Tax boost fromMBFC 1

Tax transparency for MBFC 1 should allow savings translating to 2-3% of DPU annually. We do not dismiss the possibility of similar conversions and structures for ORQ and MBFC 2, which could allow less tax leakages and potential simplification of holding structures.

We raise DPUs and DDM-based target price (discount rate: 8.2%) factoring in tax savings from K-REIT’s one-third stake in MBFC Phase 1.Maintain Outperform on favourable risk-reward. We see catalysts from an earlier bottoming of office market and furthertax savings.

What Happened

K-REIT has announced that BFC Development Pte Ltd, the entity which holds MBFC Phase 1 has been successfully converted to BFC Development Limited Liability Partnership. This will allow it to obtain tax transparency and not pay corporate tax on itsincome from its one-third stake in MBFC Phase 1.

What We Think

We expect this development to result in savings of about S$4m-5m (2-3%) for K-REIT annually. Savings are not retrospective, implying no claw-backs for previous taxes paid.

Management’s efforts on this are commendable. Previously, the tax leakage, income support and complex holding structures for ORQ and MBFC Phase 1 were some of the key contention points that some investors had when they compared K-REIT’s and Suntec REIT’s portfolios against CCT’s. We do not dismiss the possibility of a conversion for the holding company of ORQ and the use of a similar structure for a potential acquisition of MBFC Phase 2 for increased tax savings.

If these take place, not only will there be less tax leakages, but overall holding structures for portfolio could be less complex (e.g. unwinding of shareholders’ loan for tax shelter) to facilitate shareholders’ understanding and a potential narrowingin valuation gap against CCT.

What You Should Do

Overall, weview this news positively for both its tangible and intangible benefits. Maintain Outperform on favourable risk-reward from a potential bottoming of the office market and cheap valuations (0.8x P/BV and 7.5% yield).

Spectacular leasing!

K-REIT braved headwinds tolease out more than 50,000 sf of space at Ocean Financial Tower and Prudential Tower in 1Q12. Backed by attractive yields of 8% and improving office indicators, we think its risk-reward now favours a positioning for a bottom.

1Q12 DPU was slightly above our estimate and consensus on lower interest costs, at 27% of FY12. We raise DPU by 2-4% and DDM target price (disc. rate: 8.2%) on lower interest costs and higher occupancy. Upgrade to Outperform from Neutral.

Interest cost-savings

1Q12 distributable profit doubled yoy with the help of contributions from the acquisition of OFC and an additional stake in Prudential Tower. The quarter’s outperformance was led by lower interest costs though contributions from increased occupancy should flow in soon. Lower rates on construction loans accounted for the lower interest costs.

Spectacular leasing

Indicators increasingly point to a trough. In 1Q12, K-REIT braved office headwinds to lease out more than 50k sf of office space, taking occupancy at OFC from 85% to 91%. After two quiet quarters, Prudential Tower’s occupancy climbed from 94% to 98%. Signing rents were fairly in line with market rates at S$11-13psf for OFC and S$8-9 psf for Prudential Tower. Take-up was skewed to new tenants with a mix of new-to-market legal firms at OFC and some fund-management firms at Prudential.

Upgrade to Outperform

With portfolio occupancy at a higher 96.3% and lease expiries/ reviews at a low 0.3%/1.6% of NLA, we think downside is limited. Higher aggregate leverage is also likely less of a concern now that capital values are expected to remain buoyed by low interest rates. Trading at forward yields of 8%, we think its risk-reward favours a positioning for a bottom. Potential catalysts include improved take-up and rents at OFC.

K-Reit Asia's post-rights DPU doubles in Q1

Surge in property revenue from new office investments

K-REIT Asia yesterday posted a distribution per unit (DPU) of 1.90 cents for the first quarter based on an enlarged post-rights share base – compared to 0.96 cents a year ago,

The annualised DPU works out to 7.64 cents, generating a distribution yield of 7.9 per cent based on K-Reit's closing unit price of $0.965 as at March 30.

The counter ended trading yesterday at $0.94, down 0.53 per cent or 0.5 cents.

The improvement in DPU came on the back of a two-fold rise in distributable income to unitholders to $48.54 million.

Powering the increase in distributable income was a surge in property contributions from associated companies and new acquisitions including Prudential Tower, 8 Chifley Square in Sydney and Ocean Financial Centre (OFC).

Share of results of associates increased 82.6 per cent to $11.2 million as a result of higher contribution from its interest in BFC Development and One Raffles Quay.

Property income for the office Reit was $36.6 million in Q1, up $17.9 million or 96.0 per cent from a year earlier. This is mainly due to the $17.3 million contribution from the OFC interest, and the higher property income from Prudential Tower as well as the interest in 275 George Street in Brisbane.

These higher income streams translated to a 90.8 per cent increase in net property income to $28.5 million.

K-Reit's Singapore portfolio occupancy of 96.3 per cent outperformed that of the core central business district of 90.7 per cent.

The Reit has about 1.9 per cent of net lettable area due for rent review and renewal in 2012. However, it has given an assurance that that with a portfolio-weighted average lease expiry of 6.4 years and healthy capital levels, it is in "good stead" to weather the economic slowdown in 2012.

K-Reit's aggregate leverage level as at March 31 is 41.8 per cent. It has initiated negotiations to refinance $535 million worth of borrowings due at the end of 2012.

Meeting a lowered bar

Hit by fears of an office slowdown and some dissent over its OFC acquisition, K-REIT had underperformed STI by 22% in the past year. With multiple negatives priced in and increased confidence after our meetings, we see room for it to meet or surpass expectations.

We raise DPU to factor in stronger rental and occupancy assumptions. Allied with a reduced beta and discount rate, we raise our DDM target price (disc. rate: 8.7%) and upgrade the stock to Neutral from Underperform. Catalysts could include positive take-up at OFC.

Management still sanguine

We foresee portfolio stability for K-REIT despite office headwinds, underpinned by its superior assets, limited near-term lease expiries and income support for MBFC and OFC. A recent meeting with management spurs confidence, with the update that K-REIT has yet to detect signs of distress among its tenants or receive further requests for subletting. Renewal rents and rent-free periods are still stable, while management is in talks for take-up at OFC, Prudential Tower and 77 King Street.

Cash-call risks mitigated

While we were previously wary of risks of cash calls, we think stable capital values in a liquidity-fuelled environment could stave off these for now, particularly if MBFC Tower 3 is only acquired in 2013. Though cash calls are inevitable for this acquisition, we expect dilution to be more muted given an enlarged equity base and the potential divestment of its Australian (the values of its Australian assets have climbed) or older local assets for funding.

Upgrade to Neutral

With multiple negatives priced in and a lowered bar, we see room for it to meet or surpass expectations. Potential bright spots are improved take-up at OFC, a stronger-than-expected office market and a purer prime office portfolio if MBFC Tower 3 is funded by the divestment of its Australian or older assets.