Keppel KBS US REIT - DBS Research 2018-12-07: Once In A Blue Moon Opportunity

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KEPPEL-KBS US REIT (SGX:CMOU)

Keppel KBS US REIT - Once In A Blue Moon Opportunity

• Acquisitions of Westpark Portfolio and Maitland Promenade I deepen exposure to growing technology sector. 
• Under-rented portfolio provides medium term upside. 
• Concerns over tax structure and disappointment over impact of recent rights issue largely priced in. 

Catch the next wave.

• We maintain our BUY call and a revised Target Price of US$0.78 for Keppel-KBS US REIT (KORE).
• We continue to believe that Keppel-KBS US REIT offers investors the opportunity to catch the next leg of the US office market upturn. Keppel-KBS US REIT’s 12 freehold office assets are located in seven key regional markets in the US which are seeing positive dynamics and should also benefit from tenants seeking cheaper rents and the flow of capital as investors pursue markets where asset prices have yet to rally as much as some gateway cities. This thesis has been borne out with Keppel-KBS US REIT exceeding its IPO forecast since its listing a year ago.

Where We Differ: Concerns priced in.

• Keppel-KBS US REIT’s share price has corrected over the last few months due to the disappointment over having a rights issue so soon after its listing, potential for another US office REITs listing and concerns over a negative ruling on its tax structure. However, we believe the majority of these concerns have also been priced in given Keppel-KBS US REIT now trades at a 10-11% forward yield (or in the worst-case 7% assuming
• the current tax structure is ruled invalid) and c.25% discount to book value during a period when rents are still on an upswing.

Continue delivering or exceeding IPO projections.

• The correction in Keppel-KBS US REIT’s share price has cast doubts over the quality and ability of Keppel-KBS US REIT’s portfolio to perform. Thus, we believe as Keppel-KBS US REIT delivers or exceeds its IPO forecasts, investors’ concerns should be allayed resulting in a re-rating of the stock.

Valuation:

• After incorporating the recent acquisition and rights issue, we lowered our DCF-based Target Price to US$0.78 from US$0.95.

Key Risks to Our View:

• The key risk to our view is lower-than-expected rental income arising from loss of tenants or slower upturn in spot office rents, and changes to tax regulations in the US.

WHAT’S NEW - Pricing in recent rights issue and acquisitions

295-for-100 rights issue raising US$93.1m

• In late September 2018, Keppel-KBS US REIT announced its maiden acquisition with the signing of an agreement with KBS Strategic Opportunity REIT (SOR), the REIT that originally seeded Keppel-KBS US REIT, to purchase the Westpark Portfolio for US$169.4m, a 4.8% and 6.6% discount to two independent valuations by Cushman & Wakefield and JLL respectively. The acquisition price translates into an initial NPI yield of 6.80-6.85%. However, the transaction was then subject to EGM approval and Keppel-KBS US REIT had yet to finalise plans for an equity raising.
• Subsequently, Keppel-KBS US REIT obtained unitholder approval for the acquisition and announced a 295-for-100 rights issue raising US$93.1m. The rights price was set at US$0.50. The remainder of the purchase consideration for Westpark Portfolio was funded with onshore five-year debt with an all-in borrowings cost of c.4.5%.
• Post the rights issue, in late November, Keppel-KBS US REIT announced the acquisition of Maitland Promenade I (MP1) for US$48.5m, which is located next to its existing property Maitland Promenade II in Orlando, Florida. We understand the property was acquired on a cap rate of 7.7% with completion of the acquisition slated for mid-to-late January 2019.
• The purchase of MP1 is expected to be 100% debt funded at an interest cost of c.4.7%.

Westpark Portfolio overview

• See the PDF report attached for overview of the Westpark Portfolio.

Maitland Promenade I Overview

• See the PDF report attached for overview on Maitland Promenade.

Financial impact of acquisitions

• After incorporating the recent rights issue and acquisitions of Westpark Portfolio and MP1, we have lowered our FY18/19/20F DPU ....

Recent tax controversy

• Recently, there were concerns raised that Keppel-KBS US REIT’s DPU could be cut by 30%, due to an unfavourable tax ruling on the back of US tax reforms late last year, in particular Section 267A.
• The fears over the cut in DPU arise from the US tax authorities potentially ruling that its Barbados entity, which is used to repatriate cash from the US to Singapore, is deemed as a “hybrid entity”.
• Under the new US tax laws, we understand that should there be a hybrid entity within a tax structure that conducts a transaction, the REIT is unable to claim an interest tax deduction. If this was to occur, Keppel-KBS US REIT would have to repatriate the majority of cash back to Singapore as a dividend where a 30% withholding tax is applied.
• In addition, there were fears that a negative tax ruling would be applied retrospectively.

What is a hybrid entity? A new tax structure already in place to mitigate tax risk

• We understand an entity is deemed to be a hybrid entity, if an entity is
  1. classified differently in the US and another jurisdiction, and
  2. due to the differences in classification, no tax is paid in either the US or the foreign jurisdiction.
• To mitigate against the risk that the Singapore Financing SPV (receiving cash from US Parent REIT in the form of interest on shareholder loan) is being deemed a hybrid entity, a decision was made by Keppel-KBS US REIT to stream this cashflow via Barbados entities earlier this year.
• Under Barbados tax laws, the entities formed by Keppel-KBS US REIT are subject to tax ranging from
  • 2.5% on income received up to US$5m,
  • 2.0% on income received in excess of US$5m up to US$10m
  • 1.5% on income received in excess of US$10m up to US$15m
  • 0.25% on income received in excess of US$15m
• Thus, by using the Barbados entity which pays corporate tax, it avoids one of the criteria for being deemed a hybrid entity, namely no tax being paid.
• Furthermore, as the Barbados entities are
  1. currently treated as a Barbados limited partnership and a partnership for Barbados tax purposes, and
  2. based on legal and tax advice, these Barbados entities are treated as partnerships under the US tax laws, it also avoids another condition of the Barbados entity deemed to be a hybrid entity i.e. an entity being treated and classified as a different entity in the US and in a foreign jurisdiction.
• Do note when cash is repatriated back to Singapore from Barbados, we understand no withholding taxes are payable.

Areas of potential risk for the Barbados entity classification

• As the US tax authorities have not provided any rulings or guidance on the validity of the use of Barbados entities since ...
• However, we believe the following are potential areas which may cause the US tax authorities to rule that the Barbados entities are hybrid entities:
  1. The US tax authorities may decide that Barbados entities are not partnerships under the US tax code
  2. While the Barbados entities pay tax, the tax paid is too low
  3. The US authorities may look at Keppel-KBS US REIT’s tax structure in its entirety or on a look through basis and ignore the Barbados entities and focus on the Singapore Financing SPV.

Financial impact on potential negative ruling

• Based on Keppel-KBS US REIT’s estimates, in the worst-case scenario, if it is unable to claim tax deduction on interest on shareholder loans at the US Parent entity level, and income needs to be streamed back to Singapore for dividends where 30% withholding tax is applied, the impact on DPU would be approximately 30%.
• This is higher than 15% impact for Manulife US REIT, given Keppel-KBS US REIT primarily uses interest on shareholder loans as a tax shield, in comparison to MUST who also uses depreciation of its properties as a tax shield.
• Furthermore, we understand that in the event of a negative ruling occurring, Keppel-KBS US REIT would explore other potential structures and other jurisdictions that may reduce its effective tax rate. While Keppel-KBS US REIT has contingency plans, it is still unclear what is the exact ruling of the US tax authorities, and thus it is difficult to make a determination on the effective tax rate going forward and whether it would rise from current 1%.

Our thoughts post recent acquisition, rights issue and tax concerns

• While acknowledging investors disappointment over the Keppel-KBS US REIT’s funding of its maiden acquisition via a rights issue and it first transaction could have been more compelling in terms of yield accretion, we believe the correction has more than compensated for these issues given Keppel-KBS US REIT is now trading at a 10-11% forward yield.
• Typically S-REITs only trade at such a high yield unless there are fundamental problems with their portfolio. However, this is not the case for Keppel-KBS US REIT given it has outperformed its IPO forecasts, overall portfolio occupancy remains at high at 90.1% as at 30 September 2018 and it continues to report positive rental reversions.
• In addition, while there remains risk that Keppel-KBS US REIT may face a negative tax ruling, this risk has been present since Keppel-KBS US REIT’s listing and thus far, we understand Keppel-KBS US REIT’s existing tax structure is in compliance with the current US tax laws based on legal advice given to Keppel-KBS US REIT. Moreover, the negative dispersion made by some market commentators ignores the fact that the potential 30% cut in DPU is a worst-case scenario and the ability for the REIT to amend its tax structure to minimise tax leakage. At c.10-11% yield, we believe after adjusting for a 30% cut, Keppel-KBS US REIT remains attractive at c.7% forward yield in the worst-case scenario with the stock trading at a c.25% discount to book.
• Thus, we maintain our BUY call with a revised Target Price of US$0.78. 

Mervin SONG CFA DBS Group Research | Derek TAN DBS Research | https://www.dbsvickers.com/ 2018-12-07

SGX Stock Analyst Report BUY MAINTAIN BUY 0.78 DOWN 0.950