Manulife US REIT - DBS Research 2018-11-07: Correction Pricing In Recent Concerns

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MANULIFE US REIT (SGX:BTOU)

Manulife US REIT - Correction Pricing In Recent Concerns

• Manulife US REIT’s 3Q18 DPU of 1.51 UScts (+33.6% y-o-y) in line with expectations.
• Boost from recent acquisitions and base effect from equity raising in 3Q17.
• Manulife US REIT still has exposure to markets on an uptrend with 13.5% positive rental reversions achieved in 3Q18.
• Near-term headwinds from rising borrowing costs but sufficient levers in place to ensure steadily growing DPU.

Concerns largely priced in.

• We maintain our BUY call on Manulife US Real Estate Investment Trust (Manulife US REIT) with a revised Target Price of US$0.88.
• Manulife US REIT’s share price corrected recently due to disappointment over the level of accretion for its last acquisition, rising interest rates, potential negative ruling on Manulife US REIT’s tax structure and its only listed Singapore peer falling post recent rights issue.
• However, we think that these concerns are largely priced in as Manulife US REIT trades at c.10% discount to its book value which we believe is unwarranted – Manulife US REIT’s is exposed to rising office markets and its continues to deliver healthy rental reversions such as the 13.5% uplift in 3Q18.

Where We Differ: More conservative estimates.

• To better account for our DBS economists’ more hawkish interest rate expectations, we now use a higher US risk-free rate of 3.6%, up from 3.0% and assume Manulife US REIT refinances its 2.46% IPO debt over the next few years at 4.50-4.75%, resulting in our DPU and Target Price being 2-10% below consensus estimates.
• However, despite our conservative projections, we believe Manulife US REIT still offers compelling value, given its forward yield of 7.7% is close to -1SD mean yield of 8.1% and Manulife US REIT has sufficient levers to deliver a steadily growing DPU. This includes tweaking the amount of management fees paid in units and it benefiting from in-built rental escalations coupled with prior positive rental reversions.

Acquisitions a growth driver.

• Manulife US REIT’s recent de-rating makes it more difficult to find accretive acquisitions. However, we understand acquisition opportunities are still present, making M&A remaining a key re-rating catalyst going forward.

Key Risks to Our View:

• The key risk to our view is lower-than-expected rental income, arising from lower occupancy and/or slower-than-expected recovery of office rentals in the US as well as impact from changes in tax laws (see report: Manulife US REIT - Wild Stab In The Dark | SGinvestors.io) resulting in higher taxes paid. 

WHAT’S NEW - Jump in 3Q18 DPU

3Q18 DPU up 33.6% y-o-y

• Manulife US REIT reported 3Q18 DPU of 1.51 UScts which was up 33.6% y-o-y, taking 9M18 DPU to 4.04 UScts (-7.1% y-o-y). 9M18 DPU formed c.73% of our FY18F forecast, which was line with expectations. The lower 9M18 DPU was largely due to the impact from the additional units on issue due to the preferential offering earlier this year.
• Meanwhile, underpinning the jump in 3Q18 DPU was the 75.3% and 74.9% y-o-y rise in 3Q18 revenue and NPI, respectively, largely on the back of the acquisition of Penn and Phipps buildings as well as the impact from the inbuilt annual rental escalations and positive rental reversions reported in prior quarters.
• The strong y-o-y improvement was also attributed to 3Q17 DPU being depressed due to the additional units on issue from the rights issue last year but no earnings contribution from the Exchange building.
• Stripping out the impact of the enlarged share base from the preferential offering in 2018 and rights issue in 2017, based on Manulife US REIT’s estimates using weighted average number of units on issue, adjusted 3Q18 and 9M18 DPU would have risen 3.4% and 2.5% y-o-y to 1.52 and 4.53 UScts respectively.

13.5% positive rental reversions

• Over the quarter, eight leases were signed with Manulife US REIT reporting 13.5% positive rental reversions. This is largely due to Manulife US REIT’s portfolio generally under rented. We understand, Manulife US REIT was able to achieve between 2% to 47% increases in signing rents vs expiring rents. Following the renewal of leases over the quarter, only 0.2% of leases by gross rental income are up for renewal in 4Q18, down from 1.2% previously. For FY19, another 10.0% of leases set to expire, up from 7.9% at end-2Q18.
• We understand a significant proportion of leases due in FY19 are related to the Hyundai lease at the Michelson building in Orange County. In addition, the increase in lease expiry in FY19, relates to some legal tenants who have forward renewed but are expected to return some space. This is a consequence of these legal firms right sizing their space requirements as they no longer need as much space for their law libraries.
• In FY20, Manulife US REIT will need to renew another 8.3% of leases, slightly down from 8.6% reported at end- 2Q18.

High occupancy maintained

• Manulife US REIT’s overall portfolio occupancy remained high at 96.5%, marginally up from 96.0% in 2Q18 and 95.7% in 3Q17.
• The increase in occupancy on a q-o-q basis is attributed to improvements at Figueroa (94.3% vs 93.0% at end-2Q18), Michelson (96.0% vs 94.4% at end-2Q18), Peachtree (93.3% vs 92.7% at end 2Q18) and Phipps (100.0% vs 97.4% at end-2Q18), partially offset by declines at the Exchange (96.2% vs 98.3% in 2Q18) which due to a government tenant vacating the building.
• Meanwhile, the y-o-y improvement in occupancy was due to the acquisition of Penn and Phipps which are now fully occupied, and uplift at Michelson (94.3% vs 92.1% at end-3Q17).

Improving passing rents

• On the back of the inbuilt annual rental escalations averaging 2.6% for 56% of leases and mid-term or periodic rental increases for 39% of the portfolio, passing rents improved between 0.3% and 3.1% q-o-q, with the exception of the Exchange which dipped 0.3%.
• On the same store basis excluding the buildings recently acquired, passing rents for Figueroa, Michelson, Peachtree and Plaza rose 3.6%, 4.7%, 2.5% and 2.7% y-o-y respectively.

Stable gearing and borrowing costs

• Gearing was stable at 37.4% with Manulife US REIT’s weighted average interest costs steady at 3.27% due to the 100% of its borrowings on fixed rates.
• Going into FY19 and FY20, US$108.5m and US$67.3m of debt which are secured against the Figueroa and Peachtree buildings, respectively, and originally entered into at Manulife US REIT’s listing are due to be refinanced. With benchmark interest rates having risen since Manulife US REIT’s IPO in 2016, we anticipated Manulife US REIT’s borrowing costs to increase over the next few years, as it refinances its initially borrowings at IPO which averaged 2.46%.
• While Manulife US REIT seeks to lower its credit margins and explores other options to manage its borrowing costs, benchmark interest rates have risen by 2% over the past two years.
• Meanwhile, Manulife US REIT’s NAV per unit or adjusted NAV per unit (excluding distributable income) was maintained at US$0.82 and US$0.80 respectively.

AEI plans at Figueroa and Exchange

• To enhance the market position of its portfolio, Manulife US REIT announced that it will spend up to US$8m and US$12m at Figueroa and Exchange buildings respectively. At Figueroa the lobby will be upgraded with new gantries, seating areas and café being added. Furthermore, the exterior entrance will be modernised. The lobby at the Exchange will also be refurbished and entailed new flooring, security desk, glass features and LED lighting. In addition, the exterior and interior of the building will be repainted.
• Both AEI’s are scheduled for completion by end-2019.
• We understand Manulife US REIT does not have a targeted return on investment for these AEI plans given the capex spend is more defensive in nature and required to maintain the buildings’ competitive position.

Saving bullets for FY20 and pricing in more hawkish interest rate outlook

• Our DBS economists are now projecting the US 10-year bond yield to hit 3.6% by end-FY19 and are expecting four rate hikes by the Federal Reserve in 2019. This is higher than consensus expectations in the low 3% for the US 10-year bond yield and 2-3 interest rate increases in 2019.
• To better account for this more hawkish interest rate outlook, we lowered our FY19-20F DPU by 6%. In particular, we now assume Manulife US REIT refinances its forth coming debt at 4.50-4.75%, with effective borrowing costs over the next two years increasing to 3.5-3.9%, up from our previous assume of 3.4-3.5% previously.
• In addition, we have lowered our DCF-based Target Price to US$0.88 from US$0.97, after using a risk-free rate of 3.6% (up from 3.0% previously) as well as lifting our cost of debt assumption to 4.75% from 3.85% previously. Our Target Price implies a P/BV of c.1.10x, down from 1.15-1.20x previously, as Manulife US REIT is exposed to US office markets which are still on an upturn but are mature in nature as compared to two years ago when Manulife US REIT was first listed.
• Furthermore, to save bullets for FY20, where Manulife US REIT will face stronger headwinds in the form of a full impact from higher borrowing costs, we have assumed only 50% of property management fees are paid in units before reverting to 100% in FY20, to temper the expected jump in FY19F DPU. This is to ensure Manulife US REIT fulfils its mandate of providing unitholders with a steady and growing DPU.
• Without tempering the boost from acquisitions in FY19, we see risk of a more volatile DPU and potential decline in FY20.
• Overall, we believe our more conservative numbers, should now allay the concerns by some investors who hold a more hawkish interest rate outlook.

Maintain BUY with revised Target Price of US$0.88

• With Manulife US REIT’s 3Q18 results in line with expectations, we maintain our BUY call, with a revised Target Price of US$0.88.
• Following the recent correction in Manulife US REIT’s share price, we believe the concerns raised over the past few months have largely been priced in given Manulife US REIT now trades at c.10% discount to book which we believe is unwarranted when Manulife US REIT’s properties are still experiencing rising rents and potential uplift in values.
• Furthermore, its forward trading yield of 7.7% is close

Mervin SONG CFA DBS Group Research | Derek TAN DBS Research | https://www.dbsvickers.com/ 2018-11-07

SGX Stock Analyst Report BUY MAINTAIN BUY 0.88 DOWN 0.970