Why Keppel REIT and Office REIT are still not attractive

Came across S-REIT Investment blog's write up on Keppel REIT where its price has fallen to "attractive levels". While the financial ratios do look attractive, it is only one side of the story and I do not find Keppel REIT attractive yet.

Poor Office outlook

According to URA, there will be 545,000 square meters of new office space available for 2016. And judging from the office space demand during the past 5 years (2010-2014), the annual net demand is 110,000 square meters. Therefore, it is likely office space vacancy will rise by approximately 400,000 square meter. Currently there is a vacancy rate of 9.8% (746,000 sq m vacant space vs total current supply of 7,583,000 sq m). In 2016, vacancy rates are likely to spike above 11%. The last time Singapore experienced an office vacancy rate above 11% was during the GFC and 2001-2004 period.

Office Space Supply from URA

Furthermore, this oversupply is set to persist because more office spaces will be built from 2017 to 2019 and across each of these years, annual supply is greater than annual demand. Hence, in order to spur more companies to take up office spaces, rental rates are likely to fall by 15-20% from current levels. Lastly, the increase in office spaces are due to completion of new Grades A office buildings such as Guocotower and Duo. Hence the argument that Keppel or Capitacommercial are protected due to their quality grade A assets does not stand.

What does a fall in rental income mean?

Lower Distributable Income

Lower rentals mean less revenue and thus less profit. Hence, the current yield of 7.28% is set to be lower when the full effects of an office supply glut kicks in. It is worth noting majority of Keppel’s REIT tenancy contracts only expires in 2017 and after. Hence there will be a time lag in a profit fall because lower rental rates for Keppel’s office space are likely to happen after 2017 when tenancy contracts are renewed. Hence dividends are likely to be affected in the future.

Lower Valuation of properties

REITS tend to use the capitalisation methodology to value their assets. The formula is simple:

Value of Property= Net Property Income/ Capitalisation Rates (Cap Rate)

Firstly, with property income being lower in the future, Keppel’s property value will fall.

Secondly, cap rates for office spaces are likely to increase. This is because a rise in global interest rates will increase the cap rate. Also, a lack of growth in office space rental prices result in a higher cap rate as well. In short, the impending rise in global interest rates and lack of growth will increase the cap rates of office buildings.

With a fall in property income and rise in cap rates, the value of such REITS office property value are set to tumble. This can be seen in CapitaCommercial Trust’s (CCT) presentation below where the cap rates of its buildings are lower than previous years. Cap rates in some CCT assets are now creeping back to their old levels of 4+%. This phenomenon will apply to Keppel REIT as well because their office properties are similar to CCT.

CCT Capitalization Rates Table

A lower valuation of properties means a higher gearing ratio. This is because of the formula:

Gearing = Total Debt/ Total Asset

Hence for Keppel REIT, with an impending fall in valuation, it means lower value for its assets and hence a gearing ratio higher than its current 38.8%. This is not good because MAS requires all REITS to maintain a gearing level of 45% to its total assets. Should Keppel's gearing exceed 45%, it will have to raise money to pay down its debts by placing out new shares or asking shareholders for money. This will dilute the stakes of current shareholders and reduce dividend yield. The alternative is to sell off its assets which also reduces dividend yield.

Keppel itself does not have much cash in its reserves to pare down debts because it is obligated to pay at least 90% of its cashflow as dividends. Furthermore, many REITS pay only the interest and roll over the principal at the end, commonly known as Bullet Loan.

Conclusion

To conclude, given the impending fall in rental income due to a supply glut, Keppel REIT is likely to be affected and its shareholders will experience lower dividend yields. In addition, its NAV is likely to fall with lower asset prices. Hence Keppel REIT's current price to book ratio is not reflective of the actual situation.

This too may be explain why CCT/OUE Commercial (another office REIT) are trading below its book value and at a high trailing dividend yield. While Mapletree commercial and Suntec have office properties, they have a significant exposure to retail and are not as heavily weighted in office than Keppel and CCT/OUE.