Singapore Office REITs - DBS Research 2020-06-08: Grab It While It Lasts


Singapore Office REITs - Grab It While It Lasts

A lesson from history – office sector nearing inflection point

Close correlation between office demand and GDP across the past three recessions.

  • While the office sector has been the least impacted by COVID-19 directly thus far, we are cautious on the potential economic impact it might have on office demand as we move into the phased reopening post Circuit Breaker. The stock market has been exuberant with the end of Circuit Breaker on 1 June, but the critical factor for the office sector is how quickly the economy can recover.
  • Based on the past three economic crises (Asian Financial Crisis (AFC), SARS and Global Financial Crisis (GFC), we observed that office demand in downtown core tracks very closely to GDP, both bottoming out in tandem. On trade sectors, office demand remains most positively correlated to GDP from the finance and insurance sector despite increasing demand in the past few years from the information and technology trade sector, and real estate business and services trade sector.
  • Similarly, during the GFC, office REITs’ share prices tracked closely to GDP and GDP from finance and insurance sector, hitting a trough at similar period when GDP bottomed out.

2Q20 will be the bottom for the current COVID-19 recession.

  • Our DBS economist forecasts FY20F GDP to decline by 5.7% y-o-y before recovering to 3.5% y-o-y growth in FY21F. Headline GDP growth figure will contract the most in 2Q20 by 8% y-o-y but GDP (in value) will likely bottom out in 3Q20.
  • As such, while we expect office net demand to start declining in 2Q20 in tandem with the GDP, it will also likely mark the bottom. Post 2Q20, we believe office net demand can start to recover when GDP bottoms and drive the re-rating of office REITs.

Supply conducive for recovery

Minimal net supply until 2022 a catalyst for a quicker recovery.

  • We estimate that there will be little to no net supply until 2022 that could possibly be a push factor to drive the next wave of recovery in the office sector. As we head into an economic downturn, we believe the low levels of net supply, coupled with record-low vacancies currently, are saving graces in facing the economic uncertainties, limiting the risk of a significant deterioration of fundamentals. These two factors, in our view, would set this economic crisis apart from previous economic crises.
  • We believe that this current downcycle will likely be shorter and less steep leading to a quicker recovery in office sector post COVID-19. We believe the tight supply will better help support the demand and supply balance in the office market.
  • Over the next three years (FY20F-FY22F), we estimate a total of only 71k sqft of new net supply in downtown core assuming that
    1. two major office buildings slated to complete in FY22F previously, Central Boulevard Tower and Guoco Midtown, will be delayed by one year due to the delays in construction caused by the COVID-19 pandemic,
    2. redevelopment of office buildings previously highlighted will proceed according to plan, resulting in displacement of demand.
  • This is the lowest level of net supply during an economic crisis. During past economic crises (AFC, 2001-2003 crisis / SARS, GFC), total net supply over a 3-year period ranged from 818k-2,842k sqft.

How does the future of work look like?

Impact from structure changes on office demand will be progressive.

  • The COVID-19 pandemic has changed many norms and quickened the adoption of technology in many aspects including work. The successful implementation of work-from-home (WFH) thus far has change the conventional perception on the need to work in the office.
  • Given the uncertain economic outlook, corporates are becoming increasingly more cost conscious and would likely reduce their budget allocations on office renovations/relocations to necessary basis only. This pushes corporates to right-size their office space needs and they are likely to prefer renewals of existing leases vs relocation.

Near-term demand drivers.

  • Aside from economic impact on office demand, we believe there are a few moving parts that may cause changes to office space needs in the near and longer terms, post Circuit Breaker. While these dynamics are mixed, we expect longer-term structural impact to be partially offset by shorter-term needs to cope with safe distancing measures.
  • Office rationalisation decisions to take time. As more and more recognise that WFH is possible, more flexible work arrangements may lead corporates to review their office space needs to right-size their needs partly to conserve cash and manage costs. However, we expect these structural changes to impact a portion of the office space and to be executed progressively when leases are up for renewals.
  • Safe distancing in the work place – more space may be needed, instead of lesser. Although the Circuit Breaker has been lifted, we believe safe distancing measures will remain until the spread of the virus is under control. Hence, the average space per employee in office may increase to accommodate safe distancing between employees. In the short term, corporates may retain existing office space and readjust working arrangements in order to ensure a safe working environment for all staff. We do not rule out the possibility of some companies requiring more office space to cater for these needs.
  • Business continuity plan needs to drive split office sites. We believe there may be some increasing demand for business continuity plans (BCP). While we do not know how long this pandemic will last, we believe the longer safe distancing measures are required, the higher the office demand for BCP needs, particularly regional office space and even business parks.
  • Given the uncertainty for now, we believe that corporates are likely to prefer rent renewals rather than relocations not only for cost purposes

Flexible space needs will increase post COVID-19; landlords to put their game.

  • Co-working operators are one of the few office tenants that are most impacted by COVID-19. Co-working centres have not been able to operate at full capacity owing to Circuit Breaker and safe distancing guidelines. In addition, very short lease terms allow subscribers/tenants to easily suspend/reduce rents paid.
  • However, we expect the need for flexible space remains and will increase post COVID-19 in line with increasing structural shift to accommodate a “core + flex” in working operational needs. However, these demand for flexible space may not entirely be translated into demand for co-working spaces. We see increasing need for office landlords to up their service provision to meet the short-term needs of tenants within their buildings especially common areas such as meeting rooms with conference call facilities. This caters for more privacy and exclusivity compared to co-working centres.

Rental waiver Bill mandates a higher out-of-pocket rental support but to targeted tenants.

  • The new rental waiver bill will make it mandatory for office landlords to provide more out-of-pocket rental waivers to their office tenants with the mandatory top-up of one month vs previously when most office landlords have been just passing through property tax rebates up to 0.5 month of top-ups only for targeted tenants. With more clarity on the eligibility of tenants to rely on this bill, the mandatory rental support is more targeted vs a portfolio-wide provision.
  • We understand that among the five office S-REITs, the SME tenants account for 5-40% within their office portfolio while its retail segment sees a higher composition of > 50%.

Top picks are Keppel REIT and Mapletree Commercial Trust for the quality of their portfolio and pure plays by asset class/geography.

  • In view of the expected GDP contraction in 2Q20 and 3Q20, we acknowledge that the recent stock market rally is likely to be liquidity driven rather than an expectation of a rebound in fundamentals. That said, we do see that a recovery is upon us in due course. While we may be a little early in this upgrade call for office sector, we see attractive risk/reward ratios at an average of 0.8x P/NAV for the office S-REITs. We believe the sector remains attractive to ride on potential recovery post COVID-19 and any potential share price weakness upon the release of GDP data would be a good entry opportunity.
  • Our top picks for the sector are Keppel REIT (SGX:K71U) and Mapletree Commercial Trust (SGX:N2IU) with Target Price of S$1.35 and S$2.25 respectively, for the quality of their portfolio and pure plays by asset class and geography respectively.
  • We upgrade CapitaLand Commercial Trust (SGX:C61U) to BUY from HOLD and raised our Target Price to S$1.95 riding on the re-rating of CapitaLand Mall Trust's share price due to the merger of both companies.
  • We maintain our BUY rating on Suntec REIT (SGX:T82U) and OUE Commercial REIT (SGX:TS0U) but lower our Target Price to S$1.81 and S$0.50 respectively.
  • See valuation table of Singapore Office REITs in PDF report attached below.

Singapore Office REITs

Key risks.

  • Factors that could derail our thesis include
    1. slower-than-expected rebound in the economy,
    2. office buildings’ redevelopment plans are delayed given the slowdown in economic growth and supply chain disruptions due to COVID-19, and
    3. ongoing projects, especially Central Boulevard Towers and Guoco Midtown, remaining on track to complete in 2022.

Rachel TAN DBS Group Research | Derek TAN DBS Research | https://www.dbsvickers.com/ 2020-06-08
SGX Stock Analyst Report BUY MAINTAIN BUY 1.350 DOWN 1.45