Q2 Results

Riding through the trough

• 4Q14 DPU declines 23% y-o-y upon divestment of Prudential Tower
• Portfolio reversions of 17% supported by strong expansion in tech, media and telecoms (TMT) sector
• Full contribution from MBFC Phase 2 may not mitigate drop in rental support for OFC
• Maintain HOLD, TP S$1.29

Highlights

Results below due to later-than-expected acquisition completion

• Keppel REIT (K-REIT) reported 4Q14 revenue of S$42m (-11% y-o-y) and NPI of S$34m (-8%), largely attributable to lost income stemming from the divestment of Prudential Tower in 3Q14. DPU of 1.51 Scts was 23% lower y-o-y on the back of a dilution in share base post-placement and a delay in the completion of the MBFC Phase 2 acquisition.

Diversification of tenant base to include more from TMT sector

• K-REIT completed c.450k sqft of lease renewals, with average portfolio reversions of17%. This was driven by strong interest from new-to-market as well as relocating companies in the technology, media and telecommunications (TMT) industry. As a result, new leases signed in the Raffles Place/Marina Bay areas averaged S$12 psf pm.

Outlook

Positive rental outlook for 2015

• Close to 420k sqft of leases will be up for renewal or rent review, representing c.13% of portfolio NLA. We understand that the majority of spaces are located in the Raffles Place and Marina Bay areas, where new office space is not expected to be available until FY16. As such, we believe that these leases will continue to see upward reversions of 10-15%.

OFC income support to be fully drawn down by 1Q15

• According to the Manager, income support for Ocean Financial Centre is anticipated to run out by 1Q15, and we estimate that this will have a 6% impact on DPU.
• While full-year contribution from MBFC Phase 2 will more than cover lost income from the divestment of Prudential Tower, we do not expect additional income to cover the shortfall in rental support. As such, we have forecasted FY15 DPU to decline by 7%.

Valuation

Our target price of S$1.29 is based on the discounted cash flow (DCF) model; as K-REIT generates recurring rental income from its tenants. At its current price, K-REIT offers investors a dividend yield of 5.4% for FY15. We have a HOLD recommendation.

Risks

Interest rate risk

• Any increase in interest rate will result in higher interest payments that the REIT has to make annually to service their loans. This reduces the incomeavailable for distribution, which will result in lower distribution per unit (DPU) for unitholders.
  

Currency risk

• As income for S-REITs are distributed in Singapore dollars, any income derived in a foreign currency will have to be exchanged into SGD. As K-REIT earns rental income from its Australian assets in AUD, any depreciation in the AUD would result in relatively lower contributions from Australia to K-REIT’s total distributable income.
  

Economic risk

• A deterioration of the economic outlook could have a negative impact on office rents, which have a strong historical correlation with GDP growth.

Acquiring MBFC Tower 3 finally

• Acquires MBFC Tower 3 at c. 3.6% initial yield
  
• Lower risk profile due to drop in average age of portfolio and better cashflow visibility
  
• HOLD, TP maintained at S$1.29
  

Purchases MBFC Tower 3 for S$1,248m. K-REIT announced the acquisition of a one-third stake in MBFC Tower 3 from sponsor, Keppel Land, for S$1,248m or S$2,790 psf. This represents a 2-3% discount to independent market valuations and within the S$2,181-2,830psf range of recently transacted CBD properties which we think is fair considering MBFC Tower 3’s premium location. Including income support, the initial yield stands at c. 3.6%.

Strengthens exposure to tight Singapore office market. By recycling the proceeds from the sale of the older Prudential Tower, an equity fund raising of c.S$413m and additional debt raised, the purchase of MBFC Tower 3 further strengthens K-REIT’s exposure to the tight premium grade office market. In addition, KREIT’s risk profile has been reduced, as the average age of its portfolio has dropped from 6.2 years to 5.5 years, lowering the need for extensive AEI’s. Furthermore, cash flow visibility has improved with the WALE for its top 10 tenants (46% of NLA) lengthening to 9.2 years from 8.5 years. Post acquisition, our FY15/16F DPU is lifted by a marginal c.0.1% with FY15 gearing increasing to c. 42%. Our DCF-based TP is maintained at S$1.29.

Near term re-rating; medium term earnings risks in FY15/16F; maintain HOLD. With the purchase of MBFC Tower 3 and equity fund raising “overhang” removed, we expect a near term re-rating of the stock. However, we see medium term risks coming from the fall-off of rental support from Ocean Financial Center, which is fairly significant (FY15 to see a c.11% drop in DPU). As such, forward yields of c.5.6%-5.7% (ex –OFC income support) are fair in our view, and we maintain our HOLD call.

Acquisition of MBFC Tower 3

KREIT just announced the highly anticipated acquisition of MBFC Tower 3. Although this iconic office building could strengthen the REIT’s portfolio and diversify its tenant base, the resulting yield dilution is disappointing. As a result of the estimated DPU dilution of 3.6% in FY15 and 3.8% in FY16, we maintain our Hold rating with a lower DDM-based (discount rate: 8.4%) target price of S$1.21, as we factor this weakness into our model.

What Happened

Keppel REIT (KREIT) said it has entered into a conditional share purchase agreement with Bayfront Development Pte Ltd. for the acquisition of a one-third stake in Marina Bay Financial Centre Tower 3 (MBFC Tower 3) for a purchase consideration of S$1,248m. This property is a 46-storey premium grade A commercial building with ancillary retail space situated in the heart of Marina Bay, with an attributed NLA of c.447,000 sq ft and an occupancy of 94%. After the adjustments for net liabilities, total purchase consideration is S$710.1m and will be satisfied by way of issuance of S$185m worth of units to the vendor and cash payment for the balance. The cash will originate from i) 195m of new KREIT units to be issued via a placement at an issue price of S$1.17/unit (4.88% discount to the last traded price); ii) part of the proceeds (S$185.2m) from the Prudential Tower divestment; and iii) borrowings of S$120.7m.

What We Think

The value of S$1,248m translates to a value of S$2,790psf – c.9% higher than what DBS paid for its 30% stake in late 2012. Including the five-year rental support of S$10.40-10.80 psf/month, the initial yield is estimated at c.3.5%. Taking into consideration the expiry profile, coupled with an expected growth in rental spot rate by 10% and 5% in FY15 and FY16 respectively, we estimate the passing rent to surpass the supported level by FY18, by which time the majority of the leases in the property would have been renewed. However, on the back of new units being issued, coupled with a resultant leverage ratio of 43.8%, we estimate KREIT’s DPU to be diluted by 3.6% in FY15 and 3.8% in FY16 as a result of this acquisition. Having said that, this weakness could potentially be mitigated if KREIT is able to obtain the Limited Liability Partnership tax transparency status as per MBFC Tower 1 & 2.

What You Should Do

Factoring in the lower DPU over the next few years as a result of this acquisition, we have maintained our Hold rating on KREIT with a lower target price of S$1.21.

Divest to invest

KREIT has just announced that Prudential Tower will be divested for S$512m, or 6.3% above its book value. While the price is attractive and the divestment could pave the way for KREIT’s potential acquisition of MBFC Tower 3, we estimate that income support may be required to make any such acquisition yield-accretive. We slightly lower our DPU estimates and DDM-based (discount rate 8.5%) target price after adjusting for the divestment. We

maintain our Hold rating while awaiting more news on the acquisition.

What Happened

KREIT has entered into an agreement with a JV under KOP for the divestment of its 92.8% stake in Prudential Tower for S$512m. Completion of the sale is expected on 26 Sep 14.

What We Think

Attractive divestment price. The price of S$2,288 psf is 6.3% above book value, which implies that Prudential Tower will be sold at a low NPI yield of 2.3% (based on FY13 NPI and 100% occupancy), an attractive divestment price, in our view. KREIT is expected to book a net divestment gain of S$9.0m, which could pave the way for its acquisition of MBFC Tower 3. Although Prudential Tower accounts for 8.4% of KREIT’s FY13 NPI, interest savings is expected to mitigated the net drop in DPU by 3.4% and 1.6% in FY14/15 respectively.

Potential acquisition of MBFC Tower 3. Although no details have been divulged, our estimation suggests that if MBFC Tower 3 is acquired at S$2,555 psf (similar to what DBS paid last year for 30% of the tower), it can potentially add 0.9% to KREIT’s DPU yield, if: i) rental rates are supported at S$11 psf/month; and ii) 80% of the remaining S$651m (valuation of Tower 3 at S$1,150m minus S$499m) is financed through debt at an interest rate of 2.15%; resulting in a gearing of 44.2%. Having said that since S$2,555 was paid before the upturn of the office market, the income support can potentially be higher if the acquisition is executed at a higher price. The attractiveness of this potential acquisition rests largely on KREIT’s ability to lift passing rents for the property to the level of income support; considering that DBS is also the anchor tenant of the property.

What You Should Do

Continue to Hold at a slightly lower target price of S$1.21, while we await for more clarity on the potential acquisition.