Keppel REIT - DBS Research 2017-07-19: Further Market Transactions To Drive Rally

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KEPPEL REIT K71U.SI

Keppel REIT - Further Market Transactions To Drive Rally

• 2Q17 DPU of 1.42 Scts (-12% y-o-y) below expectations.
• Positive rental reversions in 2Q17.
• Management open to distributing capital gains to smoothen DPU.
• Positive sentiment from earlier-than-expected bottoming of office rents and further market transactions to sustain share price rally.

Rally to continue. 

• We maintain our BUY call on Keppel REIT (KREIT) with a Target Price of S$1.23. 
• KREIT’s share price typically leads a recovery in spot office rents by 6-12 months. With early signs that rents may have bottomed in 2Q17 and we are on the cusp of an upturn, we believe the rally in KREIT’s share price can be sustained despite KREIT’s share price having increased by around 30% since end January 2016.

Where we differ – Capital values resilient. 

• While consensus is slowly turning more bullish on a recovery in office rents, 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 to crystallise value and has a flattish DPU profile boosted by capital distributions, we believe the c.20% discount to book value is too wide for a best-in-class office portfolio.

Further transactions to support our view. 

• Going forward, we believe the expected sale of Asia Square Tower 2 and Chevron House at between S$2,600-2,800 psf will once again highlight the undervalued status of KREIT’s Singapore portfolio, which is trading on an implied c.S$2,500 psf. This, combined with a potential recovery in spot office rents, will act as catalysts to trigger a further re-rating of KREIT.

Valuation

• We maintain our DCF-based Target Price of S$1.23. Our TP implies a valuation of c.S$2,600 psf for KREIT’s Grade A offices in Singapore.

Key Risks to Our View

• 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.

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WHAT’S NEW

2Q17 DPU of 1.42 Scts 

• 2Q17 DPU fell 12% y-o-y to 1.42 Scts, which represents 23% of our original FY17 DPU forecasts.
• While we had expected DPU to fall due to the absence of income from the divestment of 77 King Street and capital distributions, the results were below expectations as we had forecast a faster recovery in occupancy at Bugis Junction Tower. In addition, trustee expenses and units outstanding were higher than expected.
• Meanwhile 2Q17 NPI came in at S$31.9m, which was only down 2% y-o-y. This was a creditable result, considering the loss of contribution from 77 King Street and a 20% y-o-y fall in income from Bugis Junction Tower. The negative drag from these two buildings was partially offset by a 1-2% increase in NPI from 
  1. Ocean Financial Centre (OFC), which was partially boosted by S$0.3m in one-off income, and 
  2. the Australian properties 275 George Street and 8 Exhibition Street, which benefited from a stronger AUD.
• Distribution income received from associates and JVs was up 9% y-o-y, mainly due to increased contribution from Marina Bay Financial Centre (MBFC) (+19% y-oy) as occupancies jump to 100% from 99.4% in 2Q16 and lower interest income. In addition, distribution from 8 Chifley Square rose 8% y-o-y as it gained from a rally in the AUD versus SGD. Nevertheless, distribution received from associates and JVs was down q-o-q owing to one-off income at MBFC and One Raffles Quay (ORQ) in 1Q17.
• Overall portfolio occupancy ticked up marginally to 99.8% from 99.4% in 1Q17 due to occupancies at Bugis Junction Tower improving to 97.6% from 95.9% in 1Q17.

Positive rental reversions in 2Q17 

• Over 2Q17, KREIT renewed 23 leases equivalent to c.288k sqft of space (mainly related to the Singapore portfolio), with positive rental reversions achieved. As a consequence, for 1H17, KREIT reported 0% rental reversions, compared to -1% in 1Q17.
• For the remainder of 2H17, KREIT faces minimal renewals, with only 2% of leases subject to negotiations with tenants. However, going into 2018, KREIT faces slightly higher amount of renewals – equivalent to 6.6% of leases.
• We understand that expiring rents for some of these leases are between mid-S$9’s and S$12.50. Depending on the pace of recovery in spot rents, there remains a risk of negative rental reversions.
• In addition, for 2018, around 14.6% of leases are subject to rent review and these are predominantly related to leases at MBFC Tower 3.

Steady gearing with no refinancing till 2018 

• Gearing remains steady at 38.5% but is expected to climb closer to 40% once the recently acquired 311 Spencer Street development is completed in 4Q19.
• Meanwhile, KREIT’s all-in costs of debt ticked up marginally to 2.59% from 2.57% in 1Q17.
• The proportion of fixed-rate loans was relatively stable at 77%, with no refinancing due until 2018.
• NAV per share (excluding distributable income) stood at S$1.40.

Trimming DPU estimates by 2% 

• After incorporating higher trustee expenses and units outstanding as well as reducing the contribution from Bugis Junction Tower, we have lowered our FY17-18F DPU by 2%. 
• To temper a fall in underlying DPU, we have also incorporated capital distributions after receiving guidance from KREIT’s management that despite not paying out capital distributions over the previous three quarters, it remains open to paying out gains to achieve a sustainable and stable DPU going forward, subject to any acquisition plans.
• Post the 2Q17 results, we have also maintained our TP of S$1.23, after rolling forward our DCF-based valuation to FY18 and including the recent A$347.2m investment by KREIT in a 50% stake in the 311 Spencer Street project located in Melbourne, Australia.
• In conjunction with CBUS, KREIT will be develop a 717k sqft Grade A office tower which, upon completion in 2019, will be leased to the Victoria Police for 30 years with an inbuilt rental escalation of between 3-4% per annum (for more details please see our report “Melbourne calls again” dated 29 June 2017).

Maintain BUY with TP of S$1.23 

• With some early signs that spot office rents may have bottomed in 2Q17 (flat q-o-q, based on CBRE estimates or up by 1-2%, according to JLL and Cushman & Wakefield) earlier than expected, we believe the positive sentiment will continue to drive KREIT’s share price higher. 
• In addition, 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$2,500 remains below that of recent market transactions of S$2,700-3,500 psf. Thus, we maintain our BUY recommendation and TP of S$1.23.

Mervin SONG CFA DBS Vickers | Derek TAN DBS Vickers | http://www.dbsvickers.com/ 2017-07-19

DBS Vickers SGX Stock Analyst Report BUY Maintain BUY 1.230 Same 1.230