Keppel REIT - OCBC Investment 2022-12-15: Beneficiary Of Office Upcycle But Macro Headwinds Looming

• Initiate coverage on Keppel REIT with fair value estimate of S$0.87; risks include rising recession risks, higher interest rates and currency fluctuations.
• Healthy occupancy rates and rental reversions given office rental upcycle in Singapore.
• However, rising cost of debt likely to weigh on growth; we forecast distribution per unit (DPU) to decline in FY23 and FY24.

Healthy occupancy rates and rental reversions.

• Keppel REIT (SGX:K71U) is a pure-play office S-REIT with a portfolio of quality Grade A commercial assets in key business districts in pan-Asia. Keppel REIT's portfolio committed occupancy rate stood at a healthy 96.8%, as at 30 Sep 2022, an improvement of 1.3 percentage points (ppt) on a quarter-on-quarter basis. Additionally, Keppel REIT was able to achieve solid positive rental reversions of ~10% in 3Q22, although the outlook for similar rental uplifts is likely less sanguine in 2023 given higher average expiring rents of S$11.35 per square foot per month (psf pm), versus S$10.06 psf pm in 2022.
• As the COVID-19 situation fades into the rear-view mirror and more office workers are gradually returning to the office, coupled with the limited new supply of office space in Singapore’s Central Business District (CBD) beyond 2023, these could provide a boost to office REITs such as Keppel REIT. However, downside risks are also rising, such as growing recession risks in the developed markets, which could have an adverse impact on the office market in Singapore.

Rising cost of debt could weight on growth

• More than 60% of Keppel REIT’s debt is maturing from 2023 to 2025. As such, we believe it faces refinancing risks, as the borrowing costs today would have increased significantly as compared to a few years back.
• While the aggressive pace of Federal Reserve (Fed) rate hikes appears to be slowing, interest rates are likely to stay elevated and will remain an overhang on Keppel REIT’s interest expenses moving into 2023, in our view. Keppel REIT has hedged 72% of its debt, which would mitigate the impact of rising borrowing costs, but would still be a drag on its DPU, in our view.

Initiate coverage on Keppel REIT with fair value estimate of S$0.87

• We value Keppel REIT using the dividend discount model (DDM) as this is a commonly used metric to value REITs, in our opinion. We forecast Keppel REIT’s DPU to increase 1.3% to S$0.059 in FY22, but to decline 1.1% and 3.6% to S$0.058 and S$0.056 in FY23 and FY24, respectively. The projected decline stems largely owing to the drag from higher expected interest expenses, which we believe will outweigh our forecasted net property income (NPI) growth of 5.3/3.0/3.5% in FY22/23/24, respectively.
• After incorporating our financial forecasts and capital asset pricing model (CAPM) assumptions (risk-free rate: 3.5%, market risk premium: 5.5%, adjusted beta (including an ESG premium): 0.66, cost of equity: 7.15%, terminal growth rate: 1%) in our model, we derive a fair value estimate of S$0.87 on Keppel REIT.
• Key investment risks include rising recession risks which would negatively impact business sentiment, higher-than-expected interest rate increases and currency exposure from its overseas assets.
• Continue to read the report attached below for complete analysis on Keppel REIT.

Keppel REIT – ESG Updates

• Keppel REIT’s ESG rating was upgraded in Dec 2021. One of the key drivers of the upgrade came from the inclusion of the Corporate Behaviour Theme in Keppel REIT’s Governance assessment. Keppel REIT’s continued emphasis toward policies that encourage strong ethical business conduct, coupled with a robust protection mechanism for whistle-blowers.
• Furthermore, Keppel REIT is ahead of the curve with 90% of its portfolio compliant to green building standards compared to the industry average of 38% in 2020. However, Keppel REIT falls short in talent pool development, where improvements can be made to its relevant policies and programs.
• According to Keppel REIT, all its Singapore office assets have consistently maintained a Building and Construction Authority (BCA) Green Mark Platinum certification and approximately half of its total borrowings are green. Additionally, T Tower in Seoul is targeting green certification by end-2022, which would translate to 100% of its portfolio being green certified.