Investment Summary

Following our observations on developments in the macroeconomic landscape and conclusions drawn from the 4QCY17 earnings season, we reaffirm our positive view on Singapore developers over S-REITs. The thesis of this report is to recommend investors to switch out of S-REITs to developers. We believe the Singapore residential market has now entered a nascent stage of a potential multi-year recovery, amid a firm economic backdrop and improving buyer sentiment. We further note the share prices of developers have outperformed S-REITs during the last major rate hike cycle from Jun 2004 to Jun 2006 and the current ongoing cycle since Dec 2016. From a valuation standpoint, we believe developers offer a more attractive risk-reward proposition than S-REITs. We are OVERWEIGHT the Singapore property sector, with a positive bias towards the residential sector. Our preferred picks are City Developments Limited (CDL), UOL Group Limited (UOL) and CapitaLand Limited (CAPL.)

  • – Prefer SG developers to S-REITs
  • – Brighter outlook and valuations for developers
  • – Top picks: CDL, UOL, CAPL

Cyclical growth themes trump defensiveness amid strengthening economic outlook

Following our observations on developments in the macroeconomic landscape and conclusions drawn from the 4QCY17 earnings season, we reaffirm our positive view on Singapore developers over S-REITs. The thesis of this report is to recommend investors to skew their real estate equity portfolio bias towards Singapore developers, or in other words, to switch out of S-REITs to developers. We are sanguine on the operational and earnings outlook of major Singapore developers with significant Singapore residential exposure and/or strong recurring income streams from diversified investment properties. We believe the Singapore residential market has now entered a nascent stage of a potential multi-year recovery, amid a firm economic backdrop and improving buyer sentiment.

Developers have outperformed S-REITs during rate hike cycles

Although the share prices of both S-REITs and Singapore developers performed well during the last major rate hike cycle from Jun 2004 to Jun 2006 and the current ongoing cycle since Dec 2016, we note that developers outperformed S-REITs on both occasions. We expect this trend to continue. Domestic benchmark rates for mortgages (SIBOR/SOR) are projected to increase as most major Central Banks continue their policy-tightening stance. Rising rates will likely partially offset fundamental tailwinds but we believe the overall impact is still manageable for developers. For investment home owners, the anticipated recovery in housing rentals ahead will also help to alleviate the pressure on rental carry from higher rates.

Valuations favor developers

Despite the robust outlook for developers, the sector is still trading at a large discount to NAV and also against historical averages. We note that during property bull-cycles, developers have traded at a premium to their NAV. For example, during the last upcycle in 2010, the forward P/B ratio of the FTSE ST Real Estate Holding and Development Index (FSTREH) reached a peak of 1.13x, while the current forward P/B ratio stands at 0.69, or 0.7 standard deviations (SD) below the 10-year average. We thus see room for further re-rating in the sector, and expect the discount gap to narrow as residential prices continue its upward trajectory. On the contrary, the S-REITs sector is trading at relatively unattractive valuations, with a forward P/B ratio of 1.04x, or 0.7 SD above its 10-year mean. In conclusion, we believe developers offer a more attractive risk-reward proposition than S-REITs.

Investment thesis: Reallocate capital from S-REITs into Singapore developers

Following our observations on developments in the macroeconomic landscape and conclusions drawn from the 4QCY17 earnings season, we reaffirm our positive view on Singapore developers over S-REITs. The thesis of this report is to recommend investors to skew their real estate equity portfolio bias towards Singapore developers, or in other words, to reallocate capital from S-REITs to developers. Our preference for Singapore developers are premised on the following three key themes:

Theme 1: Cyclical growth themes beat defensiveness amid strengthening economic outlook

We are sanguine on the operational and earnings outlook of major Singapore developers with significant Singapore residential exposure and/or strong recurring income streams from diversified investment properties. We believe the Singapore residential market has now entered a nascent stage of a potential multi-year recovery, amid a firm economic backdrop and improving buyer sentiment. Although S-REITs will also be able to benefit from a stronger economic outlook, we believe the impact will not be as pronounced as developers, given that rental leases are typically locked in for 3-5 years. Furthermore, most REIT Managers have previously sought to limit downside risks for their unit holders by placing stronger emphasis on forward renewing their leases to lock in the occupancy levels, hence missing out on potentially higher rental rates in the near future to a certain extent.

Historically, the share price performance of the FSTREH has a relatively high correlation of 0.72 with changes in the URA Private Residential Price Index. Looking ahead, we forecast Singapore residential prices to increase 3% – 8% in 2018, and also project private primary sales transaction volume in the range of 12k-15k this year. We expect this to be one key catalyst for Singapore developers.

Theme 2: Share prices of developers have outperformed S-REITs during the last major rate hike cycle and current ongoing one

Although the share prices of both S-REITs and Singapore developers performed well during the last major rate hike cycle from Jun 2004 to Jun 2006 and the current ongoing cycle since Dec 2016, we note that developers outperformed S-REITs on both occasions. During the period from Jun 2004-Jun 2006, the FSTREH rose a whopping 110.3%, while the FSTREI increased 25.8%. From 14 Dec 2016 (when the Fed first raised the Fed funds rate under this ongoing cycle) till now, the FSTREH and FSTREI increased 23.8% and 12.8%, respectively. We expect this trend to continue. Domestic benchmark rates for mortgages (SIBOR/SOR) are projected to increase as most major Central Banks continue their policy-tightening stance. According to Bloomberg consensus’ average forecasts, economists are expecting the 3M SIBOR to hit 1.78% and 2.17% by end-2018 and end-2019, respectively. To put things in perspective, the 3M SIBOR was 1.50% as at end- 2017, and last stood at 1.38%. Rising rates will likely partially offset fundamental tailwinds but we believe the overall impact is still manageable for developers and homeowners. As an illustration, if the 3M SIBOR rises by 125 bps to 2.63%, we estimate that the monthly mortgage payments for an owner of a second home in Singapore worth $1m will increase from ~S$2.2k to S$2.6k, under a 60% LTV ratio and 30-year loan tenor assumption. This is unlikely to create a significant increase in financial strain for the homeowner. For investment homeowners, the anticipated recovery in housing rentals ahead will also help to alleviate the pressure on rental carry from higher rates.

 

Theme 3: Developers still trading significantly below their 10-year average P/B but S-REITs are trading at a premium

Despite a more robust outlook for developers as compared to S-REITs, the FSTREH is still trading at a large discount to NAV and also against historical averages. We note that during property bull-cycles, developers have traded at a premium to their NAV. For example, during the last up-cycle in 2010, the forward P/B ratio of the FTSE ST Real Estate Holding and Development Index (FSTREH) reached a peak of 1.13x, while the current forward P/B ratio stands at 0.69x, or 0.7 SD below the 10-year average. We thus see room for further re-rating in the sector, and expect the discount gap to narrow as residential prices continue its upward trajectory. On the contrary, the S-REITs sector is trading at relatively unattractive valuations, with a forward P/B ratio of 1.04x, or 0.7 SD above its 10-year mean. We take our analysis further by examining the P/B spread between the FSTREH against the FSTREI. We note that the current spread (FSTREH – FSTREI) is -0.35, which is 1.3 SD below the 10-year average of -0.14.

 

We conclude that developers offer a more attractive risk-reward proposition than S-REITs. We are OVERWEIGHT the Singapore property sector, with a positive bias towards the residential sector. Our preferred picks are City Developments Limited, UOL Group Limited and CapitaLand Limited, which are trading at attractive discounts of 37.0%, 34.2% and 28.1% to our RNAV estimates, respectively. All three also bumped up their final DPS during their recent FY17 results announcement.

Firm economic outlook and buyer sentiment a key driver for higher expected residential prices

We believe the Singapore residential market reached a nadir in 2017, and is currently at a nascent stage of recovery which is sustainable, barring any unforeseen circumstances. As a recap, the URA Private Residential Properties Price Index (PPI) reached an inflection point in 3Q17, climbing 0.7% QoQ after 15 consecutive quarters of price decline, or a cumulative 11.6% dip from the last peak in 3Q13. This momentum continued in 4Q17, with the URA Private Residential PPI rising 0.8% QoQ, such that the year 2017 ended in positive territory (+1.1% from 2016).

Singapore property offers relatively better value vis-à-vis other major global cities

Given the effectiveness of the Singapore government’s property cooling measures, residential prices in the city-state declined 11.6% from its last peak in 3Q13 before bottoming-out in 3Q17, as highlighted earlier. On the contrary, property prices in other key gateway cities such as Hong Kong, Sydney, New York have largely continued on an upward trajectory during the same period.

 

Based on the annual Demographia International Housing Affordability Survey, the cost-to-income multiple (as calculated by the median house price divided by the median household income) was 4.8x for Singapore, unchanged from 2016 and lower than the 7.3x figure in 2010. This compares favourably against the likes of Hong Kong (19.4x), Sydney (12.9x), Melbourne (9.9x), San Francisco (9.1x) and London (8.5x). For Hong Kong, Melbourne and Sydney, housing affordability actually worsened in 2017 as compared to 2016. Out of these cities highlighted, Singapore was the one which saw its housing affordability multiple improve from 2010 to 2017.

In addition, we see fewer risks in the Singapore market as the amount of speculative activities have receded over the years, based on the number of sub-sales transactions tracked. To illustrate, there was an average of 3,108 sub-sale transactions between 2009 and 2012. However, in 2017, only 367 sub-sale units changed hands in the marketplace.

Foreign buying activity has room for improvement and may surprise on the upside

Based on our argument that Singapore residential properties offers compelling relative value versus other major global cities, coupled with continued economic and income growth in the region, we believe there is room for foreign buying activity to gain traction ahead. Although the stringent Additional Buyer Stamp Duty (ABSD) measure of 15% on foreigners remains in place, we believe this appear less onerous relative to other peer cities such as Hong Kong and China, which carry the possibility of furthering tightening measures. In Singapore, for all residential transactions completed in 2017, only 5.2% were contributed by foreigners, a far cry from the average of 8.1% since 2009 and last peak of 15.6% in 2011. Similarly, if we look at 2017 transactions for the CCR segment, 12.1% were attributed to foreigners, versus 27.3% in 2011 and average of 16.3% from 2009-2017.

For the first two months of 2018, we see some encouraging signs given that the proportion of foreigner transactions has increased to 6.6%.

Sizzling en-bloc market in 2017; momentum has spilled over to 2018

The red-hot en-bloc market first saw an acceleration in momentum in May 2017, and eventually translated into a colossus ~S$8.6b of collective sales being announced (including projects which have reached an agreement but yet to obtain final regulatory approvals) last year. We expect this to have a strong trickle- down effect on housing demand in the near-future as home sellers who are flushed with cash and borrowing headroom would likely seek to purchase replacement homes instead of renting given market expectations of rising property prices ahead.

Although the en-bloc ‘fever’ started showing some signs of fatigue since Dec, given a number of failed tender attempts, we believe momentum has started to pick up again, while the robust transactions concluded in 2017 would also be sufficient to fuel demand in the near-term for residential homes. YTD, a sizeable ~S$4.2b in en-bloc deals have been announced, although only City Towers (S$401.9m; 13% above reserve price; land price of S$1,847 psf ppr;) in Bukit Timah Road has been officially registered in URA’s database (as at 8 Mar 2018). Looking ahead, developers would typically launch the en-bloc sites for sale approximately 1-2 years after the transaction. Although there would likely be more units available for sale post redevelopment, the average unit size tends to be smaller and hence would fetch a higher ASP on a psf basis. We believe this has two implications: i) absolute price quantum of smaller units would cater to a wider target group; ii) higher ASP psf may lift property valuations in the vicinity.

[En-bloc transactions table attached]

Conclusion

We are overweight the Singapore property sector, with a positive bias towards the residential sector. Our preferred picks are City Developments Limited, UOL Group Limited, and CapitaLand Limited.