Investment Highlights

• Maintain OVERWEIGHT with stable occupancy rates across key assets (retail, office and hospitality). We anticipate retail REITs to continue experiencing healthy growth in 2024F, driven by stable occupancy rates and positive rental reversions. This is underpinned by a stable labour market, modestly higher inflation rate of 2.5%-3.5% accounting for the impact of subsidy rationalisation and service tax increase, coupled with a continued gradual recovery in tourist arrivals. Meanwhile, the hospitality segment of REITs is poised to benefit from government policies aimed at boosting tourism. The gradual influx of international tourists back to pre-pandemic levels is expected to contribute to retail sales improvement.

• Buying opportunities from widening yield spread against 10-year MGS yield amidst the tail end of monetary policy tightening and potential 2H24 interest rate cuts in developed economies. Our in-house economist anticipates the US Federal Reserve’s funds rate to peak at current levels of 5.25%-5.5%. We expect the uptrend in 10-year US Treasury yield to taper off after a pause in the Federal Reserve’s rate hikes in 4Q2023. Our economics team also expects the Federal Reserve to start cutting interest rates in mid-2024 by 75 bps to 100bps. This will eventually bring the Fed funds rate to 4.5%- 4.75% by end-2024. Meanwhile, 10-year MGS yield is projected at 3.95% in 4Q2023, subsequently declining gradually to 3.8% by end-4Q2024. We see buying opportunities in Malaysian REIT stocks given widening yield spreads against 10-year MGS yield (Exhibit 10) with appealing distribution yields of 6%-10% (Exhibit 11).

• Positive on prime malls as rental reversions and occupancy rates edge closer to pre-pandemic levels. Considering the strategic locations and strong market positioning of renowned shopping destinations such as Mid Valley Megamall, Pavilion Kuala Lumpur and Sunway Pyramid, we anticipate a positive mid-single-digit rental reversion of 5%-6% in 1HFY24F vs 3%-6% in FY23F, aligning with pre-pandemic levels. This is underpinned by the high occupancy rates of these malls (Exhibit 2) and healthy tenant sales on the back of higher private consumption growth of 5.7% in 2024F vs. 5.6% in 2023. We envisage this to present an opportunity for REITs with prime malls to negotiate for higher rental rates over the coming years. Meanwhile, the expected increase of 24% YoY in foreign tourist arrivals in 2024F will be another upside for these prime malls in view of their strategic locations with numerous attractions.

• Rental reversions of less established malls likely to remain flattish or slightly positive at 1%-2% for 1H2024. The increased supply of malls, particularly in the Klang Valley area, poses a challenge for less established malls with lower competitive advantages. For these smaller malls, increasing occupancy rates (Exhibit 2) through attractive rents will be imperative.

• Base rent of retail assets undeterred from the potential impact of lower consumer spending on luxury goods after implementation of high value goods tax on 1 May 2024 due to a broadly stable occupancy rate. Nevertheless, a variable portion of rents tied to sales are likely to be impacted by the imposition of luxury tax. Starting 1 May 2024, the Malaysian government is set to enforce HVGT on specific luxury items at 5%-10%. Currently, we are still awaiting the details of the implementation mechanism, product types and high-value goods tax rates (HVGT). The introduction of HVGT is expected to affect luxury consumers in making purchases in Malaysia, prompting them to explore alternative options in countries like Singapore and Hong Kong, which may offer more favourable pricing. HVGT is expected to adversely affect tenant sales in high-end malls such as Pavilion Kuala Lumpur, The Garden Mall, and Suria KLCC Kuala Lumpur, where luxury brands are prevalent. Despite a potential reduction in variable rents due to the adverse impact of HVGT, the impact on REITs is deemed manageable due to a stable rent base supported by a resilient occupancy rate. Notably, the portion of variable rent typically accounts for only 8%-12% of the malls' total rental income.

• Office occupancy and rental reversion rates expected to be flattish. Challenges persist for offices in Kuala Lumpur city center due to oversupply issues impacting occupancy rates and rental reversion recovery. Competition from The Stride Strata Office in Bukit Bintang City Centre and the recent opening of The Exchange TRX further adds to the increase in supply of office spaces in the Klang Valley. Meanwhile, we anticipate a flattish rental reversion for offices and limited improvement in office occupancy rates in 1H2024, given a persistent oversupply of office spaces amid office decentralisation and flexible working arrangement trends.
   
• Passenger movement in 9M2023 has recovered to 78% of pre-pandemic levels, according to Malaysia Airports (Exhibit 5). The sustained traffic growth momentum was attributed to the increase in summer holiday travels, expansions in airline routes and the resumption of flights to destinations in Northeast Asia. The pattern of traffic movements mirrors pre-pandemic trends, with peaks during festive seasons and school/public holidays, indicating a gradual normalisation of passenger movements. Additionally, the restructuring of routes by several airlines, utilising their active fleets, has led to increased flights to the Northeast Asian region and resumption to destinations prevalent before the pandemic.

• Hospitality segment poised to benefit from government policies and budget 2024 measures aimed at boosting tourism. According to the International Monetary Fund, global economic growth is expected to slow down to 2.9% in 2024F from 3% in 2023. Meanwhile, the gross domestic product growth of China, one of Malaysia’s major tourist source countries, is projected to decline to 4.2% in 2024F from 5% in 2023F. Due to weaker spending power resulting from slower economic growth, international travelers could adopt a cautious approach on spending and travelling. Nevertheless, we believe that the implementation of various governmental initiatives to boost the tourism sector are expected to result in a higher YoY influx of foreign tourist to Malaysia in 2024F.
  
  In Budget 2024, the government announced its commitment to improve visa-on-arrival facilities, social visit passes and multiple entry visas to encourage the entry of tourists and investors, especially from India and China. On 26 November 2023, the Malaysian government announced a 30-day visa-free entry into Malaysia for visitors from China and India, effective from 1 December 2023. Historically, China tourists have been a significant contributor to Malaysia’s total international tourist arrival, constituting 19% while India accounted for 5%. Meanwhile, the Malaysian government has announced the next Visit Malaysia Year to be held in 2026, with a target of attracting over 26mil foreign tourists, equivalent to the pre-pandemic level in 2019. These initiatives are expected to support Tourism Malaysia’s projection of international tourist arrivals in Malaysia for 2024F, targeting a 24% YoY growth to 20mil, reaching 76% of the level observed in 2019. Furthermore, these measures are expected to further enhance footfalls in tourist-centric shopping malls such as Pavilion Kuala Lumpur, Sunway Pyramid and Suria KLCC.

• Installation of electric vehicle (EV) charging bays in shopping malls to enhance ESG profile. Growing awareness of the environmental impact of regular cars is driving increased popularity for EV. This year, a noticeable trend has emerged among shopping malls in the Klang Valley, such as Sunway Pyramid, Pavilion KL and Mid Valley Megamall, where an increasing number of malls have begun installing EV charging bays in parking facilities. Meanwhile, Hektar has partnered with GMA Resources to install 13 EV charging bays in all 6 of its shopping malls, commencing from 1 January 2024. In the long term, as the adoption of EVs increases, malls offering EV charging bays could potentially raise their ESG profiles, in which Sunway REIT currently has the highest rating of 4-star amongst our sector coverage.

• Our top BUYs are Pavilion REIT (FV: RM1.62/unit), IGB REIT (FV: RM1.92/unit) and YTL REIT (FV: RM1.11/unit). For Pavilion REIT, we foresee earnings to be resilient, mainly underpinned by its prime asset portfolio as anchored by Pavilion Kuala Lumpur and Elite Pavilion Mall, which are tourist hotspots that will benefit from the return of international tourists. Further increase in earnings is expected from Pavilion Bukit Jalil (PBJ) in 2024F. We believe PBJ is positioned for a positive rental reversion in 2024F, supported by improving footfall traffic and occupancy rates. We like IGBREIT due to its resilient long-term outlook underpinned by the group’s strategically located assets in the heart of Klang Valley. Robust demand for its retail lots is evidenced by near-full occupancy rates. YTLREIT is another of our top picks due to stable recurring rental income and minimal occupancy risks for its hotel properties in Malaysia and Japan, which are secured by master lease agreements. Additionally, we anticipate higher FY24F-FY29F distributions due to the receipt of rental repayments which have been deferred earlier in the pandemic years of FY21-FY22. Currently, the stock already offers an impressive FY24F dividend yield of 10%.

• Attractive sector valuation at an average yield spread of 3.6%. This compares to the 5-year median yield spread of 2% from 2017-2022. Meanwhile, the expectation of widening yield spread due to the lowering of 10-year MGS yield to 3.8% in 2024 (Exhibit 12) will provide further upside to REIT valuations (Exhibit 10).

• Key considerations for downgrading the sector to NEUTRAL: (i) higher-than-expected interest rate hikes in the US that will not only just weaken the ringgit but also narrow yield spreads against 10-year MGS; and (ii) stagflationary risks, which could substantively dampen revenue and earnings prospects due to lower occupancy rates for REIT assets, negative rental reversions and the likelihood of rental rebates to be offered again to tenants.

• Key risks for the sector: (i) Escalation of geopolitical tensions could disrupt global trade and supply chains, leading to a prolonged period of elevated inflation. Consequently, 10Y MGS yield may persist at a higher rate if benchmark interest rate cuts in developed economies do not materialise; and (ii) continued high interest and inflationary rates will weigh down on personal consumption due to higher borrowing costs and prices for consumer goods. This could lead to the softening of tenant sales and hotel occupancy rates as consumers turn cautious in spending on discretionary goods and leisure activities.

Source: AmInvest Research - 5 Jan 2024