• CapitaLand Commercial Trust's 1Q19 DPU of 2.20 Scts (+4% y-o-y) in line with our expectations.
• Rising market rents translating to higher signing rents compared to average expiring rents; to sustain upturn in earnings.
• Awaiting execution of potential inorganic strategy.

Undervalued

• We keep our BUY call on CAPITALAND COMMERCIAL TRUST (SGX:C61U) with a revised target price of S$2.10.
• We believe CapitaLand Commercial Trust remains undervalued ahead of a multi-year upturn in office rents in Singapore on limited supply. In addition, with its property valuations below physical market transactions, CapitaLand Commercial Trust is trading at an attractive valuation at CapitaLand Commercial Trust's current share price.
• The company’s expansion into Europe also provides another growth avenue which we believe the market has not fully appreciated.

Where We Differ: Deserves to Trade at 1.10-1.15x P/Bk

• CapitaLand Commercial Trust currently trades at slight premium to book but we believe it should trade closer to 1.10-1.15x P/Bk, as it demonstrated the conservative valuation of its properties via the sale of three office buildings at 14-39% premiums to book over the past 2 years. Its book also remains understated with buildings such as Capital Tower and 999-year leasehold HSBC Building priced at S$1,847 and S$2,275 psf respectively, a discount to transactions of S$2,400-2,700 psf for comparable buildings.
• In the midst of a multi-year upcycle in office rents, CapitaLand Commercial Trust also typically trades at a premium to its book value.

Multi-year Upturn in Rents

• With Singapore office rents rising for the sixth consecutive quarter, hitting S$11.15 psf/mth at end- 1Q19, up 25% from the lows in 1H17, we believe this should generate increased investor interest in CapitaLand Commercial Trust. Focus should turn to the expected multi-year recovery in office rents as new supply over the coming three years is limited. This, and the rise in office rents, should act as re-rating catalysts.

Valuation

• After lowering our cost of debt assumption to 3.25% from 3.50%, we raised our discounted cash flow (DCF)-based Target Price to S$2.10 from S$2.00.

Key Risks to Our View

• Key risks to our positive view are weaker-than-expected rents.

What's New - Growing DPU

Strong start to the year

• CapitaLand Commercial Trust as expected had a strong start to the year with 1Q19 distribution per unit (DPU) rising 3.8% y-o-y to 2.20 Scts. 1Q19 DPU represents 25% of our FY19F DPU.
• The increase in DPU was on the back of a 3.5% and 3.4% rise in 1Q19 revenue and net property income (NPI) to S$99.8m and S$79.8m respectively as CapitaLand Commercial Trust benefited from the acquisition of Gallileo in June 2018 and an uplift in occupancy (98.1% versus 90.8% in 1Q18) at Asia Square Tower 2 (AST2) which resulted in 1Q19 NPI for the property jumping 10.3% y-o-y.
• This improvement in earnings and DPU was despite the divestment of Twenty Anson in August 2018.

Still some impact from negative rental reversions in 1H18 but at the tail end of negative drag

• CapitaLand Commercial Trust continues to be impacted by the negative rental reversions in 1H18 and 2017 as seen by the 5.2% y-o-y fall in 1Q19 NPI for CapitaGreen. Earnings for CapitaGreen were also impacted by higher marketing expenses.
• NPI for Six Battery Road fell 3.6% y-o-y as occupancy dipped to 97.6% from 99.8% in 1Q19. We understand the space vacated by a tenant was one of the units that did not benefit from the asset enhancement initiative (AEI) conducted a few years back. Post-renovations of the space to increase the floor to ceiling height and given the relative tightness in the Singapore office market, we believe CapitaLand Commercial Trust should be able to backfill the space soon.
• CapitaLand Commercial Trust’s other properties were generally stable with earnings from Raffles City Singapore benefiting from recent AEI works. Overall portfolio occupancy remains high at 99.1%.
• With CapitaLand Commercial Trust reporting positive rental reversions over the last few quarters, the negative drag from weaker rents during the downturn between 2015-2017 should dissipate going forward.

Higher signing rents

• We understand that on average CapitaLand Commercial Trust achieved positive rental reversions for leases signed over the quarter.
• Based on the mid-point of committed rents, CapitaLand Commercial Trust would have reported 2.4-15.5% increase in rents compared to average expiring rents (see overleaf).
• As spot Grade A central business district (CBD) office rents are expected to climb further from S$11.15 psf/mth at end 1Q19 versus average rents for the remainder of FY19 of between S$10.35-10.69 psf/mth, we anticipate positive rental reversions to be maintained.
• Following the renewal of leases in 1Q19, another 11% of office leases by gross rental income are up for renewal for the remainder of FY19, down from 15% at end 4Q18.

Lower borrowing cost

• Post early refinancing of the bulk of debt due in FY19, CapitaLand Commercial Trust only has S$148m of debt due in 2019 with its average cost of debt dipping to 2.5% from 2.6% at end 4Q18.
• Gearing inched up to 35.2% from 34.9% at end 4Q18 due to drawdown of debt for the development of CapitaSpring. 92% on CapitaLand Commercial Trust’s borrowings remain on fixed rates.
• On the back of the issuance of management fees in units, net asset value (NAV) per unit fell to S$1.82 from S$1.84 previously.

Awaiting other potential developments

• CapitaLand Commercial Trust guided that construction of the CapitaSpring development remains on track with the building still slated for completion in 1H21.
• In addition, we understand that CapitaLand Commercial Trust is continuing to make progress on plans to refurbish 21 Collyer Quay when HSBC vacates the building and moves to Marina Bay Financial Centre Tower 2 in 2020.
• Nevertheless, the market is awaiting on news whether CapitaLand Commercial Trust has been able to acquire Duo Tower. Recent press reports indicated that CapitaLand Commercial Trust is potentially conducting due diligence on this asset.

Lifting estimates on lower borrowing costs

• Our DBS economists have turned more dovish recently, assuming no rate hikes by the US Federal Reserve (Fed) compared to earlier projections of four increases.
• Thus, we have assumed 3.25% cost of debt versus 3.50% previously which leads us to raise our DCF-based Target Price to S$2.10 from S$2.00 previously.
• Likewise, the more dovish outlook and given lower-than-expected borrowing costs post CapitaLand Commercial Trust’s year to date, we have reduced our borrowing costs assumptions by 15-35bps which translates to 1-2% increase in our FY19-21F DPU.

Maintain BUY With Revised Target Price of S$2.10

• We maintain our BUY call with a revised Target Price of S$2.10 given expectations of a multi-year upturn in office rents as well as 14% expected total return over the coming 12 months.
• CapitaLand Commercial Trust remains our top pick among the office Singapore real estate investment trusts (S-REITs) as it offers the fastest 3 year DPU compound annual growth rate (CAGR) of 5%.

Source: DBS Research - 22 Apr 2019