First REIT - 2Q11 results within expectations (OCBC)

Downgrade to HOLD

Previous Rating: BUY

Current Price: S$0.835

Fair Value: S$0.84

2Q11 results within expectations. First REIT (FREIT) reported its 2Q11 results which were within expectations. Gross revenue surged 75.3% YoY and 0.3% QoQ (deferred rental from the Adam Road property of S$1.4m recognised in 1Q11 as revenue has been reclassified to 'gain on divestment of investment property') to S$13.2m, forming 24.0% of our fullyear projection. The YoY increase was due to contributions from its two Indonesian hospitals acquired in Dec 2010. Income available for distribution jumped 86.5% YoY but was flat QoQ at S$9.9m. However, DPU of 1.58 S cents represented a 17.7% YoY decline (flat sequentially) due to an enlarged unit base from the effects of the 5-for-4 rights issue in Dec 2010 and constituted 25.5% of our FY11 estimate. This equates to an annualised yield of 7.6%. For 1H11, gross revenue increased 76.1% to S$26.4m while DPU fell 17.3% to 3.16 S cents due to the larger unit base highlighted earlier.

Sufficient debt headroom for new acquisitions. As at 30 Jun 2011, FREIT's gearing ratio stands at a healthy 12.7%. Hence we expect any future acquisitions in the near term to be funded by debt as FREIT still has sufficient debt headroom of S$103.3-155.5m before reaching its long-term target gearing ratio range of 25-30%. While FREIT is keeping a lookout for accretive targets in the region, we opine that future acquisitions are likely to come from its sponsor Lippo Karawaci (Lippo). This is because FREIT has the first right of refusal to the pipeline of hospitals in Lippo's portfolio.

Downgrade to HOLD on valuation grounds. We fine-tune our assumptions in accordance with FREIT's 2Q11 results, and our RNAV-derived fair value estimate inches up to S$0.84 (previously S$0.835). FREIT's share price has surged 12.8% since we initiated coverage with a BUY rating on 7 Jan 2011, outperforming the STI and FTSE ST Real Estate Investment Trusts Index substantially by 15.8 ppt and 14.2 ppt respectively. We opine that current valuations appear fair, with FREIT now trading at a PBR of 1.07x, versus its historical PBR of 0.80x. We note that companies with assets in overseas countries which are economically and politically more risky than Singapore typically trade at a discount to NAV. While we continue to like FREIT for its resilient business model, strong management and proxy to Indonesia's growing private healthcare sector, we believe that these positives have already been factored in. Hence we downgrade FREIT to HOLD, purely on valuation grounds. Downside risk should be limited by its healthy FY11F distribution yield of 7.6%; while re-rating catalysts include yield-accretive acquisitions.

Refinancing needs for maturing debt in 2012. We believe that a key risk for FREIT is that all the interest on its borrowings are based on a floating rate (pegged to SIBOR plus a premium). This is unlikely to pose a problem in current low interest rate environment. However as the global economy recovers and if inflationary pressures still persist, interest rates would likely be raised and this would consequently increase the borrowing costs for FREIT. Currently FREIT has ~S$30m of its debt maturing in Jun 2012. Management highlighted that they are already speaking with financial institutions with regards to the refinancing of this debt and hope to reach an agreement by year end or early 2012. They have also mentioned the possibility of refinancing their debt on a fixed rate basis although nothing has been confirmed thus far. We believe that a successful negotiation of FREIT's refinancing on a fixed rate basis would partly mitigate its interest rate risks, although this is likely to entail a higher cost of borrowing especially since the loan facility would be encumbered partly by its overseas properties, which are perceived to carry more risk than local assets.

Valuations appear fair; downgrade to HOLD. FREIT is currently trading at a PBR of 1.07x, which is above +1 standard deviation of its historical mean PBR since listing. Although its closest comparable peer Parkway Life REIT [NON-RATED] also trades at a premium to its book value (current PBR of 1.30x), we believe this is due to its larger asset base and quality, as well as the perceived lower risk of its hospitals in Singapore and nursing homes in Japan. We further note that companies with large exposure to countries with a higher political and economic risk than Singapore typically trade at a discount to NAV. While we believe that FREIT's favourable master lease terms, strong management team and proxy to Indonesia's thriving private healthcare scene would remain as key catalysts for its future growth, current market valuations have already factored much of these positives in. With total projected returns now at 8.2%, we downgrade FREIT from BUY to HOLD, purely on valuation grounds. We believe that downside risk should be limited by its healthy FY11F distribution yield of 7.6%; while re-rating catalysts include yield-accretive acquisitions and asset enhancement initiatives.