Expectations of a bottom. Office plays have done well YTD, despite persistent global economic concerns and the fact that spot Grade A rents have been declining since the start of the year. This may be partly due to the fact that while negative rental reversions have set in, the impact has been manageable, with hopes of the market bottoming out by this year.

Office REITs lead the pack. CapitaCommercial Trust (CCT) and KREIT have seen their share prices go up by 34% and 37% YTD respectively. Along with other S-REITs, the run-up may be partly explained by yield compression, as office REITs’ yield spreads over the 10-year government bonds remain attractive at about 470 bps. DPUs have also shown to be fairly resilient, due to a combination of cost controls and in some cases, the presence of income supports.

Demand is still anaemic. Leasing demand continues to flow in dribs and drabs, with demand for large floor plates still glaringly absent. Financial institutions (FIs) have already committed to significant office space in the past 2-3 years. With the sector now undergoing fat-trimming and consolidation, FIs may in fact be sitting on excess space due to reduced headcount, which may lead to more shadow space. We do not see companies from other industries to have similar appetite for office space to pick up the slack.

Not seeing the full picture. We also believe the current net take-up rates are distorted by the fact that some FIs have yet to fully run-out their leases at their original locations. Eventually, there will be an actual hollowing-out, and their previous landlords will have to find replacement tenants. Examples include DBS’ exit from DBS Towers by end-2012 and the expiry of Citigroup’s lease at Millenia Tower at end-2013. The secondary space will face competition from new Grade A schemes, e.g. Asia Square Tower 2 and CapitaGreen.

Landlords may cede bargaining power. A number of recently completed Grade A developments have yet to achieve over 90% occupancy. E.g., the 1.3m sq ft MBFC Tower 3 is currently ~70% occupied and the recently completed One Raffles Place Tower 2, with an NLA of 335,000 sq ft, is just ~60% pre-committed. With decent supply on the horizon, we expect tenants to assert greater bargaining power, which may lead to further decline in spot rents.

Downgrade office REITs from HOLD to SELL. We expect Grade A office rents to soften by another 10% by end-2013 to average at around SGD8.30 psf. As the price gap narrows, we also expect Grade B rents to correct by 10% to average at SGD7.20 psf in end-2013. While we recognize the impact on office REITs’ DPUs may be minimal, we see little room for organic growth. CCT and KREIT are now fully-valued and we are downgrading them to SELL, maintaining our target prices of SGD1.24 and SGD0.99 respectively. We prefer retail and industrial REITs.

Office Rents Yet to Bottom

Grade A rents down ~10% on-year. 12 months ago, we correctly identified the peak for office rents and expected Grade A and Grade B office rents to head for a 10% and 20% correction respectively in 2012. We were spot-on for Grade A, where rents have already fallen by 9.4% to average at SGD9.20 psf pm in 2Q12. Grade B rents were however surprisingly resilient, correcting by a milder 5.3% YoY.

Lingering uncertainties affecting business expectations. The pace of rental decline may have moderated somewhat in the last quarter, but we do not think it has found a bottom. The global economy remains anaemic, with major concerns surrounding the future of the Eurozone and questions being asked about the true state of China’s economic health.

Singapore, being such an open economy, cannot be immune to these market uncertainties, and business sentiments have been affected. According to figures from the Department of Statistics, general business expectations in Singapore deteriorated in 2Q12, particularly for the financial sector. Our Chief Economist, Suhaimi Ilias, has a Singapore real GDP growth forecast of 2.5-3% for 2013.

Financial industry continues to consolidate. Financial Institutions (FIs) are arguably the worst-affected by the Global Financial Crisis and the Eurozone debt crisis that was to follow. Their operations in Singapore are also not spared as the FIs continue to streamline operations and trim fat as the East-West "wage arbitrage" that had worked for a while no longer seems viable. Recent reports also point to back-office jobs being moved out of Singapore to lower cost locations such as India and somewhat surprisingly, Eastern Europe.

Financial industry continues to consolidate. Financial Institutions (FIs) are arguably the worst-affected by the Global Financial Crisis and the Eurozone debt crisis that was to follow. Their operations in Singapore are also not spared as the FIs continue to streamline operations and trim fat as the East-West "wage arbitrage" that had worked for a while no longer seems viable. Recent reports also point to back-office jobs being moved out of Singapore to lower cost locations such as India and somewhat surprisingly, Eastern Europe.

Kudos to the REITs… Despite the economic slowdown, credit must be given to the managers of office REITs for mitigating the effects of negative rental reversion. In some cases, DPU yields in the foreseeable future are further supported by rental supports. REIT managers have also managed lease expiries well, either by locking in long-term leases at the start, or actively negotiating renewals ahead of expiry.

…but upside is limited. However, organic growth appears harder to come by, especially when spot rents are unlikely to rebound strongly anytime soon. There are very limited yield-accretive acquisition opportunities, unless acquisitions come with rental supports.

Downgrading office REITs from HOLD to SELL. From a valuation standpoint, we think CCT and KREIT are now fully-valued and we are downgrading them to SELL, maintaining our target prices of SGD1.24 and SGD0.99 respectively. We prefer retail and industrial REITs, which have better organic growth potential and more favourable demand-supply mechanics.

 Source: Maybank Kim Eng Research - 7 Sept 2012