Office REITs have rallied due to improving outlook for the financial services industry and an estimated 10% rebound in capital values. Revaluation with markdown in value of investment properties could result in rights issues.

Office rentals still falling but at a slower pace. Due to ongoing financial crisis, rentals for prime office space have corrected 6.8% in 4Q08 and 30.0% in 1Q09 to S$10.50psf pm after hitting a peak of S$16.10psf in 3Q08 (source: CBRE). Raffles Place micromarket registered the steepest fall of 17.9% in 4Q08 and 28.5% in 1Q09 to S$10.50psf pm (source: Colliers). Our survey of office REITs indicates that office rentals have fallen by a slower 5-10% so far in 2Q09 due to improvement in market sentiment.

Deals starting to flow. Investment in office buildings has started to pick up after a hiatus of about a year. The 16-storey Parakou Building was transacted at S$81.4m or S$1,280psf in early-May, 36.4% lower than the S$128m paid by current seller New Star Asset Management in 2007. The 13-storey Anson House transacted at S$85m or S$1,100psf was 34.3% lower than the previous price of S$129.5m. Both transactions are rather small deals at below S$100m each.

There are also more transactions in the secondary market for strata office space recently. Capital value for Suntec City Office Towers has rebounded 10.8% to S$1,781psf ytd. Capital value for International Plaza has similarly rebounded by 9.2% to S$1,100psf. Unlike previous recessions, there was no distress or fire sale in the office market during the current recession. As such, cap rates have been relatively stable.

New supply keeps rentals depressed. A total of 8.3m sf of office space will be completed from 2Q09 to 2013, representing 11.5% of total stock. Landmark developments include Marina Bay Financial Centre (phase 1: 1.6m sf, phase 2: 1.3m sf), Ocean Financial Centre (850,000sf), 1 Raffles Place (350,000sf) and North Tower at Marina View (1.2m sf). We estimate 84.8% of the new supply is concentrated in key micromarkets of Raffles Place, Marina Bay, City Hall, Shenton Way and Tanjong Pagar (Downtown Core).

Benefitting from spillover effect. Share prices of office REITs, such as CapitaCommercial Trust (CCT), K-REIT Asia and Suntec REIT have recovered, benefitting from the spillover in positive sentiment for Asian banks. Financial services industry accounted for an estimated 36%, 35% and 17.5% of gross rental income for CCT, K-REIT and Suntec REIT respectively.
Revaluation results in higher gearing. We are concerned that revaluation with significant markdown in value of investment properties will result in higher gearing and rights issues. For example, CCT valued its portfolio at S$6,029.6m in May 09, 10.1% lower than the valuation of S$6,710.6m in Dec 08. It subsequently embarked on a 1-for-1 rights issue as gearing has increased from 38.3% to 43.1%, at the higher end of management’s target optimum gearing of 30-45%.

Upgrade target prices. We expect rentals for Grade A office space within Raffles Place to correct two-thirds from its peak to S$6psf pm. We have, however, lifted our base case assumption for office occupancy from 82% to 86% due to improvement in macroeconomic outlook. Hence, we raise our target prices for CCT and Suntec REIT by 2.5% to S$1.05 and S$0.83 respectively.

Maintain OVERWEIGHT for REITs. Current yield spread is 3.61%, higher than the historical average of 2.97%. We expect yield spread to further contract due to normalisation in credit markets. Refinancing risk has abated with the potential reopening of the commercial mortgage-backed securities (CMBS) market.

We prefer switching to laggard retail and industrial REITs. BUY Frasers Centrepoint Trust (S$0.935/Target: S$1.44) and Ascendas REIT (S$1.54/Target: S$1.93). Our only BUY for office REITs is K-REIT Asia (S$0.995/Target: S$1.15). Maintain HOLD for CapitaCommercial Trust (S$1.29/Fair: S$1.05) and SELL Suntec REIT (S$1.02/Fair: S$0.83).