No reward for dilution, excess capital

Rating downgraded to 5 (Sell) from 4 (Underperform)

We have downgraded our rating for KREIT to 5 from 4, because we believe the recent three-month unit-price performance is unjustified. 

We estimate that the current market value of KREIT, more than any other office S-REIT, can only be justified if investors are willing to pay effective cap rates of 4.5-4.6%, similar to cap rates in the physical market. We regard this as risky, given the historic volatility of the Singapore office market and the imposing CBD supply pipeline for 2010-12. 

No reward for rights-issue dilution ahead of acquisitions

We do not believe KREIT should receive the benefit of the doubt for holding excess cash when there is a high degree of risk that it might not come through with a successful, DPU accretive acquisition. The opportunity cost is high, in our opinion, especially for the unitholders that have been diluted already. 

A high-yield acquisition in a high-yield market

We do not believe the acquisition of a single asset in Australia (a 50% stake in 275 George Street for A$166m) does much to improve KREIT’s financial efficiency or investment attractiveness. If anything, it only serves to deplete its recent rights issue and divert focus, if the manager’s ultimate objective is to land a major acquisition in Singapore. 

DPU forecasts revised down by 2.8-5.6% for FY10-11

We have revised down our DPU forecasts by 2.8% for FY10 and 5.6% for FY11after adjusting downward our rental-renewal assumptions. We have revised up our DPU forecast by 0.6% for FY12 after an upward adjustment to our rental-renewal assumption for KREIT’s associate, One Raffles Quay. 

Six-month target price lowered to S$0.96 (from S$1.06)

We have lowered our six-month target price, based on parity to our RNG valuation method (a finite-life Gordon Growth model), to S$0.96 from S$1.06. Our core operating-income estimate assumes average (monthly) passing rents of S$8.50 for Prudential Tower, S$6.50 for Keppel Towers and GE Tower as well as Bugis Junction Towers, and S$10.00 for One Raffles Quay (one-third stake). We have removed the presence of the recently completed Brisbane office acquisition (for A$166m) so that our valuation only considers Singapore income-producing assets discounted at Singapore cap rates and capital-market conditions. We have assumed that all excess cash (as at 31 December 2009) would be used to retire debt.

Brisbane acquisition completed

 Action
KREIT yesterday announced the completion of its acquisition in Brisbane. In this, a follow-up to our email (Adds prime Grade A office building in Brisbane to portfolio, 1 February, 2010), we revise up our estimates. The acquisition adds 0.6-0.7Scts to KREIT’s FY10-12F DPU, on our numbers, while our NAV estimate and price target are little changed at S$1.40. BUY maintained.

Catalysts
How KREIT deploys its balance-sheet capacity amid disappearing acquisitive opportunities and, on the other hand, increases stock liquidity will be key catalysts.

Anchor themes

With REITs having grappled with the issues of refinancing, the spectre of revaluation deficits and negative rental reversions should dominate. We see risks being priced in the office sector, though we retain our view that the market has been too complacent in its assessment of the retail and industrial REIT sectors.

 Acquisition of 275 George Street completed
KREIT yesterday announced the completion of its acquisition of a 50% stake in 275 George Street in Brisbane. The all-in acquisition cost of S$225.1mn was funded by rights proceeds raised in 4Q09. In our model, we have assumed rents for the 40,307 sq m occupied by Telstra and Queensland Gas on 10-year leases escalate at an annual rate of 5.5% from A$500-550psm in FY09, and rents for the retail space now occupied by Cicada remain constant at A$1,000psm over our forecast period. In addition, we have assumed a withholding tax rate of 7.5% in arriving at our estimates. There is an annual net income guarantee of A$12.8mn/year till June 2012.
 

Raising FY10-12F DPU by 0.6-0.7Scts

As highlighted previously, we had assumed the 30-month loan of S$390mn from Keppel Corp would be repaid with the rights proceeds. Following the acquisition, we are now assuming in our model a partial repayment of S$300mn with the remaining rights proceeds. Overall, we raise our FY10-12F DPU by 0.6-0.7Scts — a 1-1.2Scts accretion from 275 George Street’s income, offset by a 0.1Sct increase in tax expenses and a 0.3-0.4Sct increase in net finance costs.

Reiterating BUY; price target tweaked to S$1.40
We value KREIT’s newly acquired 50% stake in 275 George Street at its all-in acquisition cost of S$225.1mn and because the acquisition is funded by cash, there is minimal change in our NAV estimate and price target (now S$1.40, from S$1.41, on account of a marginal change to our FY10F net debt estimate). Our price target implies a potential total return of 34.8%, including a projected FY10F yield of 6.4%. Trading at an implied EV of S$1,183psf for its SG office portfolio, valuation remains undemanding, in our view.

Venturing Down Under

• Maiden foray into Australia, with purchase of a 50% stake in commercial building for A$166m
• DPUs raised by 12% in FY10 and 15% in FY11, taking into account contributions from this purchase
• Maintain Fully Valued with slightly higher TP of $1.13

Maiden overseas acquisition. K-reit has ventured overseas with the purchase of a 50% stake in a commercial property in Brisbane for A$166m (S$208m). 275 George St is a Grade A building with 40317sm of office and 1431sm of retail space. Average occupancy is 99.4% with the office tower fully occupied. Quality tenants include Telstra Corp and Queensland Gas Co. The weighted average lease to
expiry is 9.4 years underpinned by 10-year lease commitments from these 2 major tenants.

Diversifying income source. In terms of financial impact, the deal will be fully funded by the recent rights proceeds (post acquisition gross gearing at 25.2%) and is DPU enhancing, based on an annualized net profit yield of 5.9% (net profit of A$9.7m) compared to its implied yield of c4%. The vendor would provide an income support of A$1.8m over the income guarantee period till Jun 2012. We note the yield accretion and diversification merits of this deal. However, as Singapore would remain the key earnings contributor, accounting for three quarters of total income, the additional contribution is unlikely to fully offset the
expected negative rental reversion impact from its Singapore properties kicking in from FY10.

Risk-adjusted TP raised to $1.13. We are lifting our FY10 and FY11 DPU estimates by 12% and 15% respectively to take into account the latest contributions. Recent share price had brought valuations back in line with its sector peers, at FY10 and FY11 DPU yield of 6.5-6.4% respectively. Our risk-adjusted TP is adjusted up slightly to $1.13.

K-Reit buys half of Brisbane office block for A$166m

K-REIT Asia has bought a 50 per cent stake in an office building in Brisbane, Australia, its first acquisition outside Singapore.

It paid Charter Hall Opportunity Fund No 4 A$166 million (S$206.5 million) for the stake in the Grade A commercial building, the same as its appraised value.

The seller has also signed an income support agreement until 2012 that will top up the difference between actual cashflows and a guaranteed net cashflow of A$12.8 million a year.

The building at 275 George Street was completed in April last year and comprises 40,317 sq m of office space over 30 floors plus 1,431 sq m of retail space. K-Reit said it was 99.4 per cent leased and two Australian corporations, Telstra and Queensland Gas, have 10-year leases.

Ng Hsueh Ling, chief executive of K-Reit Asia Management, said the acquisition will add 10 per cent to K-Reit Asia’s asset size, or from $2.1 billion to $2.3 billion. The building is expected to be immediately yield accretive and has a weighted average lease expiry (WALE) of 9.4 years. This will extend the WALE of K-Reit’s present portfolio to 5.9 years from 5.2 years.

K-Reit said the purchase will be funded entirely by proceeds from its recent rights issue, which will improve aggregate leverage from 27.7 per cent as at Dec 31 to 25.2 per cent after the deal is completed this quarter.

K-Reit recently reported distributable income for the fourth quarter increased 11.4 per cent to $19.4 million. For the full year, distributable income to unitholders increased 21.1 per cent to $70.5 million. It said then it was considering buying a stake in Marina Bay Financial Centre from parent Keppel Land.

Results in line

At a Glance

• Results in line, lifted by positive rental reversions
• Moderating leasing environment
• Maintain fully valued, TP $1.11

Results in tune with estimates. Kreit’s 11.4% yoy jump in distribution income to $19.4m (DPU 1.45cts) is in line with expectations. This was achieved on a 13.8% rise in net property income to $13.4m while revenue increased a higher 19.1% to $17m. The better performance was due to higher rentals on reversion as well as contributions from the additional strata space acquired at Prudential Tower. Portfolio occupancy of 95% was slightly better than a quarter ago but below last year’s 99%. The group recognized a positive $21.1m surplus on its portfolio value over the level in Oct 09, bringing total writedown to $71.7m for the year, translating to book NAV of $1.47.

Operating environment moderated but still challenging. Operations wise, the office leasing market has experienced some recovery in demand as economic conditions improved. However, rents are expected to continue declining, although at a smaller pace than before due to oversupply while tenants’ flight to quality buildings would mean a more challenging leasing environment for older office buildings. On the acquisition front, the group’s current balance sheet is under optimized with a net gearing of <1% following its recent rights issue and would enable it to pursue a pan Asian acquisition strategy or for asset enhancement activities.

Recommendation

Maintain Fully Valued, TP $1.11. Amongst office Sreits, Kreit’s yields of 5.2% and 4.9% for FY10 and FY11 respectively are on the lower end of the 5-7% range. We believe a re-rating catalyst would appear only when it deploys its funds into new acquisitions both in Singapore and overseas.