Investment Highlights

• We maintain BUY on Pavilion REIT (PREIT) with an unchanged fair value (FV) of RM1.62/unit based on our dividend discount model (DDM), which incorporates a neutral 3-star ESG rating (Exhibits 7, 8). The FV implies a FY24F distribution yield of 6%, 1 standard deviation above its 5-year median.

• We make no changes to our earnings forecasts as PREIT’s 1HFY23 distributable income of RM139mil (Exhibit 1) came in within our and consensus’ estimates. It accounted for 49% of both our FY23F earnings and consensus’s estimate.

• In 1HFY23, PREIT’s gross revenue and net property income (NPI) both rose 15% YoY. This growth was primarily attributed to the newly acquired Pavilion Bukit Jalil (PBJ), which contributed for 1 month since its injection on 1 June 2023.

• Excluding the contribution from PBJ, PREIT’s gross revenue grew 9% YoY, while NPI expanded 11% YoY in 1HFY23. The improvement is mainly driven by higher occupancy rates (Exhibit 3) and favourable rental reversion in FY22, particularly in Pavilion Kuala Lumpur (PKL), Elite Pavilion Mall and Intermark Mall.

• On a QoQ comparison, PREIT’s 2QFY23 gross revenue expanded 2% while NPI slid 1%. The decline in NPI was primarily due to higher tenant sales in the previous quarter (1QFY23), which were boosted by the festive season. In addition, the NPI in 2QFY23 was dragged down by higher utility expenses from an electricity tariff hike and higher maintenance costs.

• QoQ, the overall average occupancy rate for all segments fell marginally to 83% from 84%. The decline was mainly attributed to a decrease in the occupancy rate of Pavilion Tower to 66% in 2QFY23 from 72% in 1QFY23 (Exhibit 3). Meanwhile, there was a slight drop in occupancies of PKL and Intermark Mall due to relocation of tenants within the malls.

• Nevertheless, we expect the occupancy rate of Pavilion Tower to stabilise at the current level for the remaining quarters of FY23. This is in view that the majority of its expiring leases in FY23 have already been renewed, leaving only 2% (Exhibit 4).

• However, challenges persist due to the oversupply of office spaces in Kuala Lumpur city centre, impacting the recovery of occupancy rate and rental reversion for Pavilion Tower. Competition from The Stride Strata Office in Bukit Bintang City Centre and the upcoming opening of The Exchange TRX in 4QFY23 further adds to the increase in supply of office spaces. This translates to a flattish rental reversion expectation for Pavilion Tower in FY23F.

• Despite these challenges, the weaker performance of Pavilion Tower has minimal impact on PREIT's earnings, as Pavilion Tower contributes only 1% to PREIT’s FY23F earnings.

• We are projecting a stronger rental reversion of 5%-6% for PREIT’s major contributor, PKL (accounting for 78% of FY23F NPI) in FY23F/FY24F with the expectation of improving tenant sales brought on by the return of foreign tourists. Foreign tourists made up 30% of shopper demographic in PKL prior to the pandemic. To facilitate tourist arrivals, government of Malaysia has announced yesterday under the 10-year plan aimed at easing requirements for tourists to obtain visas. The initiative is expected to further enhance footfalls in PKL.

• Meanwhile, FY23F rental reversions for Elite Pavilion Mall and Intermark Mall are expected to be lower than PKL at 2%-3% as some of the tenants still require time to recover to their pre-pandemic sales levels.

• To enhance occupancy rates at Da Men mall, it will be crucial to offer attractive rents to potential tenants. Consequently, FY23 rental reversion for Da Men mall is anticipated to remain flattish. As per management guidance, the occupancy rate in Da Men Mall is projected to rise to 75% (from 72% in 2QFY23) by the end of FY23, driven by the addition of new tenants.

• PREIT has completed the injection of Pavilion Bukit Jalil (PBJ) into its portfolio on 1 June 2023. To date, PBJ has achieved an average monthly rental rate (MRR) of RM9.50 psf (similar to MRR as at 28 Feb 2023) with an occupancy rate of 84% (vs. 81% as at 28 Feb 2023). Additionally, PBJ's monthly footfall has shown notable progress to 1.7mil- 1.8mil, which is comparable to other prime malls in Klang Valley, such as Mid Valley Megamall, The Garden Mall and Sunway Pyramid.

• In view of improving occupancy rates and tenant sales attributed to higher traffic footfalls in PBJ, we anticipate that there will be opportunities for PREIT to negotiate for higher rentals for PBJ in the upcoming expiry of tenancies in FY24. As such, we project the average MRR of PBJ to rise to RM10.21 psf in FY24F (assuming a rental reversion of 5%) and RM10.40 psf in FY25F (Exhibit 5). Moving forward, PBJ is expected to contribute 11% of PREIT’s FY23F NPI. This will gradually improve to 32%/35% in FY24F/FY25F.

• PREIT declared a gross distribution per unit (DPU) of 4.4 sen in 1HFY23 (+8% YoY), representing a 12-month trailing distribution yield of 7.1%.

• Based on the information shared during the Federal Open Market Committee's post-meeting press conference， we understand that there is no certainty that another 0.25% rate hike will take place in the next meeting on 19th-20th September 2023. The decision to implement another 0.25% rate hike appears to hinge on incoming data, particularly related to labor market and inflation expectations. While awaiting economic data updates, our in-house economists maintain their forecast, anticipating that the Fed fund rate to peak between 5.5%-5.75% by 3QCY23 from current levels of 5.25%-5.5%.

• The recent less-hawkish interest rate guidance delivered by the Federal Reserve (Fed) may suggest that we are approaching the end of global monetary policy tightening. As such, we expect the uptrend in 10-year US Treasury yield to be tapering off with the expectation that the Federal Reserve may pause rate hikes after 3QCY23. Besides, our economist forecasts 10-year MGS to be lower at 3.75% (from current level of 3.8%) in 4QCY23 with a gradual decline to 3.5% in 4Q2024. However, we do not rule out the possibility that the 10-year MGS yield could be lower than our projection of 3.75% in 2023 should there be a change in Fed’s hawkishness on rate hikes.

• We also foresee the yield spread from FY24F onwards to widen to 3.8% vs. 5-year median of 1%. Hence, PREIT will be appealing to yield-seeking investors with its higher distribution spread against 10-year MGS (Exhibit 6).

• PREIT currently trades at a compelling FY24F PE of 13x vs. its 2-year average (pre-pandemic FY18-19) of 19x. Meanwhile, distribution yield for FY24F of 7.6% is attractive vs. current 10-year MGS yield of 3.8%.

• We also like the stock due to its key assets which are strategically located in the capital of Malaysia, providing a good platform for new international brands to establish footholds for expansion into the Malaysian market while supporting demand for retail space at the malls. Looking forward, we foresee a gradual pick-up in occupancy rates and normalisation of rental reversion with the recovery of Malaysia’s economy and the return of China tourists in the postpandemic era.

Source: AmInvest Research - 28 Jul 2023