1H23: Differentiated By Focus On Growth Cities
Adjusted NPI grew 1.4% yoy in 1H23 due to better performance from its existing properties despite the divestment of two Atlanta assets. The better performance relative to its peers demonstrated the merits of KORE’s focus on growth cities and constant investment on maintenance and amenities. There was no material change and KORE did not conduct a mid-year review on valuations. KORE trades at an attractive 2023 distribution yield of 16.7% and P/NAV of 0.58x (42% discount to NAV). Maintain BUY. Target price: US$0.50.
RESULTS
• Keppel Pacific Oak US REIT (KORE) reported 1H23 DPU of 2.50 US cents (-17.2% yoy), which is in line with our expectations.
• Growing despite timely divestments that reduced leverage. Adjusted NPI increased 1.4% yoy in 1H23 due to better performance from its existing properties despite the divestment of two Atlanta assets in 2H22. Distributable income declined 17.2% yoy to US$26.1m due to: a) borrowing costs increasing 42.5% yoy due to rising interest rates, b) the divestments of Northridge Center I & II (completion: 28 Jul 22) and Powers Ferry (completion: 22 Dec 22) in Atlanta in 2H22, and c) management base fees taken in cash instead of units. On a like-for-like basis, distributable income declined by a smaller 12.6% yoy if base fees for both 1H22 and 1H23 were paid in cash.
• More stability in growth cities. Portfolio occupancy eased slightly by 1.1ppt qoq to 90.8% in 2Q23. KORE signed leases for 289,057sf of office space in 1H23. Rental reversion was – 4.6% in 1H23, which was skewed by Spectrum’s renewal/expansion at Maitland Promenade I & II. Excluding Spectrum’s lease, rental reversion was positive 4.0%. Eastside Seattle – Bellevue/Redmond, which accounted for 45.6% of portfolio NPI, saw continued positive leasing momentum.
• Room for organic growth. Management targets positive rental reversion at low single-digit for 2023. In-place passing rent remains 1.6% below asking rents. The portfolio has built-in average rental escalation of 2.5% per year.
• Prudent capital management. KORE’s all-in average cost of debt was 3.99%. Aggregate leverage remained stable at 38.4%. Interest coverage ratio was healthy at 3.4x. 77.6% of its borrowings are hedged to fixed rates. Loans that were due in Nov 23 and Jan 24 were early refinanced in Sep 22, and there are no debt refinancing requirements until 4Q24. Weighted average term to maturity is healthy at 3.1 years. KORE has no direct exposure to US regional banks.
• Stable capital values. KORE did not conduct a mid-year review for the valuation of its investment properties as assumptions made for its valuations as of Dec 22 remain valid. There was no material change in valuations because KORE focuses on: a) smaller submarkets in growth cities and smaller tenants, and b) regular and disciplined investment in maintenance and amenities. Portfolio valuation would need to fall by 24% to hit the limit on aggregate leverage of 50%.
STOCK IMPACT
• Growth from growth cities. KORE benefits from the migration of Americans in massive numbers to large Sun Belt metro areas and fast-growing suburban cities. Management expects rental reversion to be low single-digit for 2023. Management is in discussions with prospective tenants in nuclear energy, healthcare, co-working and engineering sectors. It targets to maintain portfolio occupancy above 90% by end-23.
• Gradual return to office. Walt Disney, General Motors, Walmart, Starbucks and Vanguard Group have asked employees to return to work in the office more frequently. Amazon and Microsoft have brought employees back to the office in 2Q23, which will lead to higher physical occupancies for KORE’s office buildings in Seattle – Bellevue/Redmond. Amazon required employees to return to office three days per week starting 1 May 23. Meta Platforms CEO Mark Zuckerberg is encouraging staff to “find more opportunities to work with your colleagues in person”.
• Resiliency from higher physical occupancy. On a portfolio-wide basis, KORE’s physical occupancy has improved 1ppt qoq to 65% in 2Q23. According to Kastle Systems, nationwide average for physical occupancy is 50% for the US as of Jul 23.
EARNINGS REVISION/RISK
• We maintain our existing DPU forecast.
• Revaluation losses to be manageable. We expect fair value of KORE’s investment properties to drop 4%, or US$57.5m, to US$1,391m as at end-23 assuming cap rate for KORE’s portfolio expands 25bp to 6.2%. Thus, we expect aggregate leverage to increase to 41.8% at end-23.
• Factoring in the cost to deleverage. We expect 2024 DPU to decline 22% due to a 293:1,000 rights issue with issue price at US$0.21 (30% discount to prevailing market unit prices) to raise US$64.2m and reduce aggregate leverage to 38% at end-24.
VALUATION/RECOMMENDATION
• Unique value proposition of growth and yield. We like KORE for its exposure to suburban office and Sun Belt states. KORE provides an attractive 2023 distribution yield of 16.7%. The stock trades at P/NAV of 0.58x (42% discount to NAV per unit).
• Maintain BUY. We lower our target price from US$0.68 to US$0.50 is based on DDM (cost of equity: 9.0%, terminal growth: 1.0% (previous: 2.2%)).
SHARE PRICE CATALYST
• Growth from Supernovas, Super Sun Belt and 18-hour cities driven by in-migration.
• Growth from continued positive rental reversion and built-in annual rental escalation.
