Keppel Pacific Oak US REIT: Steadfast amidst volatility
- Despite headwinds, KORE’s portfolio is expected to exhibit relative resilience compared to peers
- Majority of the properties are resilient due to tenants in defensive industries with strong submarket fundamentals
- Strategy to upgrade office facilities and introduction of spec suites will bear fruit and bring stickiness
- Maintain BUY, lower TP to US$0.48. Estimates cut to reflect more conservative forecasts, still offering c.14%-15% yield and target yield of 9%-10%
We visited 9 out of 13 properties in five markets within KORE’s portfolio. The properties contribute c.80% to gross revenue and 84% of the total portfolio valuation. In addition, we visited two other properties currently owned by the sponsor – Bowers Park in Nashville and 5100 N O’Conner, Dallas, Texas.
Key general insights/trends observed:
- Downtown offices appear to be most affected by “flexible working” arrangements. Downtown locations in most of the markets that we’ve visited appear to be very quiet, especially post COVID. From our conversations with the local team, we understand that downtown offices are most impacted post COVID, typically with lower physical occupancy.
- Selected submarkets are still active.
- More corporations are encouraging employees to return to office. In Feb 23, Amazon’s CEO Andy Jassy mandated that employees be back in office at least three days per week from 1 May 2023. We have also heard anecdotal instances of corporations looking for new/bigger office space as they are progressively bringing employees back to office. In addition, from our conversations with selected tenants, we gather that corporations are organising events to encourage employees to return to office.
- More traffic from Tuesday to Thursday. Similar to working trends observed in many other cities, there is generally more traffic from Tuesdays to Thursdays, in line with the typical three-day return-to-office policy.
- Signs of improvement in most recent physical office datapoints. The most recent datapoints from Kastle Systems note that physical office occupancy in 10 metro-cities rose to 50.3%, the highest since March 23, with key cities Washington, DC; New York City; and Chicago reaching pandemic highs. While we do not see this as a trend as yet, a sustained improvement could suggest occupancy risk is abating.
- Flight-to-quality in a tenant’s market. Given that it is largely a tenant’s market, flight-to-quality is pervasive, and landlords need to up their offerings to stay resilient by retaining or attracting new tenants. Hence, common facilities (e.g., gym, café, conference rooms) and amenities are key features that could draw tenants’ interest.
- Conversion into multifamily assets. During our conversations with the local teams, an interesting nugget of information we gathered was the rising investment in multifamily assets, especially in growing cities that still see migration of population. There were also some commercial buildings that were converted into multifamily assets, thus progressively reducing the supply of commercial assets.
Key summary of KORE’s portfolio
- Six properties that contribute >50% of GRI showing signs of resilience. Following our tour of nine properties, we are optimistic about six properties that contribute >50% of gross rental income (GRI), which we summarise in the table below. Compared to their peers, KORE’s properties are largely located in the downtown while the large US Office REITs are mainly in the key gateway cities with tenants in the professional services / financial industry that could be impacted by the structural shift towards hybrid working and economic slowdown. For example, Boston Properties, largest listed US commercial properties, has assets which are c.80% in CBD / key gateway cities. We believe that these properties are more resilient, given its locations, growing submarkets, and tenant profiles that may be less impacted by the headwinds facing the US office sector. Aside from the submarkets and building qualities of these five properties, the common attributes of these properties are that i) the buildings offer R&D facilities, so tenants will typically be more sticky as they would invest capex to build features for R&D purposes and ii) the occupants of medical/healthcare suites are typically more sticky with longer WALE, as these tenants will not relocate once they have established themselves at that location and with their patients. In addition, the capex invested to convert an office space into a clinic/healthcare facility will discourage relocation in the short term.
- Investing capex to refurbish common facilities to retain existing tenants/attract prospective tenants. KORE has been investing capex in its portfolio to refurbish the common areas to refresh the look of the buildings and offer common facilities (e.g., gym, café, conference/meeting rooms) for the benefit of the tenants. We understand that these are very well received by tenants and often attract prospective/encourage existing tenants to move into/stay in the building. Given that it is now a tenant’s market, any additional attributes to the building will likely be appealing to prospective tenants looking to lease the building. We understand that a few of the most popular facilities among employees are cold brew taps, a coffee machine, gym, and conference/meeting rooms. These facilities also assist corporations in encouraging employees to return to office. Given the success in curating facilities that tenants want, KORE has been progressively passing through some of these costs by incorporating it into the rent structure.
- Building spec suites to lease out vacant space. KORE has been the first among its peers to build spec suites to lease out vacant space during the pandemic. The “ready-to-move in” suites have been appealing to corporations looking for smaller spaces (3k-5k sqft) that are ready to move into for a quick solution to its office space needs with a short-term lease (average of three years). KORE’s first mover advantage is that it was able to renovate some of the buildings before inflation kicked in. In addition, KORE was able to build a reputation for delivering refined refurbished office space that captured post-COVID leasing activity.
Key attributes of spec suites:
- Downtime to refurbish a spec suite ranges from four to five months
- Typically, the payback period is around two to three years
- Typically pays no tenant incentives (Tis) and has a minimal rent-free period for signing tenants
- Re-leasing the spec suite requires a minimal cost of c.US$2psf
- There are cases where spec suite tenants eventually expand their space in the property (e.g., One - Twenty Five and !800 West Loop South).
- Strong working relationship among the various teams to curate office space for tenants. During the trip, we noticed that KORE works very closely with its local asset managers, leasing agents, and strategic design partner to curate office space that is appealing and fits the needs of its prospective tenants, specific to the individual submarkets. We believe that it is through this strong cooperation within the teams that it can create products that will allow it to stay ahead of its competition.
- Potential development of multifamily asset at The Plaza, Bellevue. The Plaza building has the development potential for a multifamily asset at the carpark that has yet to be realised. Given the rising trend of multifamily assets, we believe this could be a long-term potential upside for KORE’s portfolio.
- Offices are not as empty as they appear. Aside from the general market insights observed above, we observe that the offices are not as empty as the media has portrayed. During our tours, we noted that there were employees working in the offices, depending on the type of work, industry, and organisation policy. R&D, testing, and healthcare-related offices appear to have higher physical occupancy. Among the tenants’ spaces that we visited, we noted part of the employees were back to working in the office. Some examples include a i) call centre, which mandated that all agents return to office; ii) healthcare manpower outsourcing company; and iii) nuclear energy company. Below are some pictures of the carparks at the buildings we visited, as a gauge of the physical occupancy. We note that the week of the tour ended with a long weekend due to the Memorial Day holiday and understand that traffic was a little lighter than usual towards the end of the week.
Maintain BUY; lower TP to US$0.48. We maintain our BUY rating but lower our TP to US$0.48 from US$0.65 previously. We lower our FY23F-FY24F DPU estimates by 18% to 24%, factoring in higher interest rates of 4.1% to 4.4%, ahead of management’s guidance of 4% in FY23F and a slight decline in rental income given the challenging market environment. We believe our estimates are conservative, as we have priced in some of the potential downside risk ahead.
While the US office market remains volatile, we are more confident about the resilience of KORE’s portfolio post our on-the-ground research. In addition, we believe that sentiment could turn when macroeconomic sentiment has stabilised as the Fed tapers rate hikes.
Despite our conservative stance and deep earnings cut, at the current price, KORE is still offering a dividend yield of c.14%-15% in FY23F-FY24F. If we were to make a bigger cut in a bear case scenario, assuming DPU were to bottom at 4 UScts (-31% y-o-y vs. FY22), the dividend yield would still be at 13%, based on the current price. It is currently trading at 0.4x P/B. We believe most of the headwinds have been priced in at this level and valuations are attractive, given KORE’s more resilient portfolio.
Key sector update: US office REITs’ basing out with US market rally post Fed pause.
US office REITs’ bottoming out with US market rally post Fed pause; expect US office SREITs to see a similar turnaround. The share prices of both the US office REITs and US office SREITs started to price in the interest rate hikes as soon as the Fed started to hike interest rates. US office REITs peaked in Apr 22 and have seen its share price fell c.60% since then. Similarly, the US office SREITs’ share prices peaked in Mar 22, and to date, share prices fell c.70% from its peak.
Interestingly, we note that US office REITs’ saw some basing out with US market rally post Fed pause. With this early positive sign, we believe that the US office SREITs may see a similar turnaround when there are more positive datapoints, especially we are closer to the end of the Fed rate hike cycle.
The spread between US office SREITs and US office regional peers has expanded to record high, implies US office SREITs are undervalued.
The yield spread between US office REITs and US office regional peers have expanded to record high at c.7% spread, vs historical average of 1.4%. This could potentially imply that US office SREITs are undervalued. Consequently, the more resilient KORE is trading at c.15% yield which is more in line with US office regional peers.
Valuation at rock bottom, below that of US office REITs
We believe the valuation is close to the bottom, as US office REITs is still trading at the GFC low P/B of 0.78x.
On the other hand, while the US office SREITs do not have sufficient trading history that stretches back to the last crisis, i.e., GFC, we believe that at 0.3x P/B, it is closer to the bottom.
As such, based on valuations, we believe the US office SREITs are close to the bottom and are awaiting a positive catalyst for a sector re-rating. We believe the re-rating catalyst lies in the Fed moderating or pausing interest rate hikes, which will also drive a turnaround in the share price.
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