Path to prosperity

Yesterday both Keppel DC REIT (KDCREIT) and Mapletree Industrial Trust (MINT) released their results for the quarter ending Jun2020. Both REITs have performed strongly after their end-Mar lows due to their exposure to data centres. MINT has performed more strongly even though it only has a 32% exposure (by AUM) to data centres vs KDCREIT's 100% exposure. I think this could be due to the more visible growth pipeline of MINT from its sponsor's stakes in the US data centres and also redevelopment opportunities at its existing non-DC assets. 

KDCREIT reported a 1H2020 DPU of 4.375 Scts which as a 13.6% improvement yoy. This was due to new acquisitions of SGP4 and DC1 in 2019 as well as the latest acquisition of Kelsterbach DC in May 20. Based on the 1H2020 closing price of $2.54, this represents a 3.44% annualised distribution yield. As all of KDCREIT's tenants are in the data centre business, they were not subject to any shutdowns and hence did not require any rental reliefs/support from KDCREIT. KDCREIT was thus able to payout 100% of its distributable income. 

For MINT, it reported a 1QFY20/21 DPU of 2.87 Scts which was 7.4% lower yoy due to rental rebates extended to tenants due to Covid-19 as well as holding back tax-exempt income of S$7.1m to mitigate the impact of mandated rental reliefs. According to MINT, if such income was not withheld, DPU would have been 3.19 Scts, representing a 0.09 Scts increase yoy. The amount held back was about 10% of its 70.6m distributable income. 

In my opinion, MINT continues to be held back by its legacy portfolio of flatted factories and older business parks as shown in the negative rental reversions as well as lower new rents achieved during the period. However, investors could possibly see this as 'land bank' to be redeveloped into more future-ready assets. Given MINT's management's strong execution track record, there could certainly be more redevelopment opportunities like 30A Kallang Place and Kolam Ayer. 

It is hard to overstate the attractiveness of the data centre asset class during the Covid-19 period where businesses have been forced to digitize and people have been working from home. More importantly from a real estate perspective, data centre leases tend to be long (KDCREIT's WALE of 7.4 years) and provide a steady stream of income so long as service level agreements are met. 

At their current trading levels, it appears that both KDCREIT and MINT are in a virtuous cycle as their trading yields (3-4%) are much lower than data centre cap rates (5-7%). This would allow them to make accretive acquisitions even with a greater proportion of equity funding. In turn, this growth potential can further drive up the share price and make it even easier for either to make accretive acquisitions. 

Investor optimism has certainly showed up in their strong price growth and I believe that investors are pricing in additional acquisitions. Therein lies a certain amount of risk if the REITs are unable to find assets to acquire and meet investor expectations. 

The pace of leasing has been slower as marketing and property visits have been postponed. CCT also mentioned that it has seen more renewals coming in as tenants want to minimize capital expenditure. Both CCT and KREIT cited that their high tenant quality was important in keeping occupancies high and allowing them to collect rents on time. There have also been no significant requests to downsize. 

During this period, CCT highlighted flex space operators as being more affected as their members defer or waive memberships. This is usually highlighted as the downsize of flex space operators as they incur long term rent expenses but with short term membership revenues. On the bright side (for CCT), the WeWork lease at 21 Collyer Quay remains on track and there has been no indication of a withdrawal. 

KREIT cited rental reliefs as a reason for weaker property income. Zooming out a little, we expect NPI margins to compress due to higher cleaning and digitizing expenses incurred by office landlords in making their properties suitable for a return to work. While this is somewhat already expected, the investing community is still waiting on more specific guidance on how much earnings would weaken (similar to what the hospitality players have disclosed recently). 

In their outlook statements, both KREIT and CCT mentioned that the impact is still hard to assess and they would continue to be prudent in distributions. 

As generally known, demand for office space follows economic cycles and it is up to developers and urban planners to manage the supply of office space. While demand is expected to decline, Covid-19 has also resulted in construction and renovation works being pushed back and thus reducing new supply in the next few years. Furthermore, developers could also take the coming few years of weak demand to undertake redevelopments and asset enhancements at their properties. Examples of this are AXA Tower and Keppel Tower. 

Overall while the impact from Covid is still limited to the first-degree impact from rental reliefs, I think that we can see higher vacancies and even negative rental reversions in the coming years as leases expire. Office demand will not collapse as fast as hospitality and landlords generally remain fairly positive about the long term potential of office. The slide below from Keppel REIT sums the discussion up quite aptly.