Steady Income Growth, Initiate at BUY

• PRIME US REIT (SGX:OXMU) offers investors exposure to a diversified portfolio of US office properties with steady income growth potential, in our view. Its asset quality, geographical diversity, tenancy profile and capital management are comparable to if not better than its closest S-REIT peers.
• We believe its distributions are well-supported by a favourable debt profile and efficient tax structure, which minimises cash taxes payable.
• We initiate at BUY with a DDM-based Target Price of USD1.00, implying a 19% total return.
• Key risks are:
  1. adverse changes to its US REIT status;
  2. changes to tax regimes; and
  3. deterioration in US office sector fundamentals.

Prime US REIT's Corporate Information

Owns 11 commercial buildings in 9 US cities

• Prime US REIT’s initial portfolio comprises 11 commercial buildings in the US with a combined value of USD1.2b and total net lettable area (NLA) of 3.4m sf. All its buildings are located on freehold land and classified as Class A by Cushman & Wakefield. Its largest properties – 222 Main, contributes to 17.3% of its portfolio’s total value while 171 17th Street accounts for 15.1% of its total NLA. We believe its portfolio is well-diversified, particularly as its properties also span 9 US cities.
• See attached PDF report for details on leases and tenancies of Prime US REIT's assets.

Prime US REIT's Sponsor & Manager

Managed by KBS Asia Partners, Keppel and AT Capital

• KBS Asia Partners (KAP) is Prime US REIT’s sponsor.
• Prime US REIT’s manager, KBS US Prime Property Management, is owned by KAP, Keppel Capital, the fund-management arm of Keppel Corporation (SGX:BN4), one of the largest conglomerates in Singapore, Singapore Press Holdings (SGX:T39), and Expenion Holdings, with respective interests of 40.0%, 30.0%, 20.0% and 10.0%. The latter is held through AT Capital, an investment fund founded by Mr Arvind Tiku and incorporated in Singapore, with an AUM of approximately SGD2.5b.

Initial portfolio from KBS REIT III

• Prime US REIT’s initial portfolio was from KBS REIT III, an unlisted REIT managed by KBS Group. We believe the KBS Group’s motivation for injecting these assets into Prime US REIT was to recycle capital from a pool of stabilised properties to a perpetual vehicle, such as a listed REIT. Unlike Prime US REIT, KBS private fund which may have a limited fund life.

Investment Thesis

Diversified portfolio

• Prime US REIT has 11 office properties in 9 US cities with low tenant concentration risks, which minimises its exposure to downturns in a single market. Furthermore, its tenants operate across a wide range of industries, not specific sectors; no single industry accounts for more than 16.5% of its rental income while its top 10 tenants account for just 43.5% of its cash rental. These put Prime US REIT on par with, if not better than, Manulife US REIT (SGX:BTOU) and Keppel-KBS US REIT (SGX:CMOU).

Organic income growth

• We expect organic income growth in the next two years as 98.3% of its leases have built-in rental escalations of 1.0-3.0%. The majority of its properties are located in cities with favourable office demand / supply dynamics. With market rents at 24.6% and 8.8% above expiring rents in 2019E and 2020E respectively, we see the potential for positive rental reversions.
• Furthermore, with the bulk of its leases signed on a triple-net or modified full-service gross basis, potential increases in property taxes and operating expenses will be borne by its tenants, not the landlord.

Acquisition growth potential

• While no properties from its sponsor have been designated for right-of-first-refusal (ROFR) acquisition by Prime US REIT, we believe Prime US REIT could still selectively acquire assets from its sponsor. Apart from assets that would be injected into Prime US REIT, its sponsor currently has another USD11.6b worth of assets under management.
• We also believe Prime US REIT can tap its sponsor’s expertise and deep network in the US for third-party acquisitions. That said, with a gearing of 35.0%, we think future acquisitions will probably require equity fund-raising.

Favourable debt profile

• We believe potential interest-rate risks will be mitigated by a favourable debt profile, as 90.0% of its debt is locked in at fixed rates with a long weighted average tenure of 5.6 years. This means its exposure to higher interest rates will be limited to incremental debt drawn down to fund capex and when refinancing, with the first term loan due in 2023.
• Its debt profile should be viewed favourably as it has moderated concerns over interest-rate hikes. Also its 3.45% blended interest cost is just 20bp above Manulife US REIT’s, which has less than half its debt tenure.

Efficient tax structure

• An important feature of Prime US REIT is its efficient tax structure. Similar to its closest peers, Manulife US REIT and Keppel-KBS US REIT, Prime US REIT’s tax structure minimises cash taxes payable and leaves more income for distribution to investors. This is positive as S-REITs are primarily seen as yield instruments.
• Headline tax expenses mostly reflect deferred taxes, which will only be realised if properties are sold in the future.
• Refer to attached PDF report for details on Prime US REIT's tax structure.

Compelling valuations

• Prime US REIT trades at 7.0-7.3% FY19-20E DPU yields vs its office S-REIT peers’ 4.2- 5.9% and other US-listed REITs’ 2.8-5.6%, while offering high DPU visibility.
• At our Target Price, Prime US REIT would trade at a 6.6% yield, more than 5.0% above that of the 10-year US government bond.

Prime US REIT's Valuation

Valuation methodologies – DDM-based

• We view Prime US REIT as a REIT with stable distributions supported by steady income growth, and believe investors should focus primarily on a dividend discount model (DDM), and then relative valuations via dividend yields. We believe that DDM-based valuation should be primarily utilised for REITs given their reliance on underlying asset cashflows as a significant return component.
• We estimate cashflows and distribution forecasts to 2028 to arrive at a DDM-based valuation of USD1.00. This including the 7.0% promised dividend yield implies 18.8% total return upside.

Manulife US REIT, Keppel-KBS US REIT are best comparables, in our view

• Overall however we believe that Manulife US REIT and Keppel-KBS US REIT are Prime US REIT’s closest peers given both similar geographical exposure and REIT structures. They currently trade at DPU yields of between 6.5% and 7.3% for 2019-20E. Between the two, we see closer comparables to Manulife US REIT on asset quality, given Prime US REIT’s higher proportion of Class-A buildings than Keppel-KBS US REIT.

Source: Maybank Kim Eng Research - 2 Sep 2019