To recap, it was a fairly satisfactory 2Q19 for REITs, where 6 out of 7 REITs under our coverage recorded core earnings that were in-line with expectations. 2Q19 sector earnings declined 5.9% QoQ (seasonality) but increased 2.7% YoY. We lower our 10-year MGS yield assumption for our stock valuations to 3.5% (from 3.7%) to reflect current rates which has been softening for the past 3- months by -0.37ppt to 3.264%. We see an encouraging prospect for industrial REIT segment driven by rising demand in logistics facilities and new REIT guidelines. However, office REIT and retail REIT remains a challenging segment due to oversupply issue. Despite expectations for another OPR cut, these fundamental challenges prompt us to stay NEUTRAL on REITs. Still, there are selective REITs that we like to ride on this broader OPR cut theme: Axis REIT (TP: RM2.01) and KLCCSS (TP: RM8.53). Other BUY is IGB REIT (TP: RM2.17)

Recap of past results season. It was a fairly satisfactory quarter for REITs where 6 out of 7 REITs under our coverage recorded core earnings that were in-line, and the only exception was MQREIT, posting softer-than-expected core profit due to revenue weakness mainly from Platinum Sentral, Wisma Technip and QB5.

QoQ. 2Q19 sector earnings declined by 5.9% due to seasonality where 1Q operates on a higher revenue base (from festive season such as Chinese New Year and Valentine Day). Meanwhile, operating expense for the sector was flat (+0.6%). Top earnings decliners QoQ were MQREIT (-15.2%) and PREIT (-14.5%). The former registered poorer revenue contribution by Platinum Sentral (SPAD downsized & MyHSR moved out in May), Wisma Technip (tenant downsized) and QB5 (IBM moved out in April) whereas the latter recorded lower earnings due to decrease in revenue rent in Pavilion KL and higher marketing and promotional costs at Da Men Mall.

YoY. Higher 2Q19 sector gross rental income (+4.6%) has led to higher net profit (+2.7%). Positive outliers were Axis REIT (+18.2%), IGB REIT (+11.0%) and Sunway REIT (14.6%). The improved performance in Axis REIT was primarily due to the completion of acquisition in Axis Shah Alam DC4 and commencement of lease in Axis Mega DC, whilst IGB REIT was thanks to higher rental income (increased in rental reversion). Sunway REIT’s better showing was attributable to the ‘Others’ segment given the addition of Sunway university & college campus (acquired in Apr 2019).

OPR. Although BNM maintained the OPR at 3.00% on 12 Sept, our economics team expects a 25bps cut within the next 6 months following an escalation of the US-China trade war and dovish tone by global central banks. An easing interest rate environment will result in lower borrowing costs for REITs to acquire future assets. As depicted in Figure #7, KLREI index has shown somewhat an inverse correlation to the OPR, with part of the former’s movement leading the latter (i.e. KLREI increasing before an OPR cut, vice versa). This is not entirely surprising as investors view REITs as perhaps an indirect substitute to fixed income instruments.

Widened yield spread. The yield spread between M-REITs and the 10-year MGS (MAG10YR) is currently at 2.91%, which is above +2SD with its 5-year mean of 1.92% (Figure #6). We believe that the yield spread has widened drastically in recent times as a result of further OPR cut expectations and heightened risk aversion. To keep abreast with the current 10-year MGS yield (which has been going down for the past 3-months to 3.264% by -0.37ppt), we lower our assumption to 3.5% (from 3.7%); YTD average is at 3.72%.

Outlook. Another OPR cut (as hypothesised by our economics team) will bode well for share price of REITs given the inverse relationship as previously explained. The defensive appeal of REITs (via dividends) should also stand out given the uncertainties from external headwinds and risk aversion in the equity market.

Our Outlook for Each REIT Sub Segment Is as Follows:

Industrial REIT: We see encouraging prospects for this segment driven by the increasing demand in logistics facilities and the new REIT guidelines (effective 9 Apr 2018). The surge in e-commerce activity has instigated more establishment of distribution centre by retailers and e-commerce players and enhancement of infrastructure development. Meanwhile, the new REIT guideline of allowing REITs to undertake property development activities (capped at 15% of total asset value) acts as a catalyst to encourage built-to-suit (BTS) properties as they have higher potential for better net property income (NPI) yields and allows REITs to own high quality products built to specifications. This also enhances Malaysia REITs to level up with the regional trends of global REITs BTS development. We see that this is a good opportunity for Axis REIT to beef up its portfolio as the leading player in the industrial segment.

Office REIT: Market outlook for office REITs remain lacklustre due to unabated oversupply of office with incoming supply of approximately 18.0m sqft by 2022 while the vacancy rates continue to increase. KL city will feel the greatest impact, with approximately 11m sqft completing in the next 4 years according to Savills Malaysia. The opening of Exchange 106 (expected next month) and PNB 118 will further amplify supply. Market absorption in Greater KL has lagged over the past 3 years, with the absorption in 2017-18 being on half of the space in 2013-14. Hence, we remain cautious on MQREIT due to its portfolio comprising of 100% office.

Retail REIT: This segment also seen vulnerable with the emergence of new malls and strong competition in the coming years with at least 14.4m sqft retail space in pipeline according to Savills Malaysia. Although occupancy rate of major malls remain healthy (recorded 87% as of 2Q19), new malls are struggling to reach high occupancy on opening. This is as retailers are spoilt for choice given the influx of retail space over the past few years. Nonetheless, prime malls such as Suria KLCC, Sunway Pyramid, Pavilion KL, Mid Valley Megamall and The Gardens Mall continue to be the market leader and recorded strong growth despite the oversupply. Therefore, we remain positive on IGBREIT, KLCCSS, Pavilion REIT and Sunway REIT due to the prime positioning and performance of their malls.

Forecast. Unchanged.

Retain NEUTRAL. We reckon that the upside to REITs from another OPR cut is balanced by the fundamental challenges of office and mall oversupply. As such, we remain stock specific in our approach on the sector. Following the cut in our 10-year MGS yield assumption (from 3.7% to 3.5%), our valuation for REITs (based on historical spread between REITs dividend yield and 10-year MGS yield) are increased.

Top picks: (i) We like Axis REIT (BUY, TP: RM2.01), in view of high occupant tenancy in its diversified portfolio with big expansion plans, and (ii) KLCCSS (BUY, TP: RM8.53) for its concentrated prime assets, sustainable positive tenant sales growths and stimulating outlook for the upcoming Visit Malaysia 2020.

Source: Hong Leong Investment Bank Research - 3 Oct 2019