• Recent tour highlights assets’ exposure to markets with above average GDP and employment growth, and firm rental outlook.
• Exposure to Seattle and Austin provides KEPPEL-KBS US REIT (SGX:CMOU) with unique exposure to the US technology sector.
• Negative perception over “Class B” buildings and “suburban” locations unwarranted.
• Maintain BUY, Target Price lifted to US$0.90 with FY19-21F DPU lifted by 2-9%.

Positive Exposure to Markets With Average Growth; Unique Technology Play

• We recently visited KEPPEL-KBS US REIT (SGX:CMOU)’s properties in Seattle, Austin and Houston, which represented 72% of Keppel-KBS US REIT’s portfolio by value.
• The site visits reinforced our view that Keppel-KBS US REIT is focused on markets which have above average GDP and employment growth which is supportive of rents going forward.
• Furthermore, Seattle and Austin provide unique exposure to the US technology sector which is undergoing structural growth.
• This provides us with confidence on the outlook for Keppel-KBS US REIT going forward.
• Detailed below are key highlights from our site visits.

Seattle Benefiting From Technology Growth and Constrained Supply

• With limited new supply in the 3 submarkets that Keppel-KBS US REIT’s properties are located in, we understand rents are rising rapidly with strong positive rental reversions expected going forward.
• The strength in the Seattle market is mainly driven by expansion of the technology sector which represents 53% of total office demand or 69% of the Eastside area where Keppel-KBS US REIT’s properties are located. Beyond the growth from Amazon and Microsoft, who have Seattle as their home base; and, on a combined basis, take up over 30m sqft of office space according to CBRE (out of a total 109m sqft in the overall Seattle/Puget Sound region), other technology giants such as such as Google, Apple and Facebook (Oculus the VR arm of Facebook is located in Keppel-KBS US REIT’s Westpark portfolio) are also growing their presence in Seattle.
• We understand the other large technology companies have been expanding in Seattle due to access to talent as well as the high operating cost environment in San Francisco/Silicon Valley. This robust backdrop has resulted in Class A average asking rents in Bellevue CBD where the Plaza Buildings are located to jump 20% y-o-y in 1Q19 according to Colliers.
• Rents are projected to maintain their strong upward momentum going forward, given:
  1. supply constrains over the next 2 to 3 years,
  2. existing buildings under construction already having high pro-commitment rates,
  3. technology companies still on the growth path, and
  4. vacancy rates in Keppel-KBS US REIT’s submarkets already low at around 5%,.
• This should translate to positive rental reversions as net asking/signing rents for The Plaza Buildings are in the mid to high US$30 psf per year versus in place rents estimated in the high 20’s and US$30’s.
• Likewise, at Bellevue Technology Center, we understand Keppel-KBS US REIT has been able to sign net rents in the high US$20’s to US$30’s which compares to in place rents at around the US$20’s, while at Westpark, in place rents are in the mid to high teens compared to signing rents in the low US$20’s.

Austin a Choice Market

• Owing to the high cost environment in San Francisco and Silicon Valley, technology companies have been progressively moving or expanding into other markets. A key market for this move has been Austin, the state capital of Texas, which we understand benefits from absence of state taxes compared to California (a major issue for employees given recent changes in tax laws to deduct state taxes). Furthermore, Austin benefits from a steady stream of graduates from the University of Texas at Austin.
• The attractiveness of the market can be seen with the establishment of an Apple campus in the city, Facebook and Google taking large office spaces supplemented by Amazon (via Wholefoods which was founded in the city).
• While these tech giants have not taken up space directly in the submarkets where Keppel-KBS US REIT’s Westech 360 and Great Hills Plaza are located, these properties are benefiting from the general uplift in the overall Austin market. Furthermore, we understand both these properties are 15 minutes’ drive from the new Apple campus.
• Similar to the trend’s seen in Seattle, Keppel-KBS US REIT’s properties are expected to benefit from improved rents going forward and should report healthy rental reversions. Asking rents for Westech are in the mid to high US$20’s versus in place rents in the low US$20’s, while for Great Hills Plaza, net signing rents range in the mid US$20’s compared to in place rents in the high teens.

Houston a Laggard Market But Pro-active Management and Value Add Strategies Offers Upside Potential

• Notwithstanding the low unemployment and recovery in the oil and gas market, we understand companies are still cautious on their expansion plans which has affected demand for office space resulting in relative high vacancy rates in the high teens.
• Nevertheless, through pro-active management and value add strategies, we believe there is an opportunity for Keppel-KBS US REIT’s properties in Houston to drive an improvement in occupancy thereby lifting earnings despite the challenge in lifting rents.
• At 1800 West Loop South, Keppel-KBS US REIT is in the process of adding meeting rooms and a tenant lounge. Furthermore, to drive an improvement in occupancy, Keppel-KBS US REIT has been creating spec suites (i.e. offices that have been renovated and allow prospective tenants to move in immediately) which enable prospective tenants to envision their potential office space. We understand the use of spec suites is not actively used by other landlords in the market and the finishing of Keppel-KBS US REIT’s products are of a higher quality. To date, the strategy has been successful with around one floor in the building occupying spec suites that have been created.
• Meanwhile at WestLoop I & II, occupancy remains healthy at around 90% with one of the buildings anchored by medical clinic/tenants. In the medium term, should the proportion of healthcare tenants in WestLoop I increase from 60% to 80-85%, there is potential for an uplift in property values owing to tighter cap rates for medical buildings.

Is Suburban Class B Properties a Negative?

• Approximately 25% of Keppel-KBS US REIT’s portfolio by value is exposed to “Class B” properties in suburban locations. To date there is negative perception by certain investors that properties in suburban locations are “inferior”. We believe this is perception is largely due to investors in Singapore being familiar with office REITs that own Grade A office buildings in the CBD and a large proportion of business activity located in the CBD.
• In contrast, in the US, due to traffic congestion and potential lack of public transport options, offices in CBD locations may not necessary be the preferred location by tenants. Rather businesses may prefer to be located in “suburban locations” or “urban centers” which are more convenient for employees. We understand access and availability to talent is a key consideration, with the level of rents not the sole driver for the selection of office locations.
• In addition, many of Keppel-KBS US REIT’s suburban buildings are located amidst greenery which some tenants prefer and are hard to replicate in a CBD location.
• Furthermore, while Keppel-KBS US REIT’s “Class B” buildings from the outside may look older, this belies the quality of office property inside which may be comparable to other Class A buildings.
• Finally, while some of Keppel-KBS US REIT’s suburban properties may not have walkable amenities nearby, this is offset by regular visits by food trucks and having tenant lounges and convenience marts where tenants can buy their lunch, snacks and drinks.
• Pictures of the interior finishing, tenant lounges and convenience marts for “Class B” The Plaza Buildings and the Westpark Portfolio can be seen later in our report.

Raising DPU Estimates on Stronger Seattle Outlook; Target Price Lifted to US$0.90 After Imputing Lower Cost of Debt and Risk-free Rate

• Given expectations that vacancy rates are expected to remain low at 5% or lower over the next few years and higher than expected signing rents year to date, we raised asking rents assumptions for Seattle by 5-15%. In addition, given robust rental outlook which should translate to a greater uplift in property values translating to less pressure on gearing as the tenant improvements are funded through debt, we increased the payout ratio for FY20/21F to 100%/98% from 96%/93%. This results in FY19-21F DPU being lifted by 2-9%.
• While our financial model is projecting that Keppel-KBS US REIT’s gearing will drift towards the 40-41% level by FY21, this is because have not forecast any revaluation gains. In reality, revaluations gains are likely due to strong income growth which should result in Keppel-KBS US REIT maintaining a sub 40% gearing in our view.
• On the back of a dovish Federal Reserve and our DBS economists now projecting two rate cuts in 2019, we lowered our target cost of debt to 4.0% from 5.0% previously and assumed a lower beta of 0.925 versus 0.95 previously on greater confidence over Keppel-KBS US REIT’s exposure to the robust Seattle and Austin markets.
• In addition, we now use 2.5% as our new risk-free rate as our DBS economists now expect the US 10-year bond yield to be 2.5% from high 2%’s, partially offset by a lower terminal growth rate of 2.25% from 2.5% previously to account for any potential impact on the current trade tensions on the US GDP growth outlook. As a consequence, we have raised our DCF-based Target Price to US$0.90 from US$0.80 previously.
• Our Target Price implies a P/Bk multiple of 1.15x, reflective of a rising office market and upside potential for revaluation gains. The implied P/Bk is less than 1.2x ascribed to MANULIFE US REIT (SGX:BTOU) as we believe there is likely to be some lingering disappointment over the rights issue conducted in late 2018.

Maintain BUY, Target Price Lifted to US$0.90

• With over 25% total return (22% capital upside and 8.2% yield) expected over the coming 12 months and healthy 3-year DPU CAGR of 8%, we reiterate our BUY call with a revised Target Price of US$0.90.
• We believe investors have a wrong perception on Keppel-KBS US REIT, seeing it as a REIT with an inferior Class B portfolio when in fact it is one with over 60% exposure to Seattle and Austin, providing it exposure to the growing technology sector and markets with superior rental outlooks. Thus, in our view as investors come to appreciate Keppel-KBS US REIT’s qualities, this should trigger a re-rating.

Source: DBS Research - 17 Jun 2019