• NDR to European investors seeing positive feedback on CapitaLand Commercial Trust.
• Leverage into the multi-year upturn in rents.
• Conservative gearing of 35% offers upside to execute on acquisitions.
• Pipeline from Sponsor an interesting long-term prospect.

Undervalued

• We keep our BUY call on CAPITALAND COMMERCIAL TRUST (CCT, SGX:C61U) with a 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. CapitaLand Commercial Trust’s expansion into Europe also provides another growth avenue which we believe the market has not fully appreciated.

Where We Differ: Deserves to Trade Up to 1.15x P/Bk

• CapitaLand Commercial Trust currently trades at slight premium to book, an attractive level in our view. We believe it should trade up to 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 two years. See CapitaLand Commercial Trust's share price.
• CapitaLand Commercial Trust's 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.

A Myriad of Growth Opportunities

• While Singapore office rents are up 25% from the lows in 1H17, we believe the recovery remains on track given the current supply squeeze. With 30% of leases up for renewal in 2020-2021, CapitaLand Commercial Trust is highly leveraged to the ongoing office recovery.
• Deploying its lowly geared balance sheet of 35% which offers S$1bn in debt-funded acquisition capacity would also act as a catalyst for the stock.

Valuation

• Our DCF-based Target Price of S$2.10 implies a 1.15x P/NAV.

Key Risks to Our View

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

What's New - Growing From Strength to Strength

• We brought the management of CapitaLand Commercial Trust for a UK NDR and the general feedback from investors has been positive. The following points were highlighted during the meetings:

1. Views on the office market

• CapitaLand Commercial Trust to capitalise on the robust Singapore office market in the coming years. Management continues to see positive office market dynamics, which is supportive of net property income (NPI) growth in the medium term. With the Singapore economy expected to continue growing steadily, coupled with conducive office market conditions, we believe that CapitaLand Commercial Trust remains on track to deliver a robust DPU growth of 4.5% CAGR over FY19-21F.
• Growth is mainly organic as we project rental reversions to remain robust and possibly even accelerate going into 2020- 2021. This is driven by
  1. lack of new office supply completions, and
  2. strong pre-commitment rates for new buildings in 2019;
  we project market rents to increase by 5- 10% per annum from the end of 2018 for the next few years.
• Widening leasing spreads (market rents over passing rents) a positive. CapitaLand Commercial Trust have another 11% of leases expiring in FY19 and close to 28% and 26% of its rental income expiring in FY20 and FY21 respectively.
• Noteworthy is that the average passing rents in FY20-21 range between S$9.20 and S$10.72 psf pm, lower than current market transaction levels, implying that CapitaLand Commercial Trust has a good buffer to mark rents higher.
• With the new office completions, assuming a 3-year office expiry profile, and based off URA office rental downtown CBD average rents, we project rental reversions to potentially reach a high of 25-28% over the coming years.

2. Pre-leasing of new office supply to result in a supply squeeze

• Take-up rates have been strong for a majority of the new space completing in 2019-2020. Based on estimates, office buildings completing in 2019 and 2020 are already 94% and 18% pre-committed. While we do note of several large office supply completing from 2021-2022, the space is expected to be taken up progressively as completion nears. Based on estimates, 43% of the new office supply pipeline has been pre-committed ahead of completions, a positive data-point.

3. Demand and take-up

• Strong leasing momentum to continue. The manager continues to see broad-based demand from the technology, co-working and financial sectors. Average demand for the past couple of years has averaged over 1m sqft. This compares favourably to the c 0.85m sqft of supply completing in the next three years.
• Co-working demand. While not a big part of the overall CBD currently, certain co-working operators are doing well. Due to the network effect, the co-working operators with a bigger footprint are doing well and have been able to see good take-up for their space. There could be consolidation in the space over the longer term with smaller firms potentially banding together to build scale.
• Specific to CapitaLand Commercial Trust’s portfolio, one of the tenants – The Great Room, a co-working operator located at One George Street (OGS) is apparently doing well with good take-up from end-users and is still looking to grow its presence in Singapore.

4. Plans for HSBC building

• HSBC Building offers a myriad of opportunities for CapitaLand Commercial Trust. The exit of HSBC as a tenant in April 2020 will enable the manager to explore possible options for the building. The manager is still evaluating options to either divest, reposition or re-rent the property to either a single tenant or multi-tenants.
• While the manager has gotten a boost in the meantime from the 35% hike in rent to HSBC over the course of the 1-year extension to April 2020, the manager is aware that there might be a drop in rental income post HSBC vacating the building. That said, the manager is cognisant of the potential income vacuum and will be looking at avenues to mitigate this drop.

5. Leveraging the new master plan

• In the medium term, CapitaLand Commercial Trust is expected to benefit from the recent plans to rejuvenate the Central Business District (CBD), especially the Tanjong Pagar district, by the Singapore government. While most of the portfolio properties are built up close to their maximum GFA, except for Capital Tower, the manager believes that any material redevelopment must make sense given the attractive returns that they have been able to extract from its current portfolio.
• That said, the longer-term rejuvenation of the CBD with expectations that older buildings could be converted to mixed-use developments (mainly residential or hotel) could result in displacement of office demand and result in a further squeeze in supply in the CBD.

6. Financing cost trend should remain stable

• Liquidity for the market remains strong as the banks continue to prefer to lend to quality names in the real estate space. That said, CapitaLand Commercial Trust has minimal debt expiry in 2019 and 2020 with < 15% of its total debt to be renewed. Cost of funds has been kept low at 2.5% (vs 2.6% in 4Q18) amidst a longer debt expiry profile of 3.6 years. However, given the flattish yield curve, cost of funds will likely remain stable over time.

7. Where are the inorganic growth opportunities?

• Looking to deepen exposure in Europe. The manager remains on the lookout for inorganic growth opportunities across the region and in Europe. Concurrently, the manager is also looking to deepen its exposure in existing markets with Singapore as a core market.
• The manager aims to have 20% of assets from overseas. Among the countries in Europe, management is keen to deepen its exposure in Germany to gain operational scale over time. Germany remains attractive with strong property fundamentals and a solid economy while the yield spreads between cashflows and funding costs remain attractive.
• We remain positive on this strategy, in addition to diversifying its geographic exposure, tenancy base and most importantly, reducing CapitaLand Commercial Trust’s vulnerability to the cyclicality of the Singapore office market over time. This strategy, in our view, will bring about a steady growth in distributions across market cycles.
• Attractive pipeline from the sponsor. The CAPITALAND LIMITED (SGX:C31)- Ascendas Singbridge merger has provided CapitaLand Commercial Trust with an expanded pipeline which might look interesting in the longer term. While the pipeline now includes potential opportunities in Korea and an office portfolio in the US, CapitaLand Commercial Trust remains focused on ASB Tower, located in Singapore CBD, which is currently under construction and will complete in 1H20.
• Asset-divestment opportunities. Given that CapitaLand Commercial Trust has been active in reconstituting the portfolio over the past few years, selling non-core properties to sharpen its portfolio focus, the manager feels that further asset divestments will be more opportunistic.

Source: DBS Research - 17 May 2019