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Sunday, December 21, 2008

CapitaCommercial Trust @ 96 cts (REIT / Singapore) 0 comments

(P.S: Sorry for any disturbances the advertisements above may have caused you)

Main issues

1.Rents set to fall

2.Interest expense set to rise

3.Relative yield valuation is not attractive

And finally I resume my Hotstocksnot coverage. It has been a turbulent year and I have been so absorbed, enthralled and traumatised by the stock market that I preferred to spend time on my own stockpicking rather than highlighting hotstocksnots. Besides, valuations had plunged and it was getting difficult to find overvalued stocks.

CapitaCommercial Trust (CCT) had dived together with the general market, especially with the REIT segment, since the middle of 2008, hitting as low as 60 cents in early December. It didn't help that it was axed from the MSCI Singapore index in November, which further added to the selling pressure. However, in recent days, it has rallied strongly by over 50% to 96 cents on improved sentiment over property given lower interest rates. It is my view that this is not sustainable and the stock has become a hotstocknot, although it is substantially off its 2007 highs of >$3.

I will address my viewpoint along three main issues: revenue, costs (the difference will of course be earnings), and valuation.

The expected drop in demand for office space as a result of the financial crisis is probably known to all. That is the reason why CCT dived so sharply the last few months. But let's try to quantify the likely impact on the rents of CCT's properties, and hence revenue, in order to judge whether at the reduced price of 96 cents CCT might be a bargain.

Of CCT's portfolio, four properties provide the main revenue stream: 60% Raffles City Trust (30% of total gross rental), 6 Battery Road (24%), 1 George Street (17%), Capital Tower (11%); together they contribute >80% of CCT's gross rental revenue. The last three are office-dominated properties located in the CBD, with Raffles City being the exception (15% office/40% retail/40% hotel & convention). In particular, 6 Battery Road and 1 George Street are prime CBD office towers with peers commanding the highest rentals of $17-20/mth psf; this segment is also the one that has risen the fastest over the last few years. Capital Tower and Raffles City Tower (the office segment) occupy the second-tier, with peers commanding about $11/mth psf. Note that these estimates were obtained in Aug 2008; that's right, before all the mess really started.

Three things are worth noting that will have significant impact on future rents at these properties. Firstly, 35% of CCT's gross rental is derived directly from banking, insurance and financial services customers, while other segments likely to be badly affected (hospitality, property services, fashion retail) could range from 25-35%; effectively two-thirds of CCT's customers will be hit badly by the looming global recession (though of course, they might not terminate leases). Secondly, in CCT's core niche: Grade A downtown core office space, there is looming supply overhang come 2010 onwards: as at May 2008, Singapore had 6.7M sqft of Grade A office space; a walk along Shenton Way will make it clear that this supply is poised to surge, with newbuildings at various stages of completion obvious from Robinson Road to Raffles Place to of course, Marina Bay. For the last one alone, the Marina Bay Financial Centre alone is poised to add 3M sqft when both phases are completed by 2012. Property consultants had expected office rents to soften in 2010 even before the financial crisis, but the looming demand-supply dynamics look positively bleak now. Thirdly, and the scariest of all, median Category 1 (ie. prime) office rentals according to URA figures have tripled from $4.5/mth psf in 4Q04 to $13.50/mth psf in 3Q08, and it is fair to say that 3Q08 was near the peak in terms of Singapore prime office rentals. If rates were to even half from the peak, CCT yields would be disastrous.

Of course, this impact would be mitigated by lease renewals which should have upside pressure, since expiring CCT leases apparently are substantially below average market rents in the same category (a fact CCT has highlighted repeatedly during every presentation). Looking at the percentage of leases expiring in 2009 in each main property as well as the gap between CCT rates and average market rates, 6 Battery Road and 1 George Street have the most potential to provide rental growth in 2009. But my feel is that the gap between CCT rates and market rates are likely to close not by the former going up, but by the latter coming down. Also note that 1 George Street was purchased in mid-2008, before the financial crisis really hit the nadir; it can't have been a good bargain in retrospect in light of ensuing developments.

Now we examine the costs dimension. The main component is clearly interest costs. Based on 3Q08 figures, annualised interest rate on CCT's total debt of ~$2B is approximately 3.5-4%, composed of both bank loans and note issues. Most of the loans are due over 2009-11 in the proportion 25%/35%/25%, and it is clear, at least for the loans expiring in 2009, that refinancing will be at substantially higher rates. Let's use the increase in rates of ~3% that Cambridge Trust had to fork out for refinancing recently as a reference, and that means CCT could have to pay 75-100% higher interest. Since a quarter of loans expire in 2009, interest expense is more likey to rise 20-25% in 2009, and this could easily take 20% off distributable income. And in 2010-11 as loans expire the interest expenses could rise further and cut further into income. And we're not even examining the issue of bond covenant breaches yet, which could take things down further.

Now for the final issue of valuation. Based on 2008 figures and annualising the 3Q08 figures (due to mid-year acquisition of 1 George Street) distribution would optimistically be 12cts/unit or yield of 12.5%; unitholders should be happy to get this distribution for 2009 for it is probably the best that could be achieved. If we take into consideration the increase in interest costs as described above distribution should be about 10cts/unit (and probably even lower in 2010-11). Add to that the pressure on office rents given the terrible economic recession which could lead to unilateral lease terminations especially by financial customers; at best customers will reject any rental increases (URA reports that 3Q median office rental rates have begun to decline). Let's say CCT manages to achieve distribution per unit of 10 cts for FY09, by some miracle. That means yield of slightly >10% at current prices. For a sense of perspective, in the US corporate bonds overall now yield 8-9%; I guess CCT debt could be considered middle-of-the-road (and hence comparison can be done apple-to-apple) since its corporate family was rated Baa1/Baa2 (low-end investment grade) just recently in mid-2008. For the case of REITs the units could, I guess, be considered a form of junior debt and >10% yield might be just about fair given the non-guaranteed nature of the payout, its last place in the payout structure plus the expected decline in payout trend over the next few years. Indeed, if you ask me, there might be room for some convertible arbitrage which would create additional downward pressure on the unit price.

So, a 10% expected yield (an optimistic figure as I pointed out earlier) is not great by relative valuation standards.

So why the recent surge? Well perhaps it had just fallen too fast too quick. As I pointed out earlier, the REIT was one of those kicked out of the MSCI Singapore index recently, together with Venture, Yanlord and Keppel Land, providing a catalyst for downward adjustment. An interesting observation is that three of those four exclusions have been among the greatest gainers in the recent market bounce. Do I think it is sustainable? No, I don't think so, unfortunately.

(1) URA 3Q property update

I agree that CapitaCommercial Trust is a hot-stock-not: Agree/Disagree




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