Office Market: Not Out Of The Woods Yet

Semblance of stability. Management has started to see signs of stability in the office leasing market. The freefall in office rents has abated. Tenants who previously wanted to release space back to K-REIT Asia (K-REIT) have retracted their requests. Management has seen more enquiries since Jun 09. Some of these enquiries have translated into actual commitment in Sep 09. Tenants have also renewed for longer lease terms as they find current office rents attractive. The gap between office rents at Raffles Place and business parks outside the central business district (CBD) has also narrowed. Management expects average rents for Grade A offices to level out at about S$7psf.

A fragile office market. We are not as sanguine. We expect the office market to remain fragile due to the supply of 8.0m sf coming on stream from 2H09 to 2013, representing 11.0% of total office stock. A massive 2.8m sf and 2.6m sf will hit the market in 2010 and 2011 respectively, compared with the average annual take-up of 1.3m sf for the past 10 years. An estimated 87.2% of the known supply is concentrated within the CBD at Raffles Place, Marina Bay, Shenton Way and Tanjong Pagar. Take-up for office space was negative 570,000sf in 1H09. Take-up is likely to remain in negative territory in 2H09 as there is usually a time lag between retrenchment exercises and the release of excess office space. We continue to expect average rents for Grade A offices in Raffles Place to slide further to S$6.00psf by end-10, representing a two-third correction from the last peak of S$17.90psf pm recorded in 3Q08.

Maintain BUY. K-REIT is our only BUY call among office REITs. Our target price for K-REIT is S$1.32, based on a dividend discount model (required rate of return: 8.25%, growth: 2.5%).

Deepens hold on Pru Tower

• Buys 67300sf at Prudential Tower at 15% below valuation
• Strengthen strategic hold but muted earnings impact
• Maintain Hold with TP of $0.99

Strengthens strategic hold. K-reit has enlarged its ownership of Prudential Tower to 73% of the total strata space with the purchase of 67300sf NLA for $106.3m or $1579psf. This price is fair given it is 15% below market valuation of $1850psf and 24% sub the Dec 08 book value of $2066psf for its existing space. The deal will be totally debt funded, thus lifting K-reit’s current gearing from 27.6% to 31.1%.

But muted near term earnings impact. The deal comes with up to a total $5m of net income support for 5 years after completion of the transaction. Based on the proforma FY08 net income of $5.5m (inclusive of support), NPI yield is estimated at 5.2% yield. While downside risk is protected by the income support structure, earnings accretion from this purchase is marginal given that the NPI yield of 5.2% (based on $5.5m proforma FY08 net income inclusive of support) is marginally better than the present implied yield of 5.15%.

Maintain Hold. Deceleration in the pace of office rental decline and increasing dealflows in the office sector indicate some stabilization in the sector. However, transaction yields of >5% are still on the higher end of the historical band of 4.2-6%, highlighting the still cautious outlook within this segment. This deal will benefit Kreit in the long run when the office market recovers. In the near term, downside risk is small as is immediate additional earnings impact. Thus, maintain Hold with TP of $0.99.

K-Reit deal comes with 5.2% guaranteed yield

Trust’s aggregate leverage to rise to 31.1% from 27.6%

K-REIT Asia’s acquisition of six floors at Prudential Tower for about $106.29 million comes with income support from the seller that will translate to a guaranteed 5.2 per cent net property yield. The acquisition, which will be funded entirely by debt, will be yield accretive to K-Reit, the trust’s manager said yesterday.

The trust’s aggregate leverage will increase from 27.6 per cent to 31.1 per cent. The purchase will also boost K-Reit’s share of Prudential Tower’s strata area from about 44 per cent to 73 per cent.

APF Property Investments, which sold the space to K-Reit under the latest deal, has agreed to provide K-Reit up to $5 million in rental income support over a five-year period. The FY2008 proforma net property income (NPI) attributable to the acquisition is $5.5 million, inclusive of the income support. If the actual NPI is less than the guaranteed NPI, the seller shall pay the difference to K-Reit’s trustee.

‘The 5.2 per cent per annum property income yield is within the market norm and would provide accretive distributable income,’ K-Reit said.

The trust is buying levels 20 to 25 of Prudential Tower. The acquisition cost works out to $1,579 per square foot based on the net lettable area of about 67,300 sq ft. K-Reit said the $106.29 million purchase price is at a 14.6 per cent discount to the $124.5 million valuation of the property by Colliers International.

The valuation, which would reflect about $1,850 psf of net lettable area, took into account the rental income support by the seller, and was done using the market comparison, investment and discounted cash flow methods. Colliers was commissioned by K-Reit’s manager.

Prudential Tower is a 30-storey office block at the corner of Church and Cecil streets on a site with about 85 years’ remaining lease.

The six floors are leased to six tenants – including Prudential Fund Management Services, Prudential Asset Management (Singapore) and Korea Exchange Bank.

BT understands the space was sold through a private treaty deal brokered by Jones Lang LaSalle.

Market watchers say the latest transaction shows improvement in sentiment in the office investment market. ‘It also provides a badly needed transaction for valuers to use as a data point in arriving at investment-grade office capital values,’ a property consultant added.

APF Property Investments is linked to the Asia Property Fund, sponsored by LaSalle Investment Management and PruPIM, which is part of Prudential UK group.

K-Reit highlighted that the provision of rental income support will limit downside risks and provide certainty of income for the next few years.

First look

KREIT’s core operating performance in 2Q09F was better than we expected as management continued to roll over leases at higher rents. However, with further deterioration in portfolio occupancy, we believe focus will shift towards trading rental growth for occupancy, and we expect full-year rental income growth to move in line with our forecast. Trading at an implied EV of S$994psf, we believe downside risk in KREIT’s portfolio valuation is more than priced in.

Focus shift towards occupancy