Singapore Property - CGS-CIMB Research 2020-06-18: Reassessing The Office Sector


Singapore Property - Reassessing The Office Sector

  • We expect office viewing activities to resume on slower leasing momentum.
  • There is an ongoing debate on the future of the workplace. In our view, any change is likely to be gradual.
  • We reiterate our Overweight call on the overall Singapore property sector.
  • Our preferred picks amongst office landlords are Keppel REIT (SGX:K71U) and CapitaLand Commercial Trust (SGX:C61U).

Office viewings to resume post Phase 2 circuit breaker reopening

  • With the gradual reopening of the economy under Phase 2 of the post circuit breaker (CB) easing, we anticipate office viewing activities to resume. Under the limits set for Phase 2 circuit breaker reopening, site viewings are allowed, by appointment only and limited to no more than five pax per group.
  • That said, with the government revising down its official GDP growth forecast for the country this year to a range of -4% to -7%, the weaker macro outlook would mean that office tenants would likely take longer to decide on their office space requirements, in our view. Hence, we expect leasing momentum to be slow for the rest of 2020F as office tenants assess the impact of the Covid-19 outbreak on their businesses and are likely to remain cautious on any expansion plans, with some right sizing highly possible.
  • We expect annual net absorption rate of 500k-700k sq ft for 2020F, below the c.1.7m sq ft net demand in 2019 and lower than the past 10-year average of 1m- 1.5m sq ft. We expect occupiers with an appetite for office space to come mainly from the tech, telecom and media sectors.
  • With c.1.9m sq ft of new completions this year, the slower leasing demand would translate into a higher vacancy level of 11.3% by end-2020F, in our estimate. Accordingly, we tone down our office rental projections from the current 0% to -5%, to -5% to -10%, for 2020F.
  • Although existing buildings are likely to experience longer frictional vacancy periods, we believe landlords of existing buildings should likely fare better than their newbuild counterparts as tenants are likely to renew their existing leases rather than incur capex to fit out a new premise in the near term.
  • The upside catalyst to our view is that with the current virus outbreak and labour shortages, we may see slower construction as developers re-evaluate and push back some of their construction or asset enhancement plans, which could help mitigate some of the projected rental declines.

A modest start for office rents in 1Q20

  • According to the Urban Redevelopment Authority (URA) data, the Singapore office market had a modest start in 2020, with overall office rents and values dipping by 0.8% and 4% q-o-q respectively in 1Q20. The decline was due to weaker Fringe Area rental performance, partly offset by a 0.3% q-o-q increase in Central Area rents.
  • On a 12-month perspective, office rents have fallen 4.6% from their highs in 2Q19 even as absorption expanded by 1m sq ft over the same period. Island-wide vacancy stood at 11% as at end-1Q20.
  • Although there was an overall net negative absorption of 75k sq ft in 1Q20, office REITs continued to report active renewal signings, which made up two-thirds of their overall leasing activities during the quarter as companies re-evaluate relocation plans, preferring to stay in existing premises to save on fit-out costs.
  • Office REITs – CapitaLand Commercial Trust (SGX:C61U), Keppel REIT (SGX:K71U), Suntec REIT (SGX:T82U) and OUE Commercial REIT (SGX:TS0U) – recorded positive double-digit rental reversions, signing rents that are 1-32% higher than previous rents.
  • In terms of activities, CapitaLand Commercial Trust signed leases for 303k sq ft of space while Keppel REIT and Suntec REIT signed 171k sq ft and 134k sq ft of space, respectively, in Singapore, in 1Q. The bulk of demand came from the tech, media and telecom (TMT), financial services, insurance, real estate, and industrials sectors as well as some flexible space operators.

Supply beyond 2022F is minimal

  • The supply picture has been well articulated. Supply remains relatively moderate on a 5-year horizon and will likely buffer the impact of any office demand shifts in the longer term. In the near term, the front-loaded new completions (78% of total supply over 2020-2022F) and limited relocation capex budgets would mean heightened competition for tenants to fill up the new buildings, in our view. Even after taking into account any relocation demand from inventory taken out of circulation for redevelopment, the moderated macro outlook would also mean longer frictional vacancy within existing buildings which would likely continue to persist in the near-term office rental outlook, in our view.
  • Based on URA statistics, total new office supply for 2020-2024F is estimated to be around 5.55m sq ft. On an average basis, this supply translates to an average of 1.1m sq ft p.a. over this period, below the average of 1.32m sq ft p.a. over 2010-2019. Of the total supply in the pipeline, about 50% are located in CBD, mainly coming from ASB Tower (completed), CapitaSpring, Central Boulevard Tower, and Guoco Midtown, all scheduled to for completion in 2020- 2022F. Beyond 2022F, there is minimal new supply under development currently.
  • One of the key differences between the current office cycle and the previous one in 2016 is the absence of significant quasi-office or business park supply now compared to 2016 where there was a spike in business park completions. Moreover, a large proportion of the business park space completions over the next two years will be located at Cleantech Loop in the western part of Singapore. Hence, we believe the more affordable quasi-office or business park rents should remain relatively more stable than CBD office rents.

Demand – juggling safety and cost

  • There have been many debates about the longer-term prospects of the office rental market in a post Covid-19 environment and whether there will be a structural shift in demand from office space due to increasingly more work from home (WFH) trends. We make three observations:

1) WFH is here to stay but not all want to WFH.

  • We think the ease of embracing WFH due to advancement of technology that enables people to work anywhere at any time has resulted in increased demand for greater flexibility amongst both employees and employers post-Covid-19.
  • That said, distractions at home and need for social interactions would mean a proportion of employees would still prefer an office working environment. This may mean that overall demand for office space is likely to remain fairly stable for now, although the core/flex split may shift towards more flex space in the longer run. As such, landlords would need to offer ‘offices of the future’ options to tenants, comprising a mix and match of long-term office space (core) with flexible office space (flex).
  • According to Cushman & Wakefield’s ‘The Future of Workplace’ report, through its bespoke Experience per Square FootTM database (XSF) where it has a total of 4.2m data points from both pre-Covid-19 and the current WHM environment worldwide, 73% of respondents think companies should embrace flexible working policies. The new normal will be a Total Workplace Ecosystem that balances office, home and third places.

2) Physical distancing is here to stay for the long run.

  • As the economy re-opens, focus on health safety in the workplace will be key. Apart from social distancing, re-thinking office layouts, staggering work schedules, temperature taking, and using contact tracing apps, other innovations highlighted include investing in more air filtrating systems, installing sneezeguard partitions at desks, putting replaceable covers on tables to avoid contaminating surfaces and indicating safe-zones stand-in spots in elevators.

3) Re-assessing flight to efficiency.

  • Over the past few years, consolidation and expansion activities were one of the office space demand drivers as office tenants sought to make more efficient use of their work space. Post Covid-19, as companies reassess their business continuity plans, we believe the trend to de-densify the office will emerge. This can be done via establishing decentralised ‘satellite’ offices closer to home or creating ‘hub-spoke model’ offices through using co-working spaces, business centres and serviced offices. In this regard, we believe the long-term prospects of co-working operators remain intact.
  • That said, in the near term, the high-density flexible lease model would likely need to be re-looked at to enable social distancing. These changes could also mean taking a pause and scaling back expansion plans while relooking business operating metrics.

What does this all mean?

  • Overall, to put things into perspective, the same study by Cushman & Wakefield indicated that if companies make no changes in enabling flexible working, they could see footprint sizes increase 15-20% as a result of social distancing measures and the establishment of new types of collaborative environments. This can be easily offset with increased flexible working practices.
  • Furthermore, the report said that if 50% of the respondents who indicated they would increase their flexible working would actually do so, then there would be no net change in footprint.

Economic activity still fundamental to demand

  • Ultimately, demand for office space is still a function of GDP growth and business formations. Historically, appetite for office space tends to be closely correlated to GDP growth as well as Singapore’s attractiveness as a cost competitive regional HQ.
  • We project for Singapore to record a 4.9% GDP contraction in 2020F, due to the adverse impact from Covid-19, and recover to 5.3% growth in 2021F, based on our in-house preliminary GDP forecasts. This will likely affect demand for office space in the short term.
  • Under these moderated conditions, we expect net office absorption of c.500k- 700k sq ft in 2020F, down from the 1.7m sq ft of net take-up in 2019. Sectors that continue to expand their footprint include the IT, telecom, media and telecommunication sectors. We expect co-working or flexible space operators, which were one of the major consumers of office space in the past few years, will likely moderate their appetite amid the need to re-evaluate office space needs amid social distancing with the workspace environment.
  • According to Accounting and Corporate Regulatory Authority (ACRA) data, overall net business entities formation remained positive in Apr and May, with 5M20 cumulative net formations equivalent to only 23.5% of 2019's net formations. There were net cessations in the manufacturing, construction, accommodation, information and communications, real estate, admin and support services and arts, entertainment, recreation and other services activities sectors, for the months of Apr and/(or) May.
  • We believe government reliefs to companies announced to date in the form of a 1-month equivalent of property tax rebate and cash grants, which are to be matched by landlords, and the Job Support Scheme (JSS) to SMEs could help to hold off retrenchments, and hence office demand in the near term. However, resumption of economic growth and positive business formations remain long-term demand drivers for office space.

Valuation & recommendation

  • For office landlords and REITs, although near-term outlook does not exactly look rosy, some of these negative effects are mitigated by the low expiring rents, as they were signed at the trough of the market recovery in 2016-2017. This gives landlords room to be more flexible on rents as they adopt a tenant-retention strategy. Moreover, office landlords and REITs have de-risked their portfolios to a certain extent as they had re-contracted a portion of their portfolio lease expiries in 1Q20. For the remainder of CY20F, most office REITs and landlords have a manageable c.6-18% of their office portfolio NLA to be renewed, based on their 1Q20 business updates.
  • While the office segment is not our preferred amongst the various sub-sectors, we note that the valuations of office REITs are not overly expensive, trading at a market-cap weighted average of 4.9% 2020F dividend yield, which is midway between the average and +1 s.d. dividend yield over 2004-2020F and in line with the average yield of the overall SREIT sector.
  • In terms of strategy, we prefer office landlords/REITs with minimal renewals for this year as they are likely to fare better in terms of maintaining portfolio occupancy and still benefiting from positive rental reversion.
  • Our top picks are Keppel REIT and CapitaLand Commercial Trust.
  • See attached 16-page PDF report for complete analysis.

Keppel REIT (SGX:K71U) - ADD, Target Price S$1.20.

Capitaland Commercial Trust (SGX:C61U) - ADD, Target Price S$1.98.

LOCK Mun Yee CGS-CIMB Research | https://www.cgs-cimb.com 2020-06-18
SGX Stock Analyst Report ADD MAINTAIN ADD 1.200 SAME 1.200