B. Office REITs – Recovery ahead
Mixed performances in 3Q13
Office REITs displayed a mixed set of performances on their headline numbers in 3Q13 as a few of them have undergone through major overhauls in their portfolio and capital structure. For example, Frasers Commercial Trust (FCOT) saw its NPI decline 17.4% YoY due mainly to the divestment of KeyPoint and its Japan properties, but its DPU jumped 18.9% on lower interest costs and distributions following the redemption of its Convertible Perpetual Preferred Units (CPPUs). Suntec REIT, on the other hand, saw NPI recover to a 4.7% YoY growth due to the opening of Phase 1 retail space and Suntec Singapore post enhancement works. As a result, a smaller capital distribution of S$4.5m (S$7.8m in 2Q) from CHIJMES sales proceeds was needed to mitigate the dip in distribution payout. This led to a DPU of 2.289 S cents, down 2.6% YoY. For the entire office REIT subsector, aggregate NPI fell 1.9% YoY in 3Q13, while the subsector DPU increased by 3.4%.
Healthy operational momentum seen
Despite the mixed bag of results, improved operational performances were seen across the board. Healthy rental reversions were registered among the office REITs during the quarter and the subsector occupancy rate inched upwards QoQ to 98.5%. We note that office REITs have been particularly active in their leasing activities, due possibly to the more lumpy nature of the lease renewals. Over at Suntec City, precommitment at Phase 2 retail space has improved from 70.1% in 2Q13 to 83.7% in 3Q13. For CapitaCommercial Trust (CCT), management reports that they are in advanced negotiation for leasing at Capital Tower and committed occupancy is expected to be 100% upon completion. In addition, Keppel REIT also reports that it has recently achieved 100% occupancy for Ocean Financial Centre, and that all of its Singapore properties are now 100% occupied.
Overall healthy gearing ratios and balance sheet structure
On the capital management front, the office subsector gearing ratio eased 0.3ppt QoQ to 37.4% in 3Q13 which is within acceptable levels, in our view. Borrowing costs remain mostly stable at 2.6%, on a QoQ basis, and debt duration for S-REITs in the office space stayed in the 2.3 years to 3.8 years range, as shown in Exhibit B5.
Office rental now likely at inflection point
Looking ahead to 2014, we are keeping our optimistic stance on the office rental market. The subsector has weathered through a cycle of changing fortunes over the past few years, with office rentals in a downturn since 3Q11. However, we note that the rate of decline has moderated over the past few quarters, and 3Q13 Grade A and B office rents are now flat QoQ at S$9.55 and S$7.10 psf pm respectively, based on CBRE 3Q13 Real Estate market report figures. In addition, the office space continues to see steady net absorption of 786,959 sqft in 3Q13. However, with new supply coming into the market over the quarter, the CBD Core sub-market saw occupancy rates dip QoQ to 93.49% in 3Q13 from 95.05% in 2Q13.
Positive tone on office outlook
We now believe that the office market is likely on the cusp of a mild recovery, given that the office leasing activities are still expected to remain healthy going forward. As a note, CBRE expects occupier demand to remain positive across most industries, except for possibly the traditionally dominant financial industry. For 4Q13 till 2016, CBRE projects that there is a total of 7.2m sqft of potential office space supply (13.4% of current stock), with no major developments in 2015.
Staying OVERWEIGHT on office REIT subsector
The tone set by office landlords on the office outlook also appears to be more positive, as opposed to what we heard earlier in the year. Office REITs are generally very involved in enhancement works which should help them command better rental rates post completion of the projects. In addition, several office buildings within the office REITs’ portfolios are currently under-rented, and are well-positioned to capture the potential upturn of office market recovery upon lease renewal. Valuation-wise, office REITs also look appealing, given that the subsector is trading at one of the lowest subsector P/B of 0.81x and forward yield of 6.7%. In view of this, we are staying OVERWEIGHT on the office REIT subsector. We are also retaining CCT [BUY, S$1.61 FV] as our top pick for the office space due to its strong proxy for local office market recovery, lowest gearing of 29.5% and respectable forward yield of 6.0%. We also like Suntec REIT [BUY, S$1.90 FV] for its strong growth potential, attractive P/B of 0.72x and attractive yield of 6.7%.