Overwhelming retail and office space to worsen as a result of incoming supply in the pipeline. However we believe REITs located in prime regions with long term tenancy will be able to maintain occupancy thanks to heavy footfalls. We expect BNM to maintain the OPR at 3.25% in 2019. Also, the US Federal Reserve has adopted a less hawkish stance on its monetary policy. Hence, we foresee minimal risk on yield spread swinging drastically from its 5-year mean of 1.87%; presently the current yield spread is at 1.80%. All in, we keep our 10-year MGS yield assumption at 4.1% and maintain NEUTRAL call on the sector. Our top picks are IGBREIT (BUY, TP: RM1.91) and MQREIT (BUY, TP: RM1.23).

Retail. As at 3Q18, retail supply was well furnished with 63.7m sqft with an expected strong competition from incoming supply of 20.0m sqft by 2022. With retail space scheduled for completion, the oversupply issue is expected to worsen despite growing demand for e-commerce being a long-term risk. However, major retail REITs in Greater KL; which includes Mid Valley Megamall, The Gardens Mall, Suria KLCC and Pavilion KL Mall remains healthy, having a promising occupancy rate of 87.8% as at 3Q18 (FY17: 87.6%) mainly due to their prime location and catchment. Thus a stable rent is anticipated across all prime retail segments amidst the challenging retail environment. To compete with the online shopping demand, we can expect shopping malls to exercise more asset enhancement initiatives (AEI) as well as focus on tenant remixing to increase their F&B and entertainment mix in order to stay relevant.

Office. 3Q18 total office supply in Greater KL stood at 123.4m sqft, with an additional 20.0m sqft completing in the next 4 years. We do not expect the oversupply issue to be lifted in the near term as (i) a majority of the incoming supply are built without pre committed demand; thus taking a longer time to fill up occupancy and more incentives have to be offered to attract tenants; and (ii) average rentals see little or no growth due to wide availability of options, as newly-completed buildings are equipped with better specifications. Following that, we prefer key buildings with sustainable rental reversion and long weighted average lease expiry (WALE) that are less prone to the challenging market (for instance Menara ExxonMobil and Menara Petronas).

Lower risk on yield spread. The yield spread between M-REITs and the 10-year MGS (MAG10YR) is currently at 1.80%, which is in line with its 5-year mean of 1.87% (Figure #1). For 2019, we do not foresee this swinging drastically from its historical average. This comes on the back of expectations that US Fed rate incre ase has diminished from 3x to 2x for 2019. Back in Malaysia, we expect the hike pause from 2018 to continue into 2019; with OPR to maintain at 3.25%. This should alleviate some concerns on investments in REITs. As for our MAG10YR yield assumption, we leave it unchanged at 4.1%, (currently at 4.06%, stabilising from the high of 4.26% back in May 2018; (2018 average: 4.07%)). However, we do acknowledge the oversupply situation in the market is anticipated to worsen, due to the existing condition paired with the future incoming supply of more properties by 2022. Maintain

NEUTRAL on M-REITs.

Top picks. We continue to like (i) IGBREIT (BUY, TP: RM1.91) due to its concentrated prime assets, sustainable positive tenant sales growths and rental reversions and (ii) MQREIT (BUY, TP: RM1.23) given its sustainable attractive dividend yield of 7.9% (highest in our coverage), stable assets in prime locations with high occupancy rates and healthy WALE profiles.

Source: Hong Leong Investment Bank Research - 15 Jan 2019