Outlook for Retail and Office Space Remain Lacklustre Due to Incoming Supply in the Pipeline. However We Believe REITs Located in Prime Areas (KLCC Office Area and Prime Malls) With Long Term Tenancy Will be Able to Sustain Occupancy and Achieve Positive Rental Reversion. Furthermore, With the Advent of VMY2020, We Reckon Retail and Hotel Segments Will Benefit From This. We Keep Our MAG10YR Yield Assumption at 3.5% and Upgrade to OVERWEIGHT. Our Top Picks Are KLCCSS (BUY, TP: RM8.53) and Sunway REIT (BUY, TP: RM2.02).

Office REIT. The outlook for office space remains lacklustre due to an unabated glut (4.5% cumulative supply CAGR from 2014-18) with more incoming supply of c.18m sqft by 2022 (3.5% CAGR from 2019-22), adding to the current 128.8m sqft as at 3Q19 (Figure 1 & 2). Also, vacancy rates remain stable at 22.5% in 3Q19 (2Q19: 23.5%). KL city will feel the greatest impact, with c.11m sqft completing in the next 4 years. Given the oversupply situation, we believe positive rental reversion would be limited in the near term, barring the offices of KLCCSS due to its niche assets. Still we reckon there is some saving grace from the growing popularity of co-working spaces which presents an opportunity for REITs to lease out their offices to such operators.

Retail REIT. With the emergence of new malls in the coming years with at least 14.4m sqft retail space in pipeline (5.1% CAGR from 2019-21 with current supply of 65m sqft (see Figure 3 & 4)), we believe rental reversion in mass retail malls will be under pressure and remain soft on the back of an oversupply issue. However, prime malls should still continue to deliver defensive profits and achieve a decent rental reversion. Furthermore, with the expected arrival of 30m tourists in 2020 for VMY2020, we expect prime malls to record a strong growth due to its strategic location for tourist’s attraction. To back up with historical data, revenue for retail segments in KLCCSS, IGBREIT and PREIT saw a 7-8% increase during the VM2014 whilst on most other years, the increase was only about 2-3%. This shows that VMY has contributed positively to these REITs.

Industrial REIT. We see there is a demand in industrial properties driven by the surge in e-commerce activity (projected to grow at 11% CAGR according to A.T. Kearney), which has prompted more establishment of distribution centre by retailers and e commerce players and enhancement of infrastructure development. We believe there is strong growth potential for Axis REIT as a leading player in industrial segment with its strategy of pursuing quality acquisitions with focus on Grade A logistics and manufacturing facilities.

Widened yield spread. The yield spread between M-REITs and the 10-year MGS (MAG10YR) is currently at 2.72%, which is above +1SD with its 5-year mean of 1.958%. We believe that the yield spread has widened drastically in recent times given dovish expectations and heightened risk aversion. While there are some optimistic signs of cooling US-China trade tensions, we remain cautious and opine that downside risks will continue to persist. Consequently, our economics team expects BNM to cut OPR by 25bps by 1H20. As for our MAG10YR yield assumption, we leave it unchanged at 3.5% vs the current level of 3.24%, (FY19 average: 3.64%).

Upgrade to OVERWEIGHT (from Neutral) as we reckon that yield plays will remain in flavour with another OPR cut on the cards; REITs have generally performed well under dovish expectations. We like KLCCSS (BUY, TP: RM8.53) for its concentrated prime assets, Shariah compliant scarcity amongst REITs (only 4/18) and boost from VMY2020 (Suria KLCC and Mandarin Oriental). We also like Sunway REIT (BUY, TP: RM2.02) given its well-diversified portfolio in which the prominent assets are located at its unique township planning coupled with income contribution from newly acquired assets and positive outlook for their retail and hotel segments from VMY2020.

Source: Hong Leong Investment Bank Research - 10 Jan 2020