We maintain MREITs at OVERWEIGHT. MREITs’ 1Q14 results were mostly inline, with the exception of SUNREIT, which exceeded our expectations due to our aggressive cost assumptions. The asset acquisition environment remains quiet and is expected to remain so for the next 6 months. While rising operating costs remains a threat to strong rental reversions in the short to medium term, the market has priced this in while analysts have also built in more conservative estimates. We also believe the market has priced in the effects of US QE tapering as the 10-year MGS appears to be desensitized to the last two rounds of tapering. 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. Our 10-year MGS target is maintained at 3.80% which is lower than current rate of 4.00% on the premise of a possible European QE. Maintain MREITs at OVERWEIGHT. Our TPs and CALLs are: KLCC (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). Our Top Pick is KLCC due to earnings excitement from a potential acquisition.

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 last year’s rental reversions were not as strong as previous years. AXREIT and IGBREIT performed better than others as core profits increased by 4%-9% due to: (i) the gain on disposal (RM1.6m) on Axis Plaza for AXREIT, and (ii) lower operating cost for IGBREIT. KLCC, CMMT and SUNREIT suffered 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, 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 require assets with 6%-8% NPI yields based on the REITs portfolio yield for the acquisition to be earnings accretive (with the exception of KLCC). 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 KLCC has the greatest likelihood of making acquisitions as its 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 poses 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; 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. As a significant portion of Malaysian bonds are held by foreign funds (est. 40%), 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). The ECB also announced (on 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 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 (4.0%) over the next 3 months, barring any unforeseen circumstances. We reiterate our view that the 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 base our MREITs valuations on a 10-year MGS target to 3.80%, 20bps from current levels.

Sector risks priced in, with large cap retail based MREITs rallying ahead of industrial and office MREITs. We believe that most of the risk to the sector as highlighted above has been priced-in. MREITs’ share prices have adjusted upwards slightly from previous lows earlier this year. Furthermore, KLCC will be included in the FBMKLCI, replacing IOIPROP effective 23 June 2014, which should fuel share price appreciation. MREITs’ average YTD returns were unexciting at 0.9%, but large cap retail based MREITs (i.e. SUNREIT, KLCC, PAVREIT, CMMT and IGBREIT) led the way with share prices rallying the most YTD (+1.7% to +13.6%), compared to smaller cap retail based REITs (-0.8% to -8.5%), and office and industrial based MREITs (-5.5% to -7.8%) as retail-based MREITs: (i) are more sensitive to bond yield reversals (as the 10-year MGS has declined from a year high of 4.3% on 27th Jan-14 to 4.0% currently) and (ii) tend to fetch stronger rental reversions, and as such to record better organic growth. AXREIT (an industrial/ office-based REIT) also had a strong rally among other MREITs (achieving YTD gains of 12.0%) as investors chased the disposal gains which will be distributed in tranches while organic growth remains relatively less exciting than retail-based MREITs.

KLCC our Top Pick for 3Q14. KLCC has obtained shareholders’ approval during the recent AGM (17-Apr) for up to 10% placement, which should raise funds of between RM1.1b-RM1.2b for a potential acquisition. The asset acquisition environment remains challenging due to the low cap rate environment at present (5%-6%). However, KLCC benefits from this as the REIT’s effective cap rates are one of the lowest at 5.5%, close to current market’s expected rates for both retail and office assets. Additionally, in a rising cost environment, we are not worried about cost increases for KLCC as experienced by other MREITs as the group has successfully passed on the costs via Triple-Net-Lease (TNL) arrangements or have location advantage (e.g. Suria KLCC). KLCC’s net gearing is also low (0.17x) compared to other MREITs under our coverage (0.24x-0.32x), implying less financing costs and greater acquisition power. KLCC’s FY15E net yield of 5.0% is at the lower end compared to other MREITs under our coverage of 5.2%-6.5, but we believe there is more earnings excitement for KLCC from a potential acquisition.

Maintain MREITs at OVERWEIGHT. Our house view is that a European QE would be a positive re-rating catalyst to our MREITs’ valuations as this could put downward pressure on MGS yields, compelling us to rebase our target 10-year MGS yields at 3.80%, 20bps lower than current levels. We are maintaining our yield spreads to the 10-year MGS to derive our TPs as yield spreads do not change significantly unless there is more than 50 bps change in bond yields. Maintain MREITs at OVERWEIGHT as all our MREITs (save for AXREIT) warrant OUTPERFORM calls at this juncture with more than 10% total returns. Our CALLs and TP’s are: KLCCSS (OP; TP: RM6.90), SUNREIT (OP; TP: RM1.56), CMMT (OP; TP: RM1.59) and IGBREIT (OP; TP: RM1.35). We continue to recommend UNDERPERFORM for AXREIT (TP: RM3.08) as the stock has run up the most (YTD gains of 12.0%).

Risks to our call. Thus far, we have accounted for the effects of a rising cost environment. However, worse-thanexpected rising cost and weak rental reversions would bite into earnings and dividends. The US Fed has also announced that they are planning on increasing interest rates 6 months after the Fed completes tapering. Should markets continue to anticipate an interest rate hike in the US, this may cause Malaysian bond yields to increase slightly, which may put some downward pressure on MREITs share prices.

Source: Kenanga