OPR cut to 3.00% enhances the appeal on REITs under this cautious market environment. We see REITs located in prime regions with long-term tenancies to hold up their occupancy rates. Also, rising demand for industrial properties makes it a sort after sub-sector in the forthcoming 2H19. Overall, we maintain NEUTRAL on the sector, with top picks being Axis REIT (BUY, TP: RM1.93) and IGBREIT (BUY, TP: RM2.15).

OPR cut. Bank Negara Malaysia (BNM) reduced the overnight policy rate (OPR) by 25bp to 3.00% (from 3.25%) back in May 2019. However, KLREIT Index has been rising since March 2019 due to anticipation of a rate cut. With this, it encouraged the market to favour REITs given its defensive nature and often being sort after during monetary easing episodes (ability to provide higher dividend yields). Besides, an interest rate cut will result in lower borrowing costs for REITs to acquire future assets. The possibility of another OPR cut in 2019 cannot be excluded due to the Fed’s dovish tone; however our house view is no change in OPR for the rest of the year.

Retail. The retail oversupply issue is expected to worsen with supply in KL City expected to reach 14.1m sqft (4 year CAGR: +6.1%) by 2022 (1Q19: 11.3m sqft). However, major prime located retail REITs under our coverage have promising occupancy rate in 1H19 and we expect it to persist on to 2H19. This is because of their strategic location that enables them to continue having heavy footfall. Hence, we do anticipate sustainable positive rental reversion across all prime located malls because of their location driven perk, apart from active asset enhancement initiatives (AEI) being performed to keep the malls updated.

Office. In Greater KL, the total offices incoming supply is approximately 18.0m sqft by 2022; with a huge chunk of 11.3m sqft expected in the KL City (4 year CAGR: +4.0%). Currently as at 1Q19, KL City’s supply stood at 46.3m sqft with vacancy rate of 24.0%; the latter has been rising and we feel the trend is likely to continue as (i) a majority of the incoming supply are built without pre-committed demand; and (ii) rental has largely remained stagnant in the last 3 years due to plenty of options in the market. Hence, we prefer key buildings with sustainable rental reversion and long weighted average lease expiry (WALE) that are less susceptible to the challenging market.

Industrial. There has been increasing number of businesses that are embracing Industry 4.0 and expanding their reach through the e-commerce platform. Demand for industrial properties is mainly driven by the logistics and warehouse segments which are largely backed by the emergence of e-commerce. We note that rental for industrial properties rose 30% over the past 2 years; this shows that industrial lands are increasing in popularity. In addition, the new REIT guidelines (effective 9th April 2018) of allowing REIT to undertake property development activities (cap to 15% of total asset value) acted as a catalyst to encourage the matter as shorter duration and lesser capital expenditure required for constructing industrial property versus acquisitions. Also, industrial properties are fitting with its usual long lease agreements and stable revenues it offers. Overall, an encouraging scene for this segment.

Maintain NEUTRAL. We maintain NEUTRAL given the general surging oversupply situation however offset by the appeal of REITs given the cautious stance in the market. Following the OPR cut and dovish tilt by major central banks, we cut our assumptions of 10-year MGS yield from 3.9% to 3.8%, and roll forward our valuation to FY20. To note, our valuation model is based on the targeted yield of 2-year historical average yield spread between dividend yield and 10-year MGS yield, with the exceptions of Axis REIT and IGB REIT (for these 2 companies, we used 1SD below the 2 year historical average yield spread between dividend yield and 10-year

MGS yield in view of increased popularity in industrial properties and being a major prime retail REIT, respectively.

Rating changes. We upgraded our rating on Axis REIT to BUY (from Hold), while other REIT stock ratings remain unchanged. We feel strongly on Axis REIT because:

(i) It has a diversified portfolio of 45 properties that are made up of warehouse logistics (44%), manufacturing facilities (30%), office/industrial (17%), office (5%) and hypermarkets (4%); with 91% properties owning the industrial titles.

(ii) Having offices that are mainly located in the suburbs, congestion in Petaling Jaya makes it conveniently shielded by the heavy oversupply and occupancy issue which is occurring in the heart of Kuala Lumpur.

(iii) Axis REIT has a high average occupancy rate of 94% (1Q19), with 34 properties enjoying 100% occupancy.

(iv) Also, it is one out of the only 4 REITs that are listed as Shariah (out of a total of 18 listed REITs), being the second largest market cap of the companies, behind KLCCSS and followed by Al-‘Aqar Healthcare REIT and Al-Salam REIT.

(v) With the OPR cut, we anticipate the lower interest rates would lead to a lower interest expense that we feel Axis REIT would benefit with the reduction in financing costs, being that 44% of their borrowings are made up of floating rate (gearing 1Q19:38%).

Top picks. (i) We like Axis REIT (BUY, TP: RM1.93), in view of high occupant tenancy in its diversified portfolio with big expansion plans, and (ii) IGBREIT (BUY, TP: RM2.15) for its concentrated prime assets, sustainable positive tenant sales growths and rental reversions.

Source: Hong Leong Investment Bank Research - 16 Jul 2019