Strong organic growth

Comment on Results

CCT posted a smaller 15.6% improvement in net property income to $49.6m on a 23% rise in revenue to S$71.2m as higher property taxes boosted expense ratio to 30.3%. Distributable income rose 23% to $35.9m translating to a DPU of 2.59cts. The better performance was due to strong organic growth from its office and retail assets as portfolio occupancy levels reached 99.6%.

During the quarter, new and renewal office and retail leases were transacted at 195% and 159% above preceeding levels. Highest average rents of $20.50psf were committed at 6 Battery Rd. Looking ahead, CCT is expected to continue benefiting from the positive rental reversion trend with a total 56% of rental income due to be reviewed over the remaining 2008 to 2010. The significant spread between renewal and average passing rents should translate to a strong uplift in income over the 2 years.

Furthermore, acquisition of One George St, scheduled to complete in 2H08, should provide a new accretive income source. In addition, progressive completion of asset enhancement activities at Raffles City Tower should lead to a further boost in bottomline.

Recommendation

We are maintaining Buy on CCT for its strong organic earnings growth. Projected FY08 and FY09 DPU of 10.7cts and 12.9cts translates to a yield of 5.1% and 6.1% respectively. Our price target of $2.93 offers a potential upside of 40%.

Is CCT getting 1 George Street too easily?

CAPITACOMMERCIAL Trust’s (CCT) $1.165 billion proposed acquisition of 1 George Street from CapitaLand announced last month will be put to a vote of unitholders before June 30 – with CapitaLand abstaining.

By all accounts, CCT unitholders will approve the acquisition. After all, it’s not easy for Singapore real estate investment trusts (Reits) to grow through acquisitions these days. On the one hand, tight credit market conditions make it difficult to get debt funding while on the other, Reits are trading at relatively high distribution yields – because of the general stock market slide – making it difficult to make yield-accretive acquisitions if they need to raise equity to foot the bill.

CCT, however, is more fortunate. It won’t be issuing any equity and has secured full debt funding for its proposed purchase of 1 George Street; and even then, its gearing will rise to only about 40 per cent from 27 per cent now.

However, CapitaLand shareholders will not get to vote on the sale of 1 George Street to CCT because the size of the transaction does not cross any of the thresholds that would trigger a mandatory shareholder vote. Put simply, although the transaction is big, it’s small relative to CapitaLand’s size.

Some parties are complaining that CapitaLand should have conducted an open competition to ensure that it obtained the highest price for the award-winning property.

CapitaLand may have gotten more than the $1.165 billion or $2,600 per square foot (psf) of net lettable area that it will get from CCT. A competition would have been more transparent, especially since the deal with CCT involves an income-support element. CapitaLand will top up any shortfall to ensure a minimum annual net property income of $49.5 million till 2013.

Bidding competition

Another reason CapitaLand should have had a bidding competition is because the headline price of $2,600 psf is lower than the $2,700 psf at which the asset was valued in a deal last August when CapitaLand bought the remaining half-share in the property – notwithstanding that confidence in the office market is weaker today and that the higher price earlier reflected control premium.

From the viewpoint of CapitaLand shareholders, the group could make a bigger profit from selling 1 George Street to external parties than the $47.1 million it expects to book from the proposed deal with CCT. (This amount is after accounting for the five-year income guarantee and CapitaLand’s 30.5 per cent stake in CCT.)

Last month, when the deal was announced, CapitaLand Commercial CEO Wen Khai Meng said that the group has a ‘certain responsibility to help our sponsored-Reit to grow’. CapitaLand is aiming for a balanced strategy on its office portfolio by allocating part of it for outright divestment to reap capital gains – as it has done for Temasek Tower, Hitachi Tower and Chevron House – and keeping a core portfolio of office properties for recurring income by divesting them to its sponsored Reits, which provide a tax-efficient structure for holding income-producing assets. Not only does CapitaLand retain a sponsor’s stake in such Reits, it earns fees from managing the Reit – forming an integral part of its successful property fund management model. This strategy is a key attraction to CapitaLand as a stock.

Move is a departure

However, critics also note that CapitaLand’s decision to offer 1 George Street directly to CCT marks a departure of what it has done for its divestments of other Singapore office assets in the past year or so. Temasek Tower, Hitachi Tower and Chevron House were sold through a competitive bidding process to external parties.

In the case of Temasek Tower which was sold in March 2007, CapitaLand Group president and CEO Liew Mun Leong subsequently revealed that CCT had made an offer for Temasek Tower, but its price was below the $1.04 billion offered by the eventual buyer, Macquarie Global Property Advisors Group. ‘Its (CCT’s offer) was below Macquarie’s. We have no reason to give them. That shows we are very transparent. We are not inbreeding. Fair game,’ Mr Liew had said.

Why was 1 George Street different? One point to note is that CapitaLand owned Temasek Tower, Hitachi Tower and Chevron House jointly with other parties, so it could not simply offer these office buildings to CCT on a platter; CCT would have had to compete with other bidders if it had wanted to buy these assets. 1 George Street is also a newer, higher-grade office block compared with the three sold earlier and hence a more desirable asset to CCT.

Perhaps CapitaLand may wish to make clear the criteria it uses in deciding when to offer assets directly to one of its sponsored Reits and when to have an open competition. Otherwise, some big-name overseas property investors may feel that there’s a lack of transparency and a level playing field.

Of course, one could also argue that such investors may have to accept that Reits will always get the first bite when it comes to its sponsor’s assets. After all, that’s what it means to have a long-term sponsor committed to ensuring the Reit’s growth.

CCT to issue S$280m of convertible bonds

CCT issues bonds to fund acquisition and asset enhancement. CCT announced that it would issue no less than S$280m of bonds of 5-year maturity, convertible into new CCT units. CCT also has an over-allotment option to raise an additional S$90m, with the agreement of the underwriter Standard Chartered Bank, thereby raising the total proceeds to S$370m. Proceeds from the bond issue would go to refinancing their short term debt, working capital and partial financing of asset enhancement works and new acquisitions including One George Street.

Cost of bonds at 3.95%. The convertible bonds will bear interest at 2% per annum whilst its yield to maturity would be at 3.95% per annum. Holders of these bonds may convert the bonds into units between 21 May 2008 and 21 April 2013 at a conversion price of S$2.6762, or 23.9% above CCT’s closing share price of S$2.16 on 1 April 2008. If there is no redemption, conversion or cancellation, the convertible bonds would be redeemed at 110.66% of their principal amount, or S$311m on 6 May 2013.

Comments

Impact of convertible bonds (CB) issue in dilution scenario. The quantum of this CB issue is relatively small, amounting to only 24% of the S$1.165bn purchase price for One George Street. At the S$2.6762 conversion price, there would be an increase of 104.6m shares. Potential marginal dilution impact is marginal, on assumption of full conversion. If converted, 2009 DPU is lowered by 1.4% to 14.2cts (from 14.4cts) while 2010 DPU is lowered by 1.9% to 15.2cts (from 15.5cts). Conversion in the short term to be rather unlikely for now given that the conversion price is at a 25% premium to closing price of S$2.14 on 2 April 2008. In CCT’s trading history, stock traded above the conversion price only during Jan-Sep 07, hitting a high of S$3.26 when expectations of office rental escalation was more bullish. With new stock of office supply increasingly entering the market from 2010 onwards, we take the view that market expectations are unlikely to return to 1H07 levels. However, with the tight office situation currently, the conversion of this instrument cannot be totally ruled out. Our target price for CCT would decline by 1.7% to S$2.85 after incorporating full dilution from the CB.

Marginal improvement in DPU estimates in no dilution scenario. Without any impact from the potential dilution, we project a marginal 0.7% improvement in 2009 DPU estimates to 14.5cts and 0.6% increase in 2010 DPU estimates to 15.6cts. Our raised DPU estimates come as a result of the lower cost of funding (3.95%) versus our higher estimate of cost of debt (4.5%) assumptions previously. We have assumed that there would be no dilution in this convertible bond issue but have included the amortisation of interest on the convertible bonds.

Valuation and recommendation

Impact of bonds issue marginal, Maintain Outperform, target price raised to S$2.91. We reiterate our Outperform recommendation on CCT with a marginally higher target price at S$2.91, up from S$2.90 (discount rate at 6.6%) based on DDMderived valuation. This is based on the assumption that there would be no conversion to units prior to maturity of the convertible bonds in 2013. At its current price of S$2.14, CCT offers an attractive total return of 41% including a potential price upside of 36% to our target price of S$2.91 and a dividend yield of 4.8%.

One George Street – Not a sweet deal

Option to acquire One George Street
CCT has obtained an option to acquire One George Street (OGS) building from CapitaLand at SGD1.17b. OGS is a Grade A office located in Raffles Place. The offer price works out to SGD2,600/sqft of NLA, which includes income support from CapitaLand for a period of five years. The minimum NPI guarantee of SGD49.5m pa represents a 4.25% yield and an implied rental rate of SGD10.50/sqft.

To be 100% debt funded
CCT intends to fund OGS with 100% debt. It has secured committed funding for the entire purchase price. However, no covenant agreement has been established for the interest rates, leaving it exposed to interest rate fluctuations between now and its EGM at end-June 2008. With this acquisition, CCT’s gearing will rise from 27% to 40%.

Not quite a sweet deal
CCT has been successful in its recent fund raising, securing competitive interest rates at 3.1% for two of its MTN tranches, which amounted to SGD250m. In view of the high cost of long-term debt (in excess of 4%), we believe CCT will likely embrace a short-to-medium term debt capital structure to justify any immediate accretion to this acquisition. Taking into account the one-off 1% acquisition fee and assuming a 3% borrowing cost, the acquisition of OGS will be mildly yield accretive.

Weak positive carry could deteriorate credit metrics
The outright drawback from this deal is the risk of a ratings downgrade by Moody’s from A3 to Baa1. While OGS may enhance CCT’s asset quality profile and income diversity, we believe this deal could potentially deteriorate its credit metrics as the relatively low yield from OGS compared with its interest cost is likely to drag down its overall portfolio interest cover from our FY08 estimate of 4.1x. Given the low inherent rents from OGS existing tenants (about SGD4-5/sqft) and only 50% NLA expiry over 2008-09, it may take well over three years for OGS’ intrinsic rents to exceed the SGD10.50/sqft mark, hence any recovery in its interest cover. Should this deal transpire, we project CCT’s interest cover to fall to about 3.74x, assuming a borrowing cost of 3%. We remain neutral on this deal but maintain our BUY and TP of SGD2.56.

CCT gets option to buy 1 George Street for $1.17b

Deal comes with income support from seller CapitaLand till 2013

Big office investment sales deals have not ground to a complete halt. CapitaCommercial Trust announced yesterday that it has an option from sponsor CapitaLand to buy 1 George Street for $1.165 billion or $2,600 psf of net lettable area, showing that income support may be the way to make acquisitions palatable to Reits.

This is especially so when it comes to office blocks with a substantial portion of leases signed a few years ago when rentals were weak. Never mind that income support for such deals may once have been frowned upon.

The deal for 1 George Street involves a five-year rental guarantee, with seller CapitaLand ensuring a minimum net property income of $49.5 million per annum, translating to a net property yield of 4.25 per cent per annum on the purchase price till 2013.

This means that CapitaLand will top up any shortfall in net property income to ensure that the $49.5 million floor is achieved every year for the period. The acquisition will be funded entirely through debt; there will be no equity raising.

1 George Street is a 23-storey Grade A commercial building that was completed three years ago. It is fully leased and its tenants include The Royal Bank of Scotland, WongPartnership and Lloyd’s of London (Asia).)

Most of the leases were signed around 2004/2005, when office rents were weak, which is why CapitaLand is providing yield protection for the asset’s acquisition by CCT. The $49.5 million annual minimum net property income implies gross monthly rentals of $10.50 psf. Given that the current average market rental in the Raffles Place area is about $16.30 psf, this spells upside for 1 George St as leases are renewed, CapitaCommercial Trust Management CEO Lynette Leong said.

Leases for about 50 per cent of the net lettable area in the property will come up for renewal in 2008 and 2009. Recently, a new lease for a small space in the building was signed for $19 psf, Ms Leong revealed.

‘With the yield-protection given by CapitaLand, CCT will be able to attain minimum returns from this asset. The five-year yield protection eliminates all the downside risk and whatever upside there is from the asset, it will all flow through to CCT. That’s a pretty compelling offer,’ Ms Leong said.

The deal drew an inevitable comparison with K-Reit Asia’s acquisition of a one-third stake in One Raffles Quay from its parent, Keppel Land. The two deals have similarities – they involve income support and are at prices seen as lower than market.

However, Ms Leong, at a media and analyst briefing yesterday, argued that there were important differences between the two deals.

For one, CCT will get 100 per cent direct ownership of 1 George Street, and the asset will enjoy full tax transparency as a result of being owned by a Reit. This means that CCT would not have to pay tax on income from this asset, unlike K-Reit Asia’s acquisition of a one-third stake in ORQ which is being effected through the purchase of shares in the company that owns ORQ. Hence, the income that K-Reit will receive from the asset would be net of 18 per cent corporate tax.

Another difference is that KepLand will provide income support only till 2011 whereas CapitaLand is doing so till 2013, beyond the 2011/2012 timeframe when a spike in Grade A office space is expected.

CapitaLand Commercial CEO Wen Khai Meng explained that the reason for ‘providing the floor for five years is to address the view that there will be a huge supply in 2011/2012’.

Another difference: CCT has secured 100 per cent committed debt funding for its proposed acquisition of 1 George Street and will not have any equity raising exercise. K-Reit, on the other hand, is seeking unitholders’ approval for a rights issue to help partly refinance a bridging loan taken from Keppel Corp to complete the acquisition of the one-third stake in ORQ.

The $2,600 psf of net lettable area at which CapitaLand is proposing to sell 1 George St to CCT is lower than the $2,700 psf at which the asset was valued at in a deal last August when CapitaLand bought the remaining half share in the asset to gain full ownership of the award-winning property.

CapitaLand expects to book a gain of about $47.1 million after taking into account the yield protection and the company’s 30.5 per cent interest in CCT.

Mr Wen said that the group had to pay $2,700 psf in last August’s deal for control premium. ‘We feel $2,600 psf, plus income support, is a good deal given that CapitaLand still has about 30 per cent stake in CCT and given that we are the manager of the Reit and have a certain responsibility to help our sponsored-Reit to grow.

‘I personally dislike income support, because it conjures up all sorts of wrong impressions. But it would be challenging for a Reit to justify non-yield accretion for the first few years in an acquisition. Based on current rental rates at 1 George Street, the yield would be below 4.25 per cent, but we are seeing very strong rental reversion,’ he said

‘The yield-protection arrangement of 4.25 per cent pa for five years makes the acquisition compelling, given the current blended yield of CCT’s Grade A office assets is 3.2 per cent,’ Ms Leong said.

Even with 100 per cent debt funding for the acquisition, CCT’s gearing will rise to only about 40 per cent from the current 27 per cent, the trust’s manager highlighted.

The deal will be subject to CCT unitholders’ approval at an extraordinary general meeting to be held by June 30, as it is deemed an interested party transaction. CapitaLand is not allowed to vote. The acquisition is slated for completion by end-July.