K-REIT Asia

K-REIT reported 1Q09 DPU of 2.4Scts (-48% y-y, -11% q-q), which met 24% of our previous FY09F forecast of 9.9Scts and 27% of consensus’ previous FY09F forecast of 8.9Scts. Core operating performance in 1Q09 was broadly within expectations — gross rental revenue of S$14.8mn (+28% y-y, +3% q-q) and NPI of S$10.8mn (+18%, -8% q-q) met 25% and 24% of our respective full-year forecasts, while finance expenses of S$6.1 (-19% y-y, -1% q-q) met 26% of our full-year forecast.

However, we are concerned with the rise in portfolio vacancy: committed occupancy in all properties, with the exception of One Raffles Quay (ORQ; remained 100% let as of end-1Q09), declined during the quarter and the overall portfolio committed occupancy stood at 95.8% at the end of 1Q09, compared to 99.0% a quarter before. The biggest rise in vacancy came from Bugis Junction Tower (BJT), which saw committed occupancy slide from 100% at the end of 4Q08 to 91.5% at the end of the last quarter. The rise in vacancy was likely the result of a branch of Prudential Life Assurance, a major tenant that used to occupy some 20,000 sq ft in BJT, moving to a new transitional office building along Scotts Road.

To put things in perspective, the 320bp rise in portfolio vacancy was against a backdrop where 39% of the leases due for renewal this year were negotiated in 1Q09, suggesting relatively weak tenant retention. To be fair, we believe management probably traded occupancy for rents, considering the average portfolio gross rent registered a 5.9% sequential increase in 1Q09 to S$8.06psfpm. On our estimates, implied average rents at Prudential Tower (PT), Keppel Towers-GE Tower (KTGET) and BJT registered 1.3- 18.1% sequential increases in 1Q09. The passing rent at ORQ also appears to have increased, judging for the 12.9% sequential increase in dividend income from ORQ in 1Q09.

We cut our gross asset value estimate from S$1.41bn to S$1.4bn (-0.7%) and core net asset value from S$1.31/unit to S$1.26/unit (-3.8%) chiefly to reflect our revised office rental forecast and K-REIT’s updated lease expiry profile as well as FY10F valuation. On our numbers, a non-cash revaluation deficit of S$701.4mn (our gross asset value estimate of S$1.4bn vs the latest portfolio valuation of S$2.1bn) could potentially be booked over the cycle and consequently, K-REIT’s gearing could rise from the current 28.7% to 41%. Our valuation methodology assumes new equity of S$16.9mn to be raised at the current share price to ensure gearing stays within 40% to quantify the fair discount to core NAV that reflects the potential dilution. Accordingly, we lower our price target from S$1.29 to S$1.23 (-4.7%). Our price target implies a potential total return of 31.9%, including our projected FY10 dividend yield of 8.9%, at the current share price.

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