Keppel REIT - DBS Research 2017-06-30: Melbourne Calls Again

KEPPEL REIT K71U.SI

Keppel REIT - Melbourne Calls Again

Acquires 50% interest in 311 Spencer Street for A$347.8m (c.S$362.4m).
Property leased to local government for 30 years upon completion of construction in 4Q19.
DPU accretion in the medium term with average NPI yield of 6.4% during the first 15 years of the lease.

Keppel REIT (KREIT) announced that it has entered into an agreement to purchase a 50% interest in a premium office tower that will be developed at 311 Spencer Street, Melbourne, Australia. We understand the vendor is Australia Post.
The aggregate consideration is A$347.8m (c.S$362.4m). KREIT will make an initial deposit of A$1.1m (S$1.2m) with a further amount to be paid upon completion of the transaction in 3Q17. The balance of the consideration will be progressive payments during the development of the building.
The purchase of 311 Spencer Street will be funded through debt and proceeds from the divestment of 77 King Street in January 2016.
KREIT will now own two properties in Melbourne. It currently owns a 50% interest in 8 Exhibition Street.

The new Grade A office tower is located between Melbourne’s CBD and new Docklands precinct, and is within walking distance to the Southern Cross Station, a major railway and transportation hub.
The 42-storey tower has an estimated total net lettable area (NLA) of 717,000 sqft.
Construction of the office tower will commence in 3Q17 with the practical completion expected in 4Q19.
The co-owner and developer of the building is Cbus Property which is the property and development company of the Construction and Building Union Superannuation.
The building will be leased to the Assistant Treasurer for the State of Victoria on a 30-year net lease with fixed annual rental escalations (between 3-4% per annum), market rent review at the commencement of year 16 subject to a cap and collar, and options to renew for three additional terms of five years each. Based on information on the Cbus property website, the underlying tenant is the Victoria Police.
Given the 5-star Green Star rating of the building, the trust holding the property qualifies as a green Managed Investment Trust (MIT), with enjoys a preferential withholding tax rate of 10% on distributions and capital gains instead of 15% for a typical MIT.
The property is expected to provide a stable average NPI yield of 6.4% per annum during the first 15 years of the lease.

Based on KREIT’s estimates, assuming 311 Spencer Street was held from 1 January to 31 December 2016 and an average 6.4% NPI yield for the first 15 years, proforma FY16 DPU would rise by 1% to 6.44 Scts from 6.37 Scts. However, over the coming two to three years, we anticipate near term DPU dilution (potentially 2-5% subject to the final proportion of debt drawn down and proceeds used from the sale of 77 King Street). This is on the back of higher interest costs as KREIT increases its borrowings to fund its investment without a commensurate income stream as the building is under construction and the property ramps up from its initial yield to its average 6.4% NPI yield.
Proforma aggregate leverage would likewise rise by another 1.8% from 38.5% level as at 31 December 2016 to 40.3% by end 2019.
Post the transaction, KREIT’s total assets under management in Australia will increase from 11% to 15%, with income contribution from Australia increasing from 22.8% to 18.1%.
Exposure to government tenants will also rise from 8% to 16.9%.
KREIT’s overall portfolio WALE (by committed NLA) will be extended from around 6 years to nine years. In addition, WALE for the top 10 tenants (by committed NLA) will rise from 9 years to 14 years.

We are positive on the expected DPU accretion in the medium term and the good cashflow visibility provided by the property given the 30-year lease and inbuilt rental escalations. However, this is balanced against some near term dilution to DPU.
In terms of valuation, on an average 6.4% NPI yield, the property looks attractive. On an initial yield basis which we estimate to be closer to the bottom of the 5-6.5% pricing range for Melbourne office assets, it appears KREIT has a paid a premium price which we believe is reflective of the long WALE of the property, and defensive characteristic of having the local government as a tenant.
With gearing expected to rise back to 40%, we also anticipate some push back from investors. Nevertheless, we believe this should not be a major concern, given capital values in Singapore should remain steady on the back recent market transactions and strong interest from investors looking to buy office buildings in Singapore.
We maintain our BUY call with Target Price of S$1.23 for now pending KREIT’s upcoming 2Q17 results when we will incorporate this acquisition into our forecast.
We continue to like KREIT for its attractive valuations (0.8x P/Bk) and exposure to the recovery in the Singapore office market.

Melvin SONG CFA DBS Vickers | Derek TAN DBS Vickers | http://www.dbsvickers.com/ 2017-06-30

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