Manulife US REIT - CGS-CIMB Research 2019-10-31: In Top Form

SGinvestors.io

MANULIFE US REIT (SGX:BTOU)

Manulife US REIT - In Top Form

• Manulife US REIT offers DPU yield of 6.6%, higher than office S-REITs (4.5-6.4%). Initiate coverage with an ADD rating and Target Price of US$1.12.
• We believe it offers rental income stability via the long lease expiry profile (6.2 years) with inbuilt rental escalations (c. 2%).
• Catalysts are the potential inclusion into the FTSE EPRA NAREIT Global Developed Index and stronger US$ vs S$.

A portfolio of Class A and trophy assets

• MANULIFE US REIT (SGX:BTOU) has a portfolio of premium office properties located in Los Angeles, Irvine, Atlanta, Secaucus, Jersey City and Washington, DC.
• Since listing on 20 May 2016, Manulife US REIT's portfolio has grown from three properties to nine, with the acquisition of 400 Capitol Mall in Sacramento completed in Oct 2019. Accordingly, its portfolio size will expand to 4.66m sq ft of net lettable area (NLA) with a market value of US$2,076m (as at Oct 2019), ranking it ahead of its closest US-centric SREIT peer by c.70% in terms of portfolio value.

Well-located, quality portfolio

• Manulife US REIT’s portfolio is well-located, in prime areas in key US cities. Its properties are located in four of the top 10 Metropolitan Statistical Areas (MSA) in terms of median household income, population and GDP metrics. In addition, portfolio quality is high with two trophy assets and the remaining in the Class A category. A number of its properties have also been refurbished in the last 1-7 years.
• By portfolio value, its largest asset is the Michelson (located in Irvine, Orange County), accounting for 16.6% of enlarged portfolio value but making up 11.4% of NLA and 17.1% of net property in come (NPI) (as at Oct 2019). This is followed by Exchange (located in New Jersey) which accounts for 16.6% of portfolio assets under management (AUM) but 15.8% of NLA.

Diversified tenant base

• Manulife US REIT’s portfolio enjoys a long weighted average lease to expiry (WALE) of 6.2 years and occupancy of 97.2% as at end-2Q19. This is spread over 140 tenants. Post the acquisition of 400 Capitol, we expect its tenant base to increase to 184. The top trade sectors such as legal, finance and insurance, retail trade, information technology, public administration, real estate and consulting will likely account for c.77.4% of enlarged gross rental income in Sep 2019, based on our estimates.
• Given the prime locations and quality of its portfolio, its top tenants include those in the retail trade (The William Carter Co, The Children’s Place (PLCE US) and Amazon (AMZN US), legal sector (Kilpatrick Townsend and Quinn Emanuel Trial Lawyers) as well as finance and insurance industries (Chubb (CB US) and Hyundai Motor Finance) and the US Treasury. Together, the top 10 tenants make up 38.9% of end-2Q19 gross rental income.

US economic recovery supportive of office upcycle

• According to property consultants Cushman & Wakefield, the outlook for the US office market as a whole remains robust in 2019, underpinned by favourable macroeconomic factors and still robust demand/supply dynamics.

Declining unemployment, positive job creation

• US GDP growth has shown consecutive quarters of y-o-y growth since 2016 with the latest 2Q19 GDP showing 2.1% expansion. In addition to the unemployment rate trending down over 2009-1H19, US office employment numbers have been rising from 30.2m in 4Q14 to 32.9m in 2Q19.
• The proportion of office-using employment as a percentage of total non-farm employment has also been inching up from 21.5% in 4Q14 to 21.8% as at 2Q19, according to Bureau of Labour Statistics.

Office net absorption keeping pace with new completions

• According to property consultant Cushman & Wakefield, office demand came largely from technology, financial services and real estate (co-working sectors), making up 56.3% of all leasing activity in 2018. According to Cushman & Wakefield, net office absorption exceeded 53m sq ft in 2018 and a further 16.8m sq ft was absorbed in 1H19. From a medium-term perspective, net absorption totalled 186.7m sq ft in 4Q15-2Q19, keeping pace with new completions of 189.9m sq ft. As a result, the vacancy rate remained relatively stable over the past three years.
• Meanwhile, new leasing momentum remained robust with 87.1m sq ft of space leased in 2Q19. This was slightly less than the quantum in 1Q19 but well within the 84m-97m sq ft that has been the norm over the past three years, according to Cushman & Wakefield. This brought the total to 182.8m sq ft of space leased in 1H19.
• The vacancy rate stood at 13% in 2Q19, unchanged q-o-q. In terms of new supply, 120m sq ft of office space was under construction at end-2Q19. This represents c.2.2% of total office space inventory and is the highest level since 1Q01. Delving into details, the bulk of the new construction is located in Austin (11.1%), Nashville (10.3%), San Mateo County, CA (9.9%), Charlotte (7.9%), and Salt Lake City (6.2%). As such, some micro-markets may feel some near-term rental growth pressure.
• According to Cushman & Wakefield, the weighted average office rent in the US is US$32.13 psf as at end-2Q19. This is 0.5% higher q-o-q and 4.4% above the previous corresponding period. With vacancy rates trending below average, a fairly active leasing market and positive net demand from continued job growth, we expect the positive rental trajectory to continue, although at a slightly more moderate pace.

Growth drivers

• Manulife US REIT has a twin growth strategy derived from organic and inorganic means. Organic growth prospects are underpinned by built-in rental escalations while inorganic growth is achieved via new acquisitions. We have projected Manulife US REIT’s distribution per unit (DPU) to grow by a CAGR of 5.1% in FY18-21F on the back of inorganic and organic growth drivers. See Manulife US REIT Dividend History.

Portfolio AUM CAGR of 12% since IPO through inorganic expansion

• Since its listing in May 2016 until YTD, Manulife US REIT’s portfolio AUM expanded by a CAGR of 12% to c.US$2.1bn. Growth was led largely by new acquisitions with the number of properties increasing from three to nine.
• We expect Manulife US REIT to remain active on acquisitions given the positive spread between acquisition NPI yields (7.2-7.55%) for the two most recent acquisitions) compared to the current lower cost of capital will likely result in DPU and NAV accretion, in our view.

Expanding footprint to Sacramento

• Following the purchase of Centerpointe I&II in Fairfax, Washington, in Jun 2019 (at implied NPI yield of 7.6%), Manulife US REIT recently completed the acquisition of 400 Capitol in Sacramento (at implied NPI yield of 7.2%) in Oct 2019. Together, these properties cost a total of US$323.3m.
• With the purchase of 400 Capitol, Manulife US REIT is also expected to benefit from growth in Sacramento. Sacramento is widely recognised as a key location for large corporations with government, law and lobby interests. The Sacramento area is the third-fastest growing Metropolitan Statistical Area in California, supported by significant migration from nearby San Francisco and Southern California.
• The Sacramento office market has high barriers of entry due to high replacement costs and competitive micro market average vacancy of 6.3% compared to the average Class A vacancy of 11.3% as at Sep 2019, according to an independent market report by Cushman & Wakefield.

Favourable lease structure lifts organic income improvements

• On the organic growth front, Manulife US REIT’s organic growth is underpinned by favourable lease structure through three factors, in our view:
  1. inbuilt rental escalations,
  2. under-rented portfolio, and
  3. rising spot rents in its respective markets.
• Manulife US REIT portfolio enjoys high occupancy of 93.1-100% as at end-2Q19. In addition, it has a long weighted average lease to expiry (WALE) of 6.2 years as at end- 2Q19. This provides good medium-term income visibility for the REIT.
• Furthermore, about 95% of its portfolio by gross rental income has inbuilt rental escalations or is subjected to period reviews. According to Manulife US REIT, rent for 59% of its portfolio will increase by an average 2.6% p.a. while rents for the remaining 36% are set for the medium term or periodic increases.
• Manulife US REIT has an estimated remaining 1.7% and 7.1% of NLA to be renewed in 2HFY19 and FY20F, respectively. We anticipate the trust to continue enjoying positive rental reversion, underpinned by favourable supply/demand factors within its micromarkets.
• Manulife US REIT enjoyed positive rental reversion of 0.3% in 1H19 after taking into account the renewal of two of Michelson’s largest leases. The 151,000 sq ft space was re-leased for an 11-year term with escalations of 3% p.a. Given that the passing rent for a number of its properties are below current market rents, we believe the trust can continue to renew leases positively.

Benefiting from under-rented portfolio and rental upcycle

• We believe Manulife US REIT’s portfolio is under-rented by 5-10%. While Michelson and Centerpointe appear to have higher rents vs. the market, Michelson is a Trophy property while Centerpointe has been able to secure rents that are 10-25% above market rate over the past eight years. Hence, we think Manulife US REIT should continue to enjoy positive reversion when leases are renewed.
• In addition, Manulife US REIT’s portfolio are located in key cities that are expected to see positive trends. According to Jones Lang Lasalle 2Q19 outlook, New Jersey, Northern Virginia, Sacramento, Los Angeles, Orange County and Atlanta are in the rising phase of the office property clock. This bodes well in terms of rentals as well as property values.

Manulife US REIT structure

• Manulife US REIT is a Singapore-based REIT established to hold income-producing office real estate assets in the US. The REIT Manager is Manulife US Real Estate Management Pte Ltd and the Property Manager is John Hancock Life Insurance Company (USA), both of which are wholly-owned by the sponsor.
• Manulife US REIT has an efficient tax structure that allows it to minimise cash taxes payable if it can satisfy a few conditions. Amongst these are: its US parent REIT’s ability to maintain its US REIT status by deriving 75% of its revenue from real estate activities. In addition, no individual shareholder can own more than 9.8% of Manulife US REIT at any given point of time.
• The proposed 267A regulations announced by the US Department of the Treasury on 20 Dec 2018 and the Barbados Tax Changes announced on 28 Nov 2018 are not expected to necessitate any further changes to Manulife US REIT’s structure in order to preserve the deductibility of interest paid on Manulife US REIT’s inter-company financing arrangements.

Manulife US REIT's Key Management Team

• The Chief Executive Officer of Manulife US Real Estate Management Pte Ltd (the REIT Manager) is Ms Jill Smith and the Chief Financial Officer is Mr Jagjit Obhan, while the Chief Investment Officer is Ms Jennifer Schillaci. Together, they have significant depth and broad local domain knowledge of the real estate market as well as financial expertise with 14-40 years of experience collectively.

Manulife US REIT's Sponsor

• Manulife US REIT’s sponsor, The Manufacturers Life Insurance Company (Manulife), is part of the Manulife Group. The sponsor’s parent company, Manulife Financial Corporation (MFC CN), is a leading international financial services group with over US$863bn in AUM as at Dec 2018. It operates as John Hancock in the US and Manulife elsewhere, providing financial advice, insurance, and wealth and asset management solutions to individuals, groups and institutions. It operates a fully-integrated real estate management platform, Manulife Real Estate (MRE). As at end-Dec 2018, MRE had US$13.8bn of assets, of which 73% are office properties.

Manulife US REIT Fee structure

• Manulife US REIT pays management fees to its REIT Manager. This comprises a base fee of 10% of distributable income and a performance fee of 25% of the difference in DPU over the preceding year. Other fees payable include acquisition and divestment fees and property management fees and construction supervision fee (if any).
• In FY18, the total REIT Manager fee paid translates into 0.4% of AUM and 7.8% of NPI, below the SREIT sector average, both in terms of percentage of AUM or NPI.

SWOT analysis

• We think Manulife US REIT’s strengths lie in its stable portfolio with a long WALE of 6.2 years and inbuilt rental escalations of c.2%. This provides strong cashflow visibility with upside growth potential. The high portfolio occupancy is also a testament to its quality assets. Its tax efficient structure also ensures minimal tax leakage, hence optimising returns to unitholders.
• Manulife US REIT’s weaknesses include a relatively small portfolio size versus its US-listed peers as well as not having the right of first refusal for its sponsor’s asset pipeline. However, we think that the deep US office market could offer acquisition opportunities in the medium term. This will enable it to address and change its AUM profile over time, in our view.

Key Risks

Country concentration risk.

• Manulife US REIT is exposed to single country risk that includes economic, political or policy changes in the US where its properties are located. As the US economy can be impacted by adverse global economic conditions, this could affect demand for office space and in turn, have a knock-on effect on rental income and distributions to unitholders.

Risk of tenant non-renewals and frictional vacancy in the portfolio.

• From an operational perspective, any business downturn or adverse change in tenant financial soundness could result in bankruptcy or insolvency economic conditions could affect demand for office space and Manulife US REIT’s income.

Foreign currency risk.

• As Manulife US REIT’s revenue are generated in US dollars, unitholders electing to receive distributions in Singapore dollars have exposure to the US$/S$ forex rate.

Regulatory risks.

• The tax efficiency status of Manulife US REIT relies in part on its parent US REIT and sub-US REITs being able to maintain its status as US REITs as well as REIT qualifying for US Portfolio interest exemption when repatriating cashflow back to Singapore as interest income. Any change in these rulings in the US or Singapore which affects the current structure or ability to repatriate cash in a tax efficient manner could impact unitholders’ distributions.

Ownership limits risk.

• Unitholders are subject to ownership limits, i.e. they are not allowed to, directly or indirectly, own in excess of 9.8% of Manulife US REIT’s outstanding units, to ensure Manulife US REIT maintains its favourable tax status. Should they exceed this limit, the trustee has the right and power to dispose any units in excess of the limit.

Financials and Capital Management

Projected DPU CAGR of 5.1%

• Manulife US REIT’s distributable income has been growing from strength to strength since its listing. This has been achieved through a combination of organic expansion as well as acquisition growth. We project Manulife US REIT’s DPU to grow by a CAGR of 5.1% in FY18-21F, driven by inorganic and organic drivers.
• Property income comprises rental income, and recoveries income including charges to tenants for reimbursements (service charge, at cost), of certain operating costs and real estate taxes and non-cash adjustments including straight-line adjustments, amortisation of tenant improvement allowance, leasing commissions and free rent incentives, as well as carparking charges and other income.

New acquisitions boosted 2Q19 results

• Manulife US REIT posted a 33.2% y-o-y jump in 2Q19 gross revenue to U$43.3m, largely due to contributions from Penn and Phipps Tower that were acquired in Jun 2018 and maiden contribution from Centerpointe. Accordingly, 2Q19 net property income and distributable income rose 33.8% and 25% y-o-y, respectively, to US$27.3m and US$20.6m. However, 2Q19 DPU (adjusted for its May 2019 placement and preferential offering in Jun 2018) was flat y-o-y.
• 1H19 performance mirrored the 2Q performance with a 30.9%/30.8%/24.4% improvement in gross revenue, NPI and distributable income, respectively. 1H19 DPU of 3.04 US$ cts was marginally higher y-o-y.
• See Manulife US REIT Announcements; Manulife US REIT Dividend History; Manulife US REIT Latest News.

Continued strong topline growth

• We project gross revenue and NPI to increase by an average of 16.3%/16.1% per year in FY19-21F. This is driven by a combination of organic positive rental reversion and inbuilt rental escalations as well as contributions from new acquisitions completed in FY18 and FY19F. We project average passing rent for the properties within the portfolio to rise by an average of 0.7-3.0% annually and occupancy to remain stable during this forecast period.
• In terms of DPU, we project 100% payout and assume that all management fees will continue to be paid in units. Accordingly, DPU growth should average 5.1% p.a. in FY18-21F. See Manulife US REIT Dividend History.

Robust balance sheet

• Manulife US REIT’s gearing stood at 37% at end-2Q19. Its weighted average debt maturity stands at 3.1 years (post refinancing for Figueroa), with average interest cost of 3.45% as at end 2Q19, with about 96.1% of its loans are on fixed rates.
• Following the purchase of 400 Capitol and the US$142.1m equity fund raising to part fund the purchase, the proforma adjusted gearing is expected to dip slightly to 36.6% (as at Oct 2019) compared to 37% as at end 2Q19.
• With most of its portfolio assets having undergone refurbishments over the past 1-7 years, we do not anticipate significant capex requirements going forward, aside from the US$26m capex and leasing costs spent in 1HFY19.
• Based on our FY19-20F DPU forecasts of 5.97/6.20 US$ cts, Manulife US REIT is trading at FY19-20F yield of 6.6-6.9%. See Manulife US REIT Dividend History. This is still slightly better than its long-term average yield of 6.5%. In P/BV terms, the stock is trading at 1.13x book value of US$0.80 (adjusted for equity fund raising for 400 Capitol acquisition). At the current valuation, Manulife US REIT is offering an attractive 490-520bp spread over the 10-year US bond yield and 480-500bp spread over the Singapore 10-year bond yield.

Valuation

DDM valuation

• Our DDM-based Target Price values Manulife US REIT at US$1.12 and assumes a cost of equity of 7.6%, based on a risk-free rate of 2%, beta of 0.8x, assumed terminal growth rate of 1.5% and 100% dividend payout ratio. See Manulife US REIT Dividend History.
• At the current share price, Manulife US REIT offers total return potential of c.30%. See Manulife US REIT Share Price; Manulife US REIT Target Price.

Comparison vs. office SREITs and US office REITs

• Manulife US REIT is trading at FY19F DPU yield of 6.6% vs. office S-REITs’ 4.5-6.4% yields. In comparison with US-listed REITs, US-centric SREITs offer higher dividend yields of 7.0-8.1%, based on a 100% dividend payout, while the average dividend yield for US-listed office REITs is between 3.6-3.8% as the latter generally pay out only 40-80% of their funds from operations. Assuming that the entire cashflow stream is distributed, US-listed REITs would have delivered average yields of between 6.6% and 7.1% based on 29 Oct 2019 closing price, in tandem with their S-REIT counterparts.
• In terms of portfolio metrics, Manulife US REIT offers the longest WALE of 6.2 years and occupancy of 97.2% as at end 2Q19. Its tenant base is well-diversified, with the top 10 tenants accounting for 38.9% of gross rental income as at 2Q19.

Initiate with an ADD rating

• We initiate coverage on Manulife US REIT with a DDM-based Target Price of US$1.12.
• We like Manulife US REIT for its exposure to the rising office rental market in the US. Its well-curated and diversified portfolio with a long WALE and inbuilt rental escalations as well as a robust balance sheet offer investors stability and growth. In addition, it has a strong sponsor in Manulife with a strong asset pipeline, in our view. See Manulife US REIT Analyst Reports.
• With its free float market cap of slightly more than US$1.3bn as at 29 Oct 2019, we believe it is a step closer to inclusion into the FTSE EPRA NAREIT Developed Asia Index. This could broaden its investor base and support the share price in the medium term, in our view. See Manulife US REIT Share Price; Recent SGX Additions to FTSE EPRA Nareit Global Developed Index.
• Key risks include a slowdown in the US economic outlook which could dampen the appetite for office space.

See attached 31-page PDF report for complete analysis.

LOCK Mun Yee CGS-CIMB Research | EING Kar Mei CFA CGS-CIMB Research | https://www.cgs-cimb.com 2019-10-31

SGX Stock Analyst Report ADD INITIATE ADD 1.12 SAME 1.12