to see a rate hike cycle as fast as the one we are in. With REITs being highly leveraged, as the interest rates continue to rise quickly, the refinancing cost of these REITs also increases significantly. Thus, the ‘free fall’ in prices. With the price hovering at a multi-year low, is this the time to invest in Singapore REITs?
Interest rates risk
REITs may be one asset class that benefits from clarity in the interest rate cycle. The biggest concern with REITs’ valuation comes from their borrowing cost, which has risen significantly in the past year. However, this may be reaching its peak, and going forward, especially going into 2024, the cost may be lower as interest rates start to drop. Please note that the projected interest rate will still be higher than 4% in 2024 and >3% in 2025. Unless something breaks in the economy, we won’t see a 0% interest rate anytime soon. Even the market, albeit more optimistic, agrees with this general trend of higher rates throughout next year:
Most REITs will need to refinance at some point this year or next year. Unfortunately, they will still have to refinance at a much higher borrowing cost. In return, this higher borrowing cost will impact the DPU going forward. The impact may still be manageable for a well-managed REIT with debt maturity staggered equally over several years. But for those who are not, their borrowing cost may increase significantly soon.
But the good news is that there is not much surprise anymore because the interest rate has stabilized and may start to reverse next year. Some of these concerns may have been priced in with the forward-looking market.
Property Valuation & Rental Risk
Sure, the interest rate risk may have been partly priced in, but how about the high property valuation? Will it go down and impact the REIT NAV? Again, we don’t know for sure, but yes, it is possible. With higher interest rates, there will be less demand for highly-priced properties. With less demand comes lower prices. This and the potential economic downturn pose valuation risks to REITs. Should a recession comes, the demand will be even lower; thus price may be muted or even correct itself. Again, This is why we need to look at a well-managed REIT with a lower gearing ratio to ensure it can navigate this potential downturn should it arrives.
In an economic slowdown, the rental income may also be impacted because there will be less demand as business cut their spending. Lower rental income means lower DPU for the REIT unit holders.
On a separate note, the good thing about recession is that it will incentives the Fed to pivot into easing policies. If a downturn arrives, the Fed may cut their interest rate to 0% again. Rate cuts are good for REITs.
What Would We Do?
We compare the S-REITs yield spread to see if S-REITs are worth the risk.
Investors usually buy S-REITs for their dividends. With the interest rate at one of the highest levels in recent times, it makes sense for investors to expect higher dividend yields before they are willing to take risks investing in REITs.
In the past five years, on average, the difference between REIT’s yield and the risk-free rate has been hovering around 3.5%. With the current risk-free rate from 10yr Singapore government bonds hovering around 3%, investors can expect a dividend yield of 6.5% from REITs.
Guess what? We are getting there. Some blue-chip REITs already offer around 6% dividend yield. Whether the dividend yield is sustainable is another question because it may depend on interest rates and the state of the economy.
Accumulation period?
We think we may be entering an accumulation period for Singapore REITs. Although some risks remain, we can see some silver linings with the recent inflation data and the Fed’s action. The risk-to-reward profile is getting more attractive now than just a few months ago.
We may be interested in starting acquiring S-REITs using the dollar-cost averaging strategy, beginning with the more established blue-chip S-REITs, which may be in a stronger position to weather any potential downturn. We will pay more attention to the portfolio’s geographical distribution, property types, and debt profile. In particular, we prefer REITs with lower gearing ratios to have more room for maneuvering should the higher rates persist for longer or an economic downturn comes in the future. We also prefer to have less exposure to commercial real estate in the US as there are more uncertainties there as compared to the Asia region, such as Singapore.
You can check out our list of Singapore REITs data as a starting point for your research. As always, exercise prudence when investing. Happy investing!
