Maintain NEUTRAL. 3Q16 results for MREITs were mostly in line while fundamentals are intact as we expect modest reversions on minimal leases up for expiry in FY17. We believe PAVREIT (OP; TP: RM1.89) is likely to see an asset injection in FY17 (i.e. Pavilion Elite) with a visible acquisition path to follow. Going forward, we expect the 10-year MGS to be volatile in CY17, range bound between 4.0-4.5% due to Ringgit volatility. We also expect the MGS to normalise closer to 4.20%, thus, we increase our MGS target (from 3.60%). Additionally, we notice MREITs’ share price movements have been fairly stable and become less dependent on the volatile MGS, compressing yield spread, which reached YTD lows in Nov 2016. As such, we are lowering our yield spread, with our target yield closer to MREITs’ 3-year average gross yields to reflect investors’ preference for MREITs despite the volatile MGS as investors are still searching for yield play and earnings stability. All in, we have lowered our TPs by 5-13% and lowered our calls for KLCC, SUNREIT and CMMT to MP (from OP). Maintain NEUTRAL due to a lack of re-rating catalyst, while downsides are limited as MREITs are viewed as a preferred safe-haven. Our Top Picks are KLCC and PAVREIT for earnings resiliency and sizeable acquisitions or greenfield potential.

3Q16 results within expectations. QoQ, bottom line growth was flattish to mildly positive (0% - 4%), save for SUNREIT (+10%) driven by its retail segment. This was better than 2Q16 when QoQ bottom line growth was slightly negative due to seasonality factors such as lower turnover rent and weaker margins. YoY, all MREITs saw positive top line growth (1% - 11%), while most saw bottom line growth (0% - 10%) on the back of mid-to-high single-digit reversions, which was largely within our expectations, save for AXREIT (-4% RNI) on higher cost from recent acquisitions. All in, results were within expectations, except for AXREIT, which came in below due to our slightly optimistic occupancy and reversion assumptions while we forecasted a stronger 4Q16 from new asset contributions from new asset acquisitions (i.e. warehouse facility in Pasir Gudang which acquisition is yet to be completed). Most MREITs’ earnings estimates were left unchanged save for AXREIT which we lowered by 8.9%-4.7% in FY16- 17E to account for; (i) lower topline growth, (ii) delayed acquisitions and (iii) the disposal of Axis Eureka during the quarter. We also lowered AXREIT’s TP accordingly to RM1.71 (from RM1.80), and upgraded CMMT to OP (from MP) as CMMT’s valuation appeared compelling vs. MREIT peers.

IGBREIT top performer YTD, up 19.4%. IGBREIT remains the top gainer in 2016, appreciating by 19.4% YTD to RM1.60 as of our report cut-off date (22nd Dec 2016), likely due to its asset stability from strong occupancy (>99%) and double-digit reversions, while gross yields prior to the share price run-up was attractive at 6.2%, vs. other MREITs’ average of 5.8%. Most MREITs under our coverage saw positive YTD gains, as investors continued to seek safe havens and stable returns hedging against market volatility, outperforming the FBMKLCI (-4.1%) and FBM Small Cap (-8.1%) to date. Additionally, share prices for SUNREIT, MQREIT and PAVREIT have increased by 15.1%, 13.0% and 11.6% YTD, respectively, in line with our OUTPERFORM recommendation throughout 2016.

Fundamentals mostly intact as we expect modest reversions on minimal leases up for expiry. FY17 will see minimal leases up for expiry for MREITs under our coverage at 13-34% in FY17E which we have already accounted for. We have forecasted mid-to-high single-digit reversions for retail MREITs assets under our coverage, and low-to-mid single-digit reversions for office and industrial assets, to remain conservative. As such, we believe fundamentals are mostly intact while we expect modest DPU growth of 1.3-6.0% on average for 1-2 years forward from MREITs in our universe.

Unexciting market data supports our modest reversions. Recent 9M16 market data from NAPIC suggests that there has been an uptick in incoming supply for office spaces mainly in Selangor and Putrajaya further exacerbating the office oversupply situation in the Klang Valley and implying that the office market will remain a tenants market. Meanwhile, Kuala Lumpur’s incoming supply for office spaces also appears to be rising but at a slower rate since 2015, likely due to the less bullish oil and gas market in recent years, while we are unclear if incoming supply data includes mega projects such as Tun Razak Exchange and KL118, which could further inflate incoming supply data. Evidently, 9M16 office occupancy data is on a declining trend primarily in Selangor (73% occupancy rate), while Kuala Lumpur and Johor office occupancy remains flattish. However, the silver lining will be prime offices with high quality specifications that will continue to command stable occupancy and rental rates. The retail market outlook remains challenging with increasing incoming supply since 2013, mainly in Selangor while Kuala Lumpur appears to be fairly stable. Retail occupancy data by NAPIC for 9M16 also does not show significant signs of improvement with retail occupancy on a slightly declining trend in Kuala Lumpur and Selangor, ranging between c.85-86.0% in 2016 likely due to increased incoming supply and lacklustre demand for retail space. The industrial market (measured in units) has been seeing declining supply which may bode well for stable rental rates (refer to chart). Note that data for industrial occupancy is not available. Going forward, we opine that incoming supply will continue to suppress rental reversions as occupancy rates are still below optimum levels. As such, we believe our modest reversions are in line with the market’s lacklustre outlook.

Likely acquisition of Pavilion Elite in FY17. PAVREIT is expected to inject the recently completed Pavilion extension or Pavilion Elite (which opened in late Nov 2016), into its portfolio in FY17. Details remain scarce based on channel checks with management, but we estimate that its inclusion into PAVREIT portfolio could add 15.7% or RM66m to PAVREITs FY17E GRI (4% to bottom-line) based on 250,000sf NLA (11.8% of PAVREITs total NLA) on our assumed rental rate of RM22psf/month which is close to Pavilion Shopping Malls average rental rates. Additionally, accretions to earnings and DPU will depend on the finalised asset cost and methods of funding (i.e. borrowings or cash call). Assuming PAVREIT acquires the asset fully via borrowing which is likely due to the group’s low gearing of 0.26x, it could increase earnings by 4% in FY17 to RM287m, based on a 5% financing rate and asset cost of RM710m (on 6.5% NPI yield and 70% NPI margins based on PAVREIT’s historical trends). Additionally, other potential assets for acquisition by PAVREIT include: (i) fahrenheit88, (pending the sponsors’ intention to sell), as well as assets from (ii) WCT (i.e. Paradigm Mall, AEON Bukit Tinggi and gateway@KLIA2) of which Tan Sri Desmond Lim and wife has a 20% stake. However, we believe PAVREIT may acquire should cap rates become more favourable, i.e. from 6.0% and closer to 6.5%, while the group’s low gearing also allows for sizeable acquisitions.

Expecting a volatile MGS in 2017. The 10-year MGS increased to a high of 4.46% in end Nov 2016 post the results of the US Presidential election (on 9th Nov 16) as markets frantically reacted to the outcome, causing foreign investors to pull out from most emerging markets after the election. This coupled with a slew of negative press and weak oil prices did not bode well for the Ringgit and the 10-year MGS foreign shareholding declined to 48.4% in Nov 2016 (from an all-time high of 51.9%, Oct 2016). Going forward, we believe anticipation of US interest rate hikes may further affect the MGS on the premise of a volatile Ringgit. We believe the MGS will trade range bound between 4.0-4.5% in CY17 in light of market volatility throughout the year, while we expect the MGS to normalise closer to 4.2%. As such, we revise our 10-year MGS target to 4.2%, closer to current levels (from 3.60%).

Has MREITS detached from the MGS? Since the spike in the MGS in Nov 2016, MREITs’ share prices movement has remained fairly stable and appears to be detaching from the volatile MGS. Our study of MREIT’s share price volatility suggests that since CY14, MREITs’ share price volatility has been fairly stable, recording only a 2.4-4.8% standard deviation, with KLCC being the lowest and MQREIT the highest vs. the 10-year MGS of 5.0% standard deviation. Evidently, MREITs’ yield spreads have compressed, reaching YTD lows in Nov 2016 (refer to chart of MREITs’ yield spread). Additionally, MREITs’ gross yields have remained stable since the US Presidential election (9th Nov 2016) up to our report cut-off date (22nd Dec 2016), either unchanged or declining by up to 0.4% during that period. A comparison of MREITs’ share price movements vs. the 10-year MGS prior and post the results of the US Presidential Election further illustrates the detachment of MREITs’ share price movements against the MGS since Nov-16 (refer to chart of MREITs’ share price movements vs. the MGS pre- and post- results of US Presidential Election). All in, despite the MGS spiking to a high of 4.46% in end Nov 2016, the sector has remained defensive, with most MREITs recording strong YTD gains, as mentioned above, outperforming the market.

Detachment from the MGS likely because; (i) investors are still holding on to flight for safety plays, with the FMBKLCI and FBMSC down YTD, a weaker Ringgit vs. USD and other foreign currencies, coupled with an overall volatile global economy, investors continue to seek for safe havens and stable returns, allowing for MREITs to remain resilient as MREITs’ fundamentals are intact, commanding 5.1-6.9% gross yields currently, (ii) most MREITs under our coverage are institutionalised, thus, limiting downsides, and (iii) foreign shareholding remains fairly low for most MREITs under our coverage at c.3-13% (save for MQREIT at 19% from Quill Capita Ltd which will not likely to reduce its holding), unlike the MGS.

Investors are holding on to yields, compressing MREITs’ yield spreads vs. the MGS. We are lowering our MREITs yield spreads closer to current levels to reflect investors’ preference for MREITs in volatile market conditions (refer to table for changes to yield spread and MGS). We have also benchmarked our new target yields closer to MREITs’ 3-year historical average yields to reflect investors’ preference for MREITs as they are less swayed by fluctuations in the MGS and are still holding on to yield plays and earnings stability.

Maintain NEUTRAL on MREITs, with selected picks on more resilient MREITs with acquisition potential. All in, we have lowered our TP’s by 5%-13% on a higher MGS of 4.20% (from 3.60%) while lowering our yield spreads, with our target yields closer to MREITs 3-year average gross yields, thus lowering our calls for KLCC, SUNREIT and CMMT to MP (from OP). At our new TP’s, MREITs’ current gross yields are decent at 5.1-6.9% vs. the 10-year MGS of 4.2% currently as investors favour yields in volatile economic conditions. We maintain NEUTRAL on the sector as there are no strong re-rating catalysts, while downsides are limited as MREITs are viewed as preferred safe-havens.

Our Top Picks are KLCC (MP; TP:RM7.84), and PAVREIT (OP: TP:RM1.89). We continue to like KLCC and PAVREIT for earnings resiliency and asset acquisition potential. We like KLCC’s premium asset positioning with long-term leases (i.e.15 years) of which 100% of KLCC REITs assets (50% of the Groups operating profit) has the longest lease terms, and are on a triple-net-lease (TNL) basis, while PAVREIT’s occupancy remains solid at >95%. Additionally, both REITs have low gearing at 0.21x and 0.26x for KLCC and PAVREIT, respectively, allowing for sizeable acquisitions or greenfield potential. Although KLCC’s yield of 5.1% is at the thinner end of the sizeable MREIT yield range of 5.1-6.9%, the premium is justified given its low share price volatility (lowest among MREITs under our coverage), its market cap being the biggest and its premium asset positioning. PAVREITs gross yield of 5.5% provides security to investors due to its stable assets, mainly Pavilion Shopping Mall, while upsides for PAVREIT appear attractive due to its visible acquisition path.

Risks to our call. Factors that may affect our call include: (i) worse-than-expected consumer spending, (ii) cost-push factors that result in weaker-than-expected rental reversions, (iii) U.S. Fed increasing interest rates in a more aggressive manner, and (iv) weaker than expected occupancy rates, (v) further decline in oil prices and weaker MYR, which may increase pressure on the 10-year MGS.

Source: Kenanga Research - 6 Jan 2017