Keppel Corp’s stable of REITs put in a solid performance in the first half of this year but the messaging from the two managers of Keppel REIT and Keppel DC REIT (KDC REIT) were somewhat different.
Keppel REIT’s manager is focused on income stability and long-term capital appreciation of the portfolio, which is likely to be aligned with the interests of unitholders. Its portfolio of mainly Grade A office buildings is located in Singapore and Australia although it has a building each in Seoul and Tokyo.
KDC REIT’s manager has done a sterling job of maintaining DPU y-o-y, along with the growth in gross revenue, net property income (NPI) and income available for distribution (DI) in 1HFY2023 ended June 30. Unitholders can be prepared for further asset growth although KDC REIT already owns 23 data centres, six of which are in Singapore and 11 in Europe.
Anthea Lee, the outgoing CEO of KDC REIT’s manager, says: “Aggregate leverage remains healthy at 36.3% as an engine providing us with sufficient debt headroom to pursue growth opportunities. Looking forward, we remain cautiously optimistic on growth opportunities and will continue to grow our portfolio with acquisitions, with a focus on diversification to strengthen income resilience.” KDC REIT has an internal cap of 40% for its aggregate leverage.
Analysts expect KDC REIT to acquire a seventh data centre in Singapore, SGP7, which was developed by Keppel Corp, for about $600 million. That would go some way in stabilising the portfolio further as the SGD has strengthened against the other currencies of the countries where KDC REIT owns data centres. Lee says: “We have no timeline at the moment. But that definitely remains very much on our horizon in terms of looking at potentially acquiring.”
In 1HFY2023, Singapore was the largest contributor – short of $72 million — to KDC REIT’s total revenue of $140.4 million. This was followed by Ireland ($16.25 million), China ($13.3 million), Australia ($11.5 million), Germany ($8.7 million), the Netherlands ($7.8 million) and others.
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Although KDC REIT has a diversified portfolio, $59 million of revenue comes from one customer in Singapore. “Our financial performance is supported by our quality portfolio of data centres with the majority of our rental income derived from clients with investment-grade or equivalent credit profiles,” Lee says.
According to KDC REIT’s results presentation, as at July, its forecast foreign-sourced distributions have been substantially hedged till end-June 2024. Still, the depreciation of foreign currencies against the SGD resulted in lower foreign-sourced income. This was offset by an increase in China because of the acquisition of three data centres in Guangzhou.
So far, KDC REIT has weathered the sharp surge in interest rates. With 73% of debt fixed, an increase in interest rates would only affect the remaining 27% of unhedged borrowings, according to its results presentation. A 100 bps increase would have a 2.2% impact on 2QFY2023’s DPU on a pro-forma basis.
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In April, the manager completed the refinancing of all loans due this year and the next large debt expiry is likely in 2026.
Reiterating asset growth
The topic of asset growth was reiterated a few times during the July 24 results briefing by KDC REIT. Lee says: “We are well positioned to continue growing our portfolio and deliver long-term value for all stakeholders.”
KDC REIT is at an advantage versus peers and S-REITs in general because based on its annualised 1HFY2023 DPU yield of around 4.45%, its yield is sufficiently compressed for KDC REIT to acquire more data centre assets with equity or a combination of equity and debt.
In 1HFY2023, KDC REIT’s cost of debt stood at 3.1% (+30 bps since March 31) and 2QFY2023’s cost of debt was 3.3% (+50 bps since March 31). While the cost of debt is rising, an asset could well be DPU accretive when acquired with a blend of debt and equity.
In 1HFY2023, KDC REIT’s DPU of 5.051 cents was a tad higher y-o-y but below the 5.165 cents DPU recorded in 2HFY2022. Similarly, while gross revenue, net property income and DI were marginally higher y-o-y, they were all marginally lower h-o-h.
This was blamed on higher finance costs from refinanced loans and floating interest rates loans, net lower contributions from some of the Singapore colocation assets arising from higher facilities expenses including electricity costs, a lower government incentive sum for the investments in Guangdong, and less favourable forex hedges.
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On the other hand, the y-o-y growth in DI was due to contributions from Guangdong Data Centre 2 and the building shell of Guangdong Data Centre 3, reversions from contract renewals and escalations, as well as tax savings from approvals obtained for NetCo bonds as Qualifying Project Debt Securities. In 2021, KDC REIT invested $88.7 million in Netco bonds and $1 million in Netco preference shares. Netco’s equity is held by M1.
Lee indicates that the Guangdong data centres would be profit-generating at their current acquisition price and rental if the REIT were to manage them directly. (There are concerns about the financial health of Neo-Telemedia, the master lessee.) She also reveals that Cyxtera Technologies which filed for Chapter 11 bankruptcy in the US on June 6 is current with its rent obligations in a London data centre owned by KDC REIT.
A JP Morgan report notes: “Equity fundraising is still a possibility in 3QFY2023 together with the completion of the acquisition of Guangdong DC3. We believe this will be paired with other third-party acquisitions, with the most favourable positive carry likely to emerge from Japan data centres, due to low funding costs there.”
Keppel REIT prizes income, DPU stability
On the other hand, Koh Wee Lih, CEO of Keppel REIT’s manager, barely mentioned acquisitions and AUM growth. The focus during the briefing for Keppel REIT’s 1HFY2023 ended June results on July 25 was on organic performance, leasing, tenant demand and navigating a higher interest rate environment.
Koh says: “Definitely, we are not looking to raise fresh equity at the current discount rate. So, potentially, if we were to go into new acquisitions, one way to do that is through capital recycling. A lot of emphasis is placed on asset management as well as capital management.”
Despite having 16.8% of its portfolio invested in six office properties in Australia, a mid-year appraisal led to a 0.1% decline in the valuation of Keppel REIT’s total portfolio.
The decline in the valuation of the Australian portfolio was offset by a rise in the valuation of Blue & William, a Grade A North Sydney office building acquired in November 2021.
Blue & William, which has a view of Sydney Harbour, was developed by Lendlease. At that time, the acquisition was likely to be 3% accretive to DPU based on a pro-forma basis for FY2020, assuming the acquisition was fully funded by debt and including the rental guarantee provided by the developer. During the construction period, Keppel REIT received a coupon of 4.5%.
Blue & William was completed in April, enabling its valuation to rise by 28.3% to A$295 million ($264.34 million) as at June 30 compared to its December 31, 2022 valuation. This gain helped to mitigate the decline in valuations of Keppel REIT’s Australian portfolio where Pinnacle Office Park fell by 13.1% h-o-h in AUD, and by 17.2% in SGD terms. As at 2QFY2023, Blue & William is 37.7% occupied.
The other Australian properties were stable or registered marginal declines in AUD but recorded larger single-digit declines in SGD. Asset enhancement initiatives carried out at 8 Exhibition Street and Victoria Police Centre also helped keep the portfolio’s valuation stable.
Pressured by a strong SGD
The strengthening of the SGD appears to have pressured S-REITs with significant amounts of overseas properties. Keppel REIT’s net property income was a tad lower y-o-y at $80.8 million for the six months to June 30. Contribution from associates — including the one-third stakes in One Raffles Quay and Marina Bay Financial Centre — fell by 9.7% y-o-y to $40.3 million while joint ventures — comprising 8 Chifley Square and David Malcolm Justice Centre — rose 2.4% y-o-y to $11.7 million.
To recap, Keppel REIT’s 1HFY2023 DPU was lower by 2.4% y-o-y at 2.9 cents as higher rental income was offset by higher interest and operating expenses. The DPU included the impact of the $10 million anniversary distributions. Excluding this, DPU would have been 11% lower y-o-y.
Unlike other S-REITs focused on AUM growth, Keppel REIT bought back and cancelled 19.5 million units in 1HFY2023. Keppel REIT’s management declined to indicate whether unit buybacks will continue but analysts think it will continue with the buyback programme.
Aggregate leverage inched higher to 39.2% compared to 38.4% as at December 31, 2022 due to the final payment of Blue & William. Still, Keppel REIT’s capital management has been a lot more robust since Koh came on board in 2021. For instance, he appears to have been instrumental in lowering Keppel REIT’s floating rates. As at 2QFY2023, 76% of debt has been fixed with the next major refinancing due in 2QFY2024.
According to Rodney Yeo, head of asset management at Keppel REIT’s manager, the Australian portfolio has experienced good leasing momentum. “We’ve leased up more of 8 Chifley Square with a government tenant. Hopefully, by the end of the year, 100% of 8 Chifley Square is leased.”
In Singapore however, IOI Central Boulevard Towers is expected to be completed this year with around 1.23 million sq ft of office space. This could put pressure on rents in Singapore. Yeo says there is not much empty space in Keppel REIT’s portfolio with One Raffles Quay and Ocean Financial Centre more or less fully leased. Committed occupancy at Keppel Bay Tower and Marina Bay Financial Centre is more than 98%.
US office remains challenging
On July 26, the CEO of Keppel Pacific Oak US REIT’s (KORE) manager, David Snyder, addressed the elephant in the room early in his presentation — the valuation of commercial properties in the US. KORE owns around 13 properties in Washington State, Colorado, Texas and other Bible Belt states, which Snyder refers to as growth markets.
Snyder says: “We assessed the inputs and assumptions used in the 2022 year-end valuation and are of the view that there are no material changes in the inputs and assumptions. As such, we would not expect a material change in valuation at June 30. Hence, we did not conduct a major valuation.”
“While we see a challenging environment, we see many of the biggest negatives being focused in gateway markets and having a more minor impact in our key growth markets at this point,” he adds.
To assuage investor concerns, KORE’s presentation stated that portfolio valuation would need to fall by around 24% to hit the 50% leverage limit. While the presentation also indicated that KORE can borrow US$350 million ($464 million) before reaching regulatory limits and debt covenants, the REIT is unlikely to raise aggregate leverage to this extent. Snyder indicates that if conditions improve, he would like to divest of a couple of properties
When asked about the disposition of more of the portfolio, Snyder says: “The markets aren’t there. There aren’t many buyers, there’s no financing for most of these properties. And that makes it a little bit more difficult to sell a building. I would say our target and plan would be for both 1800 West Loop (in Texas) and Iron Point (in California) [to be divested]. Once we get them to a substantially stabilised occupancy of 90% or above we would like to dispose of both of those and move into some other assets in some of the markets.”
Snyder did not discuss acquisitions but expressed an aspiration to add multi-use type of properties into the portfolio. “We’ve talked a lot about live work play when we launched (the IPO). That’s something we could do within an acquisition which can have some retail component, and some housing component.” The two cities he would like to be in are Nashville (in the Bible Belt) and Charlotte, North Carolina.
His main focus for now though, is to have an occupancy rate of 90% or more by the end of the year. The current committed occupancy as in 2QFY2023 was 90.8%. However, tenant movements could bring occupancy below this level. Snyder acknowledges there are “some concerns” that a couple of larger tenancies are expiring from The Plaza Buildings in Washington state in 2024.
Financing costs continue to rise and may move to the 4.05%–4.10% range in 2HFY2023. In 1HFY2023, DPU fell by 17.2% y-o-y to 2.5 US cents. This was because of higher financing costs and the switch to an all-cash management fee. If 1QFY2022 DPU was paid in cash rather than units, 1HFY2023 DPU would be 12.6% lower.
While KORE’s portfolio is more resilient than Manulife US REIT’s in terms of the number of tenants — around 380 — with no major tenant concentration risk and higher occupancy rates, based on its annualised DPU, its DPU yield is around 16.6%. Units in KORE are trading at just 0.38x adjusted NAV of 78 US cents. Both data points represent distressed valuations.
In summary, investors interested in asset growth can bet on KDC REIT while investors who favour DPU stability can opt for Keppel REIT. However, only brave investors should take a peek at KORE.
