Is Prime US REIT a Buy at 15% Dividend Yield?

US offices have been a wreck after COVID. Here's what you need to know about Prime US REIT's 15% dividend yield play.

Prime US REIT’s shares got pummeled more than 44% since the start of 2022. 

This Grade-A office Singapore REIT now trades at a whopping 14% dividend yield. You just don’t get to see this kind of yield for a US office REIT. 

And Prime, right now, trades at its peak yield.

The thing is, these US office Singapore REITS (including Manulife REIT, Keppel-Oak REIT and so on) were popular few years back because 1) they gave Singapore investors a good way tap into US offices’ steady rental income, and not getting hit with a 30% US withholding dividend tax. 

Also, 2) the low rates made investing in US offices highly favourable.

Today, Prime is one of the worst Singapore REIT performers. 

And really, Prime shares’ lousy performance are really driven by two things here:

  • Weak occupancy rate
  • Potential squeeze in DPU

The question is — in spite of these risks unfolding into this REIT, would this be a buy, or is this another “value trap”?

Let’s unpack these.

What’s Prime US REIT?

Prime US REIT is a pure-play Grade-A office REIT. 

At US$554 million market cap, Prime owns 14 US offices located across different region’s All of these offices are freehold. And most of them leased to high-quality tenants.

Source: Prime US REIT’s 1H2022 Financial Presentation

Now, Prime’s sponsor is KBS Asia Partners, also one of the largest office property funds in the world, managing over US$7 billion of assets under management (AUM). 

Its sponsor has generated ~US$50 billion worth of deals since it started 1992. 

While I don’t have much clue of KBS Asia Partners, but as a private equity fund, I expect KBS to inject fresh assets into Prime as the world recovers from COVID, and property valuations start to go up again. 

What’s going on with the US office market?

There’s no doubt, US office market is competitive – average occupancy rate sits at 86% over the last few years.

Yet at the same time, what’s surprising is rent continue to climb year after year. In fact, over the last few years, rent has gone up to US$36 per square foot, despite no new tenants have been locked in. 

And this was what attracted many investors to US offices – the strong cap rate, or yield in a developed market.

Cap rate is a proxy of  property yield. It takes the net rental income divided by the property’s current market value. 

Over the past five years, US offices trade at a cap rate of ~6.5%, which is darn good for properties in the world’s biggest economy. 

Source: Prime US REIT’s Annual Report 2021

Before COVID, you could made good money by borrowing cheap dollars, and investing in these properties with reliable, blue-chip tenants.

The problem today with these properties, is with COVID, vacancies started soaring, many tenants have reshuffle their physical workspace priorities and offices also struggle to adjust their rents. 

Source: Prime US REIT’s Annual Report 2021

Can Prime US REIT’s occupancy recover?

Prime’s biggest concern — fall in occupancy rate. 

When this Grade-A US office REIT got listed in 2019, all of its 11 properties had an ~95% occupancy rate. Today this stood at 90%. 

Occupancy rate is a strong indicator of a property’s quality. Properties that command a high occupancy rate also implies a high chance of renewing tenants and property owners could easily find replacement tenants.

The thing is, after COVID, companies have shifted to a “hybrid work arrangement”. This allows staff to work say, only two to three days in the office. 

This also drove down occupancy rate for Prime. 

And even so for other US office REITs.

For instance, one of Prime’s properties, Village Center Station I, occupancy fell from 97% to 70% during the pandemic.

Another of its properties – Tower I at Emeryville fell from 81% to 59%, just after WeWork closed its co-working space with Prime.

Source: Prime US REIT’s 1H2022 Financial Presentation

What’s more, the bad news is many US companies, especially tech, are already cutting headcounts in view of a slowing US economy. These companies are also holding back their expansion plans.

But the good news is, Prime’s occupancy rate is still higher than the overall US office occupancy rate of 86%.

Another crucial thing is — most of Prime’s tenants are legal and financial services, which tend to be more defensive at this point of the economic cycle. 

For instance, banks are expected to report stronger earnings, enjoy rising rates, and unlike the banking crisis, banks are now more capitalized than before. 

So far, Prime’s top 10 tenants haven’t changed that much during COVID. These tenants could continue to benefit. Which means, they could possible withstand the test of a true crisis.

This could provide some cushion if things get worse from here. “

Source: Prime US REIT’s 1H2022 Financial Presentation

Prime’s potential squeeze in DPU

The Fed is pumping up rates. 

The war against inflation isn’t stopping soon. 

While Prime’s debt is mostly “fixed”, and it has enough credit lines to refinance their debt, the issue is most of its debt are due in 2023 and 2024 – the critical years where Fed rates could hit 4.5% or higher. 

By next year, Prime has to refinance US$200 million in debt, another US$315 million in debt in 2024.

And if inflation doesn’t cool by then, you could see Prime’s interest payments spiked up by then. Today, Prime’s borrowing costs is ~3%, the average cost that US property investors borrow to buy office properties. 

Now, things could get ugly if Prime can’t raise rent quickly, since higher interest payments could easily drag down Prime’s distributable income, and more importantly — DPU. 

I mean, it’s not so much about refinancing risk than getting its DPU affected.

 

Surprisingly, Prime’s financial results still solid

I’m surprised. Prime’s latest 1H2022 financial results is somewhat resilient. 

Revenues rose 9.7%, distributable income soared 16.7%, while the major US office REIT maintained its DPU — up marginally by 5.7% to 3.52 US cents per unit. 

Prime continued to record positive rental adjustments over the last eight quarters. In its latest results update, it achieved a rent increase of 11%. This is also driven by Prime’s newly bought properties — Sorrento Towers and One Tower Center in July 2021, which further raised their distributable income.

So far, Prime’s dividend distribution hasn’t been too bad. The REIT met its forecast distribution when it IPO, and now pays ~6.9 US cents DPU/year, over the last three years. 

Today, Prime’s dividend yield sits at 14.8%. 

Final Thoughts — is Prime a buy at 14.8%?

I admit. Prime US REIT trades like a garbage stock today – shares trade at a 0.56x P/NAV, a deep discount from the US office REIT’s net asset value (NAV). 

I ask myself – is the market being rational, or is this a whole lot of fear?

Well, I think it’s both. The thing is, unlike in Singapore, US is a much, much bigger place. And a big place makes more sense for employees to havea  hybrid work arrangement. COVID accelerated this mindset shift. 

What’s more, work-life balance is an increasing priority for many companies these days. And this could slow down Prime’s ability to raise its occupancy rate. 

As the Fed pumps up interest rates, people might spend less, businesses could slow and already we’re seeing many companies cutting people, further reducing physical work spaces. 

While the top tenants for Prime US REIT aren’t generally tech companies, but the war on inflation could still affect other sectors. 

But what’s interesting about Prime’s shares are, I find it hard to swallow its properties are  worth only half of what they were valued before.

I mean, Prime’s overall rent is still picking up, and management expects more rental adjustments as most of its rents are below the market rate.

Don’t forget, actually a 90% occupancy rate is still solid, way above US’s average occupancy rate. 

And more importantly, these 14 properties are still very much well-located in the CBD areas.

The way I see it, this Prime US REIT works out more of a “special situation” play, which I think, is a bet that the market is wrongly pricing Prime’s assets. 

Prime’s debt ratio also gives investors some comfort, with gearing ratio at 37.8%. 

Sometimes, investing can be simple. 

Willie Keng, CFA

Founder, Dividend Titan

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