Prime US REIT - Phillip Securities 2020-07-20: Prime For Resilience; Initiate Coverage With BUY

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PRIME US REIT (SGX:OXMU)

Prime US REIT - Prime For Resilience; Initiate Coverage With BUY

• Prime US REIT's attractive yields of 8.9% underpinned by resilient portfolio attributes.
• Long WALE with minimal lease expiry in FY20, diversified income contribution and built-in rental escalation to support the portfolio’s gross rental and distributable income.
• Initiate coverage on Prime US REIT with a BUY and a target price of US$0.88.

Prime US REIT - Background

• Listed on the SGX on 19 July 2019, Prime US REIT (SGX:OXMU) invests in office and real estate-related assets in the United States of America. Prime US REIT’s portfolio consists of 12 Class A freehold office properties that are valued at approximately US$1.4 billion, strategically located in 10 primary markets in the US. As at 31 March 2020, no single market and sector within its tenant mix contributes more than 13.5% and 15.1% to the overall portfolio (Largest market: Atlanta, Largest sector: Finance).
• Prime US REIT's portfolio maintains high occupancy rates of 94.9% with a long portfolio WALE of 4.9 years.

Prime US REIT - Investment Merits

1. Attractive FY20 dividend yields at 8.9%, 8% higher than that of US treasury yields.

• In this economic climate where global interest rates have fallen, Prime US REIT presents attractive yield spread of 8% to the US 10-year treasury yields. Prime US REIT is currently trading at 0.86x by P/NAV. Our forward dividend yield for Prime US REIT in FY20e and FY21e is 8.9% and 9.5% respectively.

2. Resilient portfolio attributes – Long WALE with minimal lease expiry in FY20, diversified income contribution and built-in rental escalation to support GRI.

• Income visibility and stability is supported by long portfolio WALE of 4.9 years, with only 5.7% of the leases are expiring in FY20. Lease expiries are also well staggered, with a maximum of 17.3% of leases expiring in the next 4 years.
• Approximately 98% of the leases have in-built rental escalations of 1-3% p.a, which provides a clear organic growth outlook for Prime US REIT. Majority of leases by net leasable area (NLA) are on a triple-net or modified gross basis, shielding Prime US REIT from increases in real estate taxes and property expenses. To top it off, the leases expiring in FY20 and FY21 are leased at an average of 7% below market, hence there may be potential rental reversions to help drive rental and distributable income.
• With no market and sector contribution exceeding 13.4% and 15.1% respectively, Prime US REIT offers high levels of diversification in terms of its market, asset and tenants mix. 33.4% of the tenant mix is exposed to the Science, Technology, Engineering, Math (STEM) and Technology, Advertising, Media and Information (TAMI) sectors, which is the growing segment in the US. Additionally, all of Prime US REIT’s properties are Class A buildings. We believe that a high quality and diversified office portfolio offers more resilience in times of uncertainty.
• Refer to Appendix I – Market outlook for Prime US REIT’s properties in PDF report attached below for more details.

3. Robust balance sheet through proactive capital management…

• As of 1Q20, Prime US REIT continues to maintain its gearing ratio at a healthy level of 33.7% and interest coverage ratio of 5.8x. There will be no refinancing required until 2024 as extension options are available to extend both Revolving Credit Facilities and Term Loans maturing in FY22 and FY23. Near term interest rate risks are also mitigated as close to 89% of the debt is locked into fixed interest rates.
• Separately, Prime US REIT restructured its existing interest rate swaps by entering into a new agreement on its borrowings through 2026. It effectively lowers the weighted average interest rate for the portfolio from 3.3% to 2.8%. Hence, subject to new loans from additional capex needs, we are not expecting interest costs to weigh heavily on Prime US REIT’s cost front.
• With a tax-efficient REIT structure, Prime US REIT’s headline tax expenses mostly reflect deferred tax expenses, which will only be realized upon sale of the properties in the portfolio. This reduces cash taxes payable, which results in more distributable income for unitholders. Additionally, Prime US REIT’s REIT structure has no tax leakage through federal income or withholding taxes, provided that the unitholders comply and furnish the required documents for Portfolio Interest Exemption. Refer to Appendix II – Prime US REIT’s Structure in PDF report attached below for more details.

4. Reputable sponsor and management team associated with one of the largest U.S. commercial real estate managers.

• Associated with KBS, one of the largest commercial real estate managers in the U.S., KBS Asia Partners (KAP) is the sponsor of Prime US REIT. KAP owns 40% of Prime US REIT’s manager, KBS US Prime Property Management. The remaining stake is held by Keppel Capital (30%), Singapore Press Holdings (20%) and AT Holdings (10%). KBS-affiliated entities invest in and manage commercial real estate assets on behalf of clients. To date, KBS has registered $41.7bn worth of transactional volume with over $8bn of AUM since inception.
• KBS has presence in all the states that Prime US REIT has presence in. Given that KBS has successfully managed properties through 4 disruptive events, its expertise and track record present more value to Prime US REIT’s organic growth potential through troubled times. Separately, Prime US REIT will also be able to benefit from KBS’ deal sourcing, deal screening and deal execution capabilities for inorganic growth opportunities. We believe that KBS will be able to help Prime US REIT navigate through occupancy woes in times of stress and offer a platform for future growth prospects when the market turns around.

5. Prime’s properties are situated in areas where the office market is attractive and still “landlord favourable”.

• Many Americans are looking to leave expensive coastal cities, including San Francisco, Los Angeles and New York for more affordable areas that still offer the amenities of a major city.
• Similarly, attributes like being home to a young population, a highly educated workforce and better affordability are key qualities in a city companies gravitate to as they poised themselves for growth.These attributes are evident in the markets where Prime US REIT is in.
• According to Redfin, Dallas (7.7% of CRI), Atlanta (12.8% of CRI) and Prime US REIT’s newest market, Sacramento (9.4% of CRI) are within the list of top 10 cities Americans are moving into in 4Q19. For the whole of 2019, we see Utah (13.4% of CRI) and Texas (6.2% of CRI) sustain a high population growth rate, while none of Prime US REIT’s key markets fall within the bottom 5 states by population growth.
• We expect under-rated cities with amenities and attributes of a major city to be more attractive to US companies and citizens moving forward, exacerbated by more permissive policies around remote work and an overall shift towards greater affordability during times of duress.
• According to Cushman and Wakefield, Prime US REIT’s portfolio is in the stage of the office market cycle where it is “landlord favorable”. Sacramento, its newest market is in the accelerating stage of the office market cycle, like that of Dallas’ and Philadelphia’s.
• Overall, Prime US REIT has exposure in 8 markets where rent growth is expected to accelerate, and 2 markets where rent growth will still be slow but positive.

6. COVID-19 Update: No rent forgiveness; rent collections for May and June are at 99%, with June’s collections on track.

• Most of Prime US REIT's leases do not have pre-termination clauses, so tenants are obliged to compensate till their leases expire in a case of lease break. As of date, only 11 rental deferments are provided to small retail tenants which contribute less than 1% of the GRI. These businesses are amenities to the buildings. Majority of the rent deferrals are expected to be recouped this and next year, while the remaining deferrals included lease extensions equivalent to the number of months’ rent that was deferred.
• Apart from Sodexo, Apache and WeWork, majority of Prime US REIT’s top 10 tenants are established tenants. All of Prime US REIT’s top 25 tenants which constitute 64% by CRI have paid 100% of April’s and May’s rent. Amidst uncertainty in the outlook for co-working spaces, it may comfort investors to know that the rents from all co-working entities (WeWork + 3 smaller operators) have been collected.
• Additionally, Prime US REIT holds a letter of credit and corporate guarantee equivalent to USD$2mn (~8 months of rent) should WeWork default on their obligations. Prime US REIT holds approximately 3 months of the portfolio’s gross rental income in the form of security deposits, letter of credit and bank guarantees.

Risk Factors

Debilitated economy to slow leasing activities for Prime US REIT in 2020.

• Slower global growth is expected in 2020; we expect leasing activities to weaken as businesses are impacted by the recent escalation of events from COVID-19. While at least half of Prime US REIT’s expiring leases (5.7% of GRI) are expected to be renewed, greater investor caution and selectivity coupled with lockdown inconveniences will increase the time required to close new leases.

Weakness in co-working spaces.

• Co-working tenants are expected to be hit hard by the outbreak, due to their focus on short-term leases and a reliance on users coming into the office. Demand for co-working spaces is expected to remain soft, which poses uncertainty to Prime US REIT’s income stream. Nevertheless, the total proportion of co-working spaces in the portfolio is only 3.7%.

Initiate coverage on Prime US REIT with a BUY rating and a Target Price of $0.88.

• Our DDM-derived target price for Prime US REIT is based on a five-year projection, cost of equity of 9.96% and terminal growth rate of 2%. It translates to a FY20e dividend yield of 8.9% and a total return of 24%. In our models, we estimated a 1-3% annual escalation rate for the leases.
• See Prime US REIT Share Price; Prime US REIT Target Price; Prime US REIT Analyst Reports; Prime US REIT Dividend History; Prime US REIT Announcements; Prime US REIT Latest News.
• In light of a lacklustre leasing environment going forward, we accounted for a 5% impact to NPI through an increase in property expenses, as well as a 50% renewal rate for the expiring leases in FY20.
• See comparison of US Office REITs - Keppel Pacific Oak US REIT (SGX:CMOU), Manulife US REIT (SGX:BTOU) and Prime US REIT (SGX:OXMU) in PDF report attached below.

Tan Jie Hui Phillip Securities Research | https://www.stocksbnb.com/ 2020-07-20

SGX Stock Analyst Report BUY INITIATE BUY 0.88 SAME 0.88