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.

DPU uplift from MSCP to come later

• Negative reversions for rest of 2011; maintain Underperform. 2Q11 results met expectations, at 25% of our FY11 forecast and consensus estimate. Despite a 15bp cap-rate compression for its Grade-A assets, operational indicators continued to decline with revenue down 9.2% yoy on negative rental reversions from 6BR and OGS. This trend is expected to persist in 2H11 with expiring leases locked in at peak levels in 2008. Plans for MSCP redevelopment have been finalised with CCT potentially gaining full stakes by 2015. However, the DPU uplift is also not expected until then. We raise our DDM-based target price by 7% to S$1.46 (8% discount rate) to account for this. Maintain Underperform on valuations (1x P/BV), with limited near-term catalysts in sight for organic growth in the next 6-12 months.

• Renewal rents in 2011 locked at peak levels. Cap rates for CCT’s Grade-A assets (Cap Tower and OGS) fell from 4.15% to 4%, resulting in a S$145m revaluation gain for 2Q11. Operationally though, gross revenue continued to trend down by 9.2% yoy, primarily from negative rental reversions for 6BR and OGS and lost rental income from earlier disposals. Debt headroom is ample for acquisition growth, but the likely lack of immediately DPU-accretive assets for purchase is evident given physical cap rates of 3-4%. 6BR which makes up 20% of CCT’s rental income, with average expiring rents this year locked in at a peak of S$15.4psf. We expect (so does CCT) negative rental reversions to persist in the remainder of 2011.

• Plans for MSCP redevelopment firmed, but uplift to come only in 2015. CCT has firmed up a 40:50:10 JV agreement with CapLand and Mitsubishi Estate Asia to redevelop MSCP into a Grade-A office tower. The development is expected to cost S$1.4bn (CCT’s share S$560m) and would be completed by 2015. CCT expects a yield on cost of 6% or S$12-14psf gross rents on completion, a level we think is achievable. More meaningful upside potentially could come from its call option to acquire the remaining stakes from its partners upon completion, at a minimum price that must yield a least a compounded return of 6.3% p.a. to the sellers. The option is valid for three years starting at the completion date, giving CCT the flexibility to optimise yield upside. For the MSCP redevelopment, execution will be its priority for now, with the DPU uplift coming much later in 2015.

CCT posts drop in Q2 distributable income

Mitsubishi Estate Asia to take 10% stake in Market Street project

CAPITACOMMERCIAL Trust (CCT) yesterday said it posted lower Q2 and first-half distributable income compared with the same year-ago periods following the divestment of two office blocks in Singapore and negative rent reversions.

It also announced yesterday that Japan’s Mitsubishi Estate Asia will take a 10 per cent stake in its Market Street Car Park (MSCP) redevelopment project. CapitaLand will take a 50 per cent stake and CCT 40 per cent.

CCT has been granted a call option to acquire CapitaLand’s and Mitsubishi’s interest in MSO Trust – an unlisted special purpose sub-trust set up to undertake the $1.4 billion project – or the completed development. It may exercise the call option any time over a three-year period after the new office tower obtains Temporary Occupation Permit (TOP). The purchase will be at market valuation that must reflect at least a compounded return of 6.3 per cent per annum – CapitaLand’s estimated cost of capital – to the sellers.

CCT also gave details of the MSCP redevelopment. A sum of $672 million is payable to the state comprising mostly differential premium or DP (equal to 100 per cent of the enhancement in land value resulting from the change of use of the site from ‘transport facilities’ to ‘commercial’), and other land-related costs.

MSO Trust will buy MSCP, currently owned by CCT, for $56 million, which reflects a 5.1 per cent premium to the $53.3 million average of two independent valuations (by Jones Lang LaSalle and CB Richard Ellis) in May this year.

The valuations were done based on the residual value of MSCP to be redeveloped into an office building, taking into account the DP payable to the state.

MSCP’s valuation as a car park facility as at end-December 2010 was $48.6 million. Construction and professional fees are estimated at $550 million. The new project’s gross floor area (GFA) will be about 887,000 sq ft and its net lettable area 720,000 sq ft.

The project is slated for completion before end-2014, when no major Grade A CBD office supply is slated for completion.

The new project can have about 170-180 car park lots which would be excluded from the GFA calculation – down from 704 lots in the existing MSCP building, which was shut on June 30.

Lynette Leong, CEO of CCT’s manager, said the group has applied to the authorities to allow the building of additional car park lots which would be excluded from the GFA.

CCT is not undertaking the MSCP redevelopment solo as it would exceed the 10 per cent limit on development projects (to total asset size) for Singapore Reits.

The trust’s portfolio of eight investment properties (excluding MSCP) was valued at $5.6 billion at end-June 2011 – up 2.8 per cent from their valuation at end-December 2010.

CCT’s total asset size stood at around $6.2 billion at end-June 2011, down 0.1 per cent from end-December 2010. Net asset value per unit, excluding distributable income to unitholders, was $1.52 at end-June 2011, an increase from $1.47 at end-December 2010.

Distributable income to unitholders dipped 2.3 per cent year on year to $54.4 million for Q2 ended June 30, 2011. Gross revenue slid 9.2 per cent to about $91 million while net property income declined 5.9 per cent to $69.8 million. Distribution per unit (DPU) fell 2.5 per cent to $1.92.

For the first-half, CCT’s distributable income eased 3.2 per cent to about $106.5 million; gross revenue fell 9.9 per cent to $182 million and net property income declined 7.9 per cent to $139.8 million. First-half DPU fell 3.3 per cent to 3.77 cents, translating to a 5.2 per cent annualised distribution yield based on CCT’s July 13 closing price of $1.46.

The counter ended one cent lower yesterday at $1.45. Unitholders can look forward to receiving their semi-annual DPU payout on Aug 26; the books closure date is July 28.

The weaker showing for both periods was due to lower revenue from Six Battery Road, where occupancy rates are lower as the office tower is being revamped; loss in rental income from the sale of Robinson Point and StarHub Centre; and negative rent reversions (that is, leases signed or renewed at lower rental rates than the previous lease agreement).

‘Current signing rents for office space are still substantially below the expiring rents for the leases due this year as they were predominantly signed during the peak of the previous cycle in 2008.

‘Hence, negative rent reversions for most of the trust’s properties are expected to persist through the rest of this year. We will continue our proactive leasing and cost management strategies to mitigate the expected fall in distributable income,’ said Richard Hale, chairman of CCT’s manager.