We are initiating coverage on Pavilion REIT (PAVREIT) with an OUTPERFORM recommendation and TP of RM1.41 based on target FY15E gross yield of 5.6% (net: 5.0%), suggesting a 10.2% total return. Its assets are located in KL Golden Triangle with Pavilion Shopping Mall being PAVREIT’s major earnings driver while Pavilion Office Tower only contributes 3.2% to its topline. Its location allows it to dictate high rental rates due to the much sought-after address. PAVREIT has a large asset base and low gearing of 0.16x, suggesting that it can borrow up to RM1.7b before reaching its internal gearing limit of 0.4x. We are assuming a more conservative valuation as we have used a similar spread to the 10-year MGS as IGBREIT (+1.8ppt), even though PAVREIT has a more visible asset acquisition pipeline compared to IGBREIT.

Strategically located assets that command high rental rates, with more room to grow. Pavilion Shopping mall (PSM) is able to command one of the highest rental rates in town at RM17psf (RM21psf with service charge), significantly higher than other KL malls such as Sungei Wang, Mid Valley and The Gardens. We do not believe that PAVREITs average rental rates have peaked as its most comparable mall, Suria KLCC, charges much higher rental rates at c.RM27psf (RM32psf with service charge) which suggest more room to grow for PSM in terms of reversions. We expect rental reversions of 5.0% in FY14 and 6.0% in FY15 for PSM, although organic growth rate for the group will be flattish, as only 17.0%-14.0% of areas are up for renewal in FY14-15E.

High exposure to retail suggesting stronger rental reversions compared to office and industrial assets. PAVREIT has extremely high exposure to retail in terms of its portfolio, with 89% of retail NLA and 11% office NLA, while the retail portion makes up 97% of GRI. We favour retailbased assets as they are known for their stronger growth potential compared to office and industrial assets due to their: (i) shorter lease terms and (ii) higher rental reversions as retailers compete to rent in prime malls. PAVREIT also has the second highest exposure to retail (by appraised value) of RM4.1b. It is preceded by IGB REIT’s RM4.8b.

Low gearing provides ample room for acquisitions. PAVREIT has an extremely low gearing of 0.16x, and is the lowest among the MREITs under our coverage and well below Securities Commission (SC)’s maximum gearing limit of 0.50x. A low gearing and large asset base does not only mean that PAVREIT assets have relatively lower financing costs compared to other retail MREITs but also greater acquisition power. PAVREIT can afford to borrow more compared to REITs with a smaller asset base before it reaches its maximum gearing level. Based on its internal gearing limit of 0.4x, PAVREIT is able to borrow up to RM1.7b for an asset acquisition before reaching the internal gearing limit.

Visible pipeline for asset acquisitions PAVREIT has a visible pipeline of assets, owning the ROFR (right of first refusal) to: (i) fahrenheit88, (ii) Pavilion extension, and (iii) USJ mall. While financing of these assets is not an issue given its low gearing, we believe the timeline for injection may only be in 2015 as the pipeline assets are not yet ripe for injection. The group is also open to third party acquisitions, but this may be challenging given the low cap rate environment. At the earliest, we believe that acquisitions are likelier towards 2015.

Initiating coverage on PAVREIT with OUTPERFORM and TP of RM1.41 based on a FY15E gross yield of 5.6% (net: 5.0%) which is on par to what we have applied for IGBREIT. Our TP implies a 10.2% total return, mainly from decent dividend yields. PAVREIT is trading at 5.9% gross yields (net: 5.3%) and it is well within MREITs’ (>RM1b mkt cap) gross dividend yield range of 5.2%-6.8%.

Source: Kenanga