Keppel REIT - DBS Research 2019-07-16: Uplift From Rising Spot Rents

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KEPPEL REIT (SGX:K71U)

Keppel REIT - Uplift From Rising Spot Rents

• Keppel REIT's 2Q19 DPU of 1.39 Scts (-2.1% y-o-y) in line.
• Near term earnings impacted by absence of income support, pre-termination income, and sale of 20% interest in Ocean Financial Centre.
• 15.8% positive rental reversion for 1H19 points to stronger earnings and DPU ahead.
• Maintain BUY, Target Price raised to S$1.45.

Leveraged to office upturn.

• We maintain our BUY call on KEPPEL REIT (SGX:K71U) with a higher Target Price of S$1.45.
• Keppel REIT’s share price typically leads a recovery in spot office rents by 6-12 months. According to CBRE, Grade A CBD rents had risen to S$11.30 psf/mth by end-2Q19, and is 26% higher from the low of S$8.95 psf/mth in 1H17. Thus, we believe office rents are on a sustained upturn and the share price rally which started in late 2018 should continue.

Where we differ – Discount to book unjustified.

• Consensus has a HOLD rating with a Target Price that implies Keppel REIT should trade at a discount to its book value. However, with FY18 likely marking a cyclical low in Keppel REIT’s DPU, we focus on growth in DPU from 2019 onwards as Keppel REIT benefits from the upturn in Singapore office rents and boost from its maiden acquisition in Korea.
• In addition, with management conducting a share buyback over the last few months, the first S-REIT to do so, this sends a strong signal that Keppel REIT is significantly undervalued, considering several office buildings in less prime locations have been sold at a cap rate of 1.7-3.2%, below the 3.60-3.65% used to value Keppel REIT’s best-in-class Grade A buildings in Singapore.

Recovery in DPU and positive rental reversions.

• We believe the expected recovery in DPU and delivery of positive rental reversions on the back of higher spot rents would be catalysts for Keppel REIT’s share price to re-rate to our Target Price of S$1.45.

WHAT’S NEW - Building up momentum

2Q19 DPU of 1.39 Scts (-2.1% y-o-y)

• Keppel REIT reported 2Q19 DPU of 1.39 Scts which was down 2.1% y-o-y but flat q-o-q.
• Stripping out S$3m worth of capital distributions made in 1Q19 and 2Q19, core 2Q19 DPU would have come in at 1.30 Scts, down 8.3% y-o-y or flat q-o-q. With core 1H19 DPU of 2.60 Scts (-8.5% y-o-y) representing c.48% of our core FY19 DPU forecast, this was largely in line with our expectations.
• The y-o-y decline in core 2Q19 DPU was largely on the back of
  1. the absence of c.S$12m worth of pre-termination payments at Ocean Financial Centre (OFC) in 2Q18,
  2. loss of income from sale of a 20% stake in OFC in late 2018,
  3. end of S$2.2m worth of income support from MBFC Tower 3 in 1Q19,
  4. depreciation in the AUD, and
  5. transitional vacancy at Bugis Junction Tower.
• These factors also resulted in 2Q19 revenue and NPI dropping 22.7% and 28.1% y-o-y respectively. Partially offsetting these headwinds were stronger underlying income from MBFC due to the positive rental reversions achieved over the past few quarters, maiden contribution from recently acquired T Tower in Seoul and 6-13% y-o-y growth in earnings for the Australian properties in AUD terms.
• 2Q19 earnings for Bugis Junction Tower fell 29% y-o-y as physical occupancy was only between 75-80%. Nevertheless, with committed occupancy at 100%, earnings for the property should improve from 3Q19 as a new tenant is expected to move in soon.
• For OFC, stripping out the S$12m pre-termination income, 2Q19 contribution was stable y-o-y.
• Overall portfolio occupancy remains healthy at 99.1% with most properties maintaining their current occupancy levels from prior quarters.
• Key highlights for the quarter include 8 Exhibition Street being fully committed versus 97.2% in 2Q18, and 275 George Street’s occupancy at 98.5% versus 93.4% in 2Q18. While One Raffles Quay’s (ORQ) occupancy of 97.0% is down from 100.0% in 2Q18, occupancy has improved from 96.1% in 1Q19.

Heathy rental reversions reported with good prospects for rental increases

• Keppel REIT disclosed that average signing rents for 1H19 stood at c.S$11.93 psf/mth, slightly down from c.S$12.03 psf/mth reported for 1Q19. This may be a function of leases signed at Bugis Junction Towers which typically would have lower rents than those in the core CBD.
• Nevertheless, Keppel REIT reported 17.8% positive rental reversions in 2Q19, taking 1H19 rental reversions to 15.8%.
• With average expiring rents for 2H19, FY20 and FY21 at S$10.70 psf/mth, S$9.70 psf/mth and S$9.60 psf/mth respectively compared to current Grade A core CBD rents of S$11.30 psf/mth, we believe Keppel REIT should continue to report healthy rental reversions going forward.
• Post the leases signed in 2Q19, only 1.6% of leases are up for renewal during the remainder of FY19 (down from 2.7% at end 1Q19) with another 8.1% of leases due to expire in FY20. Heading into peak supply in FY22, Keppel REIT has 16.8% and 19.4% of leases up for renewal in FY21 and FY22 respectively.
• Over the quarter, we understand new leasing demand and expansion are mainly from the technology, media and telecommunications sectors as well as banking and financial industries. Keppel REIT also notes that the co-working sector has been active. However, there has been some cautiousness from some sectors due to the current trade tensions. We believe this may have contributed to Grade A core CBD rents only increasing 1% q-o-q in 2Q19 to S$11.30 psf/mth, the slowest q-o-q improvement and lower than the 3% q-o-q increase seen since rents bottomed in 1H17.

Update on Deutsche Bank lease

• Keppel REIT guided that it has not received any request by Deutsche Bank to right size its office space. The current 10-year lease for Deutsche Bank at One Raffles Quay ends in mid-2025 with a rent review in 2020.
• There are no break clauses in the lease although Deutsche Bank has the option to sub-let space that it does not need.
• Deutsche Bank occupies c. 200k sqft, comprising c.16% of ORQ.

Uptick in gearing

• Due to the recent issuance of S$200m worth of 5-year convertible bonds and S$505m green secured loan facility which were used to finance the acquisition of T Tower in Seoul, Keppel REIT’s gearing rose to 38.4% from 35.7% in the prior quarter.
• Average borrowing costs was stable at c.2.9% with 92% of borrowings on fixed rates.
• NAV per unit (excluding distributions) was relatively stable at S$1.36 owing to the buyback of 9.7m units in 2Q19.
• On the potential increase in gearing limit to 50-55% by the Monetary Authority of Singapore (MAS), Keppel REIT does not expect to increase its gearing materially and it remains comfortable with a gearing in the low 40’s given the quality of its portfolio. In addition, it is open to optimising its portfolio should it receive compelling offers for Bugis Junction Tower, and will seek to deepen its exposure in Melbourne, Sydney and Seoul if the right opportunity arises.

Stronger 2H19 expected

• On the back of positive rental reversions recorded over the past few quarters and uplift in physical occupancy at Bugis Junction, we expected a stronger 2H19.
• However, DPU may still be down y-o-y owing to the absence of income support and pre-termination income as well as the impact from the sale of a 20% stake in OFC last year.

Tweaking DPU estimates

• We have tweaked our DPU estimates, lowering our FY20 DPU by 1% as we factored in the current temporary vacancy at Bugis Junction Tower, frictional occupancy when UBS vacates ORQ, and potential void periods when HSBC moves to MBFC Tower 2. We lifted our FY21 by 1% as we no longer assume an increase in interest rates.
• Meanwhile, we have lifted our DCF-based Target Price to S$1.45 from S$1.40 to incorporate a period of lower interest rates for longer as our DBS economists have projected two interest rate cuts in 2H19, partially offset by assumed conversion of the 2024 convertible bonds. To that end we have lowered our risk-free rate to 2.5% from 3.0% and cost of debt assumption to 3.0% from 3.25% previously.

Maintain BUY with a revised Target Price of S$1.45

• We maintain our BUY call with a revised Target Price of S$1.45.
• We remain bullish on Keppel REIT’s prospects as we believe the expected positive rental reversions achieved this year should translate to stronger earnings/DPU ahead.

Mervin SONG CFA DBS Group Research | Derek TAN DBS Research | https://www.dbsvickers.com/ 2019-07-16

SGX Stock Analyst Report BUY MAINTAIN BUY 1.45 UP 1.400