Prime US REIT - RHB Invest 2020-12-03: Primed For Resilience; BUY For 9% Yield

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PRIME US REIT (SGX:OXMU)

Prime US REIT - Primed For Resilience; BUY For 9% Yield

• Prime US REIT (SGX:OXMU) derives rental income from a portfolio of 12 freehold office assets in the US. Despite the US’ severe COVID-19 situation, we expect the company to see stable rental income, due to its strong asset and tenant quality, and limited near-term lease expiry. Its sustainable yield of 9% is among the highest in the REIT sector, and is unjustified, in our view, compared to the 5.4% S-REIT peer average.
• Initiate coverage on Prime US REIT with BUY and USD1.00 target price, 30% upside and c.9% yield.

Prime US REIT - Investment Highlights

Diversified portfolio across 10 key US office markets.

• Prime US REIT’s portfolio comprises 12 freehold Class A office buildings located across 10 key markets in the US. The portfolio has a total NLA of 3.9m sqf, and is currently valued at USD1.43bn. The assets are well spread across the East Coast (31%), Central (57%) and West Coast (12%).
• The assets are well-diversified with no asset accounting for more than 15% of total portfolio value. Prime US REIT's key assets are 222 Main (15%), Village Center Station I & II (16%), and 171 17th Street (13%), which account for c.44% of total value. Similarly, there is no concentration risk to any single market, with Denver (16%), Salt Lake City (13%), and Sacramento (12%), being the Top 3 markets in terms of portfolio value.
• Most of Prime US REIT's assets are new or recently refurbished, with good amenities, and located across low density urban environments, which have a highly educated workforce.

Strong rent collection and limited rent relief.

• Despite the US economy suffering a sharp negative impact from COVID-19, Prime US REIT has maintained a high rent collection rate of 99%, between March and September this year. This, in our view, highlights the good credit quality of its tenants, and portfolio exposure to the right market sectors.
• Prime US REIT also granted only USD0.2m in rent deferrals in 3Q (YTD: USD0.27m) to tenants of small retail businesses and other impacted industries. Management does not expect any significant requests for rent waivers or deferrals in the near future.

Positive rent reversions of 9% year-to-date.

• Despite the US’s leasing activities taking a big hit on the back of COVID-19, Prime US REIT has managed to sign 165,517 sqf of leases (4% of portfolio) year-to-date 2020, with nearly half of them signed in 3Q. About 60% of them are from renewals/ expansions by existing tenants. New tenant signings were mainly from established sectors, including the technology sector. Key new/renewal tenants include Nutraceutical, California Nurses Association and State Farm Insurance.
• While we expect some downsizing or right sizing of tenants in the future, we see strong demand from technology, healthcare and government-related tenants to partly offset the impact. In addition, the ongoing de-densification trend – by which tenants need more psf space per employee for safety and social distancing measures – is also likely to have a positive impact on office demand.

Portfolio average rent still 7% below market.

• Rent at eight of Prime US REIT’s 12 assets in place are still 0-31% below asking rents, as seen in Figure4 in PDF report attached below. Only Reston Square’s rents are significantly higher at 12.5% above asking rents. However, we note that the asset has no lease expiry until 2021, and accounts for only 5% of total income.
• In FY21F, we expect flattish to slightly positive rent reversion for Prime US REIT’s portfolio.

In-built rent escalation of 2% provides organic DPU growth.

• A key highlight of the US office rental structure, is that most of the office leases have inbuilt annual rent escalation clauses attached – unlike Singapore’s office leases, which are typically signed on fixed terms during the lease period – with the exception of certain long-term leases.
• In Prime US REIT’s case, 99.8% of CRI has built-in rental escalations, averaging 2%. Note that these positive rental reversions are on top of annual rent escalations. This in-built rent escalation clause provides good organic growth visibility to unit holders in the current low-inflation environment.

Less than 11% of leases expiring until 2021.

• In 4Q20, Prime US REIT has only 2% of leases (by CRI) due for renewal, and for FY21 there are c.9% leases due for renewal.
• Upcoming leases are well spread out across assets, with no more than 2% of leases due for renewal in any single asset until 2021. This, in our view, provides good near-term buffers in light of current market uncertainties. Overall WALE also remains healthy at 4.6 years.

Diversified sector and tenant profile.

• Prime US REIT has a wide range of exposure to various industries, with no one sector accounting for more than 16% of total income. More than 70% of its rental income is derived from established growth sectors such as communications & information; medical, biotech & healthcare, and professional/ technical services.
• Prime US REIT has exposure to c.230 tenants across its portfolio, with its Top 10 tenants accounting for c.42% of its CRI. Most of its Top 10 tenants are blue chip names, with the Top 3 contributions coming from Charter Communications, a leading American telecommunication and mass media company, which recently expanded its office space at Village Center Station, followed by Goldman Sachs, a leading global investment bank, and Sodexo, a food service and facility management service company.
• One risk to watch out for, would be that of Prime US REIT’s exposure to the co-working firm WeWork, (2.4% by CRI) which recently saw its credit rating downgraded by Fitch.

Low gearing provides inorganic growth opportunities.

• Since its listing in Jul 2019, Prime US REIT has grown its distributable income both organically and inorganically. In February, it announced its maiden acquisition of Park Tower, Sacramento, which was accretive to both its pro forma DPU (+3%), and NAV (+0.1%).
• Prime US REIT’s gearing of 32.7% is one among the lowest among S-REITs, and presents a debt headroom of USD324m for acquisitions (assuming 45% levels). This, in our view, presents good headroom for accretive acquisitions in 2021.
• Management noted that it is on the lookout, but does not see any distressed opportunities in the market. Key potential markets for acquisitions are Nashville, Salt Lake, Atlanta and Philadelphia. Future acquisitions will be guided by the principle of diversification accretion and market fundamentals.

Backed by strong sponsor names in the US and Singapore.

• One of the key strength of Prime US REIT, is its strong sponsor backing from KBS group (40% stake in REIT manager), which is one of the leading US office players with USD8bn assets under management (AUM).
• Keppel Capital, the asset management arm of Singapore-listed Keppel Corp (SGX:BN4) owns a 30% stake in the manager, and provides support services on the ground. Other than this, Singapore-listed media and property company SPH (SGX:T39) owns a 20% stake in the REIT manager, and has active board representation. The remaining 10% stake is owned by AT Capital, one of Asia’s leading private investment firms.

Fee structure in line with peers.

• The base fees (10% of distributable income) and performance fees (25% of DPU growth) are well-aligned to deliver stable DPU returns, and generate better shareholder value. In comparison, the majority of office S-REITs’ base and performance fees are pegged as a proportion of portfolio value and NPI.
• Property management fees – 0.85-3% of gross revenue – are on the lower side compared to the majority of its office REIT peers.
• The acquisition fee rate is set at 1%, but can be adjusted lower (at the manager’s discretion) for acquisitions from the sponsor.
• Figure11 in PDF report attached below shows the detailed comparison of Singapore office REITs (Prime US REIT, Keppel Pacific Oak US REIT (SGX:CMOU), Manulife US REIT (SGX:BTOU), Keppel REIT (SGX:K71U), OUE Commercial REIT (SGX:TS0U) and Suntec REIT (SGX:T82U)'s fee structure.

Prime US REIT - Financials

Expecting stable revenue and NPI for the next three years.

• Prime US REIT’s revenue (3-year CAGR) and NPI are expected to grow at 2% pa, as anticipated slight occupancy reductions are offset by built-in rent escalations (2%) and positive rent reversions. Our DPU forecasts assume a 100% payout ratio.

Occupancy and rent assumptions.

• We estimate that Prime US REIT's overall portfolio occupancy will slightly dip to 93% in FY21F (FY20F: 94.8%), as some leases could be non-renewed or take longer to backfill, in light of current uncertainties.
• Our sensitivity analysis on occupancy changes shows that every +/-5% change in overall portfolio occupancy will have a corresponding +/-7% impact on our FY21F-23F DPU estimates for Prime US REIT. For rent, we have assumed that new leases are secured at a 5-10% discount to current asking rents.

Cap rates have remained largely steady, pointing to limited valuation downside.

• Based on consultant reports and discussions with REIT mangers, we note that US office asset cap rates have remained relatively stable year-to-date.
• Overall, we expect portfolio valuations to come down by 3% for this year, mainly on the back of revised assumptions for occupancy and lower rent growth. For 2021F, we have assumed a 1% decline in portfolio value.

No debt maturity until 2022.

• Prime US REIT’s weighted average debt maturity (WADE) stands at 4.4 years (4.9 years fully-extended), with no debt maturity until 2022. Average cost of debt stands at 2.7% pa, with 91% of debt currently in fixed term. Interest cover also remains healthy, at 5.8x, well above minimum requirements.
• Prime US REIT also has an available undrawn facility of USD91.4m to tap into, for liquidity purposes and working capital needs. In our model, we have assumed stable interest costs over the next three years, considering limited debt maturity.

Minimal capex requirements in the near-term.

• As Prime US REIT’s assets are all relatively new/refurbished, the REIT manager expects only minimum maintenance capex for the assets in the near-term – we have estimated c.USD2-3m pa for the next three years.

Tax efficient structure.

• Prime US REIT’s existing tax structure involves deriving income from its parent US REIT, in the form of interest/principal repayments on its shareholder loan, which is exempt from tax in the US and Singapore.

Zero tax for dividends for all unitholders.

• A key advantage of US office REITs (Prime US REIT included), compared to S-REITs with only Singapore assets, is that the dividends are tax-exempt for all types of unitholders.
• In the case of S-REITs with Singapore assets, local institutional investors incur a 17% corporate tax, while foreign institutions are subject to a 10% corporate tax. This is because foreign-sourced income by REITs are not subject to tax under Singapore regulations – resulting in substantial tax savings for institutional investors.

Payment of fees in units.

• Our DPU forecast for Prime US REIT assumes 80% of management fees will be paid in units, similar to the current payment structure.

Semi-annual distributions.

• Prime US REIT declares and distributes dividends to unitholders on a semi-annual basis. The dividends will be declared in USD. The default currency for distribution is S$, with an option to elect dividends in USD. For distribution in S$, the dividends are converted at spot exchange rates.

Prime US REIT - Valuation

BUY with USD1.00 target price; resilient and attractive 9% yield.

• Our DDM-based (5-year) target price for Prime US REIT is based on a CoE of 9.0% (risk-free rate: 3.0%, terminal growth (TG): 2%). We believe our higher COE assumption (c.200bps higher than SG office REITs assumption) sufficiently buffers the risks associated with a severe COVID-19 situation, slowdown in office demand, and US-China trade tensions.
• Our DPU forecast is based on a 100% pay-out ratio, and 80% of management fees being paid in units.

Sensitivity analysis.

• Based on our sensitivity analysis to CoE/TG, we note that every 50bps change in CoE/TG has a c.8% and 6% impact to our target price.

High yield gap to S-REITs unjustified.

• Our target price corresponds to 1.2x FY20F P/BV. The implied yield at our target price is 7%, which is still more than a 150bps premium to S-REITs and office S-REITs average, and more than 600bps higher than US 10-year Treasuries. In comparison, Prime US REIT's US-listed peers (see Figure20 in PDF report attached below) are currently trading at an average forward dividend yield of just 4.9% and P/BV of 1.4x.
• The high yield gap of Prime US REIT and other US office REITs is unjustified, in our view, considering that US office leases are typically longer, at 5-10 years, and have in-built rental escalation clauses which provide organic income growth. It is also important to note that US office assets are freehold in nature, compared to a typical 99-year lease for Singapore commercial assets.

US office sector's industry outlook

Leasing activity stabilises in 3Q; Sub leasing space key to watch out for.

• According to JLL Research (3Q20), leasing activity remained severely depressed but improved marginally on a q-o-q mainly due to a handful of large deals among major technology companies. 3Q transaction volume totalled 25.9 m sqf, well below normal levels of 55-65 m sqf per quarter. Nearly 55% of leasing for the quarter came in the form of renewals on a national basis, with half of major industries firmly in defensive mode and staying put, increasingly in 3-5 year terms.
• Based on Colliers data, office absorption in the third quarter totalled negative 36.1m sqf nationwide – its lowest total in almost 20 years. As a result, US office vacancy rate now stands at 12.6%, an increase of 70 bps in the third quarter. This is still comfortably below the record peak of 16.3% seen at the height of the global financial crisis (GFC), the third quarter increase is the largest to take place since 1Q09.
• Sublease space is a key contributor to the increase in vacancy with a record 168.8m sqf of sublease space available across the US office market – significantly higher than the prior peak of 143.3 m sqf, according to Colliers. There has been a combined 35.5% increase in volume of sublease space on the market over the past six months taking the national sublease availability rate to 1.5%, the highest on record. JLL estimates that the overhang of sublease space available but not yet vacant stands at roughly 47m sqf, foreshadowing large increases in vacancy in 4Q20 and 1Q21.
• Based on CBRE estimates, overall US vacancy rates rose by 1ppt to 14% as at end-3Q20. Downtown office vacancy rates have risen at faster rate of 2.4ppts over the last one year generally due to more construction and constraints on office access. In contrast suburban vacancy has increased by 1.7ppts over past one year.

Asking rents remain steady, but surge in concession packages.

• According to CBRE, average gross asking rents increased by 0.9% from 2Q, reflecting landlords’ reluctance to reduce rents and instead offer more concessions. Based on Colliers data, Average Class-A, full-service office asking rates fell slightly in 3Q20 to USD39.06 psf. Class-A asking rates in CBD markets are USD50.80 psf, down by 2.7% in 3Q while Average Class-A suburban rates held steady at USD32.03 psf.

New construction activity takes a pause.

• According to JLL, for the first time this cycle, the development pipeline shrank slightly in 3Q20 to 124.9m sqf as more than 12m sqf delivered, and ground breakings have dropped dramatically in response to a lack of demand. Tenant improvement allowances are also up 22% at the top end of the market. These surging concession packages have helped to drive down effective rents even as landlords hold face rents relatively steady.

US economy rebounds sharply in 3Q aided by government stimulus.

• Real GDP grew 33.1% in 3Q20, according to the "advance" estimate released by the Bureau of Economic Analysis (BEA), after declining 31.4% in 2Q. The unemployment rate improved for the fourth straight month from 14.7% in Apr 2020 to 6.9% as at end-October. The rebound in the economy was driven by strong economic support from the US Government which included a USD2trn stimulus package to US businesses, families and local governments.

Key office trends post COVID-19: Flexibility the buzzword

• Prime US REIT’s management anticipates the following key trends in the US office market post COVID-19, and has been gearing up its portfolio to position accordingly:
  • Office demand. Technology sectors are expected to be a key sector that will continue to drive office demand for collaboration and innovation. Professional and financial services sectors are expected to provide a stable base of demand. Other than this, the healthcare sector has also emerged as a key counter cyclical sector driving office demand.
  • Location. Attracting talent remains the key priority of companies. Companies prefer locations that offer access to large numbers of skilled employees. The incoming generation of office workers value lifestyle amenities of the urban environment, which have historically weathered event-driven shocks.
  • WFH trends. Even prior to the pandemic, many corporates in the US had WFH policies in place. Key office tenants in general have highlighted that physical offices remain important for collaboration, talent management and development, business development, and creativity. Companies with WFH policies also still require office space for efficiency, creativity, and collaboration. Post COVID-19, however, there is expected to be more focus on more flexible work environments and task-focused approach.
  • De-densification. In the longer term, the balancing between the relaxing of space density and potentially lower office space headcount is expected to mitigate the impact from the flexible work policy approach on reduction in office footprint. Measures in the short term: spread out employees to create less dense environments, create more office collaborative spaces, and use hybrid approach combining WFH and return to office.

Prime US REIT is attractive in most metrics, compared to peers.

• Our comparative study on US office S-REITs shows that Prime US REIT offers the highest yields and trades at an attractive 0.9x P/BV. It also has the lowest gearing, thus offering good inorganic growth potential. Despite COVID-19, its portfolio has registered a +9% rent reversion year-to-date, and strong rent collection of 99% (better than peers), with minimal tenant rent relief (only 0.2% rent deferment), underpinning its good asset and tenant quality.
• 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.
• See Figure1 in the PDF report attached below for the comparison of Prime US REIT with other SGX listed US office REITs - Manulife US REIT (SGX:BTOU) and Keppel Pacific Oak US REIT (SGX:CMOU).

Vijay Natarajan RHB Securities Research | https://www.rhbinvest.com.sg/ 2020-12-03

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