We are upgrading MREITs to OVERWEIGHT (from Neutral). MREITs’ 1Q14 results were mostly inline, with the exception of SUNREIT which exceeded our expectations due to our aggressive cost assumptions. While the asset acquisition environment remains quiet, rising costs may threaten strong rental reversions in the short to medium term, although the market has priced this in while analysts have also built in more conservative estimates. We also believe market has priced in the effects of US QE tapering as bond yields have plateaued close to 4.00%, currently. However, the possible implementation of a European QE would be a positive re-rating catalyst to our MREITs valuations as bond yields may see further downward pressure. As such, we have revised our 10-year MGS target to 3.80% (from 4.15%) and also rolled forward our valuation basis to FY15E. Upgrade MREITs to OVERWEIGHT. Our TPs and CALLs are: KLCCSS (OP; TP: RM6.90), SUNREIT (OP; TP: RM1.56), CMMT (OP; TP: RM1.59), IGBREIT (OP; TP: RM1.35) and AXREIT (UP; TP: RM3.08).

1Q14 results review. All the MREITs under our coverage performed within expectations, save for SUNREIT which came in above our expectations, but within consensus’ due to our aggressive cost assumptions. On a QoQ basis, revenue growth was flattish at (-1% to 3%) for all MREITs under our coverage, as the past year’s rental reversions could not have been fully recognized by 1Q. The outliers were AXREIT and IGBREIT with core profits increase (4%-9%) due to: (i) the gain on disposal (RM1.6m) on Axis Plaza for AXREIT, and (ii) lower operating cost for IGBREIT, while KLCC, CMMT and SUNREIT saw declining earnings (-1%-6%) due to: (i) slightly lower share from associates and increased taxation cost for KLCC, (ii) increased operating cost for CMMT, and (iii) increased operating cost from assessment rate provisions and a weaker hospitality and office segment for SUNREIT. On a YoY basis, topline growth was strong for most retail based REITs such as CMMT, KLCC and IGBREIT at 6%, 10% and 13% due to positive rental reversions and relatively stable occupancy rates. IGBREIT’s core net profit was the strongest at 17% growth YoY mainly due to the full year effect of FY13’s strong rental reversions, while other retail REITs recorded 7%-8% gain, save for KLCC at 87% due to the lower taxation/MI structure from the stapled REIT. Industrial REIT, AXREIT recorded unexciting topline growth of 2%, while core net profits increased by 9% (1% after excluding the gains on disposal).

No acquisitions at half year mark. We reiterate our stance that the low cap rate environment has made asset acquisitions tough for MREITs. Among the REITs under our coverage, none have made any acquisition since Jan-13, although the likes of AXREIT, CMMT and KLCC appear to be preparing for acquisitions given their existing placement mandates. We believe cap rates are as low as 5%-6% currently, while MREITs under our coverage would prefer assets with more than 6% NPI yields for the acquisitions to be earnings accretive. AXREIT is eyeing RM380m worth of industrial assets in FY14 and is targeting an acquisition by 3Q14. AXREIT has renewed a placement mandate to increase the existing fund size by 18.65% (86m units), while CMMT had previously extended the time frame for listing approval of 20% of its fund size by six months to 1st April 2014, which it did not utilise. KLCC has recently obtained its shareholders’ approval during its AGM (17-Apr) for up to 10% placement, which should raise funds of between RM1.1b-RM1.2b and management has highlighted that they are focusing on assets within the Golden Triangle. Out of all the MREITs, we reckon KLCCSS has the greatest chance of acquisitions as their REIT cap rates are the lowest in town at 5.5%. Overall, we expect MREITs to focus on organic growth going forward, while some MREITs like AXREIT may look to dispose matured or weak assets within its portfolio in light of low cap rates.

Rising cost may mute strong rental reversions in the short to medium term. The current environment possess various threats to MREITs such as; (i) potential higher assessment rates by DBKL, which MREITs may pass partly or fully to tenants which might affect other rental reversion opportunities – however, most MREITs which have asset exposure in KL have already made quarterly provisions while we have also taken this into account in our estimates, so the issue is less of a threat now, (ii) cost push effects of subsidy rationalization (e.g. electricity hikes, which will be borne directly by the tenants) which may affect quantum of rental reversions, (iii) slower step-ups for office spaces given the glut in Klang Valley while retail space supply is also increasing at a faster rate, (iv) consumer spending is expected to plateau in 2014, (v) retailers are facing increasing competition, and (vi) looming GST implementation in Apr-2015; the REITs may have to accept softer rental reversions to maintain occupancy or ensure tenant’s sustainability.

Bond yields have plateaued, but may decline should ECB monetary stimulus (European QE) materialise. It is important to note that a significant portion of Malaysian bonds are held by foreign funds (est. 40%). As such the direction of Malaysian bond yields is heavily influenced the inflow and outflow of foreign funds. We maintain our outlook that the US Fed will continue to taper bond purchases progressively over 2014. There has been a positive inflow of funds into the local market since May-14 and we do not expect a sharp increase of Malaysian bond yields at this juncture as the positive carry trade story may continue while we believe the Malaysian markets have already priced in the effects of the US bond tapering. On the flip side, we may see another round of hot money entering the Malaysian economy with an increasing possibility of the European Central Bank monetary stimulus (European QE) occurring this coming June-14. The ECB also just announced (5th June 2014) a deposit rate cut to -0.1% which is designed to encourage lending. The effects of a European QE or rate cut would be similar to the US QE3 back in Sept-12, whereby we can expect Malaysian bond yields to compress further, as seen in the chart below.

We think that bond yield compressions will come soon. Prior to the US QE1 (25th Nov 2008) and ECB’s monetary stimulus (26th Nov 2008), the MGS was at 4.14% from the high of 5.00% in Sept-08. The MGS retraced to as low as 2.97% in Jan-09, by almost 120bps since the QE announcements. Undeniably, there could have been some overlap between the impact of US 1st QE and ECB’s monetary stimulus due to the close timing of those announcements i.e. net impact to yields. However, our in-house economists take the stance that the European QE stimulus will have more of an effect than the priced-in US QE tapering exercise and believes that the 10-year MGS yield may contract further by 10-20bps from current level (4.04%) over the next 3 months, barring any unforeseen circumstances. We reiterate our view that we believe market have been de-sensitized to the effects of the US QE tapering and will be more excited towards a European QE. As such, we have revised the basis of our MREIT valuations, i.e. target yield based on spreads to bond yields, and thus is lowering our 10-year MGS target to 3.80% from 4.15%.

Source: Kenanga