Investment Highlights

• We maintain our BUY call on Sunway REIT (SREIT) with an unchanged fair value (FV) of RM1.76/unit based on the dividend discount model (DDM) with a WACC of 7.7% and terminal growth rate of 2.5%. No change to our 4-star ESG rating (Exhibits 1, 6).

• Pending the company’s 2QFY22 results next month, we maintain our earnings forecast. We recently held a virtual meeting with SREIT’s management. Here are the key takeaways:
  (i) The retail sector's recovery has been encouraging. Notably, average retail sales for all of its retail assets in 1HFY22 were 10–15% higher than pre-Covid levels (1HFY19). With the improvement in retail store sales after the reopening of economy, we expect rental rebates in FY22F to be much lower than in FY20–21. 
  (ii) While a significant percentage of leases are expiring in FY22, we believe that the majority of leases will be renewed. This is in view of the substantial improvement in tenants’ sales and footfalls in retail malls. (Exhibit 5). Hence the risk of tenant attrition is seen as low for this year. 
  (iii) YTD, SREIT’s hotels recorded an average occupancy rate of +40% vs. 2019’s 69% (Exhibit 3). Singapore, the Middle East and China made up the majority of foreign visitors for its hotels during the pre-Covid period. Up till today, SREIT has yet to see a significant influx of foreign tourists. Assuming minimal contribution from foreign tourists, we have conservatively assumed a 50% occupancy rate for its hotels for the remaining months of FY22F. Any potential increase in foreign tourist arrivals will be an upside to our estimate. 
  (iv) Management is currently negotiating with Sunway Medical Centre (Tower A & B) on the renewal of its lease agreement, which is set to expire on 31 December 2022. The terms have yet to be finalised by the parties. For the first 10 years (December 2012 to December 2022), the agreement provides an opportunity for rentals to be increased by 3.5% annually. 
  (v) SREIT has secured a new tenant for Sunway Tower. The new tenant, Sunway XFarms, is eyeing the launch of Kuala Lumpur City Centre's largest indoor vertical farm in 3QFY22. The new farm will increase its occupancy rate from 27% in 1QFY22 to +40%. It will take up 3 floors spanning 37,000 sq ft of Sunway Tower’s lettable floor area. With a low occupancy rate in the past, management is hopeful that the entry of Sunway XFarms will bring in more tenants for Sunway Tower (Exhibit 4). 
  (vi) SREIT has maintained its target to raise the REIT’s property value to RM14–15bil by 2027. With its current property value of RM8.7bil, SREIT will require another RM5–6bil to fund potential acquisitions. Its current gearing ratio of 37% provides only financial headroom of up to RM700mil additional debt financing before it reaches REITs’ statutory limit of 50% (statutory limit after 31 December 2022). In the years to come, we expect SREIT to raise the remaining RM4–5bil through equity fundraising activities which include private placements and rights issues. 
  (vii) The performance of its pipeline of assets (including Sunway Velocity Office, Sunway Velocity and Sunway Giza Shopping Mall) were was affected during the Covid period. Hence there is no plan for the injection of these assets in the near term. 
  (viii) For subsequent acquisitions of industrial properties, SREIT is looking at assets located in first-tier cities, including Klang Valley, Johor and Penang. SREIT prefers to enter into triple net lease agreements whereby property and maintenance expenses will be borne by tenants in addition to rental payments. Moving forward, SREIT is targeting industrial properties with yields of at least 6.5%.
• SREIT is our top BUY for the REIT sector, underpinned by its well-diversified income base which could cushion potential downside risks. Its portfolio encompasses retail malls, offices, hotels, universities, hospitals and an industrial property across Malaysia.
• We remain bullish about the outlook of Sunway eMall, which offers delivery and in-store collection for online shopping across its physical malls. Also, the group is recognised for its environmental, social and governance (ESG) practices. Specifically, SREIT is the first amongst its local peers to incorporate sustainability financial considerations into its capital management strategies.

• The downside risks are: (i) a lower-than-expected tenancy renewal and occupancy rate; (ii) further contraction in yield spread against 10-year MGS amid a greater-than-expected increase in interest rates; and (iii) rental rebates reinstated if a lockdown is implemented again due to the emergence of more harmful Covid-19 variants.

• The stock currently trades at a decent FY23F dividend yield of 6% vs. the 10-year MGS yield of 4%.

Source: AmInvest Research - 12 Jul 2022