MREITs - Sticking To Conservative Valuations

Date: 06/10/2020

Source  :  KENANGA
Stock  :  KLCC       Price Target  :  8.55      |      Price Call  :  BUY
        Last Price  :  7.60      |      Upside/Downside  :  +0.95 (12.50%)

Maintain NEUTRAL. The sector came away from one of the worst quarters in MREIT’s history given the effect of the MCO, primarily on retail and hospitality’s earnings as malls had to give tenants rental rebates or waivers during the period while hotels had to halt operations. 2QCY20 results were a mixed bag with safe havens being the stable industrial segment (AXREIT) which was our top performer, up 22% YTD, and the office segment (KLCC) as both posted results that came in as expected, while MQREIT’s results were better than anticipated as its tenants remained stable. Going forward, we expect to see better days ahead as 3QCY20 should see improved earnings post MCO, but we remain cautious on 4QCY20 for now, barring any unfortunate events. Assuming a worst-case scenario prompting another round of MCO, we may look to lower earnings for retail MREITs by 3-10% assuming another 1.5 months of MCO. We maintain our +2SD spread to our 10-year MGS target of 2.80% as we are wary on the recovery path to the new normal, while AXREIT commands +1SD to the MGS target for its stable earnings profile and KLCC at +1.5SD as it is largely office-space driven. All in, MREITs are commanding an average gross yield of 5.9%, which we deem as decent. KLCC (OP; TP:RM8.55) is our Top Pick given its: (i) earnings resiliency, (ii) premium asset quality, (iii) highly stable office segment with tenants on long-term leases, (iv) easy to manage triple-net-lease (TNL) structure, and (v) Shariahcompliance’s status making it one of institutional investors’ favourites, commanding decent gross yields of 4.7%.

A mixed bag of results with two within expectations, namely AXREIT and KLCC, three broadly within expectation (CMMT, IGBREIT and PAVREIT), one outperformer (MQREIT) and one underperformer (SUNREIT). YoY-Ytd, MREITs’ bottom-line declined by 27% dragged by the weak 2QCY20 in light of MCO which affected the retail and hospitality sectors the most. On a positive note, the office and industrial segments remained stable throughout the pandemic. All in, post 2QCY20 results, we made no changes to our earnings estimates, save for MQREIT (+22%/+3% for FY20E/FY21E) on better-than-expected results, while we lowered SUNREIT’s FY21E CNP by 5% on anticipation of further weakness from the hotel segment. Subsequently, we also increased TP on a lower MGS target of 2.8% (from 3.3%), closer to current level.

AXREIT the top gainer YTD, up 22%, on stable earnings even during the weak 2QCY20 results as the Group did not endure lower rentals as there is no force majeure clause for tenants. Office REIT - KLCC’s performance came in second (-1% YTD) as KLCC’s office assets were also fairly stable during the first three months of MCO as most tenants stayed put, albeit with some concerns from its retail component Suria KLCC. The retail and hospitality segments were the most affected as tenants were not allowed to operate during the MCO and struggled during subsequent MCO phases, resulting in share prices declining by between 4% to 38%.

Office and Industrial REITs are safer havens for now, while retail and hospitality could be risky should the situation worsen. The retail segment was severely affected in 2QCY20 as malls were shut during the peak of the MCO, save for essential businesses that make up c.10-15% of the mall. However, the segment that took the biggest hit was the hospitality industry as most hotels were not allowed to house any guest or hold events from the MCO till May 2020. The bright spot was the industrial segment that has been doing well during the MCO and post MCO as most manufacturing tenants remain in operations. Meanwhile the office segment will continue to remain stable, namely KLCC and MQREIT as tenants have returned to work or have the option to utilise work-from-home arrangement, ensuring that businesses continuity. We will only be concerned with the office space on a prolonged MCO (> 6 months) which may impose cash flow pressure on tenants.

3QCY20 should see improved earnings. Given that most malls under our coverage have resumed operations in June/July 2020, we are confident that 3QCY20 earnings will see an uptick vs. 2QCY20. As such, we expect positive momentum for earnings for now, barring any unforeseen circumstances. However, recent sporadic Covid-19 positive cases in a few malls in the Klang Valley which included Suria KLCC and Sunway Pyramid is a cause for concern and as such we are cautious on 4QCY20. That said, these malls adhere to the MCO guidelines and we do not expect business to be impacted by this for now. However, assuming a worst-case scenario where the Covid-19 situation in the Klang Valley worsens in the coming months prompting another round of MCO similar to the March-April period, we may look to lower earnings for retail MREITs by 3-10% assuming a 1.5-month MCO. For now, we leave earnings unchanged until further developments but we have priced the earnings uncertainty in our conservative valuations.

Maintain NEUTRAL. We reiterate our neutral call on the sector upon maintaining conservative valuation spreads of +1SD to +2SD to our 10-year MGS target of 2.80% (which is more conservative than current MGS level of 2.70%). As it stands, MREITs are not entirely out of the woods with the re-emergence of Covid-19 positive cases in the Klang Valley. In the near term, we expect 3QCY20 earnings to see significant improvements vs. 2QCY20 post the easing of the MCO but we remain cautious on 4QCY20 should the situation worsen going forward. As such, we have updated our retail MREITs to be valued at +2SD; KLCC at +1.5SD given that it mostly consists of the stable office segment, while AXREIT has the lowest spread (+1SD) due to its stable industrial segment. All in, we lowered our TP for CMMT and PAVREIT marginally post updating our spread of +2SD. Additionally, we also upgrade our call for CMMT to MP (from UP) given the steep share price decline (-22% QoQ).

KLCC our Top Pick (OP: TP:RM8.55). We favour KLCC for its premium asset quality, highly stable office segment with tenants on longer term leases (5 years vs. retail of 2-3 years) and easy to manage triple-net-lease (TNL) structure. Its 1HFY20 results were decent, making up 47% of our earnings estimates thus far despite the MCO effect in 2QCY20, and we anticipate stronger quarters ahead post the easing of the MCO. As such we believe potential downsides to earnings have largely been accounted for, including conservative valuations. We have applied +1.5SD spread to our 10-year MGS target of 2.80% (range bound between retail MREITs of +2SD and more stable industrial MREITs at +1.0SD). Furthermore, downside is limited and we expect KLCC to remain a favourite among institutional investors as it is one of the few Shariah-compliant MREITs. Current yields of c.4.7% are decent vs. large cap MREITs of 4.5-5.0%, commanding 15% total return.

Risks to our call include: (i) stronger or weaker-than-expected consumer spending, (ii) stronger or weaker-than-expected rental reversions, (iii) U.S. Fed’s move in increasing or lowering interest rates in an aggressive manner, and (iv) stronger or weakerthan-expected occupancy rates.

Source: Kenanga Research - 6 Oct 2020

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