To change things up for this post, I will be turning my focus to a small-cap REIT instead, in the form of Prime US REIT.
For those who are unaware, Prime US REIT only debuted on SGX last year, on 19 July 2019. With an IPO price of US$0.88, the REIT has since fallen below its IPO price, closing at US$0.795 (as of 5 Sep 2020).
Looking at Prime US REIT’s performance since its IPO, there is actually really nothing much to rave about.
Prior to the price decline during the market correction in March this year, Prime US REIT can be considered to be performing steadily. However, its recovery since then has been a little slow, with prices not reaching levels shown before the market correction.
Despite its tepid performance, I bought into Prime US REIT during the market correction in March.
In this post, I will explain why I invested (and remain invested) in Prime US REIT, its potential risks, current valuation and future outlook.
Disclaimer: This post should not be used as a recommendation to buy or sell units of Prime US REIT. Rather its intended purpose is to be a source of insight and education about Prime US REIT. Any decision to buy or sell units of Prime US REIT should be taken on the personal accord of the reader. As such, I take no responsibility for any future loss or gain amounting from the trading of units of Prime US REIT. Lastly, I am also currently vested in Prime US REIT.
Prime US REIT, as the name might suggest, purely focuses on the management and leasing of US commercial office buildings. All properties currently in Prime US REIT’s portfolio are classified as Class A office properties. This means that such properties are often well-located, have good access and command the highest rent in the office market.
As of 1H 2020, Prime US REIT’s porfolio consisted of 12 Class A office properties.
Below would be a breakdown of the revenue percentage that each property contributed in FY2019. Note that it does not include Prime US REIT’s acquisition in Feb 2020. Furthermore, the revenue amount contributed was only from July 2019 (listing date) to Dec 2019.
As seen, the major contributors to Prime US REIT’s revenue were properties 171 17th Street and 222 Main.
For the next section of this post, I will cover what I like about Prime US REIT’s performance so far.
The good about Prime US REIT
Let’s start off with the good things first.
When analyzing any REIT or company, I typically like to judge them based on their performance for the past 5 years. However, in the case of Prime US REIT, as it just IPOed last year, this is not really possible.
As such, I will be basing my analysis on the REIT’s prospectus, its recent annual report and financial results for 1H 2020. In addition, I would also be comparing Prime US REIT’s performance with its two other competitors, namely Manulife US REIT and Keppel Pacific Oak US REIT.
Positive and forecast-beating top and bottom line results
Based on its financial results for 1H 2020, Prime US REIT comfortably beat its forecasted results.
As seen, gross revenue in 1H 2020 exceeded forecasted result by 5.7%. Furthermore, gross revenue from 1H 2020 also increased from 2H 2019’s gross revenue which was 60.6 Mil.
Beside the increase in overall gross revenue, gross profitability margin has also increased slightly.
Do note that the gross profitability margin pre-IPO is only an indicative performance of the REIT if it had existed then. This means that the results were derived from the current properties in Prime US REIT’s portfolio which were already operational in those particular FY.
With its most recent gross profitability margin of 67%, Prime US REIT beats both Manulife US REIT and Keppel Pacific Oak US REIT. Those two REITs had gross profitability margins of 63% and 59.4% respectively as per 1H 2020 results.
Net property income and distributable income
Using the same 1H 2020 results, we can also see that Prime US REIT outperformed its forecasted net property income and distributable income too.
Besides beating its forecast, net property income and distributable income for 1H 2020 also exceeded that of 2H 2019.
All in all, Prime US REIT has delivered promising results for its gross revenue, net property income and distributable income. Furthermore, in terms of margins, it has also performed slightly better as compared to Manulife US REIT and Keppel Pacific Oak US REIT.
Having looked at the ‘gains’ portion of the income statement, I will trun my attention to the expenses next.
Manager’s fees and trust expenses
When it comes to manager’s fees, Prime US REIT practices were inline with the other two US REITs.
For 1H 2020, Prime US REIT paid out around 10.2% of its distributable income as manager’s fees. This is slightly higher than that of Manulife US REIT and Keppel Pacific Oak US REIT, which was 10% for both. In addition, both Manulife US REIT and Keppel Pacific Oak US REIT paid out 100% of its manager’s fees in units, while Prime US REIT paid out only 80% in units.
In terms of calculating the manager’s fees and performance fees, Prime US REIT was again similar to the other two US REITs. I’m starting to think that all three REITs came to an agreement on the fee structure😂.
The fee structure for all three REITs are as such:
As seen, the only difference is in the acquisition fee for Manulife US REIT. According to its annual report, 0.75% is only applicable to properties purchased through one or more of its subsidiaries.
In terms of other trust expenses, the bulk of it for Prime US REIT came from audit and tax compliance fees. This was also similar to the two other US REITs.
All in all, Prime US REIT’s manager’s fees and other trust expenses were nothing out of the norm when compared to its competitors. Furthermore, the performance fee based upon an increased DPU also aligns the REIT manager’s interests with investors.
Positive DPU and AFFO growth
As Prime US REIT only IPOed last year, there is not much data about its DPU and AFFO growth. However, comparing both 2H 2019 and 1H 2020, Prime US REIT experienced positive growth in both metrics.
Comparing 1H 2020 and 2H 2019, DPU increased by 11.7%. In terms of AFFO and AFFO per unit over the same period, the increases were 39.1% and 21.5% respectively. In addition, the DPU for 1H 2020 also beats the forecasted DPU of 3.35 cents by 5.1%.
Although comparing Prime US REIT’s AFFO and DPU growth with the other two US REIT is pretty pointless, I still looked through the financial statements of the other two REITs to get a rough idea of their performance so far.
To be honest, nothing much can be derived from looking at the past performance of the other US REITs. Although the decline in AFFO per unit and DPU might be causes of concern, a longer timespan is needed to determine if it is a sustained trend or not.
Nevertheless, based purely on DPU growth over the corresponding period, Prime US REIT edged out both Manulife US REIT and Keppel Pacific Oak US REIT, whose DPU growth were 2.3% and 3.2% respectively. Still, I need to emphasize that investors should not look into this too much when considering whether to invest in Prime US REIT or not.
Besides producing forecast-beating results, Prime US REIT is also quite a finanically stable REIT.
As of 1H 2020, Prime US REIT had an interest cover ratio of 5.4 times and a gearing ratio of 33%. This places Prime US REIT as the best out of the three US commercial REITs on the SGX.
As seen above, Prime US REIT also had the lowest effective interest rate on its debt and lowest debt to equity ratio. Coupled with a relatively low gearing ratio, this provides future growth opportunities for Prime US REIT.
In addition, Prime US REIT also did not have any debt maturing anytime soon.
This provides some sort of financial comfort for the REIT given the uncertain future economic outlook. Furthermore, it also gives management leeway when it comes to funding potential future acquisitions.
Strong property and rental performance
Judging from the occupancy rate of Prime US REIT it can be said that its properties have performed quite well.
Out of Prime US REIT’s 12 properties, most were in high 90%s occupancy rate. The only disappointing property would be Village Center Station 1 which has a relatively low occupancy rate of 65.1%.
Despite that, Prime US REIT still managed a quite impressive average occupancy rate of 93% and WALE of 4.8 years. Additionally, Prime US REIT also managed a positive rental reversion of 7.5%.
In comparison with its competitors though, Prime US REIT losses out a little. As of 1H 2020, both Manulife US REIT and Keppel Pacific Oak US REIT had higher occupancy rate, WALE and rental reversions.
Based upon occupancy rate and rental reversions, Prime US REIT ranks behind both the other US commercial REITs. However, when it comes to WALE, Prime US REIT was in the middle position.
In terms of lease expiry profile, Prime US REIT does not have any significant short-term lease risk.
As seen, much of Prime US Reit’s tenant’s leases expire in 2024 and beyond. In the short term, only 10.7% of its rental income would be up for renewal. This means that there would not be a significant potential lease risk on Prime US REIT’s revenue in the next one to two years. This is undoubtedly crucial given the uncertain economic climate that we are in now.
Although Prime US REIT’s property performance did not come out on tops, I still feel that it has performed reasonably well.
Diversified sector mix
As of 1H 2020, Prime US REIT has a pretty well-diversified trade sector mix for its tenants.
As seen, no single industry sector took up more than 15% of rental income. Furthermore, the most notable industry sectors are those which are quite stable such as finance and communications.
Overall, what I really like about Prime US REIT is that it has delivered good results since its IPO, both in terms of providing returns to investors and growing as a REIT. Additionally, it is also a financially strong REIT with no immediate debt maturity concerns. Lastly, property occupancy is also quite strong with a relatively long average lease expiry profile.
Prime US REIT risks
Despite the many good points about Prime US REIT, it does have risks which I think every investor should be aware of. After all, we need to make investment choices with BOTH eyes wide open.
A decline in NAV
Despite good top line results since its IPO, Prime US REIT has actually decreased in NAV.
As seen 1H 2020 NAV saw a drop from the end of FY2019. This can mainly be attributed to the enlarged number of units due to Prime US REIT’s acquisition in Feb 2020. While this might not necessarily cause alarm as FY2020 has yet to end, I would still keep an eye on future NAV. In particular, I will monitor if this decline in NAV is a one-off event or a start of a continual trend.
High payout ratio
Looking at Prime US REIT’s results so far, its distributions have always exceeded AFFO. This is to be expected given that Prime US REIT has committed to distributing 100% of its distributable income till the end of 2020.
For 2H 2019 and 1H 2020, Prime US REIT’s distributions over AFFO stood at 135% and 124% respectively.
On the bright side, Prime US REIT’s distributions so far have at least been covered by funds generated from its operation.
Moving forth, Prime US REIT distribution payout ratio will continue to be on the high side at least till the end of 2020. After that, I expect it to decrease if Prime US REIT continues its stellar financial performance.
Decline in occupancy rate and WALE
Although occupancy rate and WALE were quite high in 1H 2020, it actually saw a slight decline from 2H 2019.
For 2H 2019, Prime US REIT occupancy rate and WALE stood at 95.8% and 5.1 respectively. This decreased to 93% occupancy rate and 4.8 WALE in 1H 2020.
If one was to examine property occupancy rates for 2H 2019 and 1H 2020, 6 properties saw occupancy rate decreases. The largest decreases were in Village Center Station I and 171 17th Street, where the occupancy rate decreased by 22.1% and 10.8% respectively. The occupancy rate decrease in 171 17th Street is a slight concern given that it contributed to 15% of FY2019 revenue.
Given the current economic climate, there is a possibility that the occupancy rate might decrease further. Hopefully, it will not be by a huge margin given the small amount of lease expiring in the near future.
Tenant concentration risk
When it comes to Prime US REIT tenancy mix, it can be said that there is some concentration risk.
As seen, the top 10 tenants contributed to 40.8% of rental income for 1H 2020. Its main tenants also contributed to 8.8% and 6.1%.
Although there is some risk to such a high concentration, I am not really that concerned about it. The reason being that the two tenants contributing the most to Prime US REIT’s rental income are huge companies in their respective sectors.
Furthermore, with regards to Charter Communications, it has also signed a long lease of 8 years for Village Center Station II. How I know this is because Village Center Station II has only 1 tenant and an occupancy rate of 100%. Hence, there is not much risk that Prime US REIT will lose its main contributor to rental income anytime soon.
Nevertheless, I would still prefer that Prime US REIT continues to diversify its rental income sources. On the bright side, this seems to be happening as the top 10 tenant rental contribution has decreased from 44.6% in 2H 2019 to 40.8% in 1H 2020.
All in all, when considering the risks of Prime US REIT, a lot of it comes down to its time on the market so far. Given that it just recently IPOed, more runtime is needed to gauge the validity of concern for such risks.
When it comes to valuing Prime US REIT, I mainly used the PB ratio method in comparison with its other peers on the market. Nevertheless, I would still include the three valuation methods that I regularly used for valuing REITs.
With a unit price of $0.795, Prime US REIT’s PB ratio stands at 0.94. Determining a fair valuation based upon book value for Prime US REIT is hard as it does not have enough past data to rely on. As such, I would compare its current PB ratio to that of its competitors to determine an appropriate entry price.
Based on the current market prices (as of 10 Sep 2020), the PB ratios of Manulife US REIT and Keppel Pacific Oak US REIT were 1.05 and 0.94. If one was to look at the average PB ratio for the past 5 years, Manulife US REIT would come in at roughly around 1, as seen below.
I did not input the 5 year PB ratio for Keppel Pacific Oak US REIT as there was no data from Morningstar. Furthermore, it only got listed in Nov 2017 and thus do not have much historical PB data available. I could calculate the median PB ratio, but I guess I’m just lazy to do that😅.
Based on Manulife US REIT’s average historical PB ratio, we can say that the current price of Prime US REIT is fairly valued. Personally, for me, buying at the current price leaves limited upside potential given the current economic climate. Eager investors might want to wait for the price to decrease further before entering.
Based on the current market price, Prime’s US REIT distribution yield stands at a whopping 8.55%. In comparison, Prime US REIT’s own distribution yield based on its portfolio value is around 5.03%.
If one is to conclude based purely on distribution yield, it can be said that Prime US REIT is massively undervalued. However, coming straight to this conclusion can be dangerous as market prices are often influenced by many factors. Some of these factors include financial performance, perceived risk or even popularity of the REIT itself.
If we were to calculate the ‘fair price’ of Prime US REIT off its own internal distribution yield, its corresponding price would be $1.35. However, I feel that expecting the REIT to reach that price would be unrealistic due to its market size and trading liquidity (it’s low).
Thus, in relation to Prime US REIT, I do not think that distribution yield would be an appropriate method to value it.
Using Prime US REIT’s AFFO per cent for 1H 2020, its forward AFFO yield would be 7.12%. Although Prime US REIT did not publish its internal overall capitalisation rate, I took the average of the capitalisation rate used in calculating its properties fair value. This came up to a cap rate of 6.5%.
Comparing an AFFO yield of 7.12% to a cap rate of 6.5%, it can be said that Prime US REIT is a little undervalued. A fair entry price based on Prime US REIT’s cap rate would come in at around $0.87. Entering at this price would be close to Prime US REIT’s current NAV per unit.
In conclusion, based on two valuation methods, Prime US REIT can be considered to be a little undervalued at its current market price of $0.795. However, I feel that potential investors should give themselves a wider margin of safety given the uncertain economic climate. Thus, I would only buy Prime US REIT at around $0.70 or lower.
When it comes to Prime US REIT’s future outlook, I would say that it is a little uncertain.
Decreased activity in the US office market
Even before the Covid-19 pandemic hit and altered working patterns in the US office market, leasing activity has slowed in recent quarters.
As seen, the amount of leasing activity has been declining since Q3 2019. Coupled with the decline in leasing activity, net absorption also fell in Q1 2020 as seen below.
With the fall in both leasing acitvity and net absorption, it might be said that the US office market currently faces a demand issue. This could perhaps explain the rise in vacany rate despite new supply in the US office market.
Furthermore, telecommuting is also becoming more popular with firms in the United States. The potential impact of this on the US office market would most likely be seen in Q3 and Q4 2020.
Increased rental and employment rate
While demand for office space as fallen in recent months, the silver lining is that rental rates have generally increased. In this Q1 2020 office market outlook by Colliers International, they noted how rents for Class A office buildings have inched up slightly. However, with the increase in available office spaces, I’m not sure whether this increase can be sustained. Furthermore, the increase in rental rates can also be a double-edged sword as it pushes potential tenants to look for locations with cheaper rents.
In addition to the slight increase in rental rates, unemployment rate in the US has fallen from the highs seen in April.
Despite a decline in the unemployment rate, the current rate is still around twice the level seen in the same period last year. This means that the US economy is not entirely out of the woods yet. Nevertheless, I still expect the unemployment rate to continue declining a bit further in the coming months.
All in all, I expect new rental uptakes for office space in the US to dwindle in the coming months. This is mainly due to corporations reassessing their need for office space with telecommuting potentially becoming a norm. In addition, granted that we are almost at the end of an economic cycle, I expect corporations to prioritise cost-cutting instead of expanding and looking for new office spaces.
With that said, I thus expect Prime US REIT’s occupancy rate to decline slightly in the coming months. The bright side to that is that the decline would not be huge as only 3.7% of net leasable area is up for renewal in the coming months.
So…why did I invest in Prime US REIT?
With such an uncertain outlook, you might be wondering why exactly I invested in Prime US REIT. Well, let’s just say I’m a sucker for companies with good financial results and growth opportunities. For me, Prime US REIT fits that bill.
While the REIT may face headwinds in the near future, I believe it would do well in the long run. Of course, this does not mean that I will just blindly hold onto Prime US REIT. Instead, I will constantly review its financial performance over time and make sure it continues to produce stellar results.
Another reason for investing in Prime US REIT was to diversify my investment portfolio. I always believe that investing should be diversified across geography, asset class and industry sector. Being a pure-play US commercial REIT, Prime US REIT allows me to invest in the US property market, without experiencing the 30% withholding tax on dividends. This thus allows me to build upon my desire to have a ‘global’ investment portfolio.
The last aspect of my decision to invest in Prime US REIT boils down to opportunity and risk. I first started to buy Prime US REIT when it was trading at a PB ratio of 0.9. Subsequently, I also bought in when its PB ratio dropped to 0.7 and 0.6. All in all, my average invested price currently sits at a PB ratio of 0.83. With a forward distribution yield of 9.9%, I believe that my investment in Prime US REIT affords me a healthy reward for the risk involved.
With that said, I am quite happy with how my investment in Prime US REIT has turned out.
What did you think of my reasons for investing in Prime US REIT? Let me know in the comments below!
As always keep the comments civil and happy investing!😄