RHB Group Research analyst Vijay Natarajan has maintained his “overweight” rating for US office REITs, despite the sector being down 35% year-to-date (ytd) on the back of concerns over empty office buildings, sharp interest rate hikes and fears of a possible deep recession.
In comparison, Singapore REITs (S-REITs), despite concerns of the rate hikes from the US Federal Reserve (US Fed) are 13% lower ytd.
In his report dated Sept 30, Natarajan says that he continues to remain positive on office space utility and viability as a stable real estate asset class, although he acknowledges that macro conditions have “deteriorated”.
“US office REITs are oversold in our view, trading closer to Covid-19 lows of 0.6x P/BV and around 12% yields, presenting good entry levels for long-term investments,” he says.
Natarajan believes the REITs offer a “good buffer”, with an average yield of around 12% — around 800 basis points (bps) higher than 10-year treasury yields. Cap rates currently vary from 5.0% to 7.5% depending on markets and location. “While we see the possibility of 50 to 100bps cap rate expansion by the end of the year this should not result in an over 10% decline in net asset value,” he explains.
While a key concern weighing down the US office sector has been the much slower-than-expected return to office in the US compared to other countries, the analyst notes that more employees could potentially return to offices amidst recession fears.
Based on Kastle data and according to US office REITs, physical occupancy in the US office buildings varied from 20% to 60% depending on markets and location. In comparison in Singapore 60% to 70% of employees were back to offices.
“The slow return — despite many employers trying to woo employees back to office — has been largely attributed to employees’ bargaining power amidst tight labour market conditions,” explains Natarajan. “However, in our view, rising recessionary fears and weakening labour market conditions are likely to change this sentiment, and prompt more employees to return to offices, which should lift sentiment for the office sector.”
He adds that operational metrics for US office REITs have proven resilient so far, with US office rents holding up well despite the Covid-19 pandemic. RHB’s top picks Prime US REIT and Keppel Pacific Oak US REIT (KORE) have been logging positive rent reversions every single quarter since listing, with target prices (TPs) of US$1.00 and 87 US cents respectively.
Natarajan believes the positive rent reversions for Prime and KORE have given “comfort” in terms of the attractiveness of the assets and location, diversification profile and under-rented nature of their portfolio.
“Although this situation is expected to moderate, we expect it to remain in the low to mid-single digits this year as tenants’ willingness to pay for good quality office space remains high,” says Natarajan, adding that he expects occupancy to stay above 85% due to a well-diversified portfolio, good quality assets with focus on sustainability and amenities.
Although the US Federal Reserve has hiked rates five times since the start of the year, to 3.0%–3.25%, and is expected to peak around 4.6% by 2023, the analyst believes the impact of rising rates is “manageable”.
“The latest projected pace of rate hike at the September meeting was higher than the market anticipated which has resulted in heightened market uncertainty and double digit price correction for US office REITs over the past week,” Natarajan notes.
However, he adds that from a balance sheet standpoint, the impact on interest costs is manageable since all three REITs, including Manulife US REIT, have a high fixed hedge position of around 85%, limiting distribution per unit (DPU) impact to less than 2% for every 100bps increase. All three REITs also have less than 15% of debt maturing until 2023 thus reducing loan repricing risks.
Natarajan points out that a key difference between listed US office REITs and other S-REITs is that no single shareholder can exceed a 10% stake — with very few exceptions — in order for the underlying parent of the US REIT to qualify for the favourable tax treatment under the US portfolio interest exemption rule.
“This limits sponsors’ support via holding a sizeable stake and anchor investors presence which are commonly seen in other SREITs (sponsors typically hold 25%-40%) and results in shares being widely held across a large pool of investors. As sponsors and anchor investors are long-term investors in general, this lends to increased share price stability across market cycles which is somewhat limited in case of US office REITs,” he explains.
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The way Natarajan sees it, the smaller size of US office REITs, a relatively lower liquidity, higher proportion of retail shareholding, and the volatile nature of US office markets also increase share price fluctuations during market downturns.
Key risks to his outlook include the return to office trend remaining at low levels, further increases in the pace of rate hikes to tackle inflation and a deep and prolonged recession in the US.
As at 11.53am, shares in Prime and KORE were trading at 52 US cents and 54 US cents respectively.