Slide stemmed, for now. Early indications suggest that the office rental market appears to have stabilized for now, following a 9% correction in Grade A rents in 2012. However, we believe that the respite may be brief, with further downside likely in 2014 following the completion of Asia Square Tower 2 later this year, in our view. Our HOLD recommendations on CapitaCommercial Trust (CCT SP) and Keppel REIT (KREIT SP) are maintained ahead of their 2Q13 results.

Temporal shortage boosts near-term optimism. It has been nearly a year since the completion of the last major Grade A office development in the form of One Raffles Place Tower 2. Since early 2013, landlords have been taking advantage of the temporary lack of new supply as leasing demand from a diverse pool of small tenants allowed recent Grade A completions (e.g. MBFC Tower 3 and Asia Square Tower 1) to fill up to over 90% occupancies. However, we think the dynamics will change again, once the 775,000 sq ft Asia Square Tower 2 is completed in around Sep 2013, as its pre-commitment level remains sub-par at around 20%.

Demand drivers are sorely lacking. Even as business expectations improved in 2Q13 which helped to support office rents, we think that demand is insufficient to drive rentals up substantially, especially when there is ~600,000 sq ft of Grade A space left to fill at Asia Square Tower 2. Local and regional economic growth remains challenging and expectations for growth in 2014 may also have to be moderated. We now expect flat Grade A rents in 2013 and a 5%-decline in 2014. For Grade B offices, we expect rental declines of 5% and 10% respectively in 2013 and 2014, as the relocation process gathers pace.

Stable earnings likely in 2Q13. We expect the office REITs, namely CCT and KREIT, to report flattish QoQ DPU growths in 2Q13. For CCT, we will be looking out for the progress of backfilling at Capital Tower. For KREIT, 2Q13 is expected to similarly be a non-event, as the acquisition of 8 Exhibition Street in Melbourne is only expected to be completed on or around 1 August 2013.

Not expecting a turnaround story. We see limited upside for the office REITs from rental reversion and we think it is still too early to buy into the turnaround story. On the other hand, we have adjusted our DDM valuations to incorporate a higher risk-free rate of 3% and higher cost of equity, to reflect the current market adjustment to the potential of the U.S. Fed tapering on its quantitative easing. Maintain HOLD on CCT (TP: SGD1.28) and KREIT (TP: SGD1.15).

Source: Maybank Kim Eng Research - 11 Jul 2013