Office REITs – OCBC

Common Themes of FY10 results; Maintain OVERWEIGHT

Negative rental reversion bottoming out. After FY10 results, we found a few common themes in the guidance given by Office REITs managers. Firstly, most Office REITs with Grade-A office assets expect negative rental reversions to bottom out by end 2011. In FY10, negative rental reversions were still prevalent in some Grade-A properties such as Six Battery Road and One George Street. One Raffles Quay and Suntec City1 also saw YoY declines in gross revenue contribution, but this is expected to turn around in 2011-2012. According to CBRE, Grade-A rents averaged S$9.90 psf/month in 4Q10, reflecting an increase of 10% QoQ and 22.2% YoY. Grade-A rents bottomed at S$8 psf/month in 1Q10 and have since risen some 23.8%. We see room for more rental upside ahead and forecast Grade-A rents to hit S$10.50 psf./month in 2011, more than S$11 psf/month in 2012 and above S$12 psf/month in 2013. However, non-Grade-A properties will see more gradual recovery, where they will bottom out possibly only after 2012-2013.

Hollowing-out concerns a passé. Most Office REITs hold the view that earlier concerns of the “hollowing-out effect”, as the vacated space is readily being taken up by existing tenants wanting to expand or occupiers from other buildings. This is corroborated by CRBE findings which reported that that Grade-A vacancy dipped to 2.7% in 4Q10 from 2.8% in 3Q10 and a notable turnaround from 6.2% in 4Q09, despite the new supply including MBFC Tower 1 in 1Q10 and MBFC Tower 2 in 3Q10.

40% leverage is the new norm. On the back of the low interest rate environment and mega acquisitions completed in 2010 (MBFC Phase 1), we are seeing more Office REITs shoring up their aggregate leverage ratios, with Suntec leading the pack with 40.4% on end-Dec 2010 from 33% on end-Sep 2010. K-REIT’s gearing also increased from 15.1% to 37%, while FCOT’s leverage remains flat at 39.8%. With the exception of CCT2 which had pared down its debt in 4Q10, most of the Office REITs seem comfortable reverting back to the pre-crisis target gearing levels of 40-45%. We think the 40% will be the new norm for FY2011. Debt headroom of S$1.18b in for the local Office REITs subsector indicates that sizeable debt-funded acquisitions are still possible.

Valuations. The four local Office-REITs, namely CCT [BUY, FV: S$1.61], Suntec [HOLD, FV: S$1.60], K-REIT [NOT RATED] and FCOT [BUY, FV: S$0.90] trade at an averageprice-to-book of 0.81x, which compares favourably to the broader S-REIT sector of 0.93x. We remain upbeat on the office sector recovery; and maintain OVERWEIGHT for the local Office REITs subsector.