As we navigate through the earnings season, REITs are once again under the microscope. Among the early birds is Keppel DC REIT, a global player in the data centre sector. While its Distribution Per Unit (DPU) seems robust year-on-year, a deeper dive into the earnings uncovers a dip in gross revenue, net property income, and distributable income. The culprit? A significant surge in finance or interest costs, triggered by a drastic shift in the interest rate landscape.

The Impact of Rising Finance Costs

Keppel DC REIT’s average cost of debt for Q2 2023 is pegged at 3.3% per annum. This marks a substantial 50% increase from the 2.2% per annum recorded six months ago. This spike in finance costs has eclipsed the growth in gross rental income, which is propelled by built-in rental escalation. Moreover, the turbulence caused by currency hedging fluctuations has necessitated management interventions to restore equilibrium.

Debt Maturity and Rental Escalation: The Balancing Act

The silver lining is the minimal debt maturing in 2024, and the management’s anticipation of two years of rental escalation to counterbalance the higher interest cost revision for debt maturing in 2025. The Weighted Average Lease Expiry (WALE) of Keppel DC REIT averages 8.4 years, with built-in rental escalation. Assuming a 3% annual rental escalation over the next 8.4 years, rental revenue could see a rise of approximately 28%. This boost in rental revenue may eventually offset the 50% hike in the cost of debt. However, it’s crucial to note that the DPU will likely be capped due to the balancing effect of rental escalation and interest rise.

Keppel DC REIT: A Pseudo Bond in Disguise

Keppel DC REIT can be likened to a 10-year corporate bond with a capped coupon, trading at a dividend yield of 4.4% per annum. While it may not be the most enticing option, it does offer certain perks. The REIT’s data centre operations seem to be thriving, and it boasts diversified revenue streams with international diversification.

A longer duration pseudo bond like a REIT offers cash flow stability but is also more susceptible to interest rate shocks, as witnessed in 2022. However, given that we’ve already seen a 100% change in interest costs, the future magnitude of change is expected to be less severe, which should have a lesser impact on the REIT’s share price.

The Pros and Cons of Investing in Keppel DC REIT

Investing in Keppel DC REIT comes with its own set of advantages and disadvantages. On the upside, the long WALE offers cash flow stability and is more appealing than a shorter WALE REIT. Conversely, a shorter WALE REIT can be more beneficial when interest rates fluctuate.

The attractiveness of Keppel DC REIT as an investment hinges on your long-term expectations for interest cost moderation. If you foresee a decrease in interest rates over time, then the REIT may be a good bet. However, if high interest rates persist, it may lose its charm.

Wrapping Up and FMS’s Take on Keppel DC REIT

In conclusion, Keppel DC REIT has experienced a drop in its DPU compared to six months ago due to a rise in finance costs. However, the REIT’s long WALE and built-in rental escalation offer cash flow stability and potential for future growth. While there are pros and cons to consider, Keppel DC REIT may still be an attractive investment option, especially if you expect interest costs to moderate downward in the longer term.

At FMS, we recommend our clients to consider investing in dividend funds as a strategy to build passive income. For instance, if a client invests $48,000 per year for 10 years at a 6% yield, the total value of the portfolio after 10 years would be $588,000. The annual passive income that can be generated from this portfolio at a 6% yield would be $35,280.

Building passive income is beneficial for three key reasons. First, it provides a steady stream of income regardless of market conditions. Second, it allows you to reinvest the dividends to compound your wealth.

Lastly, it offers financial independence and the freedom to pursue your passions without worrying about your finances. However, it’s important to note that while building passive income through dividend funds can be a viable strategy, it should align with the overall investment objectives and risk tolerance of the individual investor.

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Benjamin Low
Benjamin Low

Benjamin is known as The Passive Income Guy. He has helped hundreds of people to build passive income. He is also a member of the Million Dollar Round Table, and Certified Financial Planner™ (CFP®) and Certified Private Banker (CPB).

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