Sturdy Balance Sheet

At a Glance

• 9M11 DPU accounted for 83% of our FY11 forecast

• Healthy renewals sustain high portfolio occupancy of 97.7%

• Gearing at 27.4%, the lowest among its office peers.

• Maintain BUY at a lower DCF-based TP of $1.49

Comment on Results

Revenue in line with expectations .3Q11 gross revenue and NPI declined by 8.6% and 9.2% yoy to S$91m and S$69.8m respectively largely due to negative rental renewals and impact of the ongoing AEI works at 6 Battery Road. However, Raffles City’s robust performance, lower property tax payment and interest savings mitigated the decline. Hence, DPU fell by a smaller 7.8% yoy to 1.83 cents. 9M11 DPU forms 83% of FY11 DPU.

Still healthy take-up rates sustain high occupancies. The trust renewed another 151,000 sf of its office leases in the current quarter, taking year-to-date renewals to about 415,000 sf. Meanwhile, pre-commitments for 6 Battery Road AEI works had also gained traction from 79% a quarter ago to 98% for the 93,700 sf of upgraded space.

Correction in market rents is likely to have minimum impact on performance. While office take-up is likely to moderate and asking rents should see some correction amid current uncertain economic environment, we expect minimum impact on CCT earnings with only 5.5% of office leases (in terms of total gross revenue) due for renewal this year and 9.3% in FY12. Meanwhile, average portfolio office rent in the 3Q remained flattish at S$ 7.79 psf VS the S$ 7.84 a quarter ago.

Recommendation

Strong balance sheet to withstand uncertain times. We like CCT for its strong balance sheet with net gearing of 27.4%, healthy cash reserve and its ability to drive renewals to sustain its portfolio occupancies. Maintain BUY with a lower DCF-based TP of $1.49 as we roll our numbers forward into FY12 and adopt flattish market rental growth for FY12.

No surprises for 3Q11 results

3Q11 results in line. For 3Q11, CapitaCommercial Trust (CCT) reported a distributable income of S$51.9m or a DPU of 1.83 S cents, bringing the total distribution YTD to 5.59 S cents. This is line with our expectations and YTD distributions form 75.0% of our annual forecast. We also saw gross revenue fall 8.6% on a YoY basis to S$89m. This was mainly due to the absence of contributions from StarHub Center sold in Sep10, and lower occupancy and rentals at Six Battery Road (6BR) which is undergoing asset enhancement works (AEI). Given the last unit price of S$1.10, the annualized distribution yield stands at 6.8%.

Firm occupancy numbers. Overall portfolio occupancy tracked down marginally to 97.2% versus 97.7% last quarter, mainly due to lower occupancy at One George Street (OGS) as a tenant moved out. Market talk is that Llyods, Wong Partnership and Julius Baer will also move out of OGS due to demand for more space, and CCT is currently seeking new tenants at ~S$11 psf. In terms of net property income (NPI), we saw a 30% YoY dip at 6BR due to ongoing AEI. NPI at Capital Tower also fell 6.5% YoY as a major tenant (11%) left the building and negative rental reversions continued.

Mixed rental reversions in FY12. We expect to see rental reversions stay negative in 4Q11 and turn mixed in FY12. Despite expectations of reduced economic growth next year, we could still see positive reversions at a few buildings, such as Raffles City with leases expiring at S$6.99 psf. Barring a severe economic crisis, we forecast rental reversions for CCT’s portfolio to turn positive in FY13. Note that the average rental of leases expiring then would be an undemanding S$7.62 psf.

6BR and Market St office on track. Demand for the upgraded space at 6BR continues to be firm with 98% of the upgraded space (19% of net leasable area) already pre-committed – up from 79% announced in 2Q11. Nomura, which occupies 12% of the building, would have its lease expire in Nov 11 and management plans to upgrade this space as well, with 29% of the space already pre-committed. The Market Street office tower is also on track to complete in 2014 as planned.

Maintain BUY. We had downgraded the office sector to NEUTRAL on 17 Sep 2011 and forecast office rentals to fall 5-10% by FY13. Despite a weaker office outlook, however, we still see value in CCT given its quality portfolio and prices trading at ~30% discount to NAV. Maintain BUY with a fair value estimate of S$1.41 due to softer rental assumptions, versus S$1.45 previously.

Distress valuations!

We believe that market is valuing CCT’s assetsat distress valuations, unjustified given its much stronger balance sheet vs. lastcrisis. Also, CCT’s exposure should be mitigated by yield protectionfor One George Street and its under-rented portfolio.

CCT’s 3Q11 and 9M11 DPU were in line, forming 25% and 77% of our full-year estimates, respectively. Having already factored in an office slowdown, we are keeping our forecasts and DDM-based target price. Maintain Trading Buy.

Mitigation for rental downside

3Q11 NPI was down 9% on negative office rental reversions and absence of rental income from Starhub Centre (sold in 3Q10). While an office slowdown is imminent, we expect income downside to be mitigated by yield protection from One George Street (significant lease expiries next year), with rents on expiring leases pegged at levels closer to current market and a long WALE of 4.7years.

Renewing leases ahead of expiries

We believe that CCT’s proactive approach towards reducing upcoming lease expiries should mitigate risks from a sharp rental falloff on expiries. CCT signed office leases amounting to 151k sf of renewals and new leases in 3Q11, including a forward lease renewal with EDB. These took uncommitted office leases expiring in 2011 and 2012 down to 9% and 15% from 11% and 19% respectively in 2Q.

Strong balance sheet to tide through dark clouds

CCT’s strong balance sheet position should tide it through looming dark clouds. With potentially less revaluation downside risk given sub-peak asset valuations and rentals, we do not see CCT revisiting its previous trough.

Distress implied asset valuations unjustified

Trading at 0.7x P/BV, we believe that market is valuing its Grade A office portfolio at distress cap rate of 7% and capital values of S$1.4k psf, way below S$1.7k psf for prime office assets during the last downturn. We deem this unjustified given its stronger balance sheet this time round.

Distress valuations unwarranted

• Upgrade to Trading Buy from Underperform. YTD, CCT has been the worst performing S-REIT in our coverage, underperforming the STI and FSTREI by 15% and 20% respectively. Trading at 0.7x P/BV and offering DPU yields of 7%, we believe the market is valuing it at distress valuations, unjustified on account of its stronger balance sheet than the last crisis and the other S-REITs. Rental and occupancy downside (vs. the other office S-REITs) is also mitigated by NPI yield support from One George Street and its under-rented Capital Tower and HSBC Building. As such, while we lower our DDM target price to S$1.17 (discount rate 8.6%) from S$1.25 on 1-6% DPU reductions after cutting our rental and occupancy assumptions and while we retain our caution on the office sector, we upgrade CCT to Trading Buy, expecting re-rating catalysts from stronger-than-expected rentals and occupancy.

• Distress valuations unjustified. At current valuations, the market appears to be pricing its Grade A offices at capital values of S$1.4k psf and a cap rate of 7%, way below the S$1.7k psf for prime office assets during the last crisis.

• Unlikely to revisit previous trough. CCT hit a bottom of 0.2x P/BV during late 2008 to early 2009 on fears of dilutive cash calls after its asset leverage rose to finance the acquisition of One George Street in Jul 08 and on refinancing risks with debt maturing in 2009/10. With a much lower asset leverage of 27% now and more moderate sub-peak asset valuations and market rentals, we believe such trough valuations are unlikely to be revisited.

A “sweetener” in place

• 2Q results inline with expectations, on better operational performance

• Market Street CP redevelopment plans firmed up, call option to purchase remaining stake granted

• Maintain BUY, TP S$1.59

Results in line with expectation. On a yoy basis, 2Q gross revenue and NPI declined by 9.6% and 5.9% to S$91m and S$69.8m respectively. However, performance remained relatively stable on a qoq basis. Meanwhile, portfolio occupancy dropped marginally to 97.7% affected by 6 Battery Road AEI. The trust also recorded a revaluation gain of S$153.4m (+2.8% yo-y). Stripping that off, 2Q DPU was at 1.92cents, making up 56% of our FY11 numbers or 52% of street estimates.

Operations gaining traction. The trust has another 7.5% of its office leases (in terms of gross revenue) up for renewals for 2H11. With the recovery in office rents, the spread between current and expiring leases is narrowing, indicating lower downside risk from negative rental reversion. Meanwhile, precommitments for 6 Battery Road AEI had risen with 74,400sf or 79% of the total upgraded space (93,700sf) taken up.

MSCP redevelopment to commence in Sept. Tenants in the carpark had vacated the building since June 2011. A Grade ‘A’ office building will be jointly developed by MSO Trust, which is held by CapitaLand (50%), CCT (40%) and Mitsubishi Estate Asia (10%). Total development cost is expected to be S$1.4 b. The site, currently held by CCT, will be acquired by MSO at S$56m which is 5.1% above its latest valuation. CCT is also granted a call option to buy the completed asset within 3 years after the TOP date at the prevailing market value or not lower than 6.3% pa CAGR on the estimated cost of return.

Maintain our buy call with an unchanged TP at $1.59. Balance sheet is strong with a gearing of 26.9%. The group has also just completed its refinancing exercise for the year and should be in a good financial position to undertake the MSCP project, which will start in Sept. Our TP at $1.59 offers 14% total return.