Ascendas REIT - Demand concerns remain

Manufacturing output contracted 26.1% y-y in 1Q09, with double-digit declines in industrial production in most sectors (ex biomedical), suggesting that industrial landlords will be faced with declining rents, and, ultimately, downward pressure on asset prices. Net demand in the industrial factory space contracted 315,382sf in 1Q09, down from net take-up of 1.5msf in 4Q09. According to the Ministry of Trade and Industry, Singapore lost 19,900 jobs in the manufacturing sector in 1Q09. While recent data from the URA suggest that industrial factory supply is being marginally delayed, future supply is nevertheless high with 18.2-20.2mn sf expected to be completed in 2009 and 11.3- 16.8mn sf to be competed in 2010. This is compared to the ten-year average supply of 6.5mn sf and 15-year average of 9.1mn sf, with the vacancy on our numbers likely to broach 10%, adversely affecting rental expectations. We retain our view that industrial rents are likely to fall 31.7%, to about S$1.33/psf per month.

Since 2004, Ascendas REIT’s DPU yield has been an average of 6.3%, equating to a 345bp spread over the average ten-year government bond of 2.88%. Currently, AREIT’s FY10F yield is 8.2%, vs the current ten-year government bond of 2.6%, delivering a spread of 720bp vs the historical average of 345bp. The historical low yield spread between AREIT's DPU yield and the prevailing risk-free rate, in our view, reflects the market’s growth expectations of the REIT over the period driven by rental reversions and acquisitions. We note that during 2005-08, AREIT saw average annual compound growth in its DPU of 13.9%. While we believe AREIT’s growth prospects are different than those it experienced during 2005-09 (we forecast DPU to fall 21.1% over FY08-FY11, in part due to the rights issue), there is inevitably a temptation to extrapolate past trends. If one adopts the historical yield spread of (345bp) to the current risk-free rate of 2.6%, this would imply a yield of 6.057% (vs its current FY10F yield of 8.2%), equating to what we would describe as an inflated unit price of S$2.10/unit given the market outlook. We believe our asset-based approach to valuing AREIT incorporates the cashflow risks of both negative reversions and higher vacancy risk, and believe such “spread analysis” is overly simplistic.

We have revisited our earning numbers and have marginally raised our DPU forecasts for FY09-FY11 on the back of income expectations from recently completed development properties. In addition to the marginally higher earnings, we have rolled forward our intrinsic net asset valuation to FY11F and determine an NAV of S$1.24/unit. (Previously March year-end FY10, value of S$1.17/unit). We maintain our REDUCE call.

We believe the key risks remain the performance of the Singapore manufacturing and logistics sector, which would affect our forecasts for occupancy, rents and capitalisation rates, following the recent equity-raising. We expect AREIT to be adversely affected by the deteriorating economy, although we believe investors seeking liquidity in the REIT sector could offer unit price support.

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