Bright spots but upside limited

3Q12 provided a positive read-through of a stable office market. Yields are compelling but we see this as compensatory for the high asset leverage and limited accretion expected from the acquisition of MBFC Phase 2 (given the likely need for equity fund raising).

3Q/9M12 DPUs were broadly in-line with our and consensus estimates at 26/77% of our FY12 estimates. We tweak DPUs on adjustments to income support and withholding tax. Our DDM-target price is however higher due to a lower discount rate of 7.7% (prev. 8.2%). Maintain Neutral.

Leasing continues

3Q12 distributable profit was up 93.6% due mainly to acquisitions. Qoq, DPU was up a marginal 1% on improved NPI and tax-transparency from MBFC Phase 1. Results provided a positive read-through of a stable office market: Take-ups remain positive, lifting portfolio occupancy to 98.2% from 97.0%, mainly from OFC (95.0% from 92.3%), Prudential Tower (100% from 99.5%) and 77 King Street (97.4% from 92.7%). Signing rents remained fairly stable at S$8-9psf at Prudential Tower and S$12-13psf at Ocean Financial Tower, with no additional incentives offered. Leasing interest for the latter came from a mix of fund management and new-to-market legal firms.

High asset leverage

Aggregate leverage at 44% is the highest in the sector, even without factoring in its recent Australia purchase. While this is expected to be less of a concern now that capital values remain buoyed by low interest rates, higher asset leverage could still warrant equity fund-raising needs for the remaining tranches of its Aussie purchase and a potential acquisition of MBFC Phase 2. Notwithstanding, we understand that KREIT has yet to indicate its interest for the asset.

Maintain Neutral

Forward yields are compelling but we see this as compensatory for its higher asset leverage. This should warrant equity fund-raising needs for further purchases, which could in turn limit accretion. Maintain Neutral on limited upside.

Clocking K-angaroo miles

A 50:50 debt-equity funded acquisition of a Perth office development could be accretive though mainly through cheap S$ debt. Accretion is offset by a resultant higher gearing. The longer lease provides visibility but could limit upside from a buoyant Perth office market.

We tweak our DPUs by -0.3/+0.8%, fine-tuning our assumptions and assuming a 50:50 debt-equity funded acquisition. Our DDM target prices rises slightly because of these changes and the rollover of our target price. Downgrade to Neutral from Outperform given the limited upside.

What Happened

K-REIT has entered into a conditional agreement with Mirvac Projects to acquire a 50% interest in a new office tower development (slated for completion in 2H15) in Perth, Australia. Total consideration is estimated at A$165.0m (S$211.2m, 7.15% cap rate), paid through an initial 50% in Mar 13 and five further progressive tranches from Dec 13. The first tranche will be funded by debt. Management has yet to decide on the funding mode for the remaining tranches. Regular income at an effective rate of 7.0% will be paid throughout the construction phase. Development risk will largely be taken on by Mirvac. 98% of the NLA is pre-committed to the government of Western Australia.

What We Think

We are net-neutral on the deal as the accretion is offset by higher gearing. The capital value of S$1,274 psf appears a tad above recent market transactions, arguably for a relatively newer asset. Cap rates were fairly in line with some recent premium grade office transactions. While we like the visibility from a 25+25 year lease and 3-5% annual rental step-ups, the long lease could also result in limited upside for K-REIT in the buoyant Perth office market. A higher asset leverage of an estimated 45% after the first 50% payment could imply a need for equity fundraising for the remaining tranches. We estimate that a 50:50 debt-equity transaction could still be accretive though this is aided mainly by cheap S$ debt.

What You Should Do

K-REIT has outperformed the STI by 25% since we upgraded it to Outperform in Apr. With limited further upside and equity fundraising needs (as gearing creeps up) expected to limit accretion from a potential acquisition of MBFC Phase 2, we downgrade K-REIT from Outperform to Neutral.

Resilient earnings

• Results in line; 6M DPU is 52% of our FY12 forecast

• Stable rents backed by improving occupancy rates

• Proactive refinancing efforts will mitigate gearing risk

• Maintain BUY; TP is adjusted to S$1.23

Highlights

Results in line. K-REIT’s NPI and gross revenues more than doubled to S$31.3m and S$39.3m, respectively, led by its 88% stake in Ocean Financial Centre (OFC) and improving occupancy rates at all properties. Meanwhile, the income vacuum left by the expiry of One Raffles Quay’s (ORQ) was partly mitigated by the GST rebates and positive rental reversions. Distributable income was S$49.8m or 1.94cts DPU (+86.5% y-o-y, +2.1% q-o-q).

Our View

Improved occupancy, stable rents. Although the Eurozone crisis has created uncertainties in the global economic climate, KREIT’s portfolio continued to demonstrate resilience by outperforming the general office market. Occupancy is now 97% with improvement at all its properties, while leases that were renewed in the quarter saw positive rental reversions. Meanwhile, OFC signing rents continued to hold up at S$11-13 psf supported by higher occupancy of 93% vs 91% a quarter ago. In Sydney, Apple has taken up additional space at 77 King Street, lifting occupancy by 5 ppt to 93% On track to renew S$598m loan. Gearing has risen to 43.9% following the acquisition of 12.4% stake in OFC, but the trust is on track to refinance its S$598m loan due at the end of the year with a 5-year term loan. This should mitigate refinancing risk and extend its debt expiry profile from 2.5 years to 3.6 years.

Recommendation

Maintain BUY; nudged up DCK-backed TP to S$1.23. The longweighted lease expiry of 6.2 years with 48.2% of its portfolio NLA tied to long leases (> 5 years) will help to mitigate leasing risk. Meanwhile, 2H earnings will continue to improve led by rising portfolio occupancy, the additional stake in OFC, and the tax savings from MBFC Phase 1 which was obtained recently. We raised FY12/13 DPU forecast by 1-3% and TP by 1.6% to account for better-than-expected portfolio occupancy. The stock now offers close to 20% total return.

And the leasing continues

K-REIT’s portfolio remains hardy with continued lease take-ups at some key assets. Management also highlighted that it is not looking at an acquisition of MBFC Tower for now, allaying fears of near-term equity fund raising. We think yields of 7% remain compelling for now.

2Q12/1H12 DPUs were in line with our estimates at 26/51% of our full-year numbers, but slightly above consensus. We raise our DPUs and DDM target price (disc. rate: 8.2%) on adjustments to interest costs and rental support. Maintain Outperform on favourable risk-reward.

Tick-up in occupancy 2Q12 distributable profit was up 90% yoy, due to acquisitions. Qoq, DPU benefitted from a partial quarter of tax savings from MBFC Phase 1 and additional stake in OFC. Key positives came from the continued leasing – albeit for smaller spaces. Portfolio occupancy ticked up to 97.0% from 96.1%, mainly from higher occupancy at improved occupancy at OFC, Prudential, MBFC 1 and 77 King St in Australia.

And the leasing continues

Leasing interest in the quarter was dominated by new-to-market legal firms. Management noted largely positive rental reversions for its renewals/reviews. There have been some enquiries for small spaces at OFC, but management is holding out for tenants willing to take up at least half a floor. Rents are still at ‘low-teens’ for its super Grade A properties and S$9+psf for smaller spaces at Prudential, with management noting that it had not offered more incentives for tenants. Management has not seen more formal requests for subletting at its super Grade A properties.

Not looking at MBFC Phase 2 for now

Management noted that it has not started reviewing a potential acquisition of MBFC Phase 2 and that it will monitor occupancy. This should allay fears of a sizeable equity fund-raising, given current asset leverage of 43.9%. We think that the high current yields of about 7% should limit accretion and inhibit an acquisition for now.

Strong Showing at Half-Time

Growth led by OFC contributions. K-REIT reported a stellar 94.6% YoY increase in its 1H12 distributable income of SGD98.4m, underpinned predominantly by the contributions from Ocean Financial Centre (OFC). 1H12 DPU came in at 3.84 cents, broadly in line with expectations. On a QoQ basis, DPU rose by 2.1% mainly on OFC’s improved occupancy rate. The REIT has been a strong outperformer year-to-date as investors remain yield-hungry. Maintain HOLD.

Portfolio occupancy stays robust. K-REIT currently enjoys a very healthy portfolio occupancy rate of 97%. The occupancy rate at OFC has also improved to 92.3% compared to the 85% as of end-2011. Outstanding lease renewals and rent reviews for 2012 are negligible. Management revealed that recent leasing enquiries had come mainly from legal firms, some of which are new-to-market names, but their appetite had been restricted to smaller spaces. Nonetheless, K-REIT’s high occupancy rate and long portfolio WALE of 6.2 years should mitigate any potential downside if office rents continue to slide.

No immediate capital management woes. Even though K-REIT’s look-through gearing is relatively high at 43.9%, we believe this is still very manageable. Its current average all-in interest rate is at a low 2.0%, and management is confident of refinancing the SGD598m worth of debt maturing on 31 Dec 2012. In addition, the acquisition of MBFC Tower 3 does not appear on the cards in the immediate term, especially when commitment rates there are still fairly low at about 67%.

HOLD for the stable yields in the near term. We are keeping our forecasts and target price of SGD0.99 unchanged. We estimate that KREIT should be able to maintain DPU yields of ~6.6% (at current share price) each year till FY15, even if in our view, office spot rents are not likely to see a significant rebound within the next 12 months. Maintain HOLD.