To change things up, I will be looking at a small-cap REIT, in the form of Prime US REIT.
With its debut on SGX back in 19 July 2019, Prime US REIT can be considered as a relative newcomer to the S-REIT market.
In terms of its market performance since, there is nothing much to rave about.
As seen, Prime US REIT has not recovered to the heights seen prior to the market correction in March 2020. At its current market price, Prime US REIT has also fallen below its IPO price of US$0.88. If dividends were to be included, IPO investors would be sitting on a slight gain of less than 1%.
Despite its tepid performance so far, I still decided to invest in Prime US REIT.
Why? You might ask.
Well, this is exactly what I would seek to answer in this analysis post, as I highlight the factors which made me invest in Prime US REIT, its potential areas of concern, before ending it with my overall personal rating of Prime US REIT.
Without further ado, let’s delve right in.
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 amenities and command some of the highest rent in the office market.
As of FY2020, Prime US REIT’s portfolio consisted of 12 Class A office properties. These properties are all spread out across various US states.
As seen, not one state contained more than two of Prime US REIT’s properties. In addition, 9 out of 12 of the properties were also located in the top 25 US tech cities as ranked by CompTIA.
In terms of net property income (NPI) contribution, the main property contributors were 171 17th Street and 222 Main.
As seen, both these properties in total contributed to slightly more than a quarter of Prime US REIT’s NPI for FY2020. Additionally, these two properties were the only properties that each contributed more than 10% of Prime US REIT’s NPI. Thus, it could be said that there is some concentration risk when it comes to Prime US REIT’s NPI segmentation.
Having looked at the brief overview of Prime US REIT’s properties, I will now move on to my reasons for investing in Prime US REIT.
Why I invested in Prime US REIT
While most of my reasons for investing in Prime US REIT were due to its financial results, I will also touch on other aspects of the REIT which contributed to my decision to invest.
Note that FY2019 results used hence forth are from the period of July 2019 (listing date) till December 2019.
Positive and forecast-beating top and bottom-line results
In its short time on the market so far, Prime US REIT’s financial results have been quite impressive.
In both FY2019 and FY2020, Prime US REIT’s financial results surpassed forecasted estimates set out in its prospectus.
Moving forth, I am quietly optimistic that this good performance can continue given that FY2020 positive results came on the back of a United States recession due to the Covid-19 pandemic.
Positive returns to unitholders
On top of delivering good top and bottom-line financial results, Prime US REIT has also rewarded its unitholders thus far.
So far, Prime US REIT’s DPU has surpassed forecasted estimates.
In addition, growth in AFFO and distributable income per unit also means that the REIT is growing steadily. This is good news for unitholders as the REIT is both increasing the limit of dividends that can be paid out and bringing in more cash from its operations.
In addition to producing forecast-beating results and providing positive growth for unitholders, Prime US REIT is also a financially stable REIT.
As of FY2020, Prime US REIT has healthy interest coverage of 5.8 times and a gearing percentage of 33.5%. This corresponds to a debt headroom of around US$303 Million before hitting aggregate leverage of 45%.
With this ample debt headroom, Prime US REIT can make use of the low-interest rate environment and comfortably source for future growth acquisitions.
In terms of managing its debt, Prime US REIT has also done good work in reducing its effective interest rate to 2.7%. While average debt maturity has fallen to 4.1 years, I feel that it is still not too big an issue given Prime US REIT’s current debt maturity profile.
As seen, Prime US REIT does not have any debt maturing until FY2022. While there is some debt financing risk in FY2023 and FY2024, there is still ample time for Prime US REIT to even out its debt maturity profile.
Overall, I do not foresee any near-term financial issues for Prime US REIT based on its results so far.
Besides being financially stable, Prime US REIT’s dividends is also covered by its day-to-day operations.
While dividend payout percentage was high in both FY2019 and FY2020, this is mainly a result of Prime US REIT committing to paying out 100% of its distributable income. I expect this percentage to drop next FY as Prime US REIT will be paying out at least 90% of its distributable income moving forth.
Positive rental performance
For both FY2019 and FY2020, Prime US REIT recorded positive rental reversion of 6.6% and 7.2% respectively.
A positive rental reversion in FY2020 is quite impressive given the debilitating economic effects of the Covid-19 pandemic. This signals to me that overall rental space demand for Prime US REIT properties remains relatively attractive.
For FY2021, leasing activity has been strong so far with a positive rental reversion of 6.9%. As a whole, FY2021 is projected to have an overall positive rental reversion of 6.5%, as seen below.
In addition to positive rental reversion, 99.9% of Prime US REIT’s cash rental income (CRI) contain built-in annual escalations. This provides organic rental growth for Prime US REIT, which bodes well for unitholders.
High property occupancy
As of FY2020, Prime US REIT portfolio occupancy rate stood at 92.4%. This is not too bad given that occupancy rates for US office space saw sharp declines in Q4 2020.
In addition to a relative high occupancy rate, there is also no major short-term risk when it comes to lease renewals.
As seen, only 8.8% of Prime US REIT’s CRI is up for renewal in FY2021. Although Prime US REIT’s FY2019 tenant retention rate of 59.8% is not great, I still do not expect too much disruption to rental income given the positive rental reversion we have seen so far.
Diversified sector mix
As of FY2020, Prime US REIT has a pretty well-diversified trade sector mix for its tenants.
As seen, no single industry sector took up more than 16% of rental income. Furthermore, the most notable industry sectors are those which are quite stable and in-demand, such as finance and communications.
All in all, the main reasons for me investing in Prime US REIT were for its stellar performance and stability thus far. Given that this was achieved in a midst of the Covid-19 pandemic is even more noteworthy. After all, we all knew how well the US has dealt with the pandemic in 2020…
Prime US REIT areas of concern
Like every other REIT on the market, Prime US REIT has its own areas of concern. I will be highlighting whatever aspects I managed to uncover while analyzing Prime US REIT.
Net profit decline
When analysing REITs, I generally do not pay that much attention to net profit as it does not affect the dividends paid out.
However, in the case of Prime US REIT, the decline in net profit was too glaring to ignore.
As seen, much of the decline in net profit can be attributed to losses in fair value of derivatives and investment properties.
The main crux of Prime US REIT’s losses in derivatives was due to its interest rate hedging activity.
Now, I will be the first to admit that I do not know the intricacies of interest rate hedging. However, REITs generally hedge the interest rate risk of their loans by entering into interest rate swaps.
Whether a loss or profit would be incurred on such derivatives would depend on the type of interest rate swap (fixed or floating), and the direction of interest rate trends (rise or fall).
Prior to its IPO, Prime US REIT entered into floating-for-fixed interest rate swaps for both its loan facilities with floating interest rates. This means that Prime US REIT management predicted that interest rates could potentially rise after its IPO. However, given the rapid decline of interest rate since, Prime US REIT now sit on losses as its fixed interest rate differs hugely from the current applicable interest rate.
For fair value losses in investment properties, much of it is due to the Covid-19 pandemic negatively affecting valuations of Prime US REIT’s properties. As vaccination efforts are ramped up and the pandemic comes under control, I expect such losses to decrease in the future.
Decline in NAV
Despite its good financial performance, Prime US REIT’s NAV has actually decreased.
Given the earlier mentioned fair value losses in derivatives and investment properties, a decline in NAV is to be expected. Furthermore, an enlarged unit base due to the acquisition of Park Tower also contributed to the decline.
Given Prime US REIT’s stable financial standing so far, I expect NAV to gradually improve as the US recovers from the Covid-19 pandemic.
Of course, much still remains dependent on current interest rates. Should interest rates rise, it will narrow the losses on Prime US REIT’s interest hedging activities, which could lead to an increase in NAV. Conversely, should interest rates continue to remain low, NAV would decline slightly or remain flat.
Hence, I guess only time will tell which way Prime US REIT’s NAV moves.
Decline in occupancy rate and WALE
Although Prime US REIT’s occupancy rate and WALE remains high, both were a slight decline from FY2019.
Overall occupancy rate and WALE decreased by 3.4% and 0.7 years respectively.
Out of 12 properties, 6 saw declines in occupancy rates as compared to FY2019. For the other 6 properties, one was newly acquired, 3 saw increases in occupancy rates while 2 remained at 100% occupancy.
The decline in occupancy rates is to be expected given the current economic conditions the US is facing now. Furthermore, with working from home (WFH) becoming a norm, companies are also re-assessing their office space needs.
This re-assessment of office space could perhaps also be seen in the overall WALE decline of Prime US REIT’s portfolio.
If we were to individually look at the WALE of each of Prime US REIT’s property, only Promenade I & II experienced an increase in WALE in FY2020.
Despite 60% of tenants either expanding or renewing their leases in FY2020, it could not stop the WALE decline in most of the properties. This might signify that the new leases signed by these tenants are shorter in nature as compared to their previous lease agreements.
All in all, while the decline in occupancy and WALE is definitely a cause of concern, more runtime is needed to see if it will be a sustained trend or not. As such, investors should definitely look to Prime US REIT’s future 1H FY2021 business updates for more clues.
Tenant concentration risk
Looking at Prime US REIT tenancy mix, it can be said that there is some concentration risk.
As of FY2020, the top 10 tenants contributed to 41.6% of Prime US REIT’s total rental income. If we were to break it down further, 20.5% of rental income for FY2020 came from just three tenants.
While Prime US REIT’s tenant concentration is definitely risky, the silver lining is that its top 2 tenants are huge corporations in prominent industries.
In addition, Charter Communications is also the only tenant in Village Center Station II. With a property occupancy rate of 100% and WALE of 7.5 years, unitholders can at least be assured that Prime US REIT’s top tenant is tied to a long lease agreement.
Moving forth, I expect Prime US REIT to work on bringing on the rental contribution of its top 10 tenants. Given that the percentage has decreased from 44.6% in FY2019 to 41.6% in FY2020, I am quite optimistic that it would decline further in FY2021.
Uncertain US office market
It is no secret that the Covid-19 pandemic has severely battered the US office market.
For the whole of 2020, the US office market recorded negative net absorption of 84 million square foot. This means that much more office space is being vacated than being occupied.
Moving forth, many companies are also adopting a wait-and-see approach when it comes to the renewal or leasing of new office space. This is not surprising as companies are still assessing the impact and longevity of WFH measures.
However, it should also be noted that there are small signs of recovery.
The US unemployment rate has steadily decreased from a peak of 14.8% in April 2020, to 6.2% in February 2021. Furthermore, the US economy is also projected to recover in 2021 with a GDP growth of 6.5%. This is largely due to the US$1.9 trillion stimulus package and vaccination efforts being ramped up across all states.
While such signs are definitely encouraging, whether it can be translated to higher uptake of office space remains to be seen. As such, I would look to Q1 2021 US office market trends to see if there is indeed a recovery or not.
Having highlighted what made me invested in Prime US and REIT and its potential risks, I will now move on to my personal rating of Prime US REIT as an investment. As usual, I will base the rating on Prime US REIT’s stability, growth and valuation.
In terms of stability, I looked at two aspects for Prime US REIT. First would be its financial stability while the other would be the stability of its earnings.
In terms of financial stability, Prime US REIT ranks quite high in my books for reasons already mentioned in earlier parts of this post. However, the same cannot be said when it comes to Prime US REIT’s future earnings stability.
While it might be early to say that WFH would be normalised even when the pandemic has subsided, I believe that it would continue to remain in some form. This is due to the fact that huge corporations are already embracing long term WFH as part of their company policy.
As such, I feel that many companies would likely have hybrid work arrangements moving forth, allowing employees to either WFH or return to the office when necessary. This would inadvertently put pressure on the stability of Prime US REIT’s future earnings.
However, with Prime US REIT delivering forecast-beating results in FY2020 despite the pandemic, I am inclined to think that its earnings would be quite stable.
With a relatively low financial leverage, Prime US REIT is poised for growth via acquisitions.
Furthermore, there is also limited new office space in the areas that Prime US REIT properties are located in.
As seen, much of the new office space has already been preleased. This reduces rental competition for Prime US REIT properties. For those states with a majority of office space not preleased, Prime US REIT properties have shown strong occupancy performances in such states.
As such, I do feel that positive rental growth would continue for Prime US REIT.
Having said that, office space demand in the near term should still remain subdued as the US continue on the road to economic recovery. Thus, in the near term, I expect growth to be slow and steady instead of being explosive.
In determining the valuation of Prime US REIT, I would be basing it on the usual two metric, PB ratio and AFFO yield.
At its current market price, Prime US REIT has a PB ratio of 0.92.
As Prime US REIT was only listed in 2019, there is not much historical PB ratio data to draw upon. As such, I thus decided to work out the highest and lowest range of Prime US REIT PB ratio so far.
If we were to work out the average of the two median PB ratio, it would come out to around 0.985. As such, the current PB ratio can be deemed to be slightly undervalued.
For its current market price, Prime US REIT AFFO yield stands at a whopping 8.82%. This is a massive difference as compared to Prime US REIT property cap rate of 6.2%. This shows that there is some disparity in the market price in comparison to Prime US REIT’s ability to generate cash.
However, given that Prime US REIT is a relative newcomer, this disparity is to be expected as there is not much track record in the REIT’s performance.
Based upon both the PB ratio and AFFO yield, a ‘fair’ price of Prime US REIT for me would range from US$0.85 to US$0.97.
Conclusion and final rating
Putting all of my ratings together, Prime US REIT ends up with a total rating of 3.5 stars out of 5.
All things considered, I do feel that Prime US REIT is a worthy REIT to look at if you are thinking of investing in the US office market. Furthermore, I personally feel that the current dividend yield of 8.7% adequately compensates for the risk involved.
Nevertheless, the decision to invest still ultimately lies in you and your own risk appetite. I do hope that this article has at least provided some useful insights into Prime US REIT.