Keppel DC REIT - Portfolio reconstitution paying off

9M22 DPU growth protected by c.90% hedge on overseas income

3Q/9M22 revenue rose 1.4%/0.5% yoy to S$70.3m/S$64.1m due to contribution from Guangdong DC 1, 2 and 3, Intellicentre 3 and asset enhancement initiatives and positive reversions/rental escalations, partially offset by higher utilities cost at the Singaporecolocation assets, depreciation of EUR, AUD and GBP and absence of income following the divestment of iSeek DC. 9M22 NPI margin deteriorated slightly, from 91.7% to 91%. 3Q/9M22 DPU grew 5.0%/3.4% yoy to 2.585/7.634 Scts.

Rental escalations and FX hedging to mitigate inflation/volatility

Approximately 50% of its leases contain built-in income and rental escalations based on Consumer Price Index or similar indexation, or fixed rate mechanisms, providing KDC some income growth on top of its positive reversion on renewals. The manager has entered into 2-year fixed rate electricity contracts for its Singapore colocation assets, which will commence in Jan 23. While an NDR prevents KDC from sharing the fixed rates, we understand that the rates are higher than the current discounted floating rates for its existing contracts. Nonetheless, KDC is able to pass through >90% of the electricity costs to its tenants and is unaffected by higher electricity cost for its master leases as clients contract electricity directly with the power suppliers. Additionally, KDC has c.90%-hedged foreign-sourced distributions until end-2023, which provides income stability.

Seeking higher yields from off-market deals

While some SREIT managers have turned cautious towards acquisitions, KDC is undeterred by the higher interest rate environment and continues to evaluate off-market deals that would provide higher yields. Future acquisitions are not limited to China as KDC intends to maintain a diversified portfolio, with exception of its overweight position in Singapore, which will remain a core market. Gearing increased 2.2% pts qoq to 37.5% post the acquisition of Guangdong DC2 and DC3. The manager intends to amalgamate acquisitions, letting gearing trend towards its internal limit of 40% before tapping equity markets to de-leverage the portfolio. 74% of KDC's borrowings are on fixed rates. Average cost of debt increased from 1.8% as at 1Q22 to 2.0% for 9M22 (3Q22: 2.3%).

KDC trading at attractive 5.8% FY22F DPU yield, 1.3x P/NAV.

DPU estimates

We keep our FY22-24F DPU estimates unchanged. We roll forward our estimates to FY25F. DDM-based TP falls from S$2.63 to S$2.12 as we factor in higher risk-free rate (from 1.6% to 2.9%) and COE (6.6% to 7.7%). We think that tenant stickiness due to the high cost of relocation and limited supply in the near term in KDC's key markets will continue to underpin income resilience and positive reversions. Potential re-rating catalysts are faster pace of acquisitions while downside risks include larger-than-expected impact from higher electricity cost, higher cost of funds an d softer data center demand.

Key risks

Downside risks include (i) softening of data center demand which could affect reversions and ability to structure in rental escalation, (ii) larger-than-expected from higher electricity cost eroding earnings and (iii) higher interest rates/cost of capital which could price out acquisitions, eroded earnings and slowing KDC's inorganic growth momentum.