To recap, it was a fairly decent quarter for REITs where 2 out of 7 stocks under our coverage recorded core earnings that were in line, 2 were above while 3 were below expectations. Overall, the performance was affected by Covid-19 headwinds, mainly coming from rental support granted to non -essentials retail tenants/hoteliers during MCO/CMCO/RMCO periods. We are expecting a slow rebound in 2H for the REIT, as some of the rental assistance s are being extended to 3Q, and we are hopeful none will be given in 4Q, hence suggesting a gradual recovery for the REIT’s earnings. Besides, we foresee another OPR cut, which will bode well with REIT stocks but we also acknowledge the negative impact that Covid-19 will have on them (particularly retail and hotel industries). Hence, we maintain NEUTRAL rating on the sector. Furthermore, at the current level, the average yield for our stocks in coverage seems decent at 4.6%. Our top picks are MQREIT (BUY; TP: RM0.92) and Axis REIT (BUY; TP: RM2.49).

Fair 2Q20 results. The recently concluded 2Q20 results season was a fairly decent one for REITs where 2 out of 7 stocks under our coverage recorded core earnings that were in line, 2 were above estimates while the other 3 were below expectations. KLCCSS and MQREIT were above expectations as the former’s MCO/CMCO impact from in 2Q being less severe than we initially thought it to be, while the latter was due to lower-than-expected expenses. Meanwhile, CMMT, IGBREIT and SUNREIT were below estimates due to the lower-than-expected rental income arising from rental assistance to its tenants.

Rental assistance to be extended into 3Q. We gathered that some REIT managers are extending their rental assistances (i.e. rebates, deferment, and advertising assistance) into 3Q (see Figure #1) as some of their tenants have not started operation in 3Q. However, we believe the magnitude of the measures should be lesser as the situation has improved in 3Q. Shopping malls with flagship neighborhood and high bargaining power should be able to give out lesser relief as footfalls and tenants’ sales have improved significantly (estimated about 40-60% increase in footfall during CMCO/RMCO as compared to MCO period ). We do not expect any rental assistance to be given in 4Q unless Covid-19 situation worsen and prompts another lockdown. Overall, we are expecting a gradual recovery in 2H as we think that shoppers traffic and tenant sales may not be able to revert to pre-Covid 19 level in the absence of international tourists.

Flattish to mildly-negative rental reversion is expected for mall. We believe prime malls should be able to register flattish rental reversions and able to sustain their occupancy rates due to strategic locations that become attractions among retailers. However, other malls with weaker bargaining power are likely to give out mildly negative rental reversion in order to retain their tenants. Meanwhile, for office REIT and industrial REIT, we expect the rental reversions to remain flattish or slightly positive in view of their operation has remained intact even during the MCO/CMCO periods.

Hotel REIT expected to remain subdued ahead. Hotel segment has been hard hit by the profound Covid-19 outbreak and the implementation of restricted movement. We have seen that hotel occupancy deteriorated greatly in 2Q20 as a result of the pandemic, with corporates and leisure restricting travel during the MCO and CMCO periods. Although we saw some slow recovery in hotel occupancy (especially resort type hotel) arising from domestic tourism, we believe hotels in KL city will remain under pressure due to the lack of business travel, bleak hospitality and tourism outlooks as international borders remained closed.

Defensive stocks gaining investors’ interest. During 1H, we observed that Axis REIT and MQREIT have gained investors’ interest amid the pandemic situation given their defensive nature, paired with resilient earnings. Axis REIT’s and MQREIT’s 1H20 earnings have shown increments of +5.5% YoY and +8.4%YoY, respectively. Axis’s share price has appreciated +23% YTD, while MQREIT’s share price has fallen -18% YTD (but +55% since the sell-down in March). We believe MQREIT is still underappreciated and has more room to rise given its robust 1H20 earnings and high dividend yield. Meanwhile, Axis REIT’s robust growth prospects and resilient earnings will continue to be favored by investors during this challenging period, amid economics uncertainties.

Positive on OPR cut. So far, BNM has cut the OPR four time this year (totaling to - 125bps) amid slower domestic growth and worsening global economic conditions (due to the Covid-19 outbreak). Our economics team opines that there is another -25bps cut on the cards for 2H20, bringing the policy rate to 1.50%, which could happen as soon as the Sep MPC meeting. An easing interest rate environment will result in lower borrowing costs for REITs to acquire future assets. Furthermore, we believe REITs will be able to save some cost on their financing for floating rate borrowings, which will help support their earnings. (See Figure #5 for 1H20 financing cost comparisons).

Widened yield spread. The yield spread between M-REITs and the 10-year MGS (MAG10YR) is currently at 4.11%, which is above +2SD with its 7-year mean (since 2014) of 2.22%. We believe that the yield spread has widened drastically in recent times given the OPR cut and heightened risk aversion. The widened yield spread also suggests that REIT’s yield plays will remain in favor as compared to government bonds. To keep abreast with the current 10-year MGS yield (now trading at 2.557%), we lower our assumption to 3.00% (from 3.25%); YTD average is at 2.91%. New TPs are shown in Figure #7.

Maintain NEUTRAL. While the low interest rate environment bodes well for REIT stocks, we also acknowledge the negative impact that Covid-19 will have on them (particularly on retail and hotel industries). Furthermore, at the current level, the average yield for our stocks in coverage is decent at 4.6%.

Top picks. Our top picks are MQREIT and Axis REIT. We like MQREIT (BUY; TP: RM0.92) for its attractive dividend yield of 8.8% (highest among REITs in our universe) and its relatively more resilient earnings amid Covid-19 given minimal retail exposure unlike other mall-based REITs. We also like Axis REIT (BUY; TP: RM2.49) in view of increased popularity in industrial properties, high occupant tenancy in its diversified portfolio, shielded from the Covid-19 impact and one of the few Shariah compliant REITs. Other buy is SunREIT (BUY; TP: RM1.82).

Source: Hong Leong Investment Bank Research - 8 Sept 2020