Manulife US REIT - Phillip Securities 2020-07-20: Quality That Speak For Itself; Initiate Coverage With BUY


Manulife US REIT - Quality That Speak For Itself; Initiate Coverage With BUY

  • Manulife US REIT's favourable portfolio attributes – occupancy of 96.5%, long WALE of 5.7 years, built-in rental escalation (c.2% p.a.), low expiries (4.4%/6.4% FY20/FY21), and high tenant retention of 76% in FY19.
  • Relevance and preference for a physical workplace to continue; demand for office to moderate not abate.
  • Initiate coverage on Manulife US REIT with a BUY and Target Price of US$0.78; attractive FY20e/FY21e yield of 8.8%/9.0% and 0.88x P/NAV trading close to historical low (0.8x).

Manulife US REIT - Background

  • Manulife US REIT (SGX:BTOU) is a Singapore real estate investment trust (REIT) listed on the SGX since 20 May 2016. It has expanded the portfolio by acquiring 6 properties since listing.
  • As at 31 March 2020, Manulife US REIT's portfolio comprises nine prime freehold office properties strategically located in Los Angeles, Irvine, Atlanta, Secaucus, Jersey City, Washington, D.C. and Virginia with a combined asset value of US$2.1 billion as at 31 December 2019.

Manulife US REIT - Investment Merits

1. Favourable portfolio attributes – occupancy of 96.5%, long WALE of 5.7 years, built-in rental escalation (c.2% p.a.), low expiries (4.4%/6.4% FY20/FY21) and high tenant retention of 76% in FY19.

  • Income visibility owing to portfolio WALE of 5.7 years and built-in rental escalation (c.2% p.a.). Smaller tenants (occupiers of space) typically enter 3 to 5-year leases, mid-sized tenants opt for 5 to 7-year leases and large tenants will commit to longer leases of c.10 years. Manulife US REIT’s WALE of 5.7 years is long compared to the WALE of office SREIT and is due to the proportion of large tenants in the portfolio. Due to the higher percentage of leases with long terms, lease expires for FY20 and FY21 are 4.4% and 6.4% by GRI respectively, which is favourable given the weaker business sentiment induced by the COVID-19 pandemic, which is expected to put pressure on leasing demand.
  • Longer leases tend to have rental escalations written into them. 95.6% of Manulife US REIT’s leases have embedded rental escalations which average 2.0% per annum (p.a.), providing rental growth.
  • Quality attracts quality. Manulife US REIT’s has maintained high portfolio occupancy above 95% since listing and its portfolio enjoys and above-average occupancy for the majority of its comparable submarket.
  • Manulife US REIT’s high occupancy is attributed to its portfolio of Grade A and Trophy assets which are well-amenitised, located in cities with skilled work force and work-live-play characteristics. These assets usually attract HQ and mid-to-large tenants who tend to have stronger balance sheets. The top 10 tenants contribute 14.6% to GRI and have WALE of 6.7 years, majority of which are listed entities and/or use the space as HQ locations.
  • Portfolio anchored by trade sectors that are the pillars of the economy (Legal 22.2%, Finance 20.2%). While lockdowns have resulted in only 10-20% of tenants operating within Manulife US REIT’s properties, business disruptions have been mitigated by the ability to telecommute. A vast majority of Manulife US REIT’s rents up to June have been collected, with only 2% of rental deferments provided to retail and F&B tenants in April. Regardless of the economic cycle, the Finance and Legal sectors will remain a resilient cornerstone of the economy and we think that a portfolio anchored by tenants in these trade sectors will prove more stable.

2. Attractive valuations – 0.88x P/NAV near -2 standard deviation (SD) level, 3.28% yield spread at +1 SD level.

  • P/NAV of 0.88x at historical lows and attractive for Manulife US REIT’s portfolio quality. We deem Manulife US REIT’s portfolio as strong due to the visible income from rental escalations (2.0% pa), low expiries in the coming years and long WALE of 5.7 years. The high collectability of rents (only 2% of rental deferments provided in April) is also indicative of the quality of tenants in Manulife US REIT’s portfolio. And as such, while we do expect a softer leasing environment, the income visibility from existing leases is high.
  • Manulife US REIT will provide high yields of 8.8%/9.0% for FY20e/FY21e in the current low-interest rate environment. With interest rates expected to remain low (MAS10YSGS below 1% since May 2020), we think that the 8.8% yield Manulife US REIT provide are attractive, especially given Manulife US REIT’s stable stream of rental income. Yield spread of 3.28% is close to the +1 SD level.
  • The resilience of office assets. Credit report by Moody’s Investor Services highlighted that pockets of distress can be seen in lodging properties, where 22% of loans in CMBS deals were delinquent as of June, followed by 17% for retail properties but only 2.2% for office buildings, according to S&P Global Ratings. We think that office valuations will be more stable due to the stronger the financials of office landlords, as most office-using tenants experience lower business disruption in this COVID-19 environment, leading to higher collectability of rent and lower amounts of rental waivers and deferments.
  • Longer leases in the US office market to provide support for leasing demand. According to Moody’s, majority of lease terms are longer than 8 years - 37% of larger office leases will not expire until the next four to eight years, and a more significant 43% have lease terms of 8 to 12 years. The muted supply in the submarkets where Manulife US REIT operates bodes well for the REIT and will help to support rents.
  • Unemployment data is not so bleak for office tenants. Unemployment data showed marginal improvement, declining from a peak of 14% in March to 11.1% in June 2020. However, the unemployment rates for Financial activities and Professional & Business services was 5.1% and 8.6% respectively, the lowest and third lowest amongst the industries. Nonetheless, unemployment rates for these two sectors were 3.1ppts and 5.0ppts higher as compared to June 2019. Tenants in the Legal (22.2%) and Finance & Insurance (20.2%) are the top 2 contributing trade sectors for Manulife US REIT.

3. Continued relevance and demand for office space; demand for office to moderate not abate

  • Office space demand by Top 3 leasing drivers (tech, financial and professional services) which have a predisposition for the office workplace setting. Tech, finance and insurance and legal were the first, second and sixth driver of tenant demand in 2019. Legal (22.2%) and Finance (20.2%) are the two largest trade categories for Manulife US REIT.
  • The finance and legal sectors are long-standing pillars of the economy have a long heritage of refining how they do business. The existence of virtual conferencing tools predates COVID, but the fact that these sectors still choose to conduct certain functions/elements of business in the flesh implies that these sectors are best served by office premise and explains the predisposition for the office environment. We believe that the structural shifts in the office landscape will be gradual rather than immediate, with the desire for physical collaboration and networking resulting in the maintenance of an office address.
  • The desire to return to the office is higher for the US finance sector. The largest U.S. bank by assets, JPMorgan Chase & Co has established a task force to help locations establish plans for reopening, whereas Citigroup is weighing the option of opening satellite offices outside New York City through short-term leases.
  • Physical interaction viewed as the most effective mode for mentoring, collaboration, and innovation. The US is one of the developed markets with the highest telecommuting workforce pre-COVID. US is one of the markets that has employed a substantial c.15% of remote-working pre-COVID. Proponents of the office environment continues to view the office setting as a more ideal workplace for efficiency, productivity, collaboration, and creativity.
  • According to Gensler’s US Workplace Survey from 2013 to 2019, office work has evolved from an individualistic mode (2013: 50%; 2019: 45%) to one that is more learning and collaborative. While collaborating virtually has doubled to 14% in 2019 since 7% in 2013, physical collaboration has also roughly doubled (201: 17%; 2019: 30%). Barring containment measures imposed by the COVID-19 pandemic, the trend study show that the while collaboration amongst employees is on the rise, the physical face-to-face mode of collaboration is as valued as virtual collaboration.
  • Offices are the traditional choice for high value-add activities which require problem solving and creativity as the dedicated and open structure of modern office spaces encourages cross-functional collaboration and idea-sharing. It is also believed that a well-amentised and dynamic work environment helps to attract and retain employees, which in part explains how Manulife US REIT’s Grade A and Trophy assets continue to outperform its competitive set in the various submarkets.

Key risks

Higher than expected adoption of remote working and weaker than expected leasing environment.

  • We have projected for a softer leasing environment owning to lower business formation/expansions and structural shifts towards a more office-light model. A weaker-than-expected leasing environment will result in underperformance versus our estimates.

Changes in tax regulations, affecting tax exemption and deductibility of dividends.

  • Manulife US REIT’s tax structure is efficient in that it minimises taxes. However, it is susceptible to adverse policy changes that may result in tax leakages.

Initiate coverage on Manulife US REIT with a BUY rating and a Target Price of US$0.78.

Natalie Ong Phillip Securities Research | https://www.stocksbnb.com/ 2020-07-20
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