Manulife US Real Estate Inv - DBS Research 2017-11-29: Ticking The Right Boxes

SGinvestors.io

MANULIFE US REIT BTOU.SI

Manulife US Real Estate Inv - Ticking The Right Boxes

• Our US site visit reaffirms our confidence in Manulife US REIT (MUST)’s ability to capture the upside from a sustained US office up-cycle.
• Recent acquisition of 10 Exchange Plaza further expands exposure to growing New Jersey market.
• 3Q17 DPU of 1.60 Scts in line with expectations.

REIT that delivers. 

• We maintain our BUY call with a revised TP of US$0.99. Hallmarks of a successful REIT include a management team delivering on their promises and properties which it owns having strong fundamentals. 
• Since Manulife US REIT (MUST)’s listing 1.5 years ago, MUST has delivered with DPU exceeding IPO forecasts, property values increasing by 10% and the ability to identify DPU-accretive acquisitions. 
• Post our recent visit to MUST’s properties in Atlanta, Los Angeles, New Jersey and Orange County, as well as meetings with various property brokers, we believe MUST continues to be an attractive investment as its original investment thesis of rising rents and prospects of improving capital values remain intact.

Where we differ – Premium to book 

• While consensus is bullish on Manulife US REIT (MUST)’s US exposure, pegging their target prices at P/Bk of c.1.10x, we believe MUST deserves to trade at a higher P/Bk of c.1.20-1.25, given its ability to execute on DPU-accretive acquisitions and upside risk to its portfolio values as the US office market remains on an up-cycle. 
• Moreover, an additional growth premium is justified, given MUST’s near-term DPU growth is 2-3 times higher that of other listed S-REITs.

Acquisitions to be the next growth driver. 

• With gearing to stabilise at around the 33-34% level post its recent acquisitions, given the debt headroom available, we believe additional acquisitions will remain a key share price re-rating catalyst going forward. 
• We understand markets that are of interest are core submarkets that enjoy demand from a diversified type of industries (i.e. manufacturing, financial, technology and law firms) which imply stability across market cycles.

Key Risks to Our View

• The key risk to our view is lower-than-expected rental income, arising from non-replacement/renewal of leases and/or slower-than-expected recovery of office rents in the US.

WHAT’S NEW - STILL RISING

MUST has delivered on our original investment thesis 

• When we initiated coverage on Manulife US REIT (MUST) post its listing 1.5 years ago with a BUY call, our investment thesis for the stock was premised on
  • Exposure to Grade A freehold properties leveraged to the recovering US office market with resultant rising rents and prospects for increasing property values
  • Long WALE with in-built growth
  • Support from a strong sponsor with an established track record and acquisition capability.
• Since then, MUST’s management has delivered or outperformed expectations, with DPU exceeding IPO forecasts and our original estimates, property values increasing by 10%, maintaining a long WALE with organic annual escalations and MUST identifying DPU-accretive acquisitions by leveraging on its strong sponsor network.

But upside still remains post our recent US site visit 

• While the US economy has since made further strides in its recovery with the US office market continuing its upward trend and investors now having other investment options that provide exposure to the US office market, we believe MUST remains an attractive investment opportunity. Our confidence is underpinned by our belief that our original investment thesis of rising rents and capital values remains intact. 
• During our recent visit to MUST’s properties in Atlanta, Los Angeles, New Jersey and Orange County, as well as meetings with various property brokers, we learnt that rents in MUST’s key markets, while likely to moderate from the high growth achieved over the past few years, generally remains on an upturn. More importantly, MUST’s properties continue to be well positioned to capture the upside in rents as passing rents remain below market rents and its properties are located near amenities and transport links.
• Over the coming 27 months, approximately 11% of leases are up for renewal. In addition, the properties are located in areas where the talent pool including the important millennial generation is increasingly living in and where there is increasing residential development. Access to talent is a key determinant for tenants to locate their premises. Our observations from our site visit are detailed below.

MARKET OBSERVATIONS

Atlanta – Peachtree Property 

• According to CBRE, the total Atlanta office market stood at 214m square feet (sqft) with vacancy of 14.1% at end-3Q17. Midtown Atlanta, where MUST’s Peachtree property is located, is a 21.4m sqft market with vacancy of 8.8%. Meanwhile, average rents for overall Atlanta in 3Q17 rose 5.3% y-o-y to US$24.13 per sqft per year, continuing their upward trends experienced over the past few years. Class A rents in particular have grown by 29.1% since 4Q11 to US$27.88 per sqft per year. This compares to rents of around US$40 to support the construction of new office buildings in Atlanta. 
• The high level effective rents for new builds is due to competition from other uses such as residential development. This has also resulted in constraints in new office supply as the best use currently is for residential development. Similar to other cities in the US, there is a trend of millennials preferring to live in the inner city rather than the suburbs. In addition, empty nesters whose children have grown up and no longer require large living spaces, have also relocated from the suburbs. 
• Given the higher proportion of millennial residents and increased population in general, these inner city locations have gained additional amenities and retail outlets which have drawn more people to move from the suburbs. Midtown Atlanta, where MUST’s Peachtree has been the prime area, has benefitted significantly from this trend. As a consequence of having a highly desirable workforce being located in Midtown, tenants have been focused on locating their offices in the area. Thus, the discount in rents for Midtown to the nearby Buckhead area has narrowed considerably and for some buildings are commensurate with asking rents in Buckhead. Class A rents at Midtown currently stand at US$32.84 versus US$34.04. According to CBRE, rents in Midtown should increase by 3-4% versus the 6-7% experienced this year.
• The Atlanta market has also seen significant capital flows especially from foreigners. However, the pace of transactions has slowed from the peaks in 2015 and 2016, as many of the desirable buildings have been sold. Cap rates have tightened on the back of the increase in capital flows from the peak of 9.6% in 2009 to 6.6% in 2015. Headline cap rates have expanded to 7.5% over 2016 and YTD in 2017 largely due to high cap rates related to properties being transacted in the suburban locations.
• Nevertheless, we understand cap rates for Grade A buildings remain in the 5.5-6.0% level. Furthermore, there is still potential for cap rates to compress as the spread between cap rates and the 10-year bond yield remains wide compared to historical averages.

Hudson Waterfront, New Jersey – Exchange Property 

• According to Cushman & Wakefield, the Hudson Warefront submarket at New Jersey is a relatively small market at 21m sqft. Vacancy in 3Q17 rose 14.4% from 12.5% as seven new blocks of vacant space came to market. Despite vacancy increasing, asking rents have continued their upward trajectory, jumping 12.7% y-o-y to US$44.44 per sqft per annum due to the newly refurbished offices asking for higher rents.
• A key attraction of Hudson Waterfront area for prospective tenants is the area boasting a higher concentration of millennial workers than other parts of New Jersey, New York City and US as a whole. In Hudson Waterfront, millennials represent 33.5% of the population, versus 25.8% for New Jersey, 31.1% for New York City and 27.3% for the US. Given the high concentration of millennials in the area, employment growth is also projected to be stronger than the wider New Jersey area.
• This attractive workforce has resulted in growth within the technology and other industries thereby reducing reliance on the financial services industry, whose contribution has dropped from 67% in 2006 to 53.3% in 2017.
• Furthermore, the Hudson Waterfront area in recent years has undergone a residential boom, with nearly 15,000 new residents being added since 2010, making it the fastest-growing municipality in New Jersey. Twenty-four new residential developments have recently opened, are under construction or are in the planning stage, which will add 12,000 units to the existing inventory of around 7,000 units. An additional 18,000 have also been approved by the local authorities. With an increase in the residential population, combined with an expected growth in retail space and amenities, the precinct should continue to be more desirable for prospective tenants.
• The Hudson Waterfront area is also diversified across multiple segments with reliance on the financial services sector falling significantly from 67% in 2006 to 53.3% in 2017. In addition, the area also has large exposures to the computer & technology (6.8%), insurance (7.8%), and business services (6.8%) segments.

Secaucus, New Jersey – Plaza Property 

• The Northern New Jersey total office inventory stands at 96.5m sqft with vacancy of 25.6% as at end-3Q17 based on JLL’s estimates. Vacancy is relatively high due to the older office products which are harder to lease out and new supply growth despite the market reporting positive net absorption over the past few years.
• Meanwhile, the Meadowlands submarket which is where the Plaza building is located, is a smallish office market with total office inventory of 5.4m sqft (close to half in the Grade A category). Vacancy in this market is also high at 22.4% with vacancy ticking up from 19.9% at the end of 2016 due to an increase in sublease space. However, we understand the vacancy for the better-quality Grade A buildings such as MUST’s Plaza building is much lower closer to the 5% level.
• In addition, pressure on the overall market vacancy may reduce over time, if there is an acceleration in the conversion of the older Grade B office into industrial properties. Demand for industrial properties has been strong due to increased ecommerce activity. According to JLL, rents in the Meadowlands market has been generally flattish since 2016 and, based on their property clock, is in the bottoming phase. In terms of the Plaza Building, its remains in a strong competitive position as it is within walking distance of amenities which are not readily available at other locations. Furthermore, the building is well specified with good floor-to-ceiling heights.

Downtown LA – Figueroa Property 

• Based on Colliers International Data, the total Los Angeles (LA) is a 203m sqft office market. The biggest users of office space in overall LA is the entertainment industry, healthcare, legal and finance sectors. YTD Average Class A rents have risen by 6.8% y-o-y. While the market reported negative net absorption of 175,000 sqft in 1Q17 for the first time in 12 quarters due to Sony vacating some space, the market reported positive net absorption over 2Q17 and 3Q17. A key emerging trend for LA is the fact that it is becoming more of an international gateway city. More finance companies and private equity firms are moving to LA from places such as New York. In addition, as LA is an entertainment hub and place where content is created, more technology companies are increasing their presence there.
• Within Downtown LA market where MUST’s Figueroa Property is located, the total office market is 33.5m sqft. Vacancy rates have climbed to around the 20% level, largely due to the completion of the Grand Wilshire building. However, vacancy in the immediate area surrounding Figueroa stands around 13%.
• Meanwhile, gross rents for Downtown LA have increased from US$38 to US$40 as several buildings have raised rents given higher property tax, as their assessed property values have risen post their sale to new owners. Over 2018-2019, 3m sqft of new office space is expected to be completed but these new buildings are located in the art district which mainly targets the creative sector and is not in direct competition with Figueroa.
• Overall, Colliers has conservatively assumed rents to remain steady near term given the strength in rents over the past few years. However, an upside bias remains given expectations of positive net absorption. Downtown LA, in particular South Park, is becoming more popular with tenants given the increased vibrancy surrounding the LA Live/Staples Center precinct (increased entertainment and food and beverage options).
• Furthermore, with increased residential developments in the area and millennials moving to the area, tenants are focusing on being close to their workforce as part of their recruitment and retention strategy.
• Another advantage that the Figeuroa building possesses is its proximity to the freeway. In comparison, tenants at Bunker Hill the traditional CBD have to commute an additional 20 minutes to access the freeways.

Orange County – Michelson Property 

• According to Cushman & Wakefield, Orange County is a 88.1m sqft office market. On the back of growth in office-related jobs (41,500 jobs were added between 2013 and 2017), the market has been experiencing positive net absorption of 51.m sqft between 2013 and 2017. As a consequence, vacancy rates have fallen to 10.9% from over 12% in 2013. Furthermore, Class A asking rents have climbed from US$2.14 per sqft per month to US$3.05, approaching the peak of US$3.13 achieved in 2007.
• The area continues to be attractive for prospective tenants given a highly educated workforce who are among the highest earners in the US. Average household income in Orange County stands at US$105,747. While the region experienced the downsizing, exit or loss of mortgage and finance companies following the last recession, the area is diversified across many industries including finance, insurance, telecommunications, technology, real estate, engineering and professional services.
• While rents have been increasing, supply response in Orange County has lagged due to banks being cautious in funding speculative construction. With economic activity remaining on an uptrend, resulting in positive net absorption, Cushman & Wakefield believe rents should continue their uptrend, potentially rising by up to 5% with downward pressure on vacancies.
• While MUST’s Michelson property faces minimal expiries with no renewals for the remainder of FY17 and only 2.2% of leases in FY18, in the medium term, it faces potential competition from the nearby Broadwalk property, which is a 537,000 sqft Grade A office development. We understand Broadwalk is now 20% preleased.
• Despite the increased competition, we understand Michelson remains a strong position, given its offers a multitude of amenities which are within walking distance as compared to Broadwalk which will require its tenants to commute via car. In addition, as Broadwalk is only a nine-storey building, it does not offer the panoramic views that Michelson provides on the higher floors. 
• Thus, going into FY19 where 29.8% of leases are up for renewal, we believe there is a high likelihood that it will retain most of its tenants. A key tenant whose lease expires in FY19 is Hyundai Capital, which currently occupies the top floor of the building and has signage on the building.

The Exchange - Second acquisition in New Jersey 

• Beyond our recent site visit, MUST also recently announced the acquisition of 10 Exchange Place, a 30-storey Class A office building in Jersey City, New Jersey for US$313.2m or on an estimated 5.1% NPI yield. The US$313.2m purchase price is at a 6.8% and 5.1% discount to RERC’s and Collier’s independent valuations respectively. 
• The total consideration inclusive of acquisition fee, professional and other fees and expenses is approximately US$332.0m. This is MUST’s second acquisition of the year and its second property in New Jersey following its acquisition of 500 Plaza Drive in June for US$115m.

Freehold property with long WALE and in-built rental escalations 

• 10 Exchange Place, completed in 1988, is a freehold property with a net lettable area (NLA) of 730,598 sqft and occupancy rate of 93.1% as at 31 July 2017. WALE by NLA stands at 5.7 years with the property having 25 tenants. The top ten tenants represent 78.3% of cash rental income (CRI) and includes
  1. Amazon, the world’s largest e-commerce retailer (18.2% of cash rental income)
  2. Rabo Support Services, a management consulting firm (12.3%)
  3. ACE American Insurance, one of the largest public traded P&C insurance companies operating under the Chubb name (11.0%)
  4. Kuehne & Nagel, a global transport and logistics company based in Switzerland (9.5%)
  5. Opera Solutions, a global provider of advanced analytics software solutions (7.2%) 
• Over 60% of leases by NLA and CRI expire in 2022 and beyond, and there are no significant expiries until 2019 (5.9% and 11.9% by NLA due to expire in 2017 and 2019, with no expiries in 2018). The majority of leases have in-built rental escalations, with the passing rent of the property of US$38.18 per sqft per year below current market rents of US$42.05.

Strategically located 

• One of the key attractive attributes of the property is its waterfront location with views of the Manhattan/New York skyline. In addition, New Jersey City is a cheap alternative to Manhattan which has attracted global institutions such as Goldman Sachs, JPMorgan Chase, UBS and Bank of America Merrill Lynch. The property is ten minutes by train and ferry to Manhattan, with the nearby Exchange Place Station only one stop away from the World Trade Center Station. With 24-hour amenities, street life and attractive residential developments, the property also offers a “live, work, play” environment. 
• The building is also located in New Jersey City which is the strongest office market within New Jersey, according to Cushman & Wakefield and has historically outperformed the greater regional market. Going forward, Cushman & Wakefield forecast absorption to exceed new construction.

USS$208m right issue to fund acquisition of the Exchange 

• To partially fund the acquisition, Manulife US REIT (MUST) recently undertook a US$208m renounceable rights issue, with 299,288,423 rights units offered at the rights ratio of 41 rights units for every 100 existing units at a rights price of US$0.695. 
• Manulife, MUST’s sponsor which held a 7.43% interest in the REIT, took up its pro-rata entitlement, with the remaining rights underwritten by DBS Bank and Deutsche Bank.

3Q17 RESULTS IN LINE

• Similar to prior quarters, 3Q17 DPU exceeded IPO forecasts by 9.6% and came in at 1.60 UScts. 9M17 DPU of 4.83 UScts also beat MUST’s IPO projections by 8.5%. Nevertheless, 3Q17 and 9M17 DPU were in line with our original estimates before adjustments for the recent rights issue and acquisition of 10 Exchange Place.

Increase in passing rents on the back of positive rental reversions 

• The continued strength in MUST’s underlying earnings was driven by a steady increase in average passing rents at its properties with the exception of Michelson. Average gross passing rents at Figueroa rose 0.6% q-o-q to US$39.39 per sqft per year, up from US$36.62 as at 30 September 2016. 
• Likewise, average gross rents at Peachtree increased 0.4% q-o-q to US$31.70 and was up 2.6% since end-3Q16. However, average gross passing rents at Michelson fell 3% q-o-q to US$48.90 largely due to the commencement of a lease which a tenant had forward renewed in 2015 at a lower rate. Excluding this lease, average gross passing rents would have increased 0.5% q-o-q. 
• Overall for the first nine months of the year, MUST achieved a positive rental reversion of 12.2% versus 12.4% for 1H17. For the remainder of FY18, only c.1% of leases are up for renewal, down from c.3% at end-2Q17. For FY18, another c.2% of leases are up for renewal while another 12.5% of leases are set to expire in FY19.

Strong balance sheet 

• Manulife US REIT (MUST) remains in a strong balance sheet position with gearing (total debt/total assets) standing at 33.1% as at 30 September 2017. Post the recent rights issue and completion of the Exchange acquisition, we expect MUST’s gearing to stabilise at around the 33-34% level. 
• Meanwhile, average interest costs at end-3Q17 increased to 2.6% from 2.46% largely due to the higher borrowing costs associated with the acquisition of the Plaza. This is expected to climb further to around 2.8% based on our estimates post the acquisition of the Exchange.

TP revised to S$0.99 

• Post the acquisition of the Exchange and after incorporating the recent rights issue, we have lowered our DCF-based TP to S$0.99 from S$1.07. 
• Due to the impact of the additional shares on issue and higher assumed borrowing costs, we have likewise reduced our FY17/18/19F DPU to 5.34/5.98/6.01 UScts from 6.52/7.10/7.43 UScts respectively.

MAINTAIN BUY 

• With close to 21% total return expected over the coming 12 months, we maintain our BUY call with a revised TP of S$0.99.
• We continue to like MUST for its exposure to the US office up-cycle, quality portfolio of freehold properties and management which has delivered since its listing 1.5 years ago.

Mervin SONG CFA DBS Vickers | Derek TAN DBS Vickers | http://www.dbsvickers.com/ 2017-11-29

DBS Vickers SGX Stock Analyst Report BUY Maintain BUY 0.99 Same 1.070