Singapore Office REITS - Is it time to buy the office REITs?


Our view
It is not time yet. Despite a 20% share price correction for Singapore office REITs so far in 2015 (vs. a 10% decline in the FTSE STI REIT index), we are just two quarters into what should be seven quarters of rental declines. We believe actualization of declines will mean office REITs continue to underperform other Singapore REITs through 2016.

We expect office rents to fall 20% over two years. We see vacancies rising from 10% in 1Q15 to 13% by 4Q16, and rents falling 20% over that period. The depth of the down cycle would be closer to the 40-60% declines in previous cycles should we also face a global recession.

Market view
The market is split in two camps 1) Office REITs have bottomed and are ripe for a rally. 2) Supply/demand fundamentals will deteriorate further, driving continued derating of the stocks.

Dividend yields suggest 0-10% fall in rents. Singapore Office REIT one-year forward consensus dividend yield estimates suggest a range from no decline to a 10% YoY decline in office rents in June 2016. This suggests some room for dividend yields to widen (and share prices to fall).

How vulnerable are rents and cap values?
Office rents will fall 20% and prices 30% over the next two years, in our view. Beware recap risks.

Supply overwhelming, demand underwhelming. Upcoming office supply is daunting, some 3.8mn sq ft is due to complete in 2016. In addition, office landlords have to contend with some 3mn sq ft of business park and shadow space, based on our estimates. Demand, on the other hand, is waning as internet companies vacate the CBD to relocate to business parks. Soft demand is also evident in slow pre-leasing progress for the upcoming buildings, with only 3% of 2016 supply pre-committed.

Rents to fall around 20%; cap values 30% : We estimate island-wide office vacancies will rise from 10% in June 2015 to 13% by 2016 as net absorption lags behind physical completion and rents should follow, falling 21% over two years through 2016. Lower rental expectations and widening cap rates will drive a 28% peak-to-trough decline in Grade A office capital values, we estimate. At 3.6%, officecap rates have remained below the long-term average of 4% for the past five years. However, interest rates are on the rise and this will put upward pressure on cap rates as the positive spread over funding costs diminishes.

Are there any undervalued stocks?
As a whole, we believe the office REITs have limited re-rating potential relative to peers.

We think the office rental down-cycle has only begun. And, it should weigh on all office REITs alike. Among the three office REITs we cover, we think CapitaLand Commercial Trust offers the best potential for dividend growth, and may hold its value better through the rental decline. Our order of preference (descending) is: CapitaLand Commercial Trust (Equal-weight, CACT.SI,S$1.34), Suntec REIT (Equal-weight, SUNT.SI,S$1.56), Keppel REIT(Underweight, KASA.SI,S$0.96); prices as of December 4, 2015.

Potential catalysts

Actualization of rental declines
We expect rents, which began falling in 2Q15, to drive a de-rating of the office REITs as dividend yields expand.

US rate hike
The three-month SIBOR is past the 1% mark from 0.4% in December 2014. A rise in rates puts upward pressure on cap rates as the positive spread over funding costs diminishes. (Read Report)

Source : Morgan Stanley Research

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