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• Four turning points in office rents; Overweight. The magnitude of rental slides and undemanding valuations have made owning office stocks more favourable, in our view. We identify four key trends that could mark turning points for office rents and recalibrate investors’ yield expectations for office assets. Our base case suggests that future demand can absorb supply and assumes a 30% increase in office rents by 2012. Maintain Overweight on the office sector, with KepLand still our key pick. Suntec REIT is our top pick among office REITs.
• Turn in GDP. The Ministry of Trade & Industry (MTI) has raised its GDP growth forecast for Singapore to 7-9% from 4.5-5%, with our economist expecting 6-9.5% growth in 2010-12. Turns in GDP in past recoveries have typically coincided with surges in office demand. We believe this cycle is no different.
• Widest discount to Hong Kong in two decades. The competitive advantage of Singapore as a commercial hub has never been better. A 55% fall in office rents from the last peak means that Singapore has fallen off global rankings in terms of occupancy costs. Singapore is now 45-50% cheaper than Hong Kong, the highest discount in two decades. Singapore office rents are typically re-rated when rental discounts touch 30-40%, as in the last three cycles.
• Cap-rate compression. Capital values have been very resilient in this cycle even as rents nose-dived. Better credit conditions and liquidity flows into Asia (Singapore) are sustaining asset prices and preventing distress sales. Already, there are signs of a return in institutional demand with bigger deals transacted in the last 6-8 months. Investment-property deals that were done at initial yields of 6-7% last year (by our estimates) are now being done at 5+%.
• Jobs equal demand. The labour market has also been very resilient. Unemployment has fallen to a 2-year low (2.2%), the quality of jobs has improved and hiring has picked up. Our economist, Song Seng Wun, expects unemployment to dip below 2% before year-end. Industry data also indicates that new company formation is reviving which usually signals rising office rents.
• Demand to meet supply. The redevelopment of older offices is expected to remove a portion of existing office stock. Our office demand model, based on GDP growth of 6-9.5% for 2010-12, implies a net absorption of 7msf in the next three years, sufficiently satisfying pipeline supply. We see competitive occupancy costs and migration in internationally mobile jobs to Asia and Singapore to drive demand in this cycle. Already, net take-up in the last three quarters had turned positive with many Singapore landlords suggesting that tenants are now more proactive in negotiating for longer lease terms
Turn in GDP
Close correlation between GDP growth and office demand. Demand for office space is traditionally highly sensitive to the health of the economy. The close correlation between real GDP growth and new office demand is intuitive (Figure 1). Our model indicates that GDP growth explained about 75% of the variance in office demand from 1991 to 2009.
We believe the close relationship provides a very strong case for optimism on the office sector. In April, the MTI released much stronger-thanexpected 1Q10 real GDP numbers, showing yoy growth of 13.1% and 32.1% qoq seasonally adjusted and annualised (SAAR). This performance was powered by strong service-sector growth, including financial services, a key component of office demand.
Buoyed by the better-than-expected GDP, the government is now expecting 7-9% GDP growth this year vs. 4.5-6.5% previously. Song believes that 9+% growth is actually within reach. Even if there is no sequential growth in 2Q10, yoy growth should still be 9.5% to bring 1H10 growth to just over 11%. Beyond 2010, he expects real GDP growth to average 6% in 2011-12. In past recoveries, GDP growth rebounded to 8-10% (1993-95, 2004-06). We believe there is room for upside surprises in office demand going forward.
Cheaper and more competitive
Widest rental discount to Hong Kong in two decades. Singapore office rents have fallen over 55% from their last peak. Average prime rents in the CBD currently average S$7.50-8psf pm (effective), from S$15-16psf pm in 2008. While property consultants generally remain negative on office rents on the 7msf of impending supply in 2010-12, the competitive advantage of Singapore as a commercial hub has never been better. In terms of occupancy costs, CBRE estimates that Singapore has fallen from the ninth spot to 32nd in its global ranking.
Singapore is 24th (from 26th) in Collier’s list, and 43rd (from 10th) in DTZ’s. We believe that as Singapore maintains its status as one of the most preferred destinations for doing business in the world, rising competitiveness in occupancy costs will attract more tenants. Singapore’s discount in average prime office rents to Hong Kong is at its widest (45-50%) in two decades(Figures 4 & 5).
With consensus expecting Hong Kong rents to climb further and sentiment in Singapore rents still lukewarm, a widening gap between the two cities should enhance Singapore’s attractiveness as a commercial destination. Historically, the discount between Singapore rents and Hong Kong rents averaged 24%. Singapore office rents were typically re-rated when rental discounts touched 30-40% in the last three cycles.
Cost savings translate to more pre-commitments. With asking rents now back to 2006 levels and the general business outlook improving, corporates have in recent months been more willing to commit to new office space. Their flight to quality remains evident, as tenants are able to upgrade to newer premises at lower occupancy costs. Nomura and BHP reportedly have signed up for large space at MBFC Phase 1 on long leases (6-12 years) while companies like Noble Group are reportedly moving to the new Mapletree Anson from PSA Building.
We estimate that around 42% of the new supply in 2010-12 has been pre-leased. While these leasing deals were largely driven by relocations six months ago, some expansion is beginning to emerge. Law firms are allegedly expanding again while financial institutions are resuming hiring. According to the URA, net take-up of office space had stayed positive in the last three quarters (+600k sf), with vacancy rates for prime-grade buildings falling from 12.3% in 4Q09 to 10.5% in 1Q10.
Cap-rate compression
Resilient capital values. Capital values have been resilient, buoyed by a resurgence in leasing and what appears to be stabilising office rents. Average capital values for prime office assets have fallen 40% to S$1,700-1,800psf pm from their peak in 2007- 08. We believe asset prices have found a floor. Investment-property deals that were done at initial yields of 6-7% (by our estimates) last year are now being done at 5+%. Evidence of stability in asset prices has also surfaced in recent valuations of office SREITs, which indicate cap-rate compressions of 25-50bp in the last 6-8 months.
Assets in office S-REITs are currently valued at cap rates of 4.5-4.75%. In the past, cap rates typically start to compress from their peak 12-18 months before market rents and occupancy bottom, an idea we put forth at the beginning of the year (“Better value from laggards and selected commercial landlords” dated 12 Jan, 2010). This trend played out in the past three office cycles. With asset valuations and property transactions implying lower yields, we believe a similar trend is unfolding, especially for newer assets coming on stream.
Liquidity inflows to help sustain asset prices. The relative resilience in capital values is in part driven by better credit conditions. From the end of 2009, some SREITs have been diversifying their funding sources (which were limited to banking funding last year) by testing capital markets with some very positive results. Cost-ofdebt margins for fixed-rate notes have drifted down 100-150bp from a year ago for 3-year debt with all-in costs of 2.8-3.5%. At the institutional funds level, Pacific Star was recently successful in refinancing S$549m of debt for Capital Square, an office building in Raffles Place, which could only fuel further support for capital values. Refinancing fears have substantially eased on more accommodative credit conditions.
This has also dispelled fears of widespread distress sales of office assets. We believe that a shift in capital allocation to Asia will help sustain asset prices. Our banking analyst, Kenneth Ng, believes that in contrast to developed nations whose weaknesses have been exposed by the Greek debt crisis, Asian government bonds are poised to benefit from low sovereign debt and expanding economies. Singapore government bond yields have fallen 10bp after the MAS set the S$ on an appreciation path a month ago. Moody’s raised its rating on Indonesia last September.
Kenneth holds the view that liquidity flows into Asia will cap risk-free rates in healthy Asian economies like Singapore, resulting in low risk-free rates plus strong demand for Asian government and corporate bonds. This, in turn, will narrow lending spreads that banks charge to large corporates, keeping borrowing costs for large Asian corporates very low and spurring investments and M&As.
This buoys our optimism on the Singapore office market and investment deals. Our sources indicate that spreads for established property corporates are 150-180bp over SIBOR, although loan-to-value (LTV) ratios are still at the 40-50% mark, vs. 60-70% in the last upcycle. Declining spreads in the corporate lending space would contrast with consumer mortgages, as banks are expected to compensate for the risk of higher asset prices with higher spreads on consumer mortgages.
Return of institutional interest. So far, newsflow on investment-property deals has been encouraging. While private investors had dominated deals last year, institutional interest re-surfacing in 2010. Robinson Point and a portion of 1 Finlayson Green have been sold to AEW and a foreign-based fund at estimated initial yields of 5.3% (S$1,527psf) and 5.5% (S$1,629psf) respectively. Media reports suggest that many foreign investors are on the lookout for prime office assets. We believe many may be positioning themselves for a potential recovery in the office sector on the back of caprate compression and a demand recovery. That said, sellers have been standing their ground and we expect prices to remain sticky.
Jobs equal demand
Stronger labour market to form foundation for recovery. Preliminary numbers from the Ministry of Manpower (MOM) indicated that Singapore is back to full employment. The labour market in this cycle has been very resilient, thanks to sharper-than-expected improvements in domestic and external demand. The seasonally adjusted unemployment rate had dipped to 2.2% in Mar 10 from a revised 2.3% in Dec 09.
This was a 2-year low. We believe the stronger labour market will form the foundation for a firmer office recovery. Total employment is estimated to have grown by 34k in 1Q10, the third quarterly increase after two quarters of decline in 1H09. The quality of jobs has also improved as 31.2k of the net additions came from the service sector with construction shedding 800 workers. The former typically forms the crux of office demand. Our economist expects the labour market to expand strongly in the coming quarters to bring down unemployment below 2% before yearend.
Financial institutions (banks) are hiring again after their massive retrenchments of the past few years. Law firms, insurance companies and IT & communication companies are reportedly planning to raise headcounts. These anecdotal findings are consistent with a recent employment survey by Hudson, suggesting that 54% of its respondents (564 executives interviewed) plan to raise headcount in 2Q10.
The MAS also recently highlighted brighter employment prospects for the financial services sector in its recent 1Q10 macroeconomic review, driven by rising demand for corporate banking and wealth management services. This bodes well for the office sector as movements in office rents typically closely correlate with financial services job growth.
New company formation. Singapore remains a very attractive place to do business given its solid infrastructure, strong talent pool and accommodative tax structures. After a lull in 2009, MNCs are believed to be setting up shop in Singapore again. Gazprom, a natural-gas firm from Russia, reportedly has plans to increase its headcount from 35 to 100. Average office rents rose by 150% from 2006 to a peak of S$15-16psf pm in 2Q08, coinciding with the peak in new company formation. As new company formations dried up in 2009, office rents nosedived to S$7-8psf pm. Data from CEIC indicates that new company formation is reviving, particularly for the financial and insurance industries.
No structural oversupply. Empirical evidence shows that the factor of average office space to a person employed is around 25x, using data in the last two decades. At this level, prime office rents were typically at mid-cycle levels of S$10psf pm. In 2003, when the SARS epidemic hit Asia coupled with the consolidation of Singapore banks, severe oversupply lifted the factor to 33x.
Office vacancy hit a high of 18% then. Office rents subsequently tumbled to their lowest in 20 years at S$4.50psf pm. Since then, job growth in Singapore has outstripped office supply, pushing the ratio back down to 25sf currently. Our economist estimates that annual employment growth will come in at 5% in 2010, before normalising to 3.5% in 2011-12. In this case, we believe the factor of office space available per person employed will inch down to 23x by 2012, based on expected supply in the next three years. Looking at the past three office cycles, this ratio should translate to average prime rents of S$10-10.50psf pm, implying 25% upside from current levels
Demand to meet supply
Lessons from past cycles. The Singapore office sector is historically very susceptible to cyclical swings. In down-cycles, office rents have the tendency to overshoot on the downside, as in the 1996-99 and 2000-03 cycles, when prime office rents cascaded by 43% on average. However, past cycles also teach us that an office recovery can be surprisingly swift. In the recoveries of 1992-96 and 2003-07, office rents rose 34% and 245% respectively.
Average office take-up per year on both occasions was 2-2.5msf with average GDP growth of 8-10%. Although pipeline supply in 1992 was over 16msf of office space (much more severe than now), stronger-thanexpected take-up meant that vacancy fell from 11.5% to 8.5% in 1996. In 2003, the supply situation mirrored the present case – 6.5msf – although the effects of a global financial slowdown, dotcom bust, consolidation of Singapore banks and SARS culminated in a vacancy rate of 18%. This meant that 16-17msf of available office space was vacant at that time. Yet by 2007, vacancy had fallen to 6-7% with rents hitting S$15-16psf pm from a trough of S$4.50. This implies that the Singapore office market is usually more robust than expected.
What will drive demand this time round? The past few recoveries were aided by a few defining events. The new Asia-Pacific boom in the mid-1990s, dotcom boom in early 2000, and credit-led boom in 2006-07 helped shape the office recovery. While it may be premature to assume another upturn of equal impact in the near term, we see catalysts for business rejuvenation in Asia.
As western governments put their houses in order, tax hikes and cuts in government spending and public-service jobs cannot be avoided. Greece is already an example. The business environment in developed economies will get more difficult. Migration in internationally mobile jobs to Asia and Singapore can only be expected with the passage of time. With business returning and office rents much more competitive now vs. other major cities, we believe Singapore is well placed. The office sector is in its third year of de-rating. We believe a real recovery is in sight.
Residential conversions to alleviate oversupply. The demand for city living, particularly within the CBD, has taken off. Strong demand for residential apartments in the area has prompted landlords to consider the alternative use of older office buildings. It does not come as a surprise that the bulk of office acquisitions in 2009 were made for conversion to residential use. We estimate that 1.1msf of office space in the CBD will be converted in the next 1-2 years. The potential removal of office stock will certainly help alleviate oversupply.
More office-to-office redevelopments? The sharp run-up in office rents in the 2006-08 upturn was in part driven by the removal of office stock for refurbishment and upgrade. The motivation behind this was a lack of Grade A office buildings in Singapore to meet the changing needs of end-users. Attributes such as large floor plates (more than 20k sf), raised flooring and complex technical specifications are just some of the things new-age tenants are looking for. This is particularly true of occupiers in the financial services industry.
Jones Lang LaSalle (JLL) estimates that only 9% of the existing stock in Singapore has floor plates of over 20k sf, with 13% of office stock in the CBD meeting such specifications. Although impending supply is expected to push up Grade A buildings in the area to 30% by end-2012, over 68% of the office stock in the CBD is still over 11 years old. We believe that as office demand recovers in the next few years, older stock could progressively be redeveloped. Thus, impending supply could be offset by the redevelopment of stock to residential use and office space of better specifications.
Demand to meet supply. As mentioned earlier, net demand for office space in Singapore historically parallels GDP growth. GDP growth explained about 75% of the variance in office demand from 1991 to 2009. We believe this variable serves as a good basis for our office-demand estimation. We estimate that every 1% growth in GDP can raise take-up of office space by 0.2-0.25 msf, going by the historical average. This rises to 0.3-0.35msf in recovery years. Assuming 9.5% GDP growth in 2010 and 5-6% in 2011-12, net absorption should be 7msf in the next three years, inour base case. This translates to an average of 2.3msf of new office demand per year, sufficient in satisfying pipeline supply. As GDP growth rates actually touched 8-10% in past recoveries (1993-95 and 2004-06), we believe there is upside to our forecasts.
Taking a step further, we cross-checked with employment prospects. We used employment in the financial services industry as a benchmark, as this segment typically accounts for the bulk of office demand in the CBD. We assume a 130sf per employee ratio in our model, lower than the 180-200sf ratio typically seen in western countries. In our base case, we estimate that the system would need to generate an average of 17k-18k jobs per year in 2010-12, or an average 2.7% employment growth a year in the financial services industry. This also formed 30% of total net employed in the entire service industry in 2009. We believe risks are on the upside, as employment growth in the financial services industry averaged 8-15% in 2006-08, before falling to1.7% in the dark days of 2009.
Expect 30% upside in prime rents by 2012. The turning point for prime rents tends to occur when vacancy falls below 10-11%. Our model suggests that vacancy explained 80% of the variance in office rents from 1991 to 2009. Factoring in our nettake up assumptions and the potential for office stock to be redeveloped for residential use (1.1msf), we estimate that island-wide vacancy would fall to 10.5% by 2012, from 12.5% currently. Vacancy in the CBD could fall from 10.5% to 9% in the same period. On these assumptions, we estimate that prime office rents could touch S$10psf and S$11psf in 2011 and 2012 respectively. This translates to 30% upside from current levels.
We believe our estimates can be achieved. On the ground, our conversations with many Singapore landlords (including REITs) suggest that many tenants are now more proactive in negotiating for longer lease terms, always a positive sign for the sector. While the 2006-08 phenomenal run-up in office rents was partly due to a lack of options for existing tenants, the strength of organic demand should not be overlooked. While we do not expect rents to peak at S$18psf anytime soon, a 25-30% rise from current depressed levels is not inconceivable. Rents would still be 30-35% below Hong Kong levels and 40-45% below their previous peak.
Risks
Contagion from Europe. The sovereign debt crisis in Europe is just unfolding. While we believe Asian growth will remain intact, we can’t help but be wary of potential contagion. A potential recovery in office demand could be undermined by any threat to job growth. We believe demand for office space could fall short of expectations if jobs and GDP growth is not sustained. Government releasing too much supply.
The 2006-07 shortage in office space that led to astronomical rents may prompt the government to monitor the situation closely this time round. While over 7msf of new office space is expected to come through in the next three years, little supply is expected beyond 2013. We believe a premature release of too many office sites to pre-empt a repeat of 2007 could send a negative signal to the market, depressing rents and capital values further.
That said, we believe the magnitude of the fall in occupancy costs and less regulation for the sector vs. the residential segment will give rents more room for growth in this cycle. The expected relocation of government bodies such as the Ministry of National Development out of the CBD is also expected to free up 0.5msf of prime office space by 2015. Distress sales from institutional funds. Improving credit conditions have helped keep to capital values resilient, preventing distress sales so far. While newsflow of successful refinancing deals in commercial properties has been encouraging, things can reverse quickly on any deterioration in credit conditions.
Valuation and recommendation
Compelling at current levels. As economise in Asia continue to recover, 2010 may turn out to be a watershed for the office sector. Office rents are in their third year of de-rating, down 55-60% from their previous peak. Coupled with improving business activity, job growth and credit conditions, we believe investors’ yield expectations for office assets should be recalibrated. Offices as an asset class in Singapore are also less regulated than the residential segment. With valuations of major landlords still below mid-cycle RNAVs, we believe upside is significantly greater than downside.
Cap-rate and capital-value estimates. We peg our capital-value estimates for office assets at cap rates of 5% vs. 5-5.5% previously on a firmer outlook for rents. Historical mid-cycle yields of 4-4.5% offer room for further cap-rate compression. Our capitalvalue assumptions have been lifted by 6-15% as we now peg our assumptions on 2011 rents vs. 2010 previously. Prime office valuations are now pegged at S$1,700- 2,100psf, still 25-40% lower than their previous peak.
KepLand remains top pick; prefer Suntec among office REITs. KepLand remains our top pick in the sector as we view its exposure to super-prime grade offices, strong balance sheet and relative insulation from residential policy risks as ideal attributes in this environment. Valuations remain undemanding at a 26% discount to our RNAV. CityDev remains a Neutral with a lower target price of S$11.46 (from S$12.09) as we see range-bound trading due to lingering policy risks. While its large inventory of office assets (largely Grade B) provides the group with an alternative source of land bank, rental reversions could lag those of its prime grade peers, in our view. SingLand has been upgraded only to a Neutral as we see it as a beneficiary in a mature stage of an office recovery.
Our preference among office REITs under coverage is Suntec REIT. Our target price has been lifted from S$1.59 to S$1.60 as we fine-tune forward estimates for renewal rates. We prefer Suntec over KREIT (Underperform, target S$1.01) as we see the REIT having the same potential catalysts as KREIT but with higher yield support of 7.6-7.7% vs. 4.8-6.1% in 2011-12 respectively. We deem its average prospective yield of 7.5% for the next three years extremely attractive vs. physical yields of 5+%. CCT remains an Outperform on valuations, with a higher target price of S$1.37 (S$1.26 previously) on higher NPI margin assumptions.
• Four turning points in office rents; Overweight. The magnitude of rental slides and undemanding valuations have made owning office stocks more favourable, in our view. We identify four key trends that could mark turning points for office rents and recalibrate investors’ yield expectations for office assets. Our base case suggests that future demand can absorb supply and assumes a 30% increase in office rents by 2012. Maintain Overweight on the office sector, with KepLand still our key pick. Suntec REIT is our top pick among office REITs.
• Turn in GDP. The Ministry of Trade & Industry (MTI) has raised its GDP growth forecast for Singapore to 7-9% from 4.5-5%, with our economist expecting 6-9.5% growth in 2010-12. Turns in GDP in past recoveries have typically coincided with surges in office demand. We believe this cycle is no different.
• Widest discount to Hong Kong in two decades. The competitive advantage of Singapore as a commercial hub has never been better. A 55% fall in office rents from the last peak means that Singapore has fallen off global rankings in terms of occupancy costs. Singapore is now 45-50% cheaper than Hong Kong, the highest discount in two decades. Singapore office rents are typically re-rated when rental discounts touch 30-40%, as in the last three cycles.
• Cap-rate compression. Capital values have been very resilient in this cycle even as rents nose-dived. Better credit conditions and liquidity flows into Asia (Singapore) are sustaining asset prices and preventing distress sales. Already, there are signs of a return in institutional demand with bigger deals transacted in the last 6-8 months. Investment-property deals that were done at initial yields of 6-7% last year (by our estimates) are now being done at 5+%.
• Jobs equal demand. The labour market has also been very resilient. Unemployment has fallen to a 2-year low (2.2%), the quality of jobs has improved and hiring has picked up. Our economist, Song Seng Wun, expects unemployment to dip below 2% before year-end. Industry data also indicates that new company formation is reviving which usually signals rising office rents.
• Demand to meet supply. The redevelopment of older offices is expected to remove a portion of existing office stock. Our office demand model, based on GDP growth of 6-9.5% for 2010-12, implies a net absorption of 7msf in the next three years, sufficiently satisfying pipeline supply. We see competitive occupancy costs and migration in internationally mobile jobs to Asia and Singapore to drive demand in this cycle. Already, net take-up in the last three quarters had turned positive with many Singapore landlords suggesting that tenants are now more proactive in negotiating for longer lease terms
Turn in GDP
Close correlation between GDP growth and office demand. Demand for office space is traditionally highly sensitive to the health of the economy. The close correlation between real GDP growth and new office demand is intuitive (Figure 1). Our model indicates that GDP growth explained about 75% of the variance in office demand from 1991 to 2009.
We believe the close relationship provides a very strong case for optimism on the office sector. In April, the MTI released much stronger-thanexpected 1Q10 real GDP numbers, showing yoy growth of 13.1% and 32.1% qoq seasonally adjusted and annualised (SAAR). This performance was powered by strong service-sector growth, including financial services, a key component of office demand.
Buoyed by the better-than-expected GDP, the government is now expecting 7-9% GDP growth this year vs. 4.5-6.5% previously. Song believes that 9+% growth is actually within reach. Even if there is no sequential growth in 2Q10, yoy growth should still be 9.5% to bring 1H10 growth to just over 11%. Beyond 2010, he expects real GDP growth to average 6% in 2011-12. In past recoveries, GDP growth rebounded to 8-10% (1993-95, 2004-06). We believe there is room for upside surprises in office demand going forward.
Cheaper and more competitive
Widest rental discount to Hong Kong in two decades. Singapore office rents have fallen over 55% from their last peak. Average prime rents in the CBD currently average S$7.50-8psf pm (effective), from S$15-16psf pm in 2008. While property consultants generally remain negative on office rents on the 7msf of impending supply in 2010-12, the competitive advantage of Singapore as a commercial hub has never been better. In terms of occupancy costs, CBRE estimates that Singapore has fallen from the ninth spot to 32nd in its global ranking.
Singapore is 24th (from 26th) in Collier’s list, and 43rd (from 10th) in DTZ’s. We believe that as Singapore maintains its status as one of the most preferred destinations for doing business in the world, rising competitiveness in occupancy costs will attract more tenants. Singapore’s discount in average prime office rents to Hong Kong is at its widest (45-50%) in two decades(Figures 4 & 5).
With consensus expecting Hong Kong rents to climb further and sentiment in Singapore rents still lukewarm, a widening gap between the two cities should enhance Singapore’s attractiveness as a commercial destination. Historically, the discount between Singapore rents and Hong Kong rents averaged 24%. Singapore office rents were typically re-rated when rental discounts touched 30-40% in the last three cycles.
Cost savings translate to more pre-commitments. With asking rents now back to 2006 levels and the general business outlook improving, corporates have in recent months been more willing to commit to new office space. Their flight to quality remains evident, as tenants are able to upgrade to newer premises at lower occupancy costs. Nomura and BHP reportedly have signed up for large space at MBFC Phase 1 on long leases (6-12 years) while companies like Noble Group are reportedly moving to the new Mapletree Anson from PSA Building.
We estimate that around 42% of the new supply in 2010-12 has been pre-leased. While these leasing deals were largely driven by relocations six months ago, some expansion is beginning to emerge. Law firms are allegedly expanding again while financial institutions are resuming hiring. According to the URA, net take-up of office space had stayed positive in the last three quarters (+600k sf), with vacancy rates for prime-grade buildings falling from 12.3% in 4Q09 to 10.5% in 1Q10.
Cap-rate compression
Resilient capital values. Capital values have been resilient, buoyed by a resurgence in leasing and what appears to be stabilising office rents. Average capital values for prime office assets have fallen 40% to S$1,700-1,800psf pm from their peak in 2007- 08. We believe asset prices have found a floor. Investment-property deals that were done at initial yields of 6-7% (by our estimates) last year are now being done at 5+%. Evidence of stability in asset prices has also surfaced in recent valuations of office SREITs, which indicate cap-rate compressions of 25-50bp in the last 6-8 months.
Assets in office S-REITs are currently valued at cap rates of 4.5-4.75%. In the past, cap rates typically start to compress from their peak 12-18 months before market rents and occupancy bottom, an idea we put forth at the beginning of the year (“Better value from laggards and selected commercial landlords” dated 12 Jan, 2010). This trend played out in the past three office cycles. With asset valuations and property transactions implying lower yields, we believe a similar trend is unfolding, especially for newer assets coming on stream.
Liquidity inflows to help sustain asset prices. The relative resilience in capital values is in part driven by better credit conditions. From the end of 2009, some SREITs have been diversifying their funding sources (which were limited to banking funding last year) by testing capital markets with some very positive results. Cost-ofdebt margins for fixed-rate notes have drifted down 100-150bp from a year ago for 3-year debt with all-in costs of 2.8-3.5%. At the institutional funds level, Pacific Star was recently successful in refinancing S$549m of debt for Capital Square, an office building in Raffles Place, which could only fuel further support for capital values. Refinancing fears have substantially eased on more accommodative credit conditions.
This has also dispelled fears of widespread distress sales of office assets. We believe that a shift in capital allocation to Asia will help sustain asset prices. Our banking analyst, Kenneth Ng, believes that in contrast to developed nations whose weaknesses have been exposed by the Greek debt crisis, Asian government bonds are poised to benefit from low sovereign debt and expanding economies. Singapore government bond yields have fallen 10bp after the MAS set the S$ on an appreciation path a month ago. Moody’s raised its rating on Indonesia last September.
Kenneth holds the view that liquidity flows into Asia will cap risk-free rates in healthy Asian economies like Singapore, resulting in low risk-free rates plus strong demand for Asian government and corporate bonds. This, in turn, will narrow lending spreads that banks charge to large corporates, keeping borrowing costs for large Asian corporates very low and spurring investments and M&As.
This buoys our optimism on the Singapore office market and investment deals. Our sources indicate that spreads for established property corporates are 150-180bp over SIBOR, although loan-to-value (LTV) ratios are still at the 40-50% mark, vs. 60-70% in the last upcycle. Declining spreads in the corporate lending space would contrast with consumer mortgages, as banks are expected to compensate for the risk of higher asset prices with higher spreads on consumer mortgages.
Return of institutional interest. So far, newsflow on investment-property deals has been encouraging. While private investors had dominated deals last year, institutional interest re-surfacing in 2010. Robinson Point and a portion of 1 Finlayson Green have been sold to AEW and a foreign-based fund at estimated initial yields of 5.3% (S$1,527psf) and 5.5% (S$1,629psf) respectively. Media reports suggest that many foreign investors are on the lookout for prime office assets. We believe many may be positioning themselves for a potential recovery in the office sector on the back of caprate compression and a demand recovery. That said, sellers have been standing their ground and we expect prices to remain sticky.
Jobs equal demand
Stronger labour market to form foundation for recovery. Preliminary numbers from the Ministry of Manpower (MOM) indicated that Singapore is back to full employment. The labour market in this cycle has been very resilient, thanks to sharper-than-expected improvements in domestic and external demand. The seasonally adjusted unemployment rate had dipped to 2.2% in Mar 10 from a revised 2.3% in Dec 09.
This was a 2-year low. We believe the stronger labour market will form the foundation for a firmer office recovery. Total employment is estimated to have grown by 34k in 1Q10, the third quarterly increase after two quarters of decline in 1H09. The quality of jobs has also improved as 31.2k of the net additions came from the service sector with construction shedding 800 workers. The former typically forms the crux of office demand. Our economist expects the labour market to expand strongly in the coming quarters to bring down unemployment below 2% before yearend.
Financial institutions (banks) are hiring again after their massive retrenchments of the past few years. Law firms, insurance companies and IT & communication companies are reportedly planning to raise headcounts. These anecdotal findings are consistent with a recent employment survey by Hudson, suggesting that 54% of its respondents (564 executives interviewed) plan to raise headcount in 2Q10.
The MAS also recently highlighted brighter employment prospects for the financial services sector in its recent 1Q10 macroeconomic review, driven by rising demand for corporate banking and wealth management services. This bodes well for the office sector as movements in office rents typically closely correlate with financial services job growth.
New company formation. Singapore remains a very attractive place to do business given its solid infrastructure, strong talent pool and accommodative tax structures. After a lull in 2009, MNCs are believed to be setting up shop in Singapore again. Gazprom, a natural-gas firm from Russia, reportedly has plans to increase its headcount from 35 to 100. Average office rents rose by 150% from 2006 to a peak of S$15-16psf pm in 2Q08, coinciding with the peak in new company formation. As new company formations dried up in 2009, office rents nosedived to S$7-8psf pm. Data from CEIC indicates that new company formation is reviving, particularly for the financial and insurance industries.
No structural oversupply. Empirical evidence shows that the factor of average office space to a person employed is around 25x, using data in the last two decades. At this level, prime office rents were typically at mid-cycle levels of S$10psf pm. In 2003, when the SARS epidemic hit Asia coupled with the consolidation of Singapore banks, severe oversupply lifted the factor to 33x.
Office vacancy hit a high of 18% then. Office rents subsequently tumbled to their lowest in 20 years at S$4.50psf pm. Since then, job growth in Singapore has outstripped office supply, pushing the ratio back down to 25sf currently. Our economist estimates that annual employment growth will come in at 5% in 2010, before normalising to 3.5% in 2011-12. In this case, we believe the factor of office space available per person employed will inch down to 23x by 2012, based on expected supply in the next three years. Looking at the past three office cycles, this ratio should translate to average prime rents of S$10-10.50psf pm, implying 25% upside from current levels
Demand to meet supply
Lessons from past cycles. The Singapore office sector is historically very susceptible to cyclical swings. In down-cycles, office rents have the tendency to overshoot on the downside, as in the 1996-99 and 2000-03 cycles, when prime office rents cascaded by 43% on average. However, past cycles also teach us that an office recovery can be surprisingly swift. In the recoveries of 1992-96 and 2003-07, office rents rose 34% and 245% respectively.
Average office take-up per year on both occasions was 2-2.5msf with average GDP growth of 8-10%. Although pipeline supply in 1992 was over 16msf of office space (much more severe than now), stronger-thanexpected take-up meant that vacancy fell from 11.5% to 8.5% in 1996. In 2003, the supply situation mirrored the present case – 6.5msf – although the effects of a global financial slowdown, dotcom bust, consolidation of Singapore banks and SARS culminated in a vacancy rate of 18%. This meant that 16-17msf of available office space was vacant at that time. Yet by 2007, vacancy had fallen to 6-7% with rents hitting S$15-16psf pm from a trough of S$4.50. This implies that the Singapore office market is usually more robust than expected.
What will drive demand this time round? The past few recoveries were aided by a few defining events. The new Asia-Pacific boom in the mid-1990s, dotcom boom in early 2000, and credit-led boom in 2006-07 helped shape the office recovery. While it may be premature to assume another upturn of equal impact in the near term, we see catalysts for business rejuvenation in Asia.
As western governments put their houses in order, tax hikes and cuts in government spending and public-service jobs cannot be avoided. Greece is already an example. The business environment in developed economies will get more difficult. Migration in internationally mobile jobs to Asia and Singapore can only be expected with the passage of time. With business returning and office rents much more competitive now vs. other major cities, we believe Singapore is well placed. The office sector is in its third year of de-rating. We believe a real recovery is in sight.
Residential conversions to alleviate oversupply. The demand for city living, particularly within the CBD, has taken off. Strong demand for residential apartments in the area has prompted landlords to consider the alternative use of older office buildings. It does not come as a surprise that the bulk of office acquisitions in 2009 were made for conversion to residential use. We estimate that 1.1msf of office space in the CBD will be converted in the next 1-2 years. The potential removal of office stock will certainly help alleviate oversupply.
More office-to-office redevelopments? The sharp run-up in office rents in the 2006-08 upturn was in part driven by the removal of office stock for refurbishment and upgrade. The motivation behind this was a lack of Grade A office buildings in Singapore to meet the changing needs of end-users. Attributes such as large floor plates (more than 20k sf), raised flooring and complex technical specifications are just some of the things new-age tenants are looking for. This is particularly true of occupiers in the financial services industry.
Jones Lang LaSalle (JLL) estimates that only 9% of the existing stock in Singapore has floor plates of over 20k sf, with 13% of office stock in the CBD meeting such specifications. Although impending supply is expected to push up Grade A buildings in the area to 30% by end-2012, over 68% of the office stock in the CBD is still over 11 years old. We believe that as office demand recovers in the next few years, older stock could progressively be redeveloped. Thus, impending supply could be offset by the redevelopment of stock to residential use and office space of better specifications.
Demand to meet supply. As mentioned earlier, net demand for office space in Singapore historically parallels GDP growth. GDP growth explained about 75% of the variance in office demand from 1991 to 2009. We believe this variable serves as a good basis for our office-demand estimation. We estimate that every 1% growth in GDP can raise take-up of office space by 0.2-0.25 msf, going by the historical average. This rises to 0.3-0.35msf in recovery years. Assuming 9.5% GDP growth in 2010 and 5-6% in 2011-12, net absorption should be 7msf in the next three years, inour base case. This translates to an average of 2.3msf of new office demand per year, sufficient in satisfying pipeline supply. As GDP growth rates actually touched 8-10% in past recoveries (1993-95 and 2004-06), we believe there is upside to our forecasts.
Taking a step further, we cross-checked with employment prospects. We used employment in the financial services industry as a benchmark, as this segment typically accounts for the bulk of office demand in the CBD. We assume a 130sf per employee ratio in our model, lower than the 180-200sf ratio typically seen in western countries. In our base case, we estimate that the system would need to generate an average of 17k-18k jobs per year in 2010-12, or an average 2.7% employment growth a year in the financial services industry. This also formed 30% of total net employed in the entire service industry in 2009. We believe risks are on the upside, as employment growth in the financial services industry averaged 8-15% in 2006-08, before falling to1.7% in the dark days of 2009.
Expect 30% upside in prime rents by 2012. The turning point for prime rents tends to occur when vacancy falls below 10-11%. Our model suggests that vacancy explained 80% of the variance in office rents from 1991 to 2009. Factoring in our nettake up assumptions and the potential for office stock to be redeveloped for residential use (1.1msf), we estimate that island-wide vacancy would fall to 10.5% by 2012, from 12.5% currently. Vacancy in the CBD could fall from 10.5% to 9% in the same period. On these assumptions, we estimate that prime office rents could touch S$10psf and S$11psf in 2011 and 2012 respectively. This translates to 30% upside from current levels.
We believe our estimates can be achieved. On the ground, our conversations with many Singapore landlords (including REITs) suggest that many tenants are now more proactive in negotiating for longer lease terms, always a positive sign for the sector. While the 2006-08 phenomenal run-up in office rents was partly due to a lack of options for existing tenants, the strength of organic demand should not be overlooked. While we do not expect rents to peak at S$18psf anytime soon, a 25-30% rise from current depressed levels is not inconceivable. Rents would still be 30-35% below Hong Kong levels and 40-45% below their previous peak.
Risks
Contagion from Europe. The sovereign debt crisis in Europe is just unfolding. While we believe Asian growth will remain intact, we can’t help but be wary of potential contagion. A potential recovery in office demand could be undermined by any threat to job growth. We believe demand for office space could fall short of expectations if jobs and GDP growth is not sustained. Government releasing too much supply.
The 2006-07 shortage in office space that led to astronomical rents may prompt the government to monitor the situation closely this time round. While over 7msf of new office space is expected to come through in the next three years, little supply is expected beyond 2013. We believe a premature release of too many office sites to pre-empt a repeat of 2007 could send a negative signal to the market, depressing rents and capital values further.
That said, we believe the magnitude of the fall in occupancy costs and less regulation for the sector vs. the residential segment will give rents more room for growth in this cycle. The expected relocation of government bodies such as the Ministry of National Development out of the CBD is also expected to free up 0.5msf of prime office space by 2015. Distress sales from institutional funds. Improving credit conditions have helped keep to capital values resilient, preventing distress sales so far. While newsflow of successful refinancing deals in commercial properties has been encouraging, things can reverse quickly on any deterioration in credit conditions.
Valuation and recommendation
Compelling at current levels. As economise in Asia continue to recover, 2010 may turn out to be a watershed for the office sector. Office rents are in their third year of de-rating, down 55-60% from their previous peak. Coupled with improving business activity, job growth and credit conditions, we believe investors’ yield expectations for office assets should be recalibrated. Offices as an asset class in Singapore are also less regulated than the residential segment. With valuations of major landlords still below mid-cycle RNAVs, we believe upside is significantly greater than downside.
Cap-rate and capital-value estimates. We peg our capital-value estimates for office assets at cap rates of 5% vs. 5-5.5% previously on a firmer outlook for rents. Historical mid-cycle yields of 4-4.5% offer room for further cap-rate compression. Our capitalvalue assumptions have been lifted by 6-15% as we now peg our assumptions on 2011 rents vs. 2010 previously. Prime office valuations are now pegged at S$1,700- 2,100psf, still 25-40% lower than their previous peak.
KepLand remains top pick; prefer Suntec among office REITs. KepLand remains our top pick in the sector as we view its exposure to super-prime grade offices, strong balance sheet and relative insulation from residential policy risks as ideal attributes in this environment. Valuations remain undemanding at a 26% discount to our RNAV. CityDev remains a Neutral with a lower target price of S$11.46 (from S$12.09) as we see range-bound trading due to lingering policy risks. While its large inventory of office assets (largely Grade B) provides the group with an alternative source of land bank, rental reversions could lag those of its prime grade peers, in our view. SingLand has been upgraded only to a Neutral as we see it as a beneficiary in a mature stage of an office recovery.
Our preference among office REITs under coverage is Suntec REIT. Our target price has been lifted from S$1.59 to S$1.60 as we fine-tune forward estimates for renewal rates. We prefer Suntec over KREIT (Underperform, target S$1.01) as we see the REIT having the same potential catalysts as KREIT but with higher yield support of 7.6-7.7% vs. 4.8-6.1% in 2011-12 respectively. We deem its average prospective yield of 7.5% for the next three years extremely attractive vs. physical yields of 5+%. CCT remains an Outperform on valuations, with a higher target price of S$1.37 (S$1.26 previously) on higher NPI margin assumptions.
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