Keppel REIT - DBS Research 2017-10-19: Tracking The Recovery In Office Rents

KEPPEL REIT K71U.SI

Keppel REIT - Tracking The Recovery In Office Rents

3Q17 DPU of 1.40 Scts (-13% y-o-y) largely in line with expectations.
Only 0.5% of leases to be renewed for remainder of 2017; rental reversions were negative in 3Q17.
First increase in spot office rents in 10 quarters points to better times ahead for KREIT.

We maintain our BUY call on Keppel REIT (KREIT) with a revised TP of S$1.28.
KREIT’s share price typically leads a recovery in spot office rents by 6-12 months. With Grade A CBD rents increasing for the first time in 10 quarters according to CBRE, we believe we are on the cusp of an upturn and the rally in KREIT’s share price can be sustained despite over 30% increase over the past 18 months.

There remains significant scepticism that KREIT’s Singapore office portfolio should be valued at S$2,700-2,900 psf. We believe this view is incorrect, given there have been several transactions at or above this valuation for comparable buildings, by both a mix of foreign but more importantly experienced local developers and landlords, demonstrating the resilience of KREIT’s portfolio values.
While acknowledging that KREIT is unlikely to sell its buildings in the near term and has a flattish DPU profile boosted by capital distributions, we believe the implied c.S$2,550 psf for KREIT’s Singapore portfolio and c.15% discount to book value is too wide for a best-in-class office portfolio.

We believe the expected recovery in office rents, should act as a catalyst to close the discount to KREIT’s book value. In particular, the earlier than expected upturn in spot rents should provide confidence that market rents should eventually recover to S$12-14 psf per month.

To better reflect recent market transactions and the latest beta estimates, we lowered our beta assumptions from 0.80 to 0.75, which results in our DCF-based TP (WACC of 5.8%, 2% terminal growth) rising to S$1.28 from S$1.23.

Key risks to our positive view are weaker-than-expected rents, and/or KREIT not distributing capital gains, causing DPU to come in below expectations as well as investors focusing more on underlying DPU rather than headline DPU.

3Q17 DPU fell 13% y-o-y to 1.40 Scts which was largely within expectations. This took 9MFY17 DPU to 4.27 Scts which represents 74% of our underlying FY17 DPU forecasts (excluding capital distributions).
The fall in 3Q17 DPU was mainly attributed to the absence of capital distributions (S$3m in 3Q16) and one-off income from Marina Bay Financial Centre and One Raffles Quay (compensation income was recorded in 3Q16 due to some tenants vacating space).
In addition, KREIT was impacted by lower contribution from Ocean Financial Centre (OFC - impact of prior negative rental reversions). However, 3Q17 NPI was flat y-o-y, owing to better earnings from 8 Exhibition Street (+21% y-o-y) and 275 George Street (+3%) which offset the 3% drop from OFC).
Owing to the stronger AUD, distribution income from KREIT’s other Australian properties, 8 Chifley Square and David Malcom Justice Centre, were also up 10% and 4% yo-y respectively.
Overall portfolio occupancy was relatively stable at 99.6% (99.8% in 2Q17 and 99.5% in 3Q16).

While spot office rents have started to recover, KREIT continues to face downward pressure on rents. As a consequence, KREIT reported negative rental reversions in 3Q17, which resulted in 9M17 signing rents being 3% below expiring rents. We understand KREIT also faced downward pressure on some of its expiring retail leases. The falls in 3Q17 offset the increases achieved in 2Q17. As a reminder, KREIT reported -1% rental reversions in 1Q17 and 0% rental reversion in 1H17.
Post the renewal of leases in 3Q17, only 0.5% of leases are up for renegotiation for the remainder of 2017, down from 2% as at end 2Q17.
Going into 2018, 6.7% of leases are up for renewal with 14.5% of leases having rent reviews. Despite signs of office rents now on an upward path, there remains some risk that KREIT will continue to report negative rental reversions as we understand that expiring rents for some of these leases are between mid-S$9’s and S$12.50.

KREIT’s all-in costs of debt was stable at 2.58% (2.59% in 2Q17).
Gearing was 38.8% but is expected to climb closer to 40% once the recently acquired 311 Spencer Street development is completed in 4Q19.
The proportion of fixed-rate loans was stable at 76%, with no refinancing due until 2018.
NAV per share (excluding distributable income) stood at S$1.41.

While 3Q17 results was largely in line with expectations, due to higher than expected take up of the distribution reinvestment plan and slightly lower than expected contribution from Bugis Junction Tower, we trimmed our FY17-19F DPU by 2% per annum.
Going into 4Q17, we expect KREIT to temper the decline in DPU by distributing around S$3m in capital gains.

The recovery in spot office rents (up 1.7% q-o-q to S$9.10 for the first time in 10 quarters, based on CBRE estimates) and recent market transactions (sale of Asia Square Tower 2 for S$2,689 psf, and bid for the Beach Road site which implies office building price of over S$3,000 psf on a completed basis), in our view points to the holding power of office buildings in Singapore.
To better reflect this and the latest beta estimates, we have lowered our beta assumptions from 0.75 from 0.80 which results in our DCF-based TP increasing to S$1.28 from S$1.23. Our TP implies c.S$2,650 psf for KREIT’s Singapore offices.
With c.12% total return expected over the coming 12 months (7% capital upside and c.5% yield), we maintain our BUY call with a revised TP of S$1.28.
While acknowledging that KREIT’s DPU will likely remain flat over the coming couple of years and is supported by capital distributions, there remains upside to KREIT’s share price as its implied price per sqft for its Singapore portfolio of c.S$2,550 remains below that of recent market transactions of S$2,700- 3,500 psf.

Mervin SONG CFA DBS Vickers | Derek TAN DBS Vickers | http://www.dbsvickers.com/ 2017-10-19

DBS Vickers SGX Stock Analyst Report BUY Maintain BUY 1.28 Up 1.230