Following weaker-than-expected 1Q09 GDP and higher 1Q09 office vacancy, we revised our peak-to-trough rental decline estimate to 57.0% (from 47.1%). Nonetheless, on an implied EV basis, Suntec’s prime assets remain undervalued, in our view. Maintain BUY, but price target cut to S$0.82 from S$0.90.

Weaker demand is likely to see office rents fall 56.8% from peak to trough. Retail and industrial properties, in our view, are not immune, given higher supply/lower demand with rents likely to fall 17.0% and 31.7% over the cycle.

Weak macros have reinforced expectations of lower rents and rising vacancy while REITs are grappling with refinancing and the spectre of revaluation deficits raising gearing. The market appears to have priced these concerns in the office sector, but looks complacent in its assessment of the retail and industrial REIT sector.

Rapidly deteriorating macro conditions (Singapore 1Q09 GDP falling at a faster-than-expected 11.5% y-y) will further undermine office occupancy and rents beyond what we had previously anticipated. We now expect a peak-to-trough rental correction of 57% for the Singapore office market, compared to our earlier assumption of a 47% correction. Adjusting for our revised office rental outlook, we are lowering our Suntec’s asset valuation to S$3.35bn from S$3.54bn (-5.4%) and consequently paring our core NAV estimate for the stock to S$0.85/unit from S$0.96/unit (-11.5%).

Our gross asset valuation of S$3.35bn is S$2.06bn less than the latest value of Suntec’s portfolio, and the projected revaluation deficit could boost the company’s gearing from our FY09F forecast of 0.35x to 0.58x. For valuation purposes, we have consistently assumed Suntec would need to raise additional equity of about S$536.1mn at the current share price to ensure gearing remains below 0.40, which reduces our intrinsic value of S$0.85/unit by S$0.03/unit. As a result, we cut our price target to S$0.82 from S$0.90.

According to DTZ, tenant demand weakened considerably in 1Q09 “as companies continued to focus on consolidation of space and held back expansion plans”. The real estate consultancy estimates that Island-wide average vacancy rose 2.1pp to 6.4% (up from 4.3% at end-4Q08). Similar trends were seen in the city, as average vacancy in the Raffles Place precinct (Singapore CBD) rose to 7.1% (from 4.4% at end 4Q08). In the city fringe locations of Anson Road/Tanjong Pagar, vacancy rose to 6.3% (from 2.7% at end-4Q08).

Given the deterioration in demand and rising vacancy, office rents have slipped faster than expected in 1Q09. According to CBRE, Singapore Grade A office rents declined 18.0% q-q in 1Q09. Rents according to the real estate consultancy fell from S$15.00/psf pm at the end of 4Q08 to S$12.30/psf pm at end of 1Q09. Rents according to CBRE peaked in 3Q08 at S$18.00/psf pm. Jones Lang LaSalle estimates steeper falls in the Grade A market, suggesting rents in 1Q09 were down 28.1% q-q to S$10.75/psf pm versus S$14.95/psf pm in 4Q08 and down 41.6% since the 2Q08 peak rent of S$18.40/psf pm.

Our distribution projection takes into account a peak-to-trough correction of 57% in office rents, as well as overall cost of debt of 3.4% in FY09F and 3.6% from FY10F. A sharper-than-expected rental decline and increase in borrowing cost would result in our distribution forecast not being met. In addition, a wider-than-expected cap rate expansion would also result in our NAV forecast not being met, with implications for our price target.