Manulife US REIT (MUST SP) - UOB Kay Hian 2018-02-06: A Giant Leap For Manulife

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MANULIFE US REIT BTOU.SI

Manulife US REIT (MUST SP) - A Giant Leap For Manulife

• Manulife US REIT is an up-and-coming institutional player with a US$1.3b portfolio comprising five prime freehold assets with an NLA of 3m sf, 5.9 years WALE and a healthy 96% occupancy across Northern New Jersey, Orange County, Los Angeles and Atlanta. 
• Valuations are undemanding with yields of 6.5%, about 150bp higher than their Singapore peers’ despite the latter having mostly leasehold properties.
• Initiate coverage with BUY and target price of US$1.12.

COMPANY BACKGROUND

• Manulife US REIT is a Singapore-based REIT with a principal investment strategy to invest directly, or indirectly, in a portfolio of income-producing office real estate in key markets in the US, as well as real estate-related assets. 
• The manager’s strategy is to focus on optimising the operating performance of its assets (ie AEIs), and actively exploring accretive acquisition opportunities.

Tax-efficient structure of Manulife REIT. 

• Manulife US REIT invests in and holds US properties through special purpose vehicles (SPVs), which are wholly-owned subsidiaries of the parent US REIT and organised to qualify as US REITs. The status will allow Manulife US REIT to deduct dividends paid to shareholders from their US federal taxable income. 
• Each property will be acquired and held in a separate US REIT, to facilitate financing on more attractive terms. During disposal, the exit can also be structured as a sale of a share of the US REIT that owns the property, rather than a sale of the underlying real property, hence simplifying legal transfer and eliminating any otherwise applicable US branch profit tax.
• Through this arrangement, Manulife US REIT will not need to pay the 30% withholding tax on interest and principal, under the US Portfolio Interest Exemption Rule. There will also be no tax incurred in Singapore, as the income is foreign-sourced.

Current portfolio covers submarkets with strong real estate fundamentals, 

• ... like Downtown Los Angeles, Airport Area (Orange County), Midtown Atlanta, Secaucus and Jersey City. These areas enjoy a combination of limited supply, deep pool of prospective tenants from various industries, and strong demand for high-quality office space. The environments are also typically populated with a highly-educated workforce, good connectivity with transportation infrastructure, and many amenities. 
• The portfolio consists of five properties with an aggregate NLA of about 3m sf. The valuation exercises carried out by independent valuers (Cushman & Wakefield, Colliers and RERC) have placed the portfolio‘s value at US$1.3b.

INVESTMENT HIGHLIGHTS

Up-and-coming institutional play to ride on US growth in a tax-efficient way. 

• Manulife US REIT (MUST) offers a unique proposition as the preferred tax-efficient institutional vehicle to gain exposure to the burgeoning US commerical market by parking its assets in US sub-REITs.
• By investing in and holding US properties thorough special purpose vehicles (SPV), which are subsidiaries of the parent US REIT and organised to qualify as US REITs, MUST can deduct dividends paid to its shareholders from their US federal taxable income. With this, MUST will not need to pay the 30% withholding tax on interest and principal, under the US Portfolio Interest Exemption Rule. This reduces US taxes while the distributions to the Singapore REIT remain tax-exempt. 
• MUST’s portfolio stands tall at US$1.3b and its market cap has recently breached the desired US$1b threshold that could see better valuations as the improved liquidity attracts bigger institutions and fund managers.

Prime, freehold assets offering 6.5% forward yield, 150bp higher than peers. 

• Manulife US REIT’s US$1.3b portfolio consists of five prime, freehold and Class A or Trophy quality office assets, with an NLA of 3m sf, 5.9 years WALE and a healthy 96% occupancy across Northern New Jersey, Orange County, Los Angeles and Atlantla. These properties also tend to be located near amenities and growing residential developments. 
• Manulife US REIT has an undemanding valuation compared with many Singapore office REIT peers (Keppel REIT: 4.9%; Suntec REIT: 5.0%; Capita Commercial Trust: 5.0%), despite the latter holding mostly leasehold properties.

Embedded organic growth in supportive micro-markets. 

• There is limited new supply and stable demand across the Northern New Jersey, Orange County, Los Angeles and Atlanta submarkets that Manulife US REIT (MUST) operates in. 
• Manulife US REIT is well-positioned to experience strong organic growth, delivered through built-in rental escalations (about 75% of its committed leases have rental escalations averaging 2.8%).

Acquisition-led growth backed by a strong and committed sponsor. 

• Manulife US REIT is well-positioned to tap on the expertise and operational track record of its sponsor, despite not having an explicit first right of refusal. The sponsor, through subsidiary Manulife Real Estate, has acquired over 85 properties worth US$6.2b since 2010. With US$15b in real estate AUM globally, US office assets account for over US$6b, providing a strong pipeline of deals.
• Some of the sponsor assets in Orange County and Los Angles could be of potential interest after their renovations are completed. Moreover, the sponsor’s strong branding and financial muscle could also help Manulife US REIT source for and close deals. 
• Manulife US REIT may target key secondary cities, or core submarkets that derive demand from a diversified spectrum of industries, to provide additional diversification and stability to its portfolio.
• Its latest acquisition of 10 Exchange Place has demonstrated the strong support and execution from its parent, despite the current competitive landscape. The deal has led to immediate yield-accretion of 2.2%. The purchase price of US$313.2m was priced attractively (5.1% below the appraised value by Colliers) and has room for revaluation gains, as capital values in New Jersey are still in the rising phase.

Proxy to US GDP growth. 

• Manulife US REIT is a beneficiary of the improving commercial segment, on the back of a strengthening US economy. The corresponding demand for office space has been driven by technology and other creative sectors. 
• Buoyed by the recently-passed Tax Cuts and Jobs Act of 2017 and a pro-growth Republican agenda, the US economy will likely continue growing above-trend, leading to more job creation, and healthy absorption in the office market. 
• We also see US office REITs transiting from being yield to growth vehicles, with further upside on the growth premium to be priced in.

Potential play on strengthening US$. 

• As a pure play US REIT (100% of the assets in US), Manulife US REIT derives and pays out its income in US dollars, and would be an attractive play with which institutional investors can gain exposure to the US dollar. In view of President Trump’s pro-growth agenda, we expect higher inflation, bolstering the case for the lifting of US rates. 
• With the Fed forecasting three interest rate hikes for 2018, some market participants believe Fed could be even more aggressive given the strong pick-up in growth. With raised Fed rates, dollar assets will look more attractive to investors, luring fund flow back to the US and boosting US$-denominated investment vehicles. 
• UOB-GEMR forecasts mild SGD weakness to 1.33 against USD by end of the year.

VALUATION

Initiate with BUY and target price of S$1.12. 

• We value Manulife US REIT at S$1.12, based on a dividend discount model with a required rate of return of 7.8% and a terminal growth rate of 2.5%. We use a risk free rate of 3.0% vs the current 10-year US government bond yield of 2.48%, leaving room for a 50bp increase in rates. 
• Our target price implies total return of 22% (to last traded price), after factoring in capital appreciation and dividend yield. A sensitivity table is included below to highlight the sensitivity of target prices to changes in terminal growth and required rate of return.
• Manulife US REIT is offering a yield of 6.5%, about 150bp higher than its Singapore peers’ despite the latter having mostly leasehold properties. About 75% of Manulife US REIT’s leases have annual rental escalations of 2.8% on average. 
• Manulife US REIT’s low gearing of 33.1% leaves sufficient headroom for acquisition led growth.

EARNINGS OUTLOOK

High earnings visibility with recent acquisitions and built-in rental escalations. 

• We forecast revenue and distributable income to grow 42% and 30% respectively in 2018, mainly due to a full year’s contribution from the acquisition of Plaza (completed in Jul 17) and 10 Exchange Place (completed in Nov 17) in New Jersey. Revenue would grow 3.4%, while distributable income would grow about 1.3% in 2019, based on our forecasts.
• Manulife US REIT’s ability to capture the upside from a sustained US office up-cycle and continue to generate visible income streams is supported by its rental escalations averaging 2.8% for 75% of its leases, and as well as a long WALE of 5.9 years.

Distribution policy. 

• Manulife US REIT’s policy is to pay out 100% of its distributable income in 2016 and 2017, and at least 90% of its distributable income thereafter on a semi-annual basis.
• The distributions will be declared in US dollars, and unitholders will receive their share in Singapore dollars equivalent (unless they have elected to receive the distributions in US dollars).

Lowest portfolio gearing among Singapore office REITs. 

• Manulife US REIT’s 3Q17 gearing of 33.1% ranks among the lowest among office S-REIT peers (average of 36.3%). With gross borrowings of US$461m after the acquisition of 10 Exchange Place, Manulife US REIT still has acquisition headroom of over US$150m (assuming comfortable gearing of 40%). 
• Its current all-in borrowing cost of 2.6% is in line with peer group average (2.8%) and below Keppel-KBS US REIT’s 3.35%.

Cushioned against imminent US FED rate hike. 

• With 100% fixed rate loans (the highest among S-REITs in the office space) and a debt maturity of 3.1 years, Manulife US REIT is cushioned against rising interest rates.

RISK FACTORS

• We see the following key risks, among others.

Office industry vulnerable to business cycle changes. 

• The office business is highly cyclical in nature, and will be directly impacted by the performance of the US economy. A weak economy could result in companies scaling back expansion plans and hiring less, and correspondingly lead to a reduction in net absoprtion of office space, along with higher vacancies and lower rents, thereby resulting in lower office yields.

Negative forex impact will hurt NAV and distributions. 

• A portion of the revenue collected (which is received from the properties in US dollars) will be converted into Singapore dollars to settle expenses in Singapore dollars at MUST’s level and distribution payments to unitholders (except those who have elected to receive distributions in US dollars). Thus, Manulife US REIT and unitholders may be affected by exchange rate fluctuations.
• Manulife US REIT’s net income is also sensitive to changes in the US$/S$ rates. When the Singapore dollar appreciates by +/-5%, we can expect net income to hover around US$75,000.

Dependence on economic climates of submarkets. 

• A downturn in the economies of Northern New Jersey, Orange County, Los Angeles and Atlantla could hurt demand for office space. These submarkets also depend on a limited number of industries, and a decrease in demand from players in these industries, such as financial institutions and law firms, may adversely affect Manulife US REIT’s income and ability to make regular distributions.

Surge in commercial space in micro-markets. 

• New properties may be developed next to Manulife US REIT’s, ramping up the competition. These competing properties may be newer, better-located and better-furnished (more attractive floor plans, amenities, etc). The income and market value of Manulife US REIT’s properties will depend on its ability to compete for tenants.

Lack of operating history. 

• Since Manulife US REIT and its manager were only incorporated in 2015, both entities do not have sufficient operating history and past performance to be judged on.
• The lack of operating history will make it difficult for investors to evaluate and assess Manulife US REIT’s future performance.

Peihao Loke UOB Kay Hian | Vikrant Pandey UOB Kay Hian | http://research.uobkayhian.com/ 2018-02-06

UOB Kay Hian SGX Stock Analyst Report BUY Initiate BUY 1.12 Same 1.12