Why REITS can still perform well during interest rate upcycle

May 02, 2018 12:40
Mall landlords are coming up with well-thought-out marketing programs to drive visitors to the shopping venues. Photo: Reuters

Hong Kong is about to enter an interest rate upcycle. This is no surprise as the Hong Kong dollar is pegged to the US dollar, which has been in a rate upcycle since the end of 2015. Recently, we have observed that, at Hong Kong banks, a 3-month USD certificate of deposit offers up to 2.4 percent in interest rate.

In addition, Hong Kong dollar has been trading around the weak band of the USD-HKD trading range, suggesting that capital flow is finally impacting the Hong Kong unit. As a result, we have observed that HIBOR are generally trending up, with the one-month HIBOR reaching 1.30 percent in the last week of April. Since mortgage rates are said to be around 2.15 percent now, the interest rate margin is currently less than 1 percent. Thus, we expect the Hong Kong dollar to soon see some interest increases.

Our long standing view is that, on its own, interest rate increase is not a threat to real-estate prices, as long as rental income is also increasing. This interest rate upcycle is characterized by the fact that inflation remains subdue, and thus the Fed can choose to increase rates only when the economic fundamentals support it.

In this environment, investors will do well to focus on real-estate assets that can provide a stable yet growing rental income stream. Here in Hong Kong, retail real-estate and related REITs should outperform in the immediate future. Hong Kong witnessed negative retail spending growth in 2015 to 2016, and this has led to some retail rents falling in some sectors. In selected cases, spot rents have fallen by 40 percent from the 2012 peak.

However, since 2017 the retail sector has stabilized and is finally growing. Growth in 2018 seemed to be accelerating, as evidenced by data such as the reported monthly sales numbers by Sa Sa International and HKTVmall. We believe that Hong Kong retail is in a new upcycle, and retail rents should do well as well.

Retail REITs in Hong Kong have a healthy rent-to-retail-sales ratio. Link REIT, for example, is still quoting a rent-to-sales ratio of less than 13 percent, meaning that for every 100 dollars a retailer makes at a Link mall, less than 13 dollars goes as rent to Link. This is healthy compared to top retail malls in other countries. We have seen this ratio becoming as high as 20 percent.

Fundamentally, a retailer will only choose to stay in a mall if it can generate retail sales, and thus, over the long term, retail rents can only grow at a level that makes sense to the retailer. This is the reason why all mall landlords have thoughtful marketing programs to drive visitors to their malls. Only by growing visitor numbers will retail sales at the mall grow sustainably. Similarly, asset enhancement programs are taken to transform the mall, so that the total spending will increase through time.

This is why, even when they are in similar locations, not all malls give similar performance. Malls that are more successful in driving total spending are more valuable to retailers, as they directly benefit from the increased sales. Thus, retailers are incentivized to pay higher rents at well-run malls. We believe that the top mall operators in Hong Kong are able to take advantage of the retail sales upcycle and further improve their positioning. Thus, their assets may see accelerated rental growth.

At the other end of the spectrum, assets that are capturing new but stable demand will also outcompete other assets during an interest rate upcycle. For example, within residential for lease units, student housing may represent a source of growing but stable demand. Hong Kong is now established as an education destination, and we can reasonably expect the number of non-domestic students to stay the same or slowly growing in the years ahead. Thus, housing units that are close to universities and that have the correct size and amenities should continue to draw demand from the student communities. The rental income of these assets is thus stable and growing.

The above are but just two examples of how investors can approach continued real-estate investment in an interest rate upcycle. In short, investors who are willing to look at the fundamentals will pick up assets that see strong rental income rather than those with weak income.

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Chief Investment Officer, Admiral Investment Ltd.