Keppel Pacific Oak US REIT still has a role to play in a post-COVID future

Figure 1: KORE portfolio occupancy since inception

Rental collections have been healthy and were slightly above our expectations even though most tenants have not returned to office. We believe this can be attributed to the fact that the majority of the tenant base are still functioning. As of 9M 2020, 98.5% of rentals have been collected, with the remaining either being deferred or unpaid.

There has been an approximately 1.1% impact on 9M 2020 net property income (NPI) as a result of rent relief requests granted. Meanwhile, scheduled repayment of deferred rent has started for some tenants, while other tenants are likely to repay in 2021.

The management has indicated that they will be maintaining a 100% payout ratio. For the uninitiated, KORE pays its distributions on a semi-annual basis. Based on a 100% payout, we estimate that the full year DPU is likely to increase by close to 3% year-on-year.

WFH is here to stay, but offices still have a role to play post-COVID

The uncertainty over the future of offices has been weighing on the share prices of office REITs. We understand from the management that tenants have been asking for more flexible lease terms. The general observation is that tenants have been adopting a “wait and see” approach, with some signing new leases that were as short as one or two years.

Nonetheless, the leases with KORE’s top 10 tenants (Table 2), many of whom are tech companies, have remained stable. Moreover, with the top 10 tenants contributing only 19.7% of cash rental income (CRI), there is low tenant concentration risk.

Table 2: Top 10 tenants

It is undeniable that WFH is here to stay, given how it has brought about various benefits for both employees and employers.

However, we think that the downsides of a full WFH model should be also recognised. Technology used during WFH cannot fully replicate some functions that an office can provide. For instance, being able to meet colleagues in person is vital in fostering cohesiveness and collaboration. Moreover, WFH may not be the most viable option for some office workers in the US. Those living in rural areas tend to face bad or limited internet access.

In a post-COVID future, we think more companies will adopt a hybrid model that combines the best of home and office working. This will require both employers and employees to find the sweet spot between working at home and in office.

KORE has a weighted average lease expiry (WALE) of 4.0 years by CRI, which we believe will allow it to generate stable cash flows while its tenants figure out their future office needs.

Rental reversions likely to remain in positive territory

KORE’s average in-place rents are approximately 10% below asking rents, which the management believes will continue to drive growth. Based on CoStar’s estimates, rents in KORE’s key growth markets are projected to fall by -1.6% in the next 12 months, outperforming the national average (Figure 2). We think this is likely due to KORE’s exposure to key growth markets that have healthier office fundamentals.

Figure 2: Rent outlook outperforms the US average

Coupled with a built-in annual rental escalation of 2.7%, we think rental reversions are likely to remain positive albeit at a smaller magnitude. The management also expects single digit positive rental reversions going forward.

With an exposure to markets such as Seattle and Denver (growing tech hubs) and Houston (home to largest medical centre in the world), KORE has a sizable exposure (37.2% of NLA) to tenants from the growing and defensive sectors of technology, as well as medical and healthcare.

While tech companies have been the ones that are embracing the WFH model, they are still leasing office spaces. The tech sector has continued to boom during the COVID-induced recession, resulting in its rapid expansion and the need for more workspaces.

Table 3 below summarises the expansion plans of several tech giants. For instance, under its plans for major expansion, Amazon has leased two million square feet of office space that is currently under development in Bellevue CBD (where KORE’s The Plaza Building is located).

Table 3: Tech giants embracing WFH, but most are still leasing office spaces

Yield remains attractive at 9%

With its yield currently at a high level, we believe KORE is unlikely to make any near-term acquisitions since any acquisitions made is unlikely to be yield-accretive. Nonetheless, KORE has a gearing ratio of 37.7%, leaving ample debt headroom for it to pursue inorganic growth opportunities in the mid to longer term.

With COVID-19 still lingering, office landlords continue to face the threat of its tenants downsizing. While we believe KORE is likely to remain resilient due to its sizable exposure to growing tech hubs and the defensive healthcare sector, we think it is still unclear with regards to how much rentals will eventually decline.

Hence, we construct a scenario analysis based on our assumptions about rental outlook, as well as rent deferrals and reliefs. We also increase our discount rate to factor in greater uncertainties in the longer term.

In our base case scenario, we have increased our DPU estimates (Table 4) following the better-than-expected occupancy rate and rental collections. We also assume a poorer rental outlook than CoStar’s projections.

Using a dividend discount model, our base case target price has been lowered to USD 0.79. This translates to an upside potential of 13.7% based on the closing price of USD 0.695 as of 19 November 2020. Our DPU estimates imply a 2021E yield of 9.1%.

In our bull-case scenario, we expect an improvement in occupancy and a rental outlook as per CoStar’s projections. Hence, our DDM-based bull case target price is USD 0.95, which translates to an upside potential of 36.7%. The estimated yield is 9.6%.

Lastly, our bear-case assumes that COVID-19 related headwinds will persist throughout 2021, including a worsening rental outlook. Hence, our DDM-based bear case target price is USD 0.60, which translates to an upside potential of -13.7%. The estimated yield is 8.3%.

We continue to hold a positive view on KORE. In the current yield-starved environment, KORE is yielding an estimated 9.1% for 2021. While this is approximately around the average of the SGX-listed US office REITs (8.9%), it is way higher than the S-REITs average of 5.6% according to the FTSE ST REIT Index.

Table 4: DPU estimates

Table 5: Base case DPU growth

Declaration:

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