US Office REITs - RHB Invest 2019-07-12: Underappreciated, Undervalued; Stay OVERWEIGHT


US Office REITs - Underappreciated, Undervalued; Stay OVERWEIGHT

  • Maintain OVERWEIGHT; market fundamentals remain sound. We recently visited some US office REIT assets, which reaffirmed our positive sector outlook.
  • US office REITs listed on SGX currently offer an average FY19F yield of 7.4%, 220bps higher than Singapore office REITs’ average. It is also 380bps higher than average office REITs listed in the US.
  • We believe this high yield gap is unjustified – given the positive sector outlook, freehold tenure, built-in rent escalations and long WALE.
  • MANULIFE US REIT (SGX:BTOU) remains our Top Pick and we initiate coverage on KEPPEL-KBS US REIT (SGX:CMOU) with BUY.

Three key factors driving US office market.

  • From our discussions with consultants, tenants, and landlords, we see three reasons driving sector growth:
    • high replacement costs (rising land and construction cost),
    • prudent bank funding limiting speculative supply, and
    • the rise of co-working operators that are fast absorbing vacant spaces thus pushing up rents.

Favourable demand-supply dynamics.

  • Based on data from JLL, the US office market continued its growth streak in 1Q19, with net absorption of 14m sqf, driving vacant rates lower to 14.7% and rents higher by 2.4% y-o-y.
  • Leasing demand remains robust with ~40% of leasing coming from expansionary demand, and underpinning good market fundamentals. Key sectors driving demand include co-working, technology, financial and insurance.
  • On the supply front, while office deliveries in the US are expected to surge in 2H19, supply in most of the micro markets where REIT assets are located remains favourable, based on market research data.

US Fed’s dovish stance favours REITs and mitigates rising interest cost threat.

  • With the increasing likelihood of the US Fed cutting interest rates, demand for yield instruments like REITs is expected to remain strong. This also mitigates the threat of rising interest costs impacting DPU, with debt cost having fallen by 50-100bps vs the beginning of the year.

Removal of tax overhang provides room for more upside.

  • The US Department of Treasury released proposed regulations under Section 267A (Dec 2018), which are not expected to have any impact on the existing tax structure of US office REITs. The final regulations are expected to be announced soon.
  • In addition, based on draft regulations, US office REITs can potentially revert to their IPO tax structures (avoiding the need for intermediate entities), which will result in additional tax savings of up to 2%.

Growing listing pipeline benefits sector growth.

  • The planned listing of more US-based commercial REITs should help investors gain better market understanding, widen the investor base, and boost sector liquidity. The above factors should also help narrow the current high yield gap that should benefit early investors in the sector.

US office REITs relatively undervalued.

  • On average, US-office REITs listed on SGX currently offer a FY19F dividend yield of 7.4%. In comparison, Singapore office REITs offer an average yield of 5.2%, while office REITs listed in the US offer 3.6% yield.
  • In addition, US office REITs’ dividends are not subject to Singapore corporate taxes in the hands of institutional unit holders, thus further boosting the underlying yield.
  • Key risks include failure of the co-working model, declining trend of office space per employee, and threat from terrorism and natural disasters.

US Office-REITs report

Vijay Natarajan RHB Securities Research | 2019-07-12
SGX Stock Analyst Report BUY MAINTAIN BUY 0.980 SAME 0.980