Manulife US REIT-Green shoots in US office market

5 Nov 2021

No financials provided in this operational update. To recap, 1H21 DPU of 2.70 US cts (-11.5% YoY) was in line, at 47.5% of our FY21e estimate.
7% of NLA signed in 9M21 with positive reversions of 1.3%. Higher physical occupancy bodes well for carpark revenue. US office market showing green shoots.
Maintain ACCUMULATE and DDM-based TP (COE 9.1%) of US$0.84. No change in estimates. Prefer Prime US REIT (PRIME SP, Accumulate, TP US$0.94) in the sector for greater tenant exposure to STEM/TAMI sectors.

The Positives

+ Improving tenant sentiment. New leases formed 32.3% of leases signed in 3Q21, up from 3.3% for leases signed in 1H21. As of 9M21, 453,000 sq ft or 9.7% of NLA has been signed with positive reversions of 1.3%. Leasing sentiment has improved, evident by the 76% jump in leases signed year-to-October versus FY20 leasing.

+ Higher physical occupancy should lift carpark income. 3Q21 physical occupancy improved to c.30% (1Q21: 11%; 2Q21: 15%). physical occupancy varied across MUST’s assets. Government agencies has later return-to-office timelines, resulting in lower physical occupancy for the buildings they occupied. The absence of movement restrictions also benefitted entertainment and fitness venues opposite two of MUST’s assets, whose patrons utilise the carparks located in MUST’s buildings. Together with the higher physically occupancy at MUST’s offices, this points to recovery in carpark income, which contributed c.7% of FY19 revenue.

The Negatives

– 3Q21 occupancy slid 0.8ppts QoQ from 91.7% to 90.9%, still above market occupancy of 83.8%. Significant backfilling at Michelson brought occupancy to 87.2%, up from 80.4% in 2Q21. This was offset by a tenant exercising its lease break, returning one floor of space in MUST’s Atlanta asset as it adopted a remote work model for its IT department. That said, leases signed post quarter improved occupancy to 91.6%. Leasing remains an immediate priority for MUST. There is still some way to go to bring occupancy back to historical levels of c.95%, but the US office sector is showing signs of recovery.

– Gearing elevated at 42%, above MUST’s targeted gearing of 40%. Gearing crept up largely due to valuation declines since the pandemic. Tenant incentives (TI) offered on new and renewed leases will be financed by debt, which may push gearing higher. However, the management believes that the TI requirements are still manageable but hopes to bring gearing down eventually, doing so in conjunction with portfolio reconstitution.

Outlook

Green shoots for US office market.

This can be seen from (1) improving net effective rents; (2) lower TIs; (3) longer lease tenures signed; (4) decline in subleasing; (5) 46.4% QoQ improvement in transactional volume and (6) improving rental growth outlook for MUST’s cities. Net effective rents improved 4.4% and 2.5% since 1Q21 and 2Q21 on the back of declining TIs. TIs declined 5.5% since 1Q21, although free rent period unchanged QoQ at 8.9 months. Tenants are signing leases for longer tenures, lengthening from 7.1 years as at 1Q21 to 7.7 years as at 3Q21. Subleasing has also declined for the first time since the start of the pandemic. Twelve-month rental forecasts by CoStar Group were less negative for MUST’s submarkets, ranging from 0% to +1.1%. This compares to Jul21’s outlook of -2.4% to 0%.

Shifting focus to New Economy sectors and secondary markets

According to CBRE, tenants in the tech, healthcare and life science sectors accounted for 31% of leasing demand in 2020. Research by JLL in April 2021 confirmed these sectors are among the top-paying tenant industries. However, these New Economy industries only account for 10% of MUST’s tenants, which limits its ability to increase rents. MUST’s future acquisitions are likely to focus on secondary markets where these industries are frequently located. MUST is eyeing assets with cap rates ranging 6.5% to 7.5% in sunbelt and magnet cities, which includes Seattle, Salt Lake City, Austin, Boston, and Raleigh. MUST aims to increase its exposure to New Economy tenants to 20%. It is open to divesting, M&As and JVs to reposition its portfolio. The manager has been actively evaluating deals and has assessed 47 deals YTD.

Maintain ACCUMULATE and DDM TP of US$0.84

No change to our estimates. US office market showing green shoots. Catalyst include stronger than expected leasing and portfolio reconstitution. Current share price implies FY21e/FY22e DPU yield of 8.2%/8.7%. Prefer Prime US REIT (PRIME SP, Accumulate, TP US$0.94) in the sector for greater tenant exposure to STEM/TAMI sectors.