Can Keppel REIT Possibly Be A Bargain Now?

Keppel REIT (SGX: K71U), an owner of nine commercial properties in Singapore and Australia and one of the largest real estate investment trusts in Singapore, closed at S$0.945 per unit yesterday.

Is there any value to be found in the REIT at that price? Let’s find out.

The art of value

A REIT’s value should be a key deciding factor for investors when it comes to making an investing decision.

There are two main ways for investors to estimate the value of a REIT. One method works forward, in that an investor will try to estimate the growth rates that a REIT will achieve in important financial metrics like its distribution per unit (DPU) and/or net asset value.

The other works backward, in that we can look at a REIT’s current price and work out how much growth the market’s expecting the trust to achieve. From that, we can determine if the market’s expectations are reasonable or ridiculous.

Moving backwards

In this example, we’d be using a variant of a simple dividend discount model called the Gordon Growth Model to figure out how much growth in future distributions the market’s expecting from Keppel REIT.

A dividend discount model is meant to value a company based on the total amount of dividends that the firm would distribute to shareholders in perpetuity; the Gordon Growth Model simply adds in a factor to account for a company’s future growth in dividends. The formula for the Gordon Growth Model is shown below:

Share Price = Expected Dividend Per Share One Year From Now / (Discount Rate – Dividend Growth Rate)

Keppel REIT’s annual distribution for its fiscal year ended 31 December 2014 (FY2014) was 7.23 Singapore cents per unit, down by 8% from the figure of 7.88 cents seen in 2013.

Based on the REIT’s current trajectory in its distributions, it wouldn’t be unreasonable to assume that a further shrinking in the payout is in order. In the first-half of 2015, Keppel REIT saw an 11.6% year-on-year decline in its DPU; so, let’s assume that the DPU for the whole of 2015 will also be 11.6% lower than in 2014. This puts the number at 6.39 cents per unit.

As for the Discount Rate, the textbook method – which follows the Capital Asset Pricing Model (it’s perfectly acceptable to not follow the CAPM when trying to estimate the value of a stock, but I’d still use the model in here for the sake of completeness) – is to incorporate the risk-free rate as well as the beta of Keppel REIT.

The risk-free rate is normally taken to be the 10-year government bond yield; currently, the yield on a 10-year Singapore government bond is around 2.6% and so, that shall be our risk-free rate.

Meanwhile, the beta of any stock is simply a measure of a stock’s volatility in relation to a broad market index; in Keppel REIT’s case, data taken from investing research outfit Morningstar has the beta figure pegged at 1.26.

With the explanations out of the way, here’s how the formula for the Discount Rate looks like:

Discount Rate = Risk Free Rate + Beta (Market Return – Risk Free Rate)

You’d notice that there’s one last variable in the Discount Rate formula which I have not discussed, and that is the Market Return.

The Market Return is simply the long-term return of the stock market as a whole. In this exercise, I’d be using the long-run return of the SDPR STI ETF (SGX: ES3), an exchange-traded fund which tracks Singapore’s market barometer, the Straits Times Index (SGX: ^STI). Since its inception in April 2002, the SPDR STI ETF has generated a total annual return (inclusive of reinvested dividends) of 7.11%.

So, when we input all the relevant figures into the Discount Rate formula, we’d end up with a Discount Rate of 8.28% for Keppel REIT.

The next thing we have to do now is to punch all the numbers we have obtained so far into the Gordon Growth Model. This is what we’d end up with:

0.945 = (0.0639) / (0.0828 – Dividend Growth Rate)

As you can see, the only variable that’s now unknown in the Gordon Growth Model is Keppel REIT’s future growth in distribution. Some basic arithmetic would give us the conclusion that the market expects Keppel REIT to be able to grow its DPU at an average annual pace of 1.52% over the long-term future.

So what’s the value?

The expected growth rate of 1.52% can then be used to compare against our own assessment of what Keppel REIT may be able to achieve. For some historical perspective, from 2007 to 2014, Keppel REIT has produced DPUs that have declined at an average pace of 2.93% per annum.

So, based on all the above assumptions, if you expect Keppel REIT to be able to grow its distribution at a faster clip than 1.52% annually, the trust will be undervalued at S$0.945. But, if you’re not confident at all about Keppel REIT’s growth and think that its future distributions will step up at a much slower pace or possibly even decline, then S$0.945 might be too high a price to pay.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore writer Stanley Lim doesn't own shares in any companies mentioned.