Lighter and stronger after divestment

• In line; maintain Neutral with higher target price of S$1.41 (from S$1.27). 3Q10 results met Street and our expectations with 9M10 DPU of 5.9cts forming 78% of our FY10 forecast. We maintain our estimates and roll over our DDM target price to CY12, raising it to S$1.41 (from S$1.27) with an unchanged discount rate of 7.8%. CCT trades at book value and offers a prospective dividend yield of 5.2%. In our last report, we estimated 7-8% DPU accretion assuming acquisitions of S$800m at NPI yields of 5.6% (which could raise our target price to S$1.46). However, in view of recent Grade-A transactions (Marina Bay Financial Centre and Chevron House) at under 4% net yields, acquiring at our estimated yields and accretion appear difficult, without income support at those levels. Announcements of accretive acquisitions and better-than-expected rental reversions for leases expiring in 2011 would provide re-rating catalysts, in our view.

• YTD DPU up 14% yoy. Despite a marginal decline in YTD revenue of S$299.8m (-0.1%) from loss of income after StarHub and Robinson Point were sold, net property income grew 3.6% yoy on lower property tax and operating expenses. Distributable income of S$145.6m grew even stronger at 14% yoy, boosted by lower interest costs, a result of lower borrowing levels. Stripping out gains from the sale of Robinson Point and StarHub Centre, and asset and derivatives revaluation losses, core net profit grew a healthy 11% yoy.

• Portfolio occupancy up 3% pts to 98.2%, almost single-handedly due to the divestment of StarHub Centre whose occupancy had been around 68%. Occupancy at other buildings was roughly flat with under 1%-pt movements. New leases/renewals for a total of 560,000sf have been signed YTD with tenants primarily in the Banking & Financial Services and Business Consultancy sectors. Average portfolio rents were down 0.7% qoq to S$8.73psf, excluding StarHub (S$8.79psf in 2Q10).

Fresh catalysts needed; maintain HOLD

Rents are bottoming out. The Office Rental Index in 2Q registered an increase of 1.1% QoQ, buttressing the uptrend rental recovery since the start of the year, which pre-ceded six consecutive quarters of decline. Office rents have also turned around on the back of strong economy recovery and office demand, rising to an average of S$8.45 psf/month (up 5.6% QoQ) for Grade-A office space.

Office transactions pick up pace. Investment activity in the office market has also warmed up. With close to S$2.6b of deals done YTD, buoyed in part by the entry of foreign property funds and the economic recovery, transaction sizes were also larger and prices have hit $2,000 psf in 2H10 (versus S$3,000 psf peak in 2008). This was in stark contrast to the relatively bite-sized deals of less than S$200m during the financial crisis. We believe that CCT stands to benefit in this rising rental/demand environment, since it has a large exposure to Grade-A office space. And in anticipation of faster growing rentals for Grade-A offices, we also expect more tenants to make a ‘flight to quality’ to take advantage of the still narrow gap between Grade A and prime office rentals.

MSCP conversion unlikely. CCT first revealed its plan to redevelop Market Street Car Park (MSCP) into a new Grade-A office tower in 2008, with a GFA of 850k sf. But management was unsuccessful in topping up the leasehold duration for MSCP (expiring on 31 Mar 2073). The remaining period makes it unappealing for CCT to pursue the premium office conversion option any further, given that development works will probably take up at least another three years, leaving the property with a lease of less than 60 years.

Reinvestment risk. CCT is also sitting on a cash pile of some $750m following the sales of Robinson Point & StarHub Centre. The challenge, however, lies in sourcing for yield-accretive Grade-A office acquisitions, given the growing competition for quality commercial properties and CCT’s geographic focus within Singapore. And given the persistently low interest environment, having excess cash on the balance sheet could also result in a cash drag; but an option would be to pare down its debt.

Maintain HOLD. On the back of favourable conditions in the office sector, our RNAV-derived fair value for CCT rises from S$1.26 to S$1.50. But given the limited upside, with total return <10%, our HOLD rating remains; potential re-rating would need to come from further yield-enhancing acquisitions/redevelopment-projects.

Office offering

CCT may redevelop Market Street Car Park if it fails to acquire an existing grade A asset, in our view. We view this as a positive, given the low holding cost for the asset. CCT may not require to raise equity for any acquisitions, given its significant cash pile. We remain positive on the office sector. Reiterate Buy.

Potential redevelopment of Market Street Car Park?

We think the time is ripe for CCT to redevelop Market Street Car Park into a grade A office given good visibility on office rents and relatively low construction costs. If redeveloped, the property could be ready by 2013-14, during which time we expect office supply to be tight. We estimate a redevelopment cost of S$1,125 psf for a new grade A office on this site, which seems more attractive than the seller asking price of at least S$2,000 psf for existing grade A assets. However, CCT would have the capacity to redevelop only 60% of the asset solo, based on the regulatory limit. This is the main drawback for any redevelopment, in our view.

Sitting on a cash pile

We estimate CCT will sit on a cash pile of about S$780m after the sale of Starhub Centre. We also estimate it will have debt capacity to acquire up to S$0.8bn-1.4bn worth of assets based on a gearing of 40-45%. Hence the company may not need to raise equity once it acquires a grade A office or redevelops the Market Street Car Park.

Office leasing activities gather steam

Leasing deals for grade A offices have intensified, with financial institutions such as Citigroup and BoA in negotiations to move into the upcoming Asia Square Tower 1 and 50 Collyer Quay, respectively. Industry sources said that monthly rents are now transacted at S$8.50-10.00 psf vs S$7-8 psf for uncompleted offices at end-2009 and current average grade A rents of S$8.45 psf. Where previous preleasing involved companies effectively swapping office space, the firms are now increasing headcount. Therefore, for instance, BoA may be doubling its office space to 120,000 sq ft. Higher demand and a corresponding decline in office stock (due to conversions into residences) bodes well for the office sector. We estimate 2m sq ft of office stock will be removed from the system over the next two years.

Maintain Buy

We have a Buy rating on CCT with our DCF-based target price of S$1.50, which includes potential upside from the acquisition of a grade A office. We like CCT as we see it is the largest pure office play in Singapore. The REIT is expected to yield 5.4% in FY10 and 5.0% in FY11 and is trading on a par with its current book value of S$1.36.

Is CCT saving cash hoard for Market Street Car Park?

CAPITACOMMERCIAL Trust (CCT) reiterated last week that it will not distribute a special payout to unit-holders when it completes its $380 million sale of StarHub Centre in September. Likewise, it did not return proceeds to shareholders when it completed the sale of Robinson Point in April.

The trust has said it is setting aside the net cash proceeds from these two divestments – totalling about $577.5 million – for future acquisitions and to reduce debt.

On the debt front, CCT can choose to refinance debt when it falls due, given its current gearing ratio is relatively low at about 33 per cent.

As for acquisitions, the trust has thus far found it difficult to buy office blocks. In fact, it has been selling office blocks which it believes have reached the optimal stage of their life cycle as office assets – such as Robinson Point and StarHub Centre.

CCT’s manager says it is keen to increase its exposure to the Singapore Grade A office sector. But buying such assets in today’s market is not easy for a Reit, as owners of Grade A office buildings are pricing the recovery in rents into their asking prices. As a result, the yields on these properties are not high enough to generate accretion for a Reit if it were to buy such expensive assets.

Given this challenge, some analysts think that instead of keeping its cash for future acquisitions, CCT could be saving it for something else – perhaps to re-visit plans to redevelop Market Street Car Park into a Grade A office project.

It was in January 2008 that CCT first disclosed it had obtained outline planning permission (OPP) from the Urban Redevelopment Authority to redevelop Singapore’s first multi-storey car park into a new office tower with gross floor area of about 850,000 sq ft and a maximum plot ratio of 14.49. It estimated the total cost then at $1-1.5 billion.

But the global financial crisis struck – and Singapore office rents started to slide. In January 2009, CCT’s manager announced its decision to abort the redevelopment plan, citing the uncertain market outlook and tight credit conditions, as well as high development cost and significant project size.

Quizzed about the possibility of re-visiting the Market Street plan at CCT’s second-quarter results briefing last week, CapitaCommercial Trust Management chief executive Lynette Leong said the OPP had lapsed, but added that the group continually reviews its assets. She also said that the Market Street property is generating an attractive net yield of more than 8 per cent based on its $47 million valuation as at June 30, 2010, thanks to a shortage of CBD parking lots. The yield surpasses that for office space.

However, some analysts think that the time could be right for CCT to make a fresh planning application to redevelop Market Street Car Park into offices. And approval from authorities should again be forthcoming. For one, there is concern among property consultants about a potential shortage of new prime Grade A office space post-2012. The redevelopment of Market Street Car Park into offices could help alleviate this to some extent.

Redeveloping the property will mean the loss of 704 CBD parking lots that provide season and hourly parking. But of course, the authorities could always require CCT to reinstate this supply in its new project. And some relief will come soon from 250 public parking lots – for hourly parking – that will be ready by October this year underneath the Lawn @ Marina Bay, which is part of the Marina Bay Financial Centre project.

Standard Chartered Equity Research estimates the cost of redeveloping Market Street Car Park has fallen from 2008, probably to $1 billion to $1.1 billion today, given lower construction costs and development charges now. ‘If the Grade A office building (about 850,000 sq ft) conversion is completed by 2015 and rented for $10-14 per sq ft a month, the yield on cost would be about 6-8 per cent and development profit would be 6-25 cents per unit,’ it said.

Given CCT’s $6 billion asset size and the rule that development properties must make up no more than 10 per cent of a Reit’s asset size, CCT will no doubt have to seek the appropriate structure to undertake the development, perhaps jointly with parent CapitaLand.

A cash hoard will come in handy for such a venture.