• Keppel REIT acquires 99.38% interest in T Tower in Seoul, Korea for KRW253bn (c.S$301m) on initial 4.7% NPI yield.
• 1-2% accretion to our FY19-21F DPU.
• Exposure to rising office rents in Korea with majority of leases expiring after peak supply in 2020.

Leveraged to Office Upturn

• We maintain our BUY call on KEPPEL REIT (SGX:K71U) with a revised Target Price of S$1.40. Keppel REIT’s share price typically leads a recovery in spot office rents by 6-12 months.
• According to CBRE, Grade A CBD rents had risen by another 3% q-o-q to S$11.15 psf/mth by end-1Q19, and is 25% higher from the low of S$8.95 psf/mth in 1H17. Thus, we believe office rents are on a sustained upturn and the share price rally which started in late 2018 should continue.

Where We Differ – Discount to Book Unjustified

• Consensus has a HOLD rating with a Target Price that implies Keppel REIT should trade at a discount to its book value. However, with FY18 likely to mark a cyclical low in Keppel REIT’s DPU, we are more forward looking and focus on growth in DPU from 2019 onwards as Keppel REIT benefits from the upturn in Singapore office rents and boost from its maiden acquisition in Korea.
• In addition, with management conducting a share buyback over the last few months, the first S-REIT to do so, this sends a strong signal that Keppel REIT is significantly undervalued, considering several office buildings in less prime locations have been sold at a cap rate of 1.7-3.2%, below the 3.60-3.65% used to value Keppel REIT’s best-in-class Grade A buildings in Singapore.

Recovery in DPU and Positive Rental Reversions

• We believe the expected recovery in DPU and delivery of positive rental reversions on the back of higher spot rents would be catalysts to narrow the discount to Keppel REIT’s book value of S$1.38.

Key Risks to Our View

• Key risks to our positive view are weaker-than-expected rents causing DPU to come in below expectations.

What's New - Maiden Acquisition in Korea

Acquires Seoul office building on 4.7% NPI yield

• Keppel REIT announced that it has entered into an agreement with a value-add strategy fund managed by PGIM Real Estate to acquire a 99.38% interest in T Tower, a freehold Grade A office building in CBD Seoul, Korea for KRW252.6bn (c.S$301.4m). This is 2.5% below the independent valuation conducted by Cushman & Wakefield. Acquisition fee is estimated to be S$3.0m with other professional and transaction fees associated with the acquisition at S$10.7m.
• The remaining 0.62% interest in the property currently owned by its current asset management company will be acquired by Keppel REIT’s Sponsor, Keppel Capital.
• The initial NPI yield of T Tower is 4.7% and the acquisition is expected to be funded with KRW- denominated loans and the recently issued 1.9% five-year convertible bonds (CBs). The all-in-cost of funds including the CBs’ is sub 3%.

DPU-accretive deal

• Assuming financial close at end-May, we estimate 1-2% accretion to our FY19-21F DPU. In addition, Keppel REIT guided that assuming a 60/40 debt/equity funding mix and assuming the convertible bonds are converted to equity, they estimate a 1% DPU accretion of proforma FY18 DPU. Gearing is also projected to rise from 36% to 38%.
• Post acquisition, income (based on 1Q19 numbers) from Singapore and Australia will drop from 79.9% and 20.1% to 75.7% and 19.0% respectively, with Korea contributing 5.3% of income.
• By asset value, Korea will make up 3.6% of the portfolio, with Singapore and Australia at 82.4% and 14.0%, down from 85.5% and 14.5% previously.

T Tower overview

• T Tower is a freehold 28-storey Grade A office building that was completed in 2010 with attributable GFA and NLA of 444,979 sqft and 226,945 sqft respectively. The property, which is located in Seoul’s CBD, is close to Seoul Station and is well serviced by various rail, subway and bus networks.
• Key tenants include Philips Korea (country HQ), LG Electronics and SK Communications. Majority of the leases have fixed annual rental escalations of 3%. The annual escalation is the usual market practice in Korea with leases typically being 3-5 years in length.
• See attached PDF report for further details of T Tower. 

Investment Rationale / Market Outlook

• Beyond the expected DPU accretion and diversification benefits, a key rationale for the acquisition is exposure to the favourable Seoul office market.
• Based on Cushman & Wakefield’s estimates, effective rent is expected to improve going forward with CBD vacancy expected to fall to 13% in 2022 after peaking at 16% in 2020.
• While a near-term jump in supply for the overall Seoul office market is expected, this is coming mainly from the Gangnam Business District (GBD, the newest major market) and Yeouido Business District (YBD, a government-driven finance hub on an island), both of which are outside Seoul’s traditional CBD and supply is expected to be limited in the medium term. In 2020, in excess of 800,000 sqm is expected to be added to the overall Seoul market versus historical net absorption of 200,000-500,000 sqm per annum based on CBRE data.
• Within the CBD market, there are two buildings expected to be completed in 2019. One of the developments, the Summit Building has already been pre-committed (c.145,000 sqm) to Daewoo E&C and BC Card. Another building, Seosomun 5 District (c.38,000 sqm) which is 10 minutes away from T Tower is currently under active leasing. However, it is a relatively small property as per management and according to CBRE, around 80% of the space of the two properties has been pre-leased.
• For 2020, Namdaemunro5-ga (c.125,367 sqm) is expected to come on stream in the CBD but is not pre-committed yet. We understand it is normal for buildings not to be the construction phase in Korea.

Our Thoughts

• Given prior guidance by Keppel REIT that it was actively seeking acquisitions including in new markets outside its core markets of Singapore and Australia, the acquisition in Korea is not a surprise.
• We also believe the market should react positively to Keppel REIT deploying its strong balance sheet and the expected DPU accretion, as well as being able to dispose its 20% stake at an exit yield in the low 3% and redeploying part of the proceeds at 4.7%.
• Nevertheless, we anticipate some investors to be cautious on Keppel REIT’s expansion into a new market, despite acknowledging that given current cap rates in Singapore and Australia, it is difficult for Keppel REIT to buy in its core markets.
• In addition, near-term supply in Seoul will be a concern, although we note that T Tower has a WALE of 2.8 years which should help Keppel REIT manage the peak in supply in 2020. Furthermore, with Keppel REIT’s Sponsor, Keppel Capital having been in Korea for 15 years and having managed a total AUM of S$3bn and 5.2m sqft of GFA, this on-the-ground experience and expertise should help Keppel REIT manage any potential risk.
• In terms of valuation, while cap rates have compressed from the 6-7% level 10 years ago, we understand office buildings in the CBD have transacted recently at cap rates of low to mid 4%. Thus, the initial NPI yield of 4.7% is fair considering the Seoul Station submarket in which T Tower is located has traditionally commanded a higher yield.
• With Keppel REIT poised to benefit from the expected upturn in the Singapore office market and expected boost to its DPU from its maiden acquisition in Korea, we maintain our BUY call with a higher Target Price of S$1.40.

Source: DBS Research - 24 Apr 2019