The SC has come up with a consultation paper to revise MREITs guidelines with the main highlight being Proposal 1 (Property Development Activities) which will allow MREITs to undertake greenfield development. The other proposals by SC are catered towards facilitating growth by increasing the scope of permitted activities by MREITs (i.e. Proposals 2-6), to facilitate earnings and share price growth whilst capping downside risk. Proposals 7 to 11 are catered towards enhancing governance to protect investors and ensure the sustainability of MREITs without burdening the managers, while Proposals 12 to 13 are geared towards streamlining post listing requirements. All in, we are positive on most proposals, primarily Proposal 1. Although there is no earnings accretion in the near term, as greenfield development is only earnings positive in the longer run, we expect news flow related to Proposal’s 1-4 to bode well for share price sentiment and valuations. We make no changes to earnings and valuations for MREITs under our coverage. We have previously accounted for AXREIT’s development of Axis PDI, while SUNREIT’s impact to earnings is not significant in the near term (3-4 years) and pending finalisation of development plans. Maintain NEUTRAL with selected picks on more resilient MREITs. Our preferred MREITs include KLCC (OP; TP: RM8.25), PAVREIT (OP; TP: RM2.15) and SUNREIT (OP; TP: RM1.85). We continue to like KLCC and PAVREIT for their earnings resiliency as both REITs have maintained strong asset stability and future asset acquisition potential, and SUNREIT on contributions from SPP and visible acquisition pipeline.

SC’s Consultation Paper a step in the right direction. The Securities Commission (SC) has come up with a consultation paper to revise its guidelines for MREITs which we believe is a positive step in the right direction as it aims to: (i) enhance MREITs’ growth by broadening the scope of permitted activities, (ii) improve governance to safeguard investors and maintain long-term sustainability, and (iii) increasing efficiency by streamlining post listing requirements. The main highlight is Proposal 1, for Property Development Activities, which will essentially allow MREITs to undertake greenfield development subject to the development not exceeding 15% of the REITs enlarged total asset value (TAV) in aggregate, thus capping the exposure to development risk, while downside risks will also be mitigated by other proposals such as Proposal 6 (Leverage Limit). All in, we are positive on Proposal 1. Although there is no accretion to earnings in the near term, and is only earnings positive in the longer run, we expect news flow on greenfield development to bode well for share price sentiment and valuations.

Our View on Proposal 1: Another way around the low cap rate environment. We view Proposal 1 positively as it allows REITs to grow earnings given limited opportunities for accretive acquisitions in the current low cap rate conditions (4%-6% cap rates for retail assets and 6%-8% for industrial assets). MREITs would be able to own assets at lower capital outlays; essentially, the real ROI on development cost (Gross Development Cost) will be better than buying already completed buildings, which are based on Market Value with lower asset financing cost. Additionally, there is the icing on the cake when the greenfield development is completed, arising from revaluation exercise to reflect market valuation, which will further boost their asset and book value without additional cash-outlay. This opens the door of opportunity for MREITs’ earnings growth in the longer run and will help alleviate the burden of low cap rates plaguing the market currently, but the impact to earnings is expected to be neutral in the near term, and accretive only in the longer run post construction.

Finance cost will be capitalised during the construction period. Furthermore, we do not expect any negative impact to earnings during the construction period as financing for development cost would be capitalised. MREITs that require placements/rights to fund the development may dilute DPU/ROE in the near term, but this is unlikely for the larger cap MREITs under our coverage as their gearing are within 0.15x-0.34x (vs. MREITs max gearing limit of 0.50x based on Proposal 6, implying ample headroom to gear up for greenfield development. Based on our analysis, assuming the development cost is maxed out at 15% of enlarged TAV, MREITs under our coverage would still be able to stay below the 0.50x gearing threshold, and as such there would be less of a need to do a cash call to raise funds for development cost, while smaller cap MREITs such as AMFIRST, HEKTAR, YTLREIT and MQREIT may require cash calls for such developments. Additionally, note that gearing levels may ease further post completion of construction as the asset will be revalued higher at market rates.

Exposure to construction risk will be capped at 15% of the enlarged TAV. We are not overly concerned on Proposal 1 with regards to MREITs being exposed to construction risk as MREIT’s are already exposed to construction risk of 10% of the TAV (after the acquisition) that is already embraced in the existing MREIT guidelines, which is mainly for refurbishment but does not include greenfield development. On the flip side, this is still low compared to Singaporean REITs (SREITs) that allow 25% of TAV exposed to development (including greenfield development). It is also important to note that the new guideline stipulates that the REITs would have to hold the assets for a minimum

We believe industrial MREITs would be the main beneficiary. Although all MREITs would be able to benefit from Proposal 1 by gaining higher development cost yields, we believe industrial REITs may fare better as development cost for industrial assets may be cheaper than retail, while it would also be easier for industrial MREITs (i.e. AXREIT) to find a pre-committed tenant as it can operate on fewer tenants or a single tenant basis vs. retail MREITs that require multiple tenants and may not be able to secure a pre-commit during or before construction. As such, retail MREITs have greater leasing risk, which we believe can be mitigated should the REITs have extensive tenant network to leverage on.

AXREIT and SUNREIT ready to develop greenfield, which will be earnings accretive in the longer run. AXREIT (on 22nd Aug 2016) had already snapped up the opportunity to develop a greenfield with a pre-committed tenant (Nestle Products Sdn Bhd, 8.8% of enlarged TAV), while SUNREIT has purchased land adjacent to Sunway Carnival (0.3% of enlarged TAV) and is looking to expand via greenfield at Sunway Carnival mall, which may take a longer period of time before the asset is fully occupied as details on the development are still scarce at this juncture, while we expect both developments to be earnings accretive in the longer run. We have previously “priced-in” into our TP the expectations of AXREIT’s development of Axis PDI upon the Group finalising its development plans which we expect to be DPU accretive post FY18; we did this by lowering our MGS spread to +1.85ppt (from +2.00ppt) to encapsulate better earnings accretion in the longer run (post FY18)as we believe AXREIT has identified exciting catalysts for its DPU which we believe was needed to re-rate the stock, while SUNREIT’s impact to earnings is not significant in the near term (3-4 years) while details are scarce pending finalisation of the development plans.

All in positive on SC’s list of Proposals, as we expect news flow related primarily to Proposal1 to 4 to bode well for share price sentiment and valuations, with minimal impact to earnings in the near term. Overall, besides Proposal 1, Proposals 2 to 4 are expected to be beneficial to unitholders as it is catered towards facilitating earnings growth by increasing the scope of permitted activities by MREITs, making it easier for MREITs to secure tenants or minimise vacant space. Proposal 5 (unit buy-back) aims to lend stability to share price and is a form of returning cash to unitholders, while Proposal 6 will help limit balance sheet risks amidst increased exposure to property development, but we are neutral on Proposal 6 as most MREITS under our coverage have maintained below 0.50x gearing on TAV. Proposals 7 to 10 are catered towards enhancing governance and transparency which we view positively as it will benefit shareholders as it aims to protect shareholders and ensures the sustainability of MREITs without burdening the managers. Additionally, Proposal 11 (Revaluation of assets) which is also targeted at enhancing governance (similar to Proposals 7-10),requires the REIT to revalue its assets once every financial year vs. once in three years previously, which we view as neutral impact to unitholders. Although frequent asset valuations capture the assets current market value which is beneficial for transparency to unitholders, asset revaluations do incur additional costs, while volatile property market conditions may affect capital values of the assets, and may negatively impact the REITs gearing ratio. Proposals 12 to 13 are geared towards streamlining post listing requirements allowing MREITs to be on par with other listed corporations, including the process for rights issuance which is currently longer and more arduous for MREITs. Other proposals include Proposal 14 (Property Management) will be beneficial to investors and managers as it aligns the interest of the REIT Manager with the property manager. Proposal 15 (Internal Management) will be beneficial to investors as it forces the existing REIT manager to perform, while failure to do so will allow a ‘Change of the REIT Manager’ (Proposal 9), giving shareholders the option to remove the existing manager and allow the REIT to be managed by hiring executives to internally manage the REIT. Lastly, Proposal 16 which limits the offer of unlisted REITs to Sophisticated Investors aims to protect investors that do not have privy access to information to invest in an unlisted REIT (refer to table titled ‘List of SC’s New Proposals’ below).

Maintain NEUTRAL on MREITs, with selected picks on more resilient MREITs. We make no changes to our 10-year MGS target of 3.60%. The sector lacks strong near-term catalyst going forward as most upsides have been priced in, as evident from the decent YTD gains for MREITs under our coverage of 6.7%-24.6% YTD. As such, we maintain NEUTRAL on MREITs for now, but investors can look out for selected REITs with a visible acquisition pipeline in FY17, (i.e. PAVREIT, SUNREIT, KLCC, AXREIT), which may lend some excitement to earnings growth, should: (i) the acquisitions be sizeable (>5% accretion to bottom-line), (ii) with attractive asset yields (>7.5% NPI yield for industrial assets, >6.5% NPI yield for retail assets). At current levels, MREITs are commanding gross yields of 5.1-6.1%

Preferred MREIT’s include KLCC (OP; TP: RM8.25), PAVREIT (OP: TP: RM2.15) and SUNREIT (OP; TP: RM1.85). We continue to like KLCC and PAVREIT for their earnings resiliency as both REITs have maintained strong asset stability, with KLCC’s assets on long-term leases (i.e.15 years) and a triple-net-lease (TNL) basis, while PAVREIT's occupancy is strong at >97%. Additionally, both these REITs have low gearings (0.15-0.25x), allowing for sizeable acquisition’s or greenfield potential based on SC’s new proposed guidelines, while further clarity on its asset acquisition pipeline will be a positive re-rating catalyst for the stock. As for SUNREIT, we maintain our OUTPERFORM call for its income contribution from Sunway Putra Place and visible acquisition pipeline, thanks to its parent, SUNWAY.

Source: Kenanga Research - 29 Sep 2016