Manulife US REIT - RHB Invest 2016-11-23: A "MUST" BUY

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MANULIFE US REIT BTOU.SI

Manulife US REIT - A “MUST” BUY

• We believe MUST offers a compelling value proposition for yield-hungry cum growth-oriented investors as it offers: 
  1. Superior and stable yields from its freehold US office properties; 
  2. Organic growth combined with the ability to grow inorganically; 
  3. Exposure to a rebounding US economy and stable USD.
• We believe much of its relative underperformance to S-REIT peers is mainly due to market unfamiliarity and investor scepticism on its tax and shareholding structures. A closer look proves that this is unwarranted.

Initiate coverage with BUY and a street-high TP of USD0.96. 

• Manulife US REIT (MUST) is the first and only listed US office REIT in Asia. It offers the best proxy for investors looking to benefit from a rebounding US economy and stable USD exposure. Its portfolio comprises three well-located US freehold office properties with a total value of USD813.2m. 
• Our TP is based on a 5-Year DDM model (COE: 8.5%, TG: 2%). MUST offers high FY17F-18F dividend yields of 8% and 8.1% respectively, a good 100bps above the office S-REITs average.

Rental escalations of 3% pa vs fixed leases in Singapore. 

• About 84% of its portfolio leases have inbuilt rent escalation clauses averaging 3% pa, with the remaining 15% under periodic rental reviews. This provides clear visibility of DPU growth. 
• Also, rental upsides from measurement standard changes (BOMA 2010) and asset enhancement initiatives (AEIs) offer scope for more upside.

Minimal impact from interest rate hikes. 

• While the US Federal Reserve rate hike generally has a negative impact on yield instruments like REITs, we believe the impact on MUST may be mitigated, as it would coincide with a pick- up in the US economy and office demand. 
• The rate hike would also result in the strengthening of the USD, benefitting Asian investors. In addition, MUST refinanced its IPO bridge loan facility (Jul 2016) to a 4-year fixed-term loan at a lower interest cost of 2.46%, thus shielding it from higher borrowing costs.

Strong pipeline assets to drive inorganic growth. 

• Its sponsor, Manulife group, has total assets under management (AUM) of USD718bn. Of this, its US office assets account for > USD6bn, providing a strong acquisitions pipeline. 
• Also, the depth of the US market offers scope for third-party acquisitions. Its gearing remains modest, at 34.7%. 
• Near-term acquisitions are expected to be smaller-sized (USD100-150m) and geographically-diversified. It targets to acquire one asset a year.

Tenant profile and long leases provide stability. 

• It has a 97% portfolio average occupancy rate, with a long weighted average lease to expiry (WALE) of 6.1 years. < 7% of leases by NLA are due for expiry over the next two years.

Tax-efficient structure. 

• MUST aims to receive 100% income from its parent US REIT in the form of interest/principal repayments on its shareholder loan, which is exempt from tax in the US and Singapore.

Valuation 

• Strong BUY with a TP of USD0.96.
• Our DDM (5-year)-based TP of SGD 0.96 is derived based on a cost of equity (COE) of 8.5% (risk-free rate: 3%, terminal growth: 2%). We have assumed a 100% payout ratio, considering the REIT’s near-term capex requirements and management fees are to be fully paid in units. Our model also does not assume any tax leakages from the structure.
• Based on our sensitivity analysis, every 0.5% change in terminal growth or COE assumptions would result in a corresponding +/- c.6% change to our TP.
• Our TP corresponds to 1.1x FY2017F P/BV, compared to its peers’ trading average of 0.8x P/BV. While this may seem to be on the high side compared to office S-REITs, it is still cheaper than the US office REITs’ average of 1.8x (Figure 4). We also believe the REIT deserves to trade at a higher P/BV level due to its superior tax-efficient structure, which leads to better yields. Additionally, we see room for its book value to expand from the ongoing cap rate compression of US office properties.
• Trading at a high FY17F yield of 8.0%. MUST currently offers high FY17F and FY18F yields of 8% and 8.1% respectively, which implies that it offers yields a good 100bps above its Singapore-listed office REIT peer average. In comparison, US-listed peers are currently trading at an average forward dividend yield of just 4.2%. MUST’s portfolio of freehold properties, coupled with annual rent escalations and high trading yields, makes it a value play in the Singapore REIT sector.

Key Risks: 

• These include:
  1. Changes in underlying tax efficient structure. The REIT’s ability to generate superior yields compared to its peers is mainly due to its tax-efficient structure. Any regulatory or policy changes that can impact tax structure would have a negative impact on distributable income and dividend yields;
  2. Ability to retain its key tenants. MUST’s top 10 tenants account for nearly 64% of the cash rental income, making it one of the REITS with the highest total cash rental income among Singapore-listed REITs. Nearly 70% of the tenants are concentrated among law firms (44.4%) and financial institutions (24.6%). Thus, an industry-wide downturn in its two key tenant sectors (financial institutions and law firms) or MUST’s inability to retain its key tenants would negatively impact net profit;
  3. Asset concentration risk for the volatile US office market. MUST’s office portfolio subjects it to the vagaries of the volatile US economic cycle and office market demand;
  4. Declining trend of office space allocation per employee. A recent Harvard study revealed that office space per worker in the US has been on the decline. Companies have reduced office footprint to cut costs, improve energy efficiency and adjust to workers telecommuting. If the trend continues, this could have a long-term negative impact on US office demand;
  5. Potentially dilutive equity fundraising to fund acquisitions. We expect MUST to use a combination of debt and equity to fund future acquisitions. With the ongoing compression in US office cap rates, there is a possibility that future acquisitions could be marginally dilutive in nature for existing unit holders;
  6. Risk of terrorism and natural disasters. The rising terrorism risk in the US poses a threat to MUST’s office properties. The properties face the risk of suffering physical damage caused by fire, terrorism, acts of God such as natural disasters like earthquakes or other causes, as well as potential public liability claims, including claims arising from the operations of the properties. Currently, MUST’s property and casualty insurance policies for the properties do not cover acts of war, intentional or dishonest acts, nuclear reaction or radioactive contamination, asbestos contamination or other long-term environmental impairments.

Vijay Natarajan RHB Invest | http://www.rhbinvest.com.sg/ 2016-11-23

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