Suntec REIT: Relative value & retail attraction

Office income at turning point.
In 3Q09, Suntec REIT reported a decline of 11.4% QoQ and 41.9% YoY in average achieved Suntec City Office rents to S$7.30 per square foot per month. 22.2% of the REIT's total office NLA (including One Raffles Quay) expires in 2010. Office REITs have yet to feel the full brunt of falling rents because of the time lag created by the three-year leasing cycle. But 2007 leases, which were secured as the market began its meteoric ascent, finally begin to expire in 1Q10. We believe we have approached the inflection point where spot rents are lower
than passing rents on expiring leases, impacting revenue and distributions
unfavorably.

Potential dilution risk.
In 2009, Suntec avoided resorting to a dilutive equity issue to refinance a chunky CMBS maturity. Looking ahead, Suntec could see gearing increase due to a fall in office asset values at the 4Q09 portfolio revaluation. With declining office income and book value risk, Suntec could decide to go the acquisition route in 2010. It is likely to keep aggregate portfolio gearing unchanged or lower, necessitating a combination of both equity and debt financing on any purchase. Assets could be acquired from the original vendors of the Suntec assets, which have (presumably) been de-levering the parent portfolio as seen with the recent Fortune REIT transaction and the sale of both the Suntec City Convention Centre and Suntec City's property manager. Asset yields are unknown - creating potential dilution risk.

Relative value and retail attraction.
Suntec has appreciated over 9% since our October upgrade. Current price-to-book of 0.65x compares favorably to the 0.73x averaged in 2006, though the 11% value gap is partially offset by the revaluation risk in 4Q09. We see relative value versus CapitaCommercial Trust [HOLD, S$1.13], which is trading at 0.78x book and 5.4% FY10F yield. Gearing for the two is also fairly comparable (34.3% Suntec, 31.2% CCT) but note that CCT's property valuations are more recent.
We note that Suntec's strong retail portfolio, which should benefit from the
revitalization of the Marina Bay area and the full opening of the new Circle
Line, is consistently undervalued. Retail income should also support distributions. We have changed our assumptions, including on the pace and extent of the recovery in office rents from FY12 onwards. Our SOTP value for Suntec increases from S$1.21 to S$1.43. Adjusting for fund-raising risks, we derive a fair value of S$1.40 (prev: S$1.21). Maintain BUY (15.6% total return).