To Recap, It Was a Fairly Decent Quarter for REITs Where 6 Out of 7 Under Our Coverage Recorded Core Earnings That Were In-line. We Have Cut Our Earnings by -8.6% to -21.7% to Impute the Negatives From Covid-19. With the Recent Share Price Fall (KLREI Dropped -19.8% in the Past 2 Days From Its Highest Peak on Aug 2019), We Feel That These Negatives Have Been Well Reflected. As Such, the Positives From a Dovish Setting (expect Another -50bps OPR Cut), Should Outweigh From Here On. Maintain OVERWEIGHT With Top Picks Being Axis REIT (TP: RM2.46) and KLCCSS (TP: RM8.17).

Recap of past results season. The recently concluded 4Q19 results season was a fairly decent one for REITs where 6 out of 7 under our coverage recorded core earnings that were in-line. The only exception was KLCCSS (missed estimates), due to higher MI; if not for this, KLCCSS’s core PAT was within our expectations at 98% of full year forecast.

Positive on OPR cut... So far, BNM has cut the OPR twice this year (totalling -50bps) amid slower domestic growth and worsening global economic conditions (due to the Covid-19 outbreak). Our economics team opines that there is another -50bps cut on the cards for 2020, bringing the policy rate to 2.00%, which could happen as soon as the 5 May MPC meeting. An easing interest rate environment will result in lower borrowing costs for REITs to acquire future assets. Furthermore, we believe that REITs will be able to save some cost on their financing for floating rate borrowings, which will help support their earnings. (See Figure #1 for debt profile of REITs under our coverage). Additionally, we also believe that a dovish environment bodes well for REITs given (i) broad inverse relationship between REIT’s share price and OPR; Figure #8 and (ii) defensive appeal amid the current market uncertainty.

…but Covid-19 may impact retail and hotel segments. With Covid-19, the targets set under Visit Malaysia Year 2020 (VMY2020) are pretty much derailed (30m tourists and RM100bn receipts). The outbreak has led to a fall in travel plans and discouraged people from going out in general. As a result, footfall rate in the malls and occupancy rate in the hotel has been declining since the outbreak. Retail associations said many members have reported sales dropping by as much as 50%, with some expecting revenue to decline by more than 80% over the next three months. Moreover, retailers are urging mall to provide rebates of 30-50% for a period of 6 months since Feb 2020. Other than that, Malaysia Association of Hotel reported a total of c.96k room cancellations due to Covid-19 resulting in a loss of revenue of over RM40m at that point of time. Some REIT management have also shared that they have seen cancellations of rooms and events bookings in their hotel.

Too early to accurately assess the impact. We are unable to fully pencil in the magnitude of the decline at this juncture due to uncertainties of this outbreak . In addition, Malaysia Shopping Malls Association said they shall need more time for monitoring sales turnover over the next few months, depending on further development of the current situation. To help combat with the cautious consumer sentiment, malls are undertaking more thorough hygiene and cleanliness measures for shoppers. Some REIT management also said that some retailers have asked for rental rebates but it is too early for them to grant their wishes as it is normally a quiet period post CNY break and school reopening. However, REIT management said that they will be doing a more rigorous on-going marketing and promotions programs, designed to support tenants during this lull period.

Stimulus packages should aid the scenario. Government announced a 15% discount in monthly electricity bills to hotels, travel agencies, airlines, shopping malls, conventions and exhibitions centres from Apr-Sept 2020 and 6% service tax exemption for hotels from Mar-Aug 2020. The 15% electricity bill discount will help REIT to reduce operating cost, while the 6% service tax exemption may aid hotel demand. However, these positives may be partially offset by the Government’s moral suasion for them to offer hotel discounts and lower shopping mall rent. Furthermore, personal income tax relief of up to RM1k on expenditure related to domestic tourism and digital vouchers for domestic tourism of up to RM100/person for domestic flights, rails and hotel accommodation should help mitigate the impact of declining footfall rate in malls and occupancy rate in hotel as it may encourage domestic tourism.

Exposure on hotel and retail segments. There are 6 stocks under our REIT coverage that have the exposure on hotel and retail. (See Figure #2). Should Covid- 19 prolong, it is not farfetched to envisage this impacting their earnings from (i) lower footfall at malls leading which pressures management to offer rent rebates and (ii) lower hotel occupancy from travel restrictions and contagion fears. Moreover, landlords (i.e. REITs) will have to incur any cleaning and sanitisation costs should a case be detected within their premises. After running a sensitivity analysis on our stocks under our coverage (refer to Figure #3), we find that after imputing 10% rental rebate for about 6 months, our annual earnings decline is not more than 10%.

Movement Control Order. The Movement Control Order (MCO) is enforced from 18 to 31 Mar 2020, which includes closure of retail outlets and some hotels. However, based on our channel checks, malls will not be closed but opening is only limited to essential services such as supermarket, pharmacies, convenience stores, ATMs and clinics. Also, we gathered that most REITS have not firmed out any strategy moving forward in relation to rental during the MCO period; we do not rule out the possibility of “rent free” rebates accorded to tenants during the MCO period.

Widened yield spread. The yield spread between M-REITs and the 10-year MGS (MAG10YR) is currently at 4.53%, which is +4SD above its 5-year mean of 2.08% (Figure #4). We believe this drastic widening is a result of recent share price fall (which cause higher yield) alongside with further OPR cut expectations and heightened risk aversion. To keep abreast with the current 10-year MGS yield, we lower our assumption to 3.25% (from 3.5%); YTD average is at 3.07%.

Forecast. While it is still in the early days to pinpoint the exact dent to our REIT stocks’ earnings from Covid-19, we are revising our earnings as shown in Figure #5; with cuts ranging -8.6% to -21.7% for FY20 with exception on Axis REIT (due to newly acquired properties). The earnings cut largely stems from flat-to-negative rental reversion imputed for expiring tenancies and assumption on lower turnover sales from retail segments.

Retain OVERWEIGHT. While we acknowledge the negative impact that Covid-19 will have on REITs (particularly retail and hotel), we feel this has already been reflected by its recent share price fall (KLREI dropped by -19.8% in the past 2 days from its highest peak on Aug 2019). Furthermore, we have tried to best reflect the impact of Covid-19 via our earnings cut. With this in mind, coupled with continued dovish expectations (another -50bps OPR cut this year), we retain our OVERWEIGHT rating on REITs. Following the cut in our 10-year MGS yield assumption (from 3.5% to 3.25%) and earnings revision, our valuation for REITs (based on historical spread between REITs dividend yield and 10-year MGS yield) are changed; new TPs are shown in Figure #7.

Top picks. Our top picks are Axis REIT and KLCCSS. We like Axis REIT (BUY; TP : RM2.46) in view of increased popularity in industrial properties, high occupant tenancy in its diversified portfolio, shielded from the Covid-19 impact and also one of the few Shariah compliant REITs. We also like KLCCSS (BUY, TP: RM8.17) for its concentrated prime assets, Shariah compliant scarcity amongst REITs (only 4/18) and long-term tenancy agreement with Petronas. Other buys are IGB REIT (BUY; TP: RM1.83), SunREIT (BUY; TP: RM1.74) and newly upgraded MQREIT (BUY; TP: RM0.71)

Source: Hong Leong Investment Bank Research - 19 Mar 2020