SINGAPORE (July 9): CapitaLand Commercial Trust’s share price has fallen 17% since the start of the year, significantly underperforming the FTSE ST Real Estate Investment Trust Index, which is down less than 7%. Office real estate investment trusts in general are down around 10%.
Part of the reason for CCT’s underperformance was the acquisition of Galileo, an office building in Frankfurt’s CBD. The move sent CCT’s gearing ratio up to 39%, and the accretion to distribution per unit (DPU) based on pro forma numbers was just 1.4%. On July 2, CCT announced that it was selling Twenty Anson for $516 million, or a capitalisation rate of 2.7%. The sale price is 20% above the purchase price of $430 million and will lower the REIT’s leverage to 35.9%. For 1QFY2018, Twenty Anson contributed 3% to total net property income. Although the divestment could lead to lower NPI, this should be offset largely by interest savings from debt repayment and lower asset management fees.
JPMorgan favours office REITs such as CCT because of three price catalysts. First, overseas acquisitions are likely to contribute to NPI and buoy DPU for this year. Second, the Singapore office rental cycle has turned up. But there is a time lag between the upturn and impact that the higher rents have on REITs’ rental revenue. Rental reversions for the office REITs depend on their leases, which are typically three years. The last upcycle in rents ended in 1Q2015.
According to data provided by CCT, the average rent of its expiring leases this year is $10.82 psf per month, which is still higher than the average Grade-A CBD rent of $9.70 psf per month for 1Q2018, according to CBRE. Next year, average rents of expiring leases is $10.37 psf per month and, in FY2020, the value is $9.45 psf per month.
By 4Q2018, the rental reversions should turn positive, JP Morgan estimates (see chart). Lastly, although interest rates are rising, the liquidity for office property in Singapore is driving their capitalisation rates lower.
Based on capital values alone, office space for the REITs are at new highs. Capital Tower, Six Battery Road, HSBC Building and Twenty Anson are at historical highs, as are One Raffles Quay and Marina Bay Financial Centre Phase 1. Keppel REIT and Suntec REIT own a one-third share each in ORQ and MBFC Phase 1. Bugis Junction Tower, Ocean Financial Centre and MBFC Phase 2, which are in Keppel REIT’s portfolio, saw a small decline in their valuations. JPMorgan blames this on negative rental reversions last year.
The US bank has calculated that office yields compressed for 10 straight quarters since 2Q2015, before inching up one basis point and five basis points to 3.56% and 3.61% in 4Q2017 and 1Q2018 respectively. This represents a yield spread of 1% when measured against yields of 10-year Singapore Government Securities.
If yields on 10-year SGS rise to 2.9% in 2019, office capitalisation rates are likely to expand to 3.9% by next year, according to JPMorgan. The capitalisation rate used for valuing OFC, ORQ and MBFC was 3.75% as at Dec 31. CCT had a range of cap rates for its buildings, with HSBC Building and Six Battery Road at 3.6% — both occupy 999-year leasehold land — and 3.7% for Capital Tower.
JPMorgan expects the cap rate expansion, which would cause valuations to dip, to be offset by stronger rental improvement, which together would keep valuations elevated. “Our sensitivity analysis reveals that, for every 10 basis points cap rate expansion, rent has to increase by 2.5% for a neutral impact to capital value,” a recent JPMorgan report states. “The impact to office S-REITs’ net asset values would vary, given their different exposures to the domestic office sector.” Based on a sensitivity analysis, Keppel REIT would be the most affected by changes in cap rates, followed by CCT and, finally, Suntec REIT (where Suntec City, excluding the office towers, contributes 52% to NPI).
The US bank has “overweight” ratings on CCT and Keppel REIT. For CCT, it forecasts a 0.6% change in DPU for this year to 8.7 cents, and a further 4.2% y-o-y rise for FY2019 to 9.1 cents. CCT is trading at 0.94 times its March 31 NAV of $1.74. Keppel REIT’s DPU is likely to rise 1.5% this year to 5.79 cents, and a further 1.3% to 5.86 cents for next year. Keppel REIT is trading at just 0.8 times NAV and at forward yields of 5.26% and 5.33% for 2018 and 2019 respectively. CCT is trading at forward yields of 5.3% and 5.5% for 2018 and 2019 respectively.
