We maintain our NEUTRAL view on MREITs as strong near-term catalyst for MREITs are generally lacking while downsides have been largely priced in. Asset acquisitions may pick up towards end-2015 and in 2016 as asset valuations are trending closer to more realistic cap rates. We are comfortable with our earnings estimates while operationally resilient MREITs include KLCC and PAVREIT which own stable assets. Our main concern is the bond market volatility due to on-going macroeconomic issues (i.e. possible interest rate increase by US Fed and weakening Ringgit). We had previously expected medium-term knee-jerk reactions up to 3Q15, pending more concrete news of the Fed’s interest rate decision, and once negative sentiment has subsided. However, this has taken longer than anticipated, compelling us to raise our 10-year MGS target to 4.00% (from 3.90%). As such, we lower all our TPs by 1.5% to 2.0% but maintain the calls. We advise investors to wait for the bond market to stabilize before selectively repositioning for MREITs, preferably those with betterthan- average earnings growth and strong yields. Our Preferred Pick is SUNREIT (OP; TP: RM1.73) due to strong earnings growth in FY16 mainly boosted by value accretion of Sunway Putra Place (SPP), and we also have an OP for PAVREIT. Meanwhile our recommendations on KLCC, IGBREIT, AXREIT, are all MARKET PERFORMs, while CMMT is UNDERPERFORM.

2Q15 results review. 2QCY15 saw AXREIT and CMMT coming in below expectations; (i) AXREIT was affected by untenanted assets, (ii) CMMT underperformed due to aggressive interest income estimates while IGBREIT exceeded expectations. This is slightly worse off than 1Q15 when only AXREIT came in below expectations. QoQ, GRI was mostly flattish to negative (-3%-1%). Bottomline followed suit, save for AXREIT, which saw higher RNI growth (5%) from better cost savings. Evidently, topline growth was weaker in 2Q15 (more flattish to negative) vs. 1Q15. YoY, GRI was mostly positive for all MREITs (2%-18%) while RNI was positive (2%-17%) for all MREITs except CMMT on higher financing cost and expenditure. Over the last reporting season, we trimmed FY15-16E earnings for CMMT, AXREIT and SUNREIT but upped FY15-16E earnings for IGBREIT.

Are fundamentals intact? We think so. In 2Q15, we continued to see MREITs facing weaknesses such as: (i) AXREIT’s weak office/multi-tenanted segment, (ii) CMMT’s negative rental reversions on one asset, Sungei Wang Plaza, and (iii) the hotel segment for SUNREIT and KLCC due to softer consumer spending. That said, we have already accounted for AXREIT’s weaker occupancy and CMMT’s negative rental reversions of -20% by trimming FY15-16E earnings for AXREIT, CMMT, and SUNREIT, while KLCC’s was left unchanged despite a weak hotel component as: (i) it makes up a small portion of revenue (c.10%), while, (ii) we believe a weaker Ringgit in 2H15 will help attract tourist arrivals to KLCC’s landmark hotel assets.

Operationally resilient MREITs include; (i) KLCC due to its long-term, triple net lease (TNL) offices and high-end mall that can weather the effects of GST better, (ii) PAVREIT due to its rock-solid occupancy and prime asset positioning. IGBREIT may surprise on the upside if tenant sales manage to weather the effects of GST, which could be a positive for turnover rent and GRI. Additionally, we do not expect any major surprises going forward (save for IGBREIT). We anticipate the upcoming 3Q15 results to be unexciting as MREITs under our coverage will see minimal leases up for renewal (between 0%-25% expiring in FY15), which would mainly happen in 4Q15.

FY15E unexciting in terms of organic growth. Evidently, average RNI growth in FY15 for MREITs under our coverage (save for AXREIT and CMMT), is generally less bullish at 4.4% vs. FY13 and FY14 of 9.7% and 6.7%, respectively as: (i) most MREITs will not see any major lease expiry’s in FY15 (up to 25% of NLA), and (ii) rental reversions are expected to be softer in FY15 due to rising cost pressures and GST suggesting that most earnings downsides have been accounted for. AXREIT and CMMT are exceptions because of new acquisitions. However,

FY16 will be slightly more exciting with higher lease expiries, (21%-67% of NLA). FY16 will be a major lease expiry year for PAVREIT (67% of NLA), and CMMT (47% of NLA), commanding 6% and 4% organic growth, respectively in FY16E, while other MREITs will see minimal lease expiry’s (20%-34% of NLA). 

GST will NOT have a direct material impact on MREITs. We do not expect any direct material impact to earnings from GST, which would inevitably be a replacement of the current 6% sales tax. As anticipated, in light of GST implementation on 1st April 2015), we expected that retail sales may slow down for 3-6 months as consumers will take time to acclimatize, while channel checks have suggested that tenant sales have slowed down c.1% to -5% YTD-YoY for malls under our coverage. In terms of rental reversions, we reckon that it could be relatively softer over CY15 for retail-based MREITs as retailers may see weaker demand post-GST. However, GST is less detrimental on office and industrial assets as they have longer lease periods and lower step-up rates comparatively. We believe GST will pose more of an ‘indirect’ impact to REITs which will be felt in 2Q15-3Q15 as it will affect tenants facing increasing operating cost from: (i) higher incidental costs depending on whether the tenant is GST-compliant and whether their supply chain is also GST-compliant, (ii) slower consumer demand in the short run, and (iii) higher rent cost or occupancy cost as tenants will have to pay GST on rental post GST implementation in April 2015. GST on rental will not be reflected in REITs’ rental revenue as the REIT will collect GST arising from tenant’s rental which will then be passed on directly to Customs. Evidently, tenants will have to bear higher costs, which may limit strong rental reversion opportunities for MREITs in CY15 because MREITs may not want to overload tenants with unmanageable rental rates as they prefer to prioritise occupancy over strong rental reversions.

PAVREIT the top performer under our coverage on acquisition catalyst. PAVREIT stood out as the top gainer YTD, appreciating by 6.2% to RM1.55 which we believe was mostly due to; (i) earlier anticipation of an asset acquisition in FY15, which was confirmed when it acquired Damen Mall on 17th Sept 2015 for RM488m, and (ii) resilient assets in terms of occupancy and minimal rental reversions this year. The only other gainer was KLCC (+4.1%), while the observable trend between the two REITs were; (i) minimal lease expiry’s in FY15 as it is a risky year due to GST (0% for KLCC, 14% for PAVREIT), (ii) occupancy is extremely stable at 95%-100%, and (iii) both have premium and more tourist-centric malls, which can weather the effects of the rising inflation and GST better compared to mass or neighbourhood malls as their shoppers tend to enjoy higher purchasing power. Other MREITs under our coverage saw flat to negative YTD gains (0.0% to -5.8%), in tandem with the overall stock market selldown and expanding bond yields. We believe investors prefer to hold on to MREITs with more resilient asset positioning or catalysts, as mentioned above, and may have reduced their holdings in CMMT, AXREIT and SUNREIT due to the perceived weakness from: (i) AXREIT’s multi-tenanted assets segment facing occupancy weaknesses, (ii) CMMT’s negative rental reversions at Sungei Wang Plaza, and (iii) SUNREITs challenging hotel segment. 

Acquisition less frequent post GST. In 2QCY15, MREITs under our coverage saw only one assets acquisition (Damen Mall by PAVREIT for RM488m), which was well within our expectations as highlighted in our previous Strategy Report (dated 15th July 2015), while there have been three asset acquisitions YTD, (Tropicana City Mall (TCM) and Tropicana City Office Tower (TCOT) by CMMT). Additionally, there are two more pending acquisitions by AXREIT; (i) Prai industrial facility (RM38.0m) and, (ii) a Letter of Offer (LO) to acquire and leaseback an industrial Facility in Port Klang for RM46.0m from Haisan Resources Berhad (PN17) which should materialise by 4QCY15 or 1QCY16. The asset acquisition environment is slightly behind CY14 in terms of numbers of asset (CY14 saw 6 acquisitions, 2 from SUNREIT and 4 from AXREIT) vs. 3 assets in CY15, but total considerations of assets acquired were higher in CY15 at RM1.0b vs in RM568m in CY14. Acquisitions may prove to be challenging post GST, which will be imposed on acquisitions. Evidently, we have only seen one acquisition in CY15 post GST (i.e. by PAVREIT). However, we believe the market will adapt in due time and sellers will have to offer more realistic rates to see an asset disposal going through, and the acquisition market may pick up towards end-2015 to 2016 as rental reversion cycles have peaked over 2014, which will help with asset valuations. Our channel checks indicate that prime retail asset valuations are trending closer to more realistic cap rate values of above 6.0% from 5.5%, while industrial cap rates are fetching better rates of 7%-8%, as evident from AXREIT’s recent acquisitions and Letter of Offers (LOs).

Bond yield volatility keeps rising. The bond market has become increasingly volatile as of Aug-15, breaching 4.3% (21st Aug 2015) due to: (i) weakening Ringgit vs. USD and other currencies, (ii) debate on the timing of the US Fed rate hike which was postponed to Oct 2015 or even 1CYQ16, and (iii) waning confidence on the domestic front. Our 10-year MGS volatility analysis (refer to Graph below) indicates that when volatility breaches the 20.0% threshold, the 10- year MGS tends to spike to highs of 4.25%-4.40%, but when the volatility cools off, bond yields revert closer to 4.00%. As at Aug-15, foreign holdings of the MGS were still high at 46%, (from 48% in July-15); it usually ranges between 44%-49%. As foreigners have been selling heavily in the equities market since early May, we believe this may have also cascaded into the local bond market in August, i.e. when bond yields spiked.

However, we do not expect bond yield highs to persist. Recall back in Nov-14 when the 10-year MGS spiked to 4.30% due to: (i) plunging oil prices, and (ii) weakening Ringgit; bond yields were also quick to revert back to 3.90% (normalised within 2 months). During this period, foreign shareholdings in the bond market remained high at 46%. As at Aug-15, foreign shareholding of the 10-year MGS was still high at 46% while bond yields spiked to 4.47%. As we have previously qualified, it has been apparent in recent months that the 10-year MGS has been volatile due to uncertainty in the timing of the US interest rate hike which has caused both local and foreign bondholders to become cautious. This may have caused knee-jerk reactions despite the fact that this news is well expected by the market. As such, we increase our 10-year MGS target to 4.00% (from 3.90%) pending more concrete news on the outcome of the US interest rate hike as medium term market volatilities may still linger from negative sentiment.

4Q15 still plagued with uncertainty, position to accumulate post US interest rate hike and a stabilising Ringgit. We are not expecting any strong catalyst for the sector over the next six months, as acquisitions are tougher to come by post GST. Meanwhile, most downside risks have been priced in because a rate hike has been well expected by the market. We also anticipate a volatile bond market over the next quarter. Investors may want to wait for the bond market volatility to settle down i.e. for the 10-year MGS to be closer to the 4.00% mark (currently 4.35%) before positioning to accumulate MREITs. We initially expected the bond market to stabilise by 4Q15, but this may be dragged on further post confirmation on two major events; (i) US interest rate hikes, and (ii) a stabilising Ringgit. As such, we are increasing our FY15E full-year target 10-year MGS to 4.00% (from 3.90%) due to increased volatility, which may persist for longer than expected, i.e. post the Fed meeting in Oct or even Dec. We advise investors to stay on the sidelines for now until the bond situation stabilises.

Maintain NEUTRAL. We raise our 10-year MGS target marginally to 4.00%, and will continue to monitor the US Fed’s decision closely in the upcoming Oct and Dec 2015 meetings as we expect bond yields to normalise shortly after the first rate hike and upon the Ringgit stabilising. We maintain our yield-spread assumptions and thus, keeping our CALLs for all MREITs unchanged. We have MARKET PERFORM calls for KLCC, IGBREIT and AXREIT, and an OUTPERFORM for SUNREIT (OP; TP: RM1.73) given its better-than-average earnings growth and strong yields, and PAVREIT (OP; RM1.67) on strong acquisition potential. We have an UNDERPERFORM call on CMMT (UP; TP: RM1.31) given the lack of fresh catalyst, and negative sentiment from Sungei Wang Plaza.

SUNREIT (OP; TP: RM1.73) is our Preferred Pick due to strong DPU growth prospects. We believe SUNREIT will see strong earnings growth in FY16 (+15.9%) from: (i) value accretion mainly from Sunway Putra Place (SPP) which came online in 2QCY15, and (ii) slight accretion (+0.8%) to earnings from SUNREIT’s recent acquisitions of Wisma Sunway and Sunway Georgetown hotel accreting directly to shareholders in FY16. SUNREIT’s valuation is based on FY16E to better encapsulate the earnings from SPP and the two new acquisitions. Valuation-wise, SUNREIT is a strong laggard play as it is commanding attractive gross yield of 6.7% (net: 6.0%) vs. other sizeable MREITs of 5.2%-6.4% (net: 4.9%-5.8%).

Risks to our call. Factors that will cause us to alter our calls are: (i) worse-than-expected consumer spending in 2Q15 and 3Q15 post GST implementation, (ii) cost-push factors that may result in weak rental reversions, (iii) the US Fed increasing interest rates in a more aggressive than expected manner, and (iv) further decline in oil prices and weakening MYR, which may put increased pressure on the 10-year MGS.

Source: Kenanga Research - 7 Oct 2015