The One REIT You Must Have To Ride The Multi-Year Office Upcycle

Dwindling supply due to a limited pipeline, coupled with returning demand driven by rising employment numbers has led to office rental rates rising for five consecutive quarters. We believe that Singapore’s office market might be at the start of a multi-year upcycle.

Investors who want to ride this upcycle should consider Capitaland Commercial Trust (CCT), as its Singapore-centric portfolio places it in prime position to benefit from this trend.

With a relatively short WALE and the majority of its leases expiring during the market upcycle, CCT should be able to renew its leases at substantially higher rates.

Using a DDM, we estimate the intrinsic value of CCT to be SGD 2.17, representing a 22% upside from its last traded price. Also, the potential for growing dividends should also boost the total returns for CCT shareholders.

Singapore’s Office Market On Track For A Strong Upturn

Plagued by an oversupply of office space and sluggish economic growth, Singapore’s office market has been on a down cycle for the past three years. Rental rates, which are primarily determined based on supply and demand characteristics of the market, experienced tremendous downward pressure, falling to as low as SGD 8.95 psf/month.

However, as supply dwindled and demand returned, things are once again starting to look up for the office market. Ever since rental rates bottomed in the first half of 2017, the office market has been on a steady path to recovery, recording five consecutive quarters of rising rents. With rental rates hitting a high of SGD 10.45 psf/month in 3Q18 (Chart 1) and favourable conditions expected to persist, we believe that this could be the start of a multi-year upcycle for Singapore’s office market.

Chart 1: Since Bottoming In The First Half Of 2017, Office Rents Have Been On A Roll

Rising Employment & A Wider Variety Of Tenants To Drive Demand

Propelled by rising employment numbers, demand for office space has started to pick up over the past two years (Chart 2), driven by a wider variety of tenants. Although the financial sector still remains the primary occupants of central area office space, companies from other sectors such as technology have also been expanding their footprint in the CBD, contributing to higher take up rates.

In 2018, Facebook moved into its new office at Marina One, occupying 260,000 sqft of Grade A office space across four floors, a generous upgrade from its previous location at South Beach Tower which was only 70,000 sqft. Grab, South East Asia’s leading ride hailing platform also made Marina One its new home with a 100,000 sqft office.

Chart 2: Rising Employment Numbers Is Triggering Demand For Office Space

Apart from the technology sector, co-working spaces are another up and coming source of demand for central area office space. Thought to be a passing fad patronised mostly by start-ups and freelancers, co-working spaces have grown tremendously since 2015 as more and more companies are beginning to embrace the sharing economy.

According to a report by Colliers International, out of the 2.9 million sqft of office space taken up last year, co-working spaces accounted for 19%. The demand from co-working spaces is expected to persist as the share of total office space occupied by them is projected to reach 20% in 2020, up from just 2.4% in 2017. Recent major take-ups include WeWork’s 56,000 sqft office in Suntec Tower 5 and JustCo’s massive 70,000 sqft office at Marina One.

To avoid being left in the dust, Singapore’s largest property developers are also jumping on the bandwagon. Earlier this year, City Development (SGX.C09) announced that it has invested CNY 72 million for a 24% stake in Distrii, one of China’s leading co-working space operators. Distrii marked its first overseas venture by opening a 62,000 sqft facility in Republic Plaza, one of the largest co-working spaces in Singapore. Also, Capitaland (SGX.C31) and Keppel (SGX.BN4) both launched their own co-working spaces last year, reaffirming the stand that co-working spaces are here to stay and will become an important growth engine for Singapore’s office market.

Upcoming Supply Crunch A Blessing For Landlords

Besides the returning demand, data from CBRE and URA reveals that the office market will most likely undergo a period of tightening supply over the next few years, moving away from a supply glut that has plagued it since 2016.

2016 and 2017 saw an abundance in supply of central area Grade A office space, with nearly 4 million sqft hitting the market. The bulk of this is contributed by Gucco Tower and Duo Tower, both of which were completed in 2016, as well as Marina One, which was finished in 2017. The completion of these three projects within a short span of time caused a supply glut in the office market, which pushed rental rates lower.

Thankfully, supply is expected to taper with estimates showing only 3.8 million sqft of office space will be made available between 2019 and 2022 (Chart 3). This works out to be 0.95 million sqft/year, which is less than the 10-year historical average supply of 1.2 million sqft/year. Notable upcoming projects include the redevelopment of Golden Shoe Carpark into CapitaSpring. The project is expected to be completed in the first half of 2021, and will add approximately 0.635 million sqft of Grade A office space to the central area (Table 1).

Chart 3: Limited Supply Of Office Space Over The Next Few Years Should Drive Rental Rates Up

Table 1: Summary Of Upcoming Projects And Their Completion Dates

However, if we take into consideration that only half of the 3.8 million sqft of office space will be available within the next three years, the average supply available per year falls from 0.95 million sqft to just 0.67 million sqft, drastically lower than the 10-year average supply. Consequently, the supply crunch over the next few years is likely to lead to higher rents, benefiting office landlords.

In a nutshell, rising employment numbers and a wider range of tenants seeking Grade A office space in the central area should accelerate demand. Coupled with a supply crunch over the next three years, office rents will almost certainly climb, enabling landlords to experience positive rental reversions before the next wave of supply hits in 2022.

Capitaland Commercial Trust The Prime Beneficiary Of The Office Market Upcycle

Singapore’s office REIT space is fairly concentrated, dominated by a few major players. The largest of them all is Capitaland Commercial Trust (SGX.C61U), with a market capitalisation of SGD 6.63 billion (as of 14 Dec 18). CCT is also the largest office landlord in the central area, controlling roughly 20% of the entire Grade A office stock (Table 2).

More importantly, CCT’s portfolio of assets is heavily concentrated in Singapore, from which it derives 95% of its net property income (NPI), substantially higher than any of its competitors (Chart 4). As such, we believe that out of all the available REITs, CCT is in the best position to benefit from the office market’s upcycle.

Chart 4: CCT Has The Highest Exposure To Singapore’s Office Market

Getting Ready For The Next Leg Of Rally

Since its listing in May 2004, CCT’s portfolio has grown extensively to 10 properties with a total value of SGD 11.1 billion today. Close to 80% of its portfolio is made up of Grade A offices located in Singapore’s central area. These include several iconic skyscrapers in the CBD such as the recently acquired Asia Square Tower 2 (AST2), CapitaGreen and Capital Tower.

CCT recognises that every unique asset performs differently during various stages of the market cycle, which is why the REIT adopts a portfolio reconstitution strategy, where it aims to realise the maximum value of its assets by divesting them at an optimal stage of their life cycle, and recycling the proceeds to generate growth in other areas.

Following this strategy, CCT has divested several of its fringe CBD assets over the recent years, such as Twenty Anson and Wilkie Edge, using the proceeds to fund the acquisition of AST2 and the development of CapitaSpring. CCT’s focus on core CBD Grade A assets will reposition the REIT nicely for the upcoming market cycle, where diminishing supply and increasing demand is expected to put upward pressure on the rental rates for central area office space.

Majority Of Lease Expiries Coincides With Upcycle

As of 3Q18, CCT has a weighted average lease expiry (WALE) of 3.4 years, which is relatively short compared to other office REITs. A closer look at the REIT’s lease expiry portfolio shows that approximately 70% of its leases will expire by 2021 (Chart 5), when the office market is still in its upcycle. CCT should thus be able to renew its leases at substantially higher rates, allowing to it to enjoy positive rental reversions.

Chart 5: CCT’s Short WALE Allows It To Renew Its Leases At Higher Rates

Perhaps the most exciting development for CCT is its current project to redevelop the former Golden Shoe Carpark into CapitaSpring, a 51-storey integrated development comprising of Grade A offices, a 299 room serviced apartment, ancillary retail space and a food centre. CapitaSpring is expected to be completed in the first half of 2021, and will add 635,000 sqft of Grade A office space to the central area. CCT has a 45% interest in CapitaSpring and holds a call option to acquire the remaining 55% interest in the commercial component from its partners.

Fortunately for CCT, CapitaSpring is the only supply of Grade A office space coming out in that year. The limited supply will not only lead to less competition, which gives CCT more pricing power, but also ensures higher and faster take-up rates. As of April 2018, CCT has already secured an anchor tenant in the form of JP Morgan, which has agreed to lease a third of CapitaSpring’s NLA. With the limited supply and two more years to completion, we are confident that CapitaSpring should be able to secure near full committed occupancy before it receives its TOP.

Rising Interest Rates A Negative For REITs?

Rising interest rates tend to have a negative impact on REITs as it reduces the present value of future cash flows while at the same time increases the cost of servicing debt. Anticipating that interest rates will continue to rise over the near term, CCT has been actively refinancing its loans. At the end of 3Q18, the REIT has 92% of its borrowings on fixed rate loans with an average cost of debt of 2.6%. With a sizeable amount of fixed rate borrowings, CCT should be well insulated from the rising interest rates.

Also, a weakening global economy may hurt the profitability of firms, resulting in softer demand for office space which may derail the office market’s recovery. However, despite a bumpy year for the global economy, we expect global growth to remain healthy in 2019, but at a slightly slower pace.

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Favourable Industry Trends Backed By Attractive Fundamentals

Besides the favourable outlook for Singapore’s office market, CCT stock is also fundamentally attractive. Although at first glance it might seem overvalued with a Price/NAV ratio of 0.99 that is much higher than the peer average of 0.82, we believe that CCT still has room to appreciate as it is still quite far off from the high of about 1.15 seen during the peaks of previous market cycles (Chart 6).

Chart 6: CCT Is Still Trading Below Its Previous Peak Cycle’s Price/NAV Ratio

There are several reasons to justify CCT’s higher valuations. CCT has the lowest leverage ratio among its peers (Table 2), which means that it has more room to make further yield-accretive acquisitions without diluting shareholder equity. On top of that CCT’s dominant position in the office market will likely make it the main beneficiary of the office market’s upcycle.

Table 2: CCT Has The Lowest Gearing Ratio And A Decent Dividend Yield

Using a two-stage dividend discount model, we estimate the intrinsic value of CCT to be SGD 2.17 by the end of 2019, which represents a 22% upside from its last traded price (as of 14 Dec 18). Our assumptions are as follows:

Table 3: Dividend Discount Model Assumptions

In addition to the high upside potential, investors can also expect to receive an estimated dividend yield of 5% for 2019, a good source of income while waiting for its share price to re-rate. Following the rising rental rates, we believe that there is immense potential for dividends to grow, which will play a part in boosting the total returns for investors.

With a portfolio of high quality Grade A offices, short WALE, exciting new developments and an extensive exposure to Singapore, Capitaland Commercial Trust (SGX.C61U) will almost certainly be the main beneficiary of the upcycle in Singapore’s office market. Investors who do not want to miss this upcycle should jump in now.

Declaration:

For specific disclosure, at the time of publication of this report, IFPL (via its connected and associated entities) and the analyst who produced this report hold a NIL position in the abovementioned securities.

The Research Team is part of iFAST Financial Pte Ltd.