US Office SREITs: Are we there (near bottom) yet?
- US Office SREITs are one of the biggest ‘casualties’ having declined 35% to 49% YTD, hitting below COVID low; in line with US Office REITs.
- Potential earnings headwinds but could be partially offset by mitigating factors
- Headwinds largely priced in at >12% headline yield; yield at 8%-10% in a bear case scenario
- Prefer KORE but MUST and PRIME valuations are compelling
US Office SREITs are one of the biggest ‘casualties’ YTD with share prices hitting below or close to COVID low. Given the volatile global macro economic environment, US Fed hawkish rate hikes and geopolitical tensions causing heightened fears of recession, the US Office SREITs have been one of the biggest ‘casualties’ among the SREITs with share prices have declined 35% to 49% YTD. Manulife US REIT “MUST” and PRIME US REIT “PRIME” share prices are now 39% and 10% below that of Mar20 (COVID) low while Keppel Pacific Oak US REIT “KORE” is still 32% above Mar20 (COVID) low. The US Office REIT were not spared either having declined 41% YTD (gateway office REITs -41% YTD; regional office REITs -40% YTD).
Down but not out – potential earnings headwinds but with mitigating factors to partially offset. While headline yields are looking very attractive at above 10% yield, we believe there are potential headwinds that could impact earnings such as i) vacancy risks from rationalization of office space, ii) sharp increase in interest rates impacting floating rates and debt refinancing, partially offset by high hedging ratio of above 80% and iii) may convert the paying management fees in cash due to share price at deep discount to NAV. On a bear case scenario, these could lead to DPU to decline by 30% to 50% (details in next segment).
Headwinds priced in? We believe that the majority of known downside risks have been priced in at current price levels. It is arguable what the fair value yield should be given the negative macro economic outlook, but at 8% to 10% yield, US Office SREITs would have priced in a DPU decline of 30% to 39% led by 10% decline in NPI, average cost of debt of 5% and management fees paid in cash. Macro economic concerns may delay potential recovery but we do not rule out short-term rallies with any positive news. Prefer KORE but MUST and PRIME valuations are compelling.