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How The US Federal Reserve Interest Rate Affect S-REITs

The decisions of the US Federal Reserve, particularly regarding interest rates, hold significant sway over global financial markets. This influence stems from the dominant role of the US Dollar in international transactions and capital flows. When the Fed adjusts interest rates, it directly impacts the cost of borrowing, with a benchmark like US Treasuries reflecting the risk-free rate of return. As interest rates rise, borrowing becomes more expensive across the board. This has a cascading effect, pushing lending rates higher and reshaping the investment landscape.

The real estate investment trust (REIT) sector is particularly sensitive to these changes, and this is especially true for Singapore REIT market, accounting for a substantial portion – roughly 12% as of April 2024 – of the entire listed stock market. Investors in this market need to be aware of the challenges posed by recent US interest rate hikes. These adjustments have rippling effects that influence the performance and attractiveness of S-REITs.

Rising Rates Cast a Shadow on Singapore REIT Growth

The increase in interest rates presents a significant challenge for S-REITs. As borrowing costs climb, S-REITs face a double whammy that hinders their ability to fuel growth.

Traditionally, S-REITs have relied on two main strategies to increase distributions (dividends) to investors:

  • acquiring new properties
  • achieving positive rental reversions (raising rent on existing properties)

However, rising interest rates make both strategies more difficult.

  1. Higher borrowing costs make it more expensive for S-REITs to take on new debt, which is essential for financing property acquisitions. This directly restricts their ability to expand their portfolios and generate additional rental income.
  2. The rise of interest rates creates a more competitive landscape for investor capital. With Singapore Treasury bills (T-bills) now offering attractive returns close to 4% per annum, considered the risk-free rate in Singapore, S-REITs must offer significantly higher returns to remain competitive. This puts pressure on S-REITs to deliver superior performance despite the headwinds of rising interest rates.

In essence, higher interest rates squeeze S-REITs' margins on both ends – making it more expensive to grow and demanding higher returns to retain investors. This creates a challenging environment for S-REITs to maintain their historical growth trajectories.

The Weigh of Financing Debt

Adding another layer to the challenge, the cost of debt for S-REITs has been steadily climbing. 

Many S-REITs took advantage of the low-interest-rate environment during the COVID-19 pandemic, issuing debt at attractive rates with varying maturities. However, as these loans are refinanced at today's higher rates, the cost of borrowing is set to rise significantly. This trend, directly linked to US Federal Reserve policy, threatens to erode the debt advantage S-REITs previously enjoyed and substantially increase their overall debt burden in the coming years.

REITs don’t ever fully repay their debts but only service the interest expense on their loans. Therefore, the cost of debt is an important factor affecting REITs’ yield.

Squeezed Profits, Shrinking Dividends: The Pain of Rising Rates for S-REIT Investors

Rising interest rates are not just a financial headache for S-REITs, they're impacting investors directly. As the cost of servicing debt increases, the pool of profits available for distribution as dividends shrinks. This translates to real pain for unitholders, many of whom have already seen their payouts decline.

Data from The Business Times paints a concerning picture. In the latter half of 2023, a whopping 28 S-REITs saw a drop in their distribution per unit (DPU), with the median decline a worrying 8%. This is happening even though many S-REITs are reporting higher revenue and net property income (NPI). Unfortunately, these gains are being gobbled up by the rising cost of financing.

Source: Business Times, company announcements

This trend highlights a critical point for investors – rising rates directly impact the returns you can expect from your S-REIT investments. It's no longer just about growth potential, but also about the sustainability of dividend payouts, a key reason many invest in REITs in the first place. Understanding this dynamic is crucial for making informed investment decisions in the current environment.

Higher Rates Here to Stay?

The dream of falling interest rates seems bleak for S-REITs. Back in early 2024, a chorus of optimism filled the market, with expectations of two to three rate cuts for the year fueled by encouraging inflation data. However, recent developments have slammed the brakes on that hope.

The US economy continues to chug along, while progress on taming inflation remains sluggish. This has financial markets revising their forecasts down to just one rate cut in 2024, with some experts even predicting no cuts until 2025.

This shift in expectations has hit S-REITs hard. The iEdge S-REIT Index has plunged, nearing multi-year lows by April 2024. This serves as a stark reminder of how intertwined the fortunes of S-REITs are with US Federal Reserve policy.

For investors with S-REITs, a clear understanding of the Fed's evolving stance is crucial. As the Fed pivots away from accommodative policies, it's likely to continue impacting the performance of the sector for the foreseeable future.