By Kevin Tan (OCBC)

We now see fairly solid grounds for a base case that the Fed would taper QE3 in Sep 2013 or soon after, and we downgrade the S-REIT sector to NEUTRAL on three key reasons. First, we believe this is the beginning of a long term secular, not cyclical, trend of rising interest rates. Higher discount rates and liquidity factors, due to capital re-allocation across asset classes, would likely negatively impact REIT prices over the mid to long term. Second, we believe a limited fundamental growth outlook for the sector is unlikely to trump the negative impact of rising rates on S-REIT prices. Finally, a key proxy for cheapness ? the sector?s yield spread against the SG 10Y bond ? implies that the sector appears fairly priced now. Our most preferred sub-sectors are domestic retail and office where rental outlooks and valuations still appear fairly appealing. Our top picks are CapitaCommercial Trust [BUY, FV: S$1.61], Starhill Global REIT [BUY, FV: S$0.95] and Suntec REIT [BUY, FV: S$1.80].

Base case is for Sep taper
On 22 May 2013, Fed Chairman Bernanke first raised the specter of a reduction in monthly purchases under the QE3 program. As the dust begins to settle after significant volatility in global markets, and with subsequent US data pointing to a moderate recovery, we now see fairly solid grounds for a base case that the Fed would taper QE3 in Sep 2013 or soon after.

A secular, not cyclical, trend of rising interest rates
We now opt to downgrade the S-REIT sector to  NEUTRAL  on three key reasons. First, we believe this is the beginning of a long term secular, not cyclical, trend of rising interest rates. We expect higher discount rates and liquidity factors, due to capital re-allocation across asset classes, to negatively impact REIT prices over the mid to long term. To be clear, while history shows that S-REITs can outperform in periods of rising interest rates, we believe this is unlikely to happen ahead, which brings us to the second basis for our downgrade.

Limited growth won?t trump negative impact of higher rates
Second, while DPUs are expected to grow 4.3% in FY14, this is to a large extent due to positive reversions off expiring leases signed near the last financial crisis troughs rental outlooks across sub-sectors are generally only neutral to mildly positive. In addition, we see limited scope for much capital appreciation ahead given current cap rate levels. Also, as interest rates rise, we believe REIT managers will also find it increasingly challenging to grow DPU through accretive M& A. 

S-REIT sector looks fairly valued now
Finally, a key proxy for cheapness ? the sector?s yield spread against the SG 10Y bond ? implies that the sector appears fairly priced now. At 379 bps currently, the spread is within one standard deviation of the three-year average and to maintain this spread, we think that REIT prices would have to come down in an environment of decelerating liquidity, particularly as we begin to normalize out of ultra-low interest rates.

Prefer domestic retail and office plays
Over the last three months, we have adjusted the discount rates in our valuation models by 140 bps to 170 bps to reflect higher risk free rates, and regional and sector betas, and have consequently reduced our fair value estimates by 3% to 20%. Our most preferred sub-sectors are domestic retail and office where rental outlooks and valuations still appear appealing. Our top picks are  CapitaCommercial Trust  [BUY, FV: S$1.61 ...last: $1.375],  Starhill Global REIT  [BUY, FV: S$0.95] and  Suntec REIT  [BUY, FV: S$1.80].

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