Keppel Pacific Oak US REIT share price at all-time low. Here's why it may be different from Manulife US REIT

What happened?

We received several questions about the share price performance of Keppel Pacific Oak US REIT, or KORE, in the Beansprout community recently.

The share price of Keppel Pacific Oak US REIT has declined close to 50% year-to-date and recently closed at an all-time low of US$0.22.

The persistent weakness seems to mirror what is happening at KORE’s peer, Manulife US REIT (MUST), as the latter faces a loan covenant breach and has temporarily halted distributions.

This led investors to wonder if we should be equally cautious about Keppel Pacific Oak US REIT. 

What you need to know about Keppel Pacific Oak US REIT’s woes

Keppel Pacific Oak US REIT, like Manulife US REIT, operates in a similar sub-market – the US office space. Hence, investors seem to perceive that the challenges faced by Keppel Pacific Oak US REIT, are similar to MUST. 

The table below shows Keppel Pacific Oak US REIT’s revenue, net property income and distribution per unit (DPU) from 2018 up till the first half of 2023 (1H 2023).

Keppel Pacific Oak US REIT’s DPU started its decline in 2022 when a fall of 8.5% year on year was registered, even as gross revenue continued to head up.

Management attributed the 2022 drop to higher interest rates as the US Federal Reserve executed its fastest rate hike in history.

The decline in DPU continued into the first half of 2023, where Keppel Pacific Oak US REIT’s distribution per unit fell to US$0.025, a 17% decline compared to the previous year. 

Let us take a quick look at the issues faced by the REIT that are causing its distributable income and DPU to dive.

#1 - Low physical occupancy in the US office market

The numerous problems faced by the US office market, including a slowdown in leasing activity, increase in vacancy rates, and fall in asset values have been widely reported. 

Real estate firm Savills reports that a “new normal” is emerging with the impact being a negative structural change that is leaving office properties with low physical occupancy.

Many companies are realising that they need much less space as hybrid work takes over and hot desking can help to reduce their rental costs.

Numerous cities face a glut of empty buildings with vacancy rates in cities such as Houston, San Francisco, and Seattle approaching 35% or higher.

On top of this problem, fewer transactions have also been recorded, making it tough for landlords to offload properties that are witnessing sharp declines in value.

Coupled with higher interest rates, landlords are facing stricter loan requirements from banks where these owners are not spending enough to upkeep their buildings.

By doing so, it precipitates a downward spiral where a poorly-maintained building commands lower rental rates which in turn leads to higher vacancies.

More recently, co-working space operator WeWork has also warned of possible bankruptcies, and is looking to renegotiate its leases with landlords. 

Overall, it would seem like the sector’s troubles are far from over and vacancy rates may continue to rise in various cities within the US.

However, investors have good reasons to be more positive on Keppel Pacific Oak US REIT compared to MUST.

For one, Keppel Pacific Oak US REIT’s portfolio committed occupancy stood at 90.8% as of June 2023 whereas MUST’s came in at just 85.1%.

Keppel Pacific Oak US REIT’s portfolio is well-diversified and spread out across eight regions within the US, as seen in the slide above. The company believes that its exposure to fast-growing technology, advertising, media, and information industries, as well as medical and healthcare sector provides income resilience

Moreover, MUST’s top 10 tenants made up 34% of its gross rental income while Keppel Pacific Oak US REIT’s top 10 tenants only took up around a quarter of total rental income.

#2 - Potential devaluation of KORE’s portfolio

Investors may be concerned over Keppel Pacific Oak US REIT’s latest property valuation after accounting for the stresses witnessed in the US office market.

After all, Manulife US REIT saw its portfolio valuation slide 14.6% in just six months. According to the MSCI Real Capital Analytics Commercial Property Price Index, the average valuation of properties in the US has fallen by 8% in the second quarter of 2023 compared to the previous year. 

Thus far, Keppel Pacific Oak US REIT’s portfolio value seems to have held up well. For 2022, based on its original portfolio of 13 properties, valuation increased slightly from US$1.421 billion to US$1.423 billion.

Keppel Pacific Oak US REIT did not conduct a mid-year revaluation review unlike MUST as it believes its valuation assumptions as per 2022 are still valid.

The REIT has the advantage of focusing on smaller sub-markets in growth cities and deals with smaller tenants.

Accordingly to the company, Keppel Pacific Oak US REIT needs to suffer a 24% decline in valuation before its gearing hits the 50% threshold. 

#3 - Surging finance costs put a strain on distributable income

Higher interest expenses have taken a toll on Keppel Pacific Oak US REIT’s distributions.

For 2022, finance expenses climbed 27.1% year on year to US$18.7 million with the REIT reporting that its all-in average cost of debt stood at 3.2% as of 31 December 2022.

Within six months, this cost of debt had jumped to 3.99% with finance expenses for 1H 2023 soaring 42.5% year on year to US$11.7 million.

The latest cost of debt is also a sharp escalation from the 2.8% that was recorded at the end of 2021.

With slightly more than three-quarters of Keppel Pacific Oak US REIT’s loans being hedged to fixed rates[19] , there is hope that future increases in finance costs can start to moderate.

Another positive factor is that the US office REIT has no refinancing obligations till the fourth quarter of 2024.

What would Beansprout do?

The concerns that investors have about Keppel Pacific Oak US REIT (KORE) are understandable given the weakness in the US office market. 

Using Beansprout's framework to evaluate REITs, we can see that Keppel Pacific Oak US REIT is in a better position to weather the downturn compared to Manulife US REIT. 

In terms of fundamentals, Keppel Pacific Oak US REIT has a strong sponsor in Keppel Corporation Limited that should provide investors with some assurance. Due to its exposure to different sub-segments of the office market, KORE’s portfolio committed occupancy stood at 90.8% as of June 2023 whereas MUST’s was at just 85.1%.

Comparing their financial position, Keppel Pacific Oak US REIT also boasts the lowest gearing of the three US office REITs and has no refinancing requirements till late next year. It has an aggregate leverage at 38.4% versus 56.7% for MUST and 42.8% for Prime US REIT. This puts it in a better position to weather a potential devaluation of its properties.

Based on the distribution per unit of US$0.025 in the first half of 2023 and the latest unit price of US$0.22, Keppel Pacific Oak US REIT’s annualised distribution yield stands at a lofty 22.7%. However, there is a risk that distributions could be cut further with the weakness in the US office market. 

Overall, the US office market remains under significant pressure, and we'd be looking out for how changes in the valuation of US office assets could impact the financial position of the US office REITs. 

Relevant links:

• Keppel Pacific Oak US REIT Share Price Performance 
• Keppel Pacific Oak US REIT Target Price and Analysis
• Keppel Pacific Oak US REIT Dividends

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