Prime US REIT - DBS Research 2019-11-05: Good Time, Great Place!

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PRIME US REIT (SGX:OXMU)

Prime US REIT - Good Time, Great Place!

• Portfolio positioned in landlord favorable markets with runway for rental upside.
• Robust growth outlook underpinned by in-built rental escalations and rental reversion opportunities.
• Strong Sponsor via the KBS group platform.
• Initiating coverage with BUY and Target Price of US$1.05.

Initiate coverage with BUY and Target Price of US$1.05.

• We believe PRIME US REIT (SGX:OXMU), the newest US office REIT to be listed on the SGX, is in a sweet spot to grow its portfolio of assets as it builds its own track record to deliver superior DPU growth and DPU-accretive acquisitions. As investors familiarise themselves with its growth strategy overtime, we believe there is potential for share price to trade up closer to its peers. (See Prime US REIT Announcements; Prime US REIT Latest News)

Good time, great place!

• While acknowledging that the US economy and US office market have done well over the last few years, Prime US REIT’s properties are positioned in markets which are still in the “landlord-favourable” stage of the office cycle due to the favourable demand-and-supply dynamics, which implies continued increase in rents to underpin the REIT’s growth outlook.
• In addition, average rents for leases expiring in FY19 and FY20 are below market rents and new contracted leases have in-built rental escalations of between 1% and 3% per annum.

A diversified Class A prime portfolio in a rising US office market

Portfolio of Class A prime properties.

• Prime US REIT offers investors a unique opportunity to invest in a geographically diversified portfolio of 11 high quality prime office assets located in US office markets with attractive dynamics namely robust economic and employment growth, diverse pool of tenants that have strong demand for high-quality office space, highly educated workforce, excellent transport connectivity and favourable demand/supply outlook.
• The initial portfolio comprises 11 Class A freehold office buildings with an appraised value of US$1.22bn, based on the average of two independent valuations. Total aggregate net leasable area (NLA) stands at c.3.4m sqft. The top 5 markets which represent 73.2% of the portfolio value are Denver (19.1%), Salt Lake City (17.3%), Atlanta (14.4%), Washington D.C. (Suburban Maryland and Virginia) (12.5%) and San Francisco Bay Area (Oakland) (9.9%). The remaining portfolio is split between the markets of Philadelphia (8.0%), St Louis (6.5%), Dallas (6.1%), and San Antonio (6.0%). By value, the largest property is 222 Main (17.3%) followed by 171 17th Street (14.4%), Village Center Station II (11.8%), Tower I at Emeryville (9.9%), and One Washingtonian Center (8.4%). These 5 properties contribute c. 61.8% of the overall portfolio’s appraised value.
• The top 5 markets contributed an estimated c.67.5% of overall January 2019 cash rental income, comprising the markets of Atlanta (15.7%), Washington D.C. (Suburban Maryland and Virginia) (14.7%), Salt Lake City (14.5%), Denver (13.7%) and St Louis (8.9%). The top 5 properties also contributed c.57.2% of January 2019 cash rental income and they are 171 17th Street (15.7%), 222 Main Street (14.5%), One Washingtonian Center (9.5%), 101 South Hanley (8.9%) and Tower 909 (8.6%).

Above market average occupancy

• As at 1 January 2019, the initial portfolio had an average occupancy of 96.7% and a committed occupancy of 97.3% which is above the typical market average. In addition, most of the initial portfolio, nine out of 11 properties had a committed occupancy above 95.0% as at 1 January 2019.

Properties located in urban locations with strong market attributes.

• The initial portfolio is predominantly (9 out of 11 properties) situated in locations with strong attributes such as key business districts within their respective office markets or in prominent urban centres with proximity to mixed-use amenities.
• The properties are located near or surrounded by retail, restaurants, open spaces, recreational facilities and residential apartments. This promotes a “live-work-play” environment for employees, which in turn attracts prospective employers/tenants who seek to attract and retain skilled staff.
• Furthermore, eight out of the 11 properties are strengthened by being in close vicinity to a light rail network. This adds to the attractiveness of Prime US REIT’s buildings to tenants as their employees have another transport option so as to avoid traffic and costs associated with car ownership.

Diversified tenant base with stable lease expiry profile

High-quality tenant base with diverse industry mix.

• A key attribute of Prime US REIT’s portfolio is its diversified tenant base of 184 tenants (as at 1 January 2019), spread over multiple trade sectors. Indicative of the portfolio’s low tenant concentration risk is that the top ten tenants account for only 43.5% of total cash rental income, with the two largest tenants Charter Communications and Goldman Sachs contributing only 7.9% and 6.0% of total cash rental income respectively. Other top tenants include Sodexo Operations (5.9%), Wells Fargo Bank (5.0%), Holland & Hart (4.7%) and Arnall Golden Gregory (3.9%).
• The diversity of the tenant mix is also reflected by the fact that no single trade sector represents more than 16.5% and 16.3% of cash rental income and NLA respectively (for the month of January 2019).
• The largest trade sector is Financial Services (16.5% of January 2019 cash rental income), followed by Legal (13.3%), Communications (11.9%), Real Estate (8.7%) and Accommodation & Food (8.7%). An attractive feature of the tenant mix is the exposure to the science, technology, engineering and math (STEM) and technology, advertising, media and information (TAMI) industries which are new and emerging growth industries. Both STEM and TAMI tenants contribute c.29% of cash rental income.

Well-staggered lease expiry profile

• Beyond a diversified tenant mix, the stability of Prime US REIT is also reinforced by a well-staggered lease expiry profile, with not more than 19.8% and 18.8% of leases by cash rental income and NLA expiring in any given year respectively.
• Furthermore, good cash visibility and resilience arises from Prime US REIT having a long WALE by NLA of c.5.5 years with the top ten tenants having an even longer WALE of c.6.7 years (as at 1 January 2019). This relatively long WALE is a function of leases generally signed for tenures of between five and ten years with anchor tenants having leases in excess of ten years

Visible growth drivers

In-built rental escalations.

• In addition to the stability that Prime US REIT offers, we believe the REIT has visible levers to drive income higher over time. Firstly, approximately 98.3% of contracted leases have fixed annual escalations between 1-3% and average around 2.1% annually on a blended portfolio basis (as at 1 January 2019).
• Furthermore, to mitigate the impact of rising cost pressures, leases are typically structured whereby property expenses are passed through to tenants. This is demonstrated by having more than 99.0% of leases being on a triple-net or modified/full service gross basis, which provides a buffer against an escalation in real estate taxes and property expenses.
• Majority of FY19 and FY20 income already locked in. Prime US REIT’s strong cashflow visibility also arises as c.97.6% and c.91.6% of our estimated rental and recoveries income have also been locked in and is derived from existing leases (as at 1 January 2019).

Positive rental reversion potential

• The average rents on expiring leases for FY19 and FY20 are generally below the market asking rents for comparable buildings in the respective submarkets by 24.6% and 8.8% respectively. Assuming Prime US REIT can maximise rents as it renews its leases, there is potential for the REIT to achieve positive rental reversions over the next two years.

Positioned in rising US office markets

Properties strategically located in key office markets.

• The majority of Prime US REIT’s properties are strategically located in key office markets across the US that are on an uptrend underpinned by strong underlying fundamentals which are experiencing robust economic and employment growth, catering to a diverse pool of tenants from various trade sectors that have demonstrated strong demand for high-quality office space, attracted by the cities’, high educated workforce, robust transportation infrastructure with excellent connectivity.

Supportive macro backdrop.

• Underpinning the favourable property fundamentals in the REIT’s office markets is a supportive macro US backdrop. Consumer confidence is at its highest level since 2000 and business sentiment is being buoyed by expectations around the full impact from recent changes in tax laws.
• According to Cushman & Wakefield, the US is deemed to be approaching full employment with the unemployment rate at the lowest levels since early 2000s, suggesting better business activity ahead. Tightening employment rates have pushed up demand for office space and office-using employment is currently 21.7% of all nonfarm payroll jobs in the US, near its record high. In addition, Prime US REIT’s properties are in the markets where the number of office-using jobs generally grew by more than 10% p.a. from October 2009 to April 2018.
• Cushman & Wakefield also notes that the availability of capital should continue to support the expansion of the US real estate market and the US economy which it forecasts to grow between 2.5% and 3.0% p.a. between 2018 and 2019. This should underpin the positive outlook for the overall office market and the markets that Prime US REIT’s properties are located in. The favourable outlook is also premised on Cushman & Wakefield’s expectations of sustained improvement in office-using job growth and positive net absorption albeit at a slower pace than over the last three years.

Prime US REIT’s properties are located in accelerating or landlord-favourable markets.

• On the back of a growing US economy as well as the favourable demand-and-supply dynamics in the individual office markets, the initial portfolio according to Cushman & Wakefield are in primary markets which are an attractive proposition in the context of the overall national US office market.
• Based on Cushman & Wakefield’s analysis, seven of the primary markets that Prime US REIT has exposure to are in the accelerating part of the office market cycle in which rent growth is “accelerating”, with the remaining four primary markets being in the “landlord-favourable” part of the cycle whereby rents are expected to continue to increase, although at a slower pace than the “accelerating” phase.

Properties located in markets with improving market dynamics

Strategically located in key business markets in the US.

• Prime US REIT’s initial portfolio is strategically located across key markets in the US which are continuing to see positive job creation and population growth which is higher than the national average, according to Cushman & Wakefield. In our view, this implies that demand for office space will remain strong on the back of growing business activities and employment opportunities.
• In addition, with the cap rates for National CBD office assets now down towards 10-year lows due to strong capital inflows, investment demand has spilled over to suburban office assets.

A quality portfolio backed by a promoter with extensive reach and scale.

• Demand drivers for each city are varied and growing, which allows Prime US REIT to tap on an extensive addressable pool of prospective tenants looking to expand or take-up new space. We note that the majority of the markets that Prime US REIT has exposure to are experiencing a property upcycle with rents expected to be either accelerating (where close to c.78% of the assets are located at) or still rising and still favourable to the landlord albeit at a slowing pace (the remaining c.22%).
• In addition, the ability to tap the expertise and extensive scale of KBS real estate operating platform in the US, enables the REIT to be close to the ground, be at the forefront of any major leasing transactions out in the market, as well as to remain competitive and fulfil their own tenant needs.
• In addition, given the Sponsor’s sizeable scale in the US, Prime US REIT may also gain access to any deals that are being made available for the group.

Markets with positive dynamics

• We believe that the initial portfolio’s strong asset quality, location and being part of the management of the enlarged umbrella of KBS Realty in the US ensures that the properties remain relevant to evolving tenant needs and remain competitive in their respective micro-markets.
• Our thoughts on the respective markets are shown below:

East Bay/Oakland, San Francisco Bay Area, California

• Emeryville Tower 1 to benefit from the spill-over demand from San Francisco. Emeryville Tower I is located in the Oakland (I- 88/880 Corridor) market which enjoys the spill-over demand of tech and biotech tenants from San Francisco and the Silicon Valley where real estate costs have risen significantly, pushing tenants to look for cheaper alternatives in the nearby submarkets. According to Cushman & Wakefield, the cost of doing business in Oakland is 17% higher than the US average but is still cheaper than in San Francisco and San Jose which are 39% and 35% higher respectively. This means that tenants who opt to remain in the Bay Area may choose to be in East Bay/Oakland.
• Ability to lease out the property in the medium term. The attractiveness for a cost-efficient office alternative will likely drive tenant demand for Oakland properties, with vacancy forecasted to remain in the 8.0% level over 2018-2020, according to Cushman & Wakefield. New constructions are also limited but two office towers amounting to 931,000 sqft will complete in 2019 and 2020, resulting in increased competition for tenants. Likewise, rental rates are expected to remain positive in 2019, but weaken from 2020 onwards.

Greenwood Village, Denver, Colorado

• Suburban market in Denver supported by a diverse tenant base. Village Center Station I & II are located in the Greenwood Village, in the Southeast of metropolitan Denver where the economy has significant exposure to the telecommunications, healthcare and aerospace sectors which are the largest employers in the area. The attractiveness of Denver is its well-educated workforce and relatively low business cost which continues to attract businesses to expand there. Specifically, Village Center Station I & II, being located near the Village Station RTD light rail passenger station, have the advantage of being easily connected to downtown Denver.
• According to Cushman & Wakefield, rental growth outlook in the submarket is expected to remain stable going forward with absorptions to keep up with new completions. Market rents are projected to increase by 2-3% per annum. That said, we understand that the tenants at Village Center Station I & II are sticky and have been at the property for some time, supported by amenities and a residential base. Occupancy rates of 97.5% is high while the rollover risk is low given < 10% of rental income is expiring for Village Center Station I, implying strong earnings visibility. Village Center Station II is 100% let out to Charter Communications on a 10-year lease.

Midtown, Atlanta, Georgia

• Located in a strong suburban market; properties to deliver strong uplift in net property income (NPI) in the medium term. 171 17th Street is located within the Midtown/ Pershing/Brookwood submarket of Atlanta, one of fastest-growing economies within the US. Atlanta is home to over 2,500 high-tech companies and one of the largest tech markets, by The Business Journals. One of the key attractiveness of Atlanta is having a young and highly educated and skilled workforce, strong population growth and a low cost of doing business.
• According to Cushman & Wakefield, the properties are located within a desirable mixed-use development of Atlantic station and located near several MARTA stations, which links midtown to other submarkets in Atlanta and the airport.
• Going forward, Cushman & Wakefield believes that the leasing environment is expected to remain strong going forward, supporting rental growth momentum on the back of meaningful employment growth. Supply will also increase, with close to 2,098,000 sqft of new space to be completed within the submarket but absorption will likely keep up. Thus, vacancy rates will stay within 13-14% in the medium term.
• Market rents are forecasted to range from S$30.87 – 32.60 psf.
• We note that there are more expiries coming from 171 17th Street (c.22% of cash rental income over 2019F-2020F), and we expect strong uplift in rents when these leases come due over 2018-2020.

Clayton, St. Louis, Missouri

• Major upgrades over time to reposition property. 101 South Hanley is a 19-storey multi-tenanted office building located within Clayton Office submarket of the St. Louis Office market. Clayton is a major employment centre for the region with major tenants including the Centene Corporation, the St. Louis County Government Center, Washington University, Brown Shoe, etc.
• While Kansas City is expected to see a fair number of new completions in the coming years, we note that the Clayton submarket will see limited completions, just as in the past five years (2013-2017), where the majority of developments are mainly multi-family projects. Looking ahead, according to Cushman & Wakefield, Clayton’s vacancy rate of 11.5% in 1Q18 is expected to remain fairly stable going into 2022. Market rentals should continue to rise steadily by c.2% per annum from S$26.37 psf (1Q18) to S$28.66 psf in 2022.
• 101 South Hanley will see a fairly high number of expiries in 2019 and with average in-place contract rent estimated to be c.6% below the market level, this will result in positive reversions when these leases are renewed.

Gaithersburg, Montgomery, Washington DC

• Long WALE supports income visibility. One Washingtonian Center is located at 9801 Washingtonian Boulevard, Gaithersburg, a submarket of the Montgomery County office market, which is part of the greater Washington market. The location is in the I-270 corridor, a leading bio-tech and medical research market. According to Cushman & Wakefield, the Washington, D.C., the office market will continue to display healthy fundamentals with tenants leasing 4.2m sqft of space and moving into 460,974 sqft of office space, helping the region’s vacancy to improve to 17.6%. In Maryland submarket, the vacancy rate is higher at close to c.20%, which will be an overhang for the property to raise rents.
• However, we note that One Washingtonian Center has over time seen improvements being made to the property, enabling it to continue to attract tenants compared to peers. The presence of anchors Sodexo and Covance which occupy 61% and 15% of the leasable area respectively, provides near-term income visibility. The property has minimal near-term expiries as these leases expire from 2023 and 2026 onwards.

King of Prussia, Wayne, Pennsylvania

• Located in a strong suburban market. CrossPoint is located at Swedesford Road in Wayne PA. The property is located within the King of Prussia submarket which has 6.2m sqft, consisting of 5.5% of the region’s supply. Close to 111,000 sqft of space was completed in 2013-2018 with another 83,000 sqft completing in the coming years. The submarket vacancy increased from 15.9% to 17.6% over 2013-2017 as completions outpaced absorption. Looking forward, due to the limit completions, the submarket vacancy is expected to dip to 16.1% by 2022. Rental rates are expected to increase to US$26.58 psf in 2022 from S$25.12 psf in 1Q18 as new project completions should not surpass absorptions.
• With stable market conditions, Crosspoint is expected to remain stable, given its high occupancy rates with minimal lease rollovers over the next five years, estimated at only c.33% of income. According to Cushman & Wakefield, the opportunity will come from the Manager taking back space from some of the subleases and unutilised space from tenants and renting them out at higher rates.

West, San Antonio, Texas

• Strong property attributes a key attraction. Promenade I & II at Eilan is a Class A office property located at San Antonio. Improvements were completed in 2011 and are in good condition, which makes the property one of the best-quality buildings in San Antonio, according to Cushman & Wakefield. The property’s proximity to amenities – retail, hotel and restaurants – makes it a desirable location for tenants and gives it an edge against competition from other Class A buildings in the submarket.
• The West office submarket has seen vacancy rates decrease since 2013 but they are expected to rise from 18.3% in 2018 to 18.6% in 2022. This is because of new construction activity of close to 566,000 sqft over 2018-2022, surpassing absorption rates. As a result, rental growth will range from S$22.03-24.13 psf in 2022 on a triple net basis. That said, according to Cushman & Wakefield, in-place rents are 4% below market, which is an opportunity for the Manager to hike rents when leases come due.
• One of the key risks for the property will come from competition within downtown CBD in San Antonio, where the increasing leasing activity might pose a threat for the property given the attractiveness of working in a more urban environment.

Urban Center, Irving, Texas

• Strong property attributes a key attraction. Tower 909 is located in the Urban Center submarket in Irving, Texas. The submarket has seen strong rental growth over recent years. The attractiveness of the Urban Center submarket is its desirable “lifestyle” amenities, easy freeway access and proximity to DFW airport. The abundance of new multifamily housing will contribute to the submarket’s ability to provide tenants a work-live-play offering to their employees.
• Vacancy rates have declined over time from 16.9% in 2013 to 13.1% in 2017. Vacancy levels increased slightly in 2018 to 15.0% due to new completions. Looking ahead, according to Cushman & Wakefield, we believe that Tower 909 will continue to perform well due to its strategic location within the submarket and strong demand for its product offerings.

CBD, Salt Lake City, Utah

• Overcoming supply risk. 222 Main is located at South Main Street, Salt Lake City, Utah in the Central Business District. Vacancy rates have declined over time but expected to increase from 15.7% in 2018 to 17.5% in 2022 on the back of new completion of new Class A buildings surpassing absorptions.
• Given that Utah is a fairly small office market, the number of tenants who can pay high asking lease rates is limited.
• Despite greater competition in the immediate term, which will impact the Manager’s ability to hike rents when leases come due, we note that limited expiries in the next few years will likely shield the property from the current supply spike.

Reston, Fairfax, Virginia

• Limited expiries. Reston Square is located along the northern side of Sunrise Valley Drive in the Reston area of Fairfax County. Vacancy rates have remained high at 19.8% as of 1Q18 with the overall vacancy rate standing at a higher 21.1%. To meet tenants’ needs and retain them, the property underwent various upgrades over the years, which make it one of the better properties in the submarket.
• Given the high market vacancy, rentals are likely to remain under pressure in the immediate term but the property’s limited expiries shield it from any meaningful downside to revenues in the near term.

Financials

2.5% growth in Gross Revenues.

• We project Prime US REIT’s top line to grow at 2.5% from FY19F (annualised) to FY20F underpinned by
  1. in-built annual rental escalations of 1-3% p.a. for c.98.3% of its initial portfolio’s leases, and
  2. positive rental reversions given average expiring rents in FY19 and FY20 are 24.6% and 8.8% below current average market rents.
• Underlying cash income is stronger, growing at 3.1%. Meanwhile, overall average portfolio occupancy is expected to improve to 97.7% in FY20 from 97.0% in FY19.

Healthy increase in NPI.

• On the back of the healthy growth in rental income, we estimate Prime US REIT’s cash NPI to increase by 3.2% from FY19F (annualised) to FY20F. This is stronger than the 2.2% increase in NPI on an accounting basis over the same period. Over this period, accounting and cash NPI margins are expected to remain relatively stable at around 66% and 61% respectively.

Management fees – pegged to distributable income.

• The base fees and performance fees of Prime US REIT are structured to motivate the Manager to grow revenues and keep costs in check, ensuring that the Manager’s interests are well aligned with that of unitholders. Annual base fees are paid based on 10% of distributable income.
• In addition, the Manager will only be paid an annual performance fees that is based on 25% of the growth in DPU in a financial year compared to the preceding year. For FY19F and FY20F, no performance fee will be payable. The Manager has elected to received 80% of the base management fees in units.

Non tax-deductible expenses.

• Largely consists of management fees payable to the Manager, non-cash property tax adjustments and the amortisation of upfront fees.

Distribution income – 100% till FY20F.

• Prime US REIT’s distribution policy is to pay out 100% of its annual distributable income till the end of FY20F. Thereafter, the trust will have a distribution payout of at least 90% of its distributable income. Distributions will be made on a half-yearly basis. The first distribution will be paid on or before 31 March 2020 for the period till 31 December 2019. Thus, based on the growth in cash NPI, we project distributable income to increase by 3.5% from FY19F to FY20F.

Gearing at c.37-38%.

• Based on our estimates, Prime US REIT will maintain its gearing relatively stable at 37-38%. However, with capex and leasing costs expected to be debt funded and assuming no revaluation gains, we expect gearing to rise over time. We understand Prime US REIT intends to keep its gearing at 35-40%.

All-in interest cost of 3.45%.

• Interest expenses are expected to remain relatively stable as the trust has obtained three debt facilities with a weighted average debt maturity of 5.6 years and intends to hedge 85.1% of its interest rates. The average effective interest cost (excluding upfront fees) is expected to be 3.45%.

Capex requirements.

• We have assumed S$7.0m and US$9.8m of capex and leasing costs for FY19F and FY20F respectively. We have assumed that the capex and leasing costs will be funded with debt.

Valuation & Peers Comparison

Initiate with BUY rating; Target Price of US$1.05.

• Our target price of S$1.05 is based on DCF valuation which has factored in a normalised US risk-free rate of 3.0%, US market return of 9.1%, beta of 0.9x (a premium to the average US office REITs beta of 0.8x due to Prime US REIT’s smaller size and shorter track record), post-tax cost of debt of 4.0% and cost of equity of 8.5%. See Prime US REIT Share Price; Prime US REIT Target Price.
• We have used a target gearing of 40.0%, given projections that gearing will rise towards the 40.0% level in the medium term from an initial 35.0% level as capex and leasing costs are expected to be debt funded. This translates into a WACC of 6.7%.
• Coupled with a terminal growth rate of 2.3%, we derive a DCF valuation of US$1.05. This implies a FY19F and FY20F yield of 6.2% and 6.4% respectively.

Potential to trade closer to Manulife US REIT as it builds its own track record of outperformances.

• Prime US REIT is currently trading at 6.9% and 7.1% FY19F and FY20F dividend yield respectively. See Prime US REIT Dividend History. Meanwhile, its peers, the US office REITs listed in Singapore, trade at a range of 6.7-8.2% for FY19F and 7.0-8.6% for FY20F dividend yield.
• We believe there is potential for Prime US REIT to trade closer to Manulife US REIT (SGX:BTOU) TP’s target yield of 5.8% in the medium term (see Manulife US REIT Share Price; Manulife US REIT Target Price; Manulife US REIT Dividend History), given it owns a portfolio of Class A office buildings that is of comparable quality, and as it builds its own track record of outperforming its prospectus forecast, consistently demonstrate superior DPU growth and ability to identify DPU-accretive acquisitions. .
• See Prime US REIT Analyst Reports.

See attached 43-page PDF initiatio coverage report for complete analysis.

Rachel TAN DBS Group Research | Derek TAN DBS Research | https://www.dbsvickers.com/ 2019-11-05

SGX Stock Analyst Report BUY INITIATE BUY 1.05 SAME 1.05