Recent 2Q17 results were a mixed bag as 4 came in within, and 3 below our expectations (i.e. AXREIT, KLCC and PAVREIT) due to delayed acquisitions, higher cost and lower pay-out, which we have already accounted for in our earnings model. YoY, most MREITs saw positive top-line growth of 1% to 39%, save for CMMT (-1%), while bottom-line growth followed suit, (0% - 48%), except CMMT (- 1% RNI), and PAVREIT (-8% RNI) due to higher operating and financing cost. QoQ, top-line was mostly flattish to negative (1% to -5%) as 2Q and 3Q are seasonally less exciting quarters, which translated to negative bottom-line for most (-1% to - 10%), save for AXREIT. All in, we left MREIT’s earnings unchanged, save for AXREIT, KLCC and PAVREIT which we downgraded by 7-14% for FY17-18E and 3-6% in FY18-19E on weaker quarterly results, and subsequently lowering their TPs. Most of our calls were maintained, save for KLCC which we downgraded to MP (from OP).

IGBREIT top performer YTD, up 8%. IGBREIT is the top gainer YTD under our coverage, up 8% as of 21st Sept 2017, backed by its asset stability from strong occupancy (>99%) on double-digit reversions, and decent 1H17 results. This is similar to CY16 when IGBREIT was the top performer as well, up by 19.4% vs. other MREITs (at between -1.8% to +17.1%), due to similar reasons and superior yields of 6.2%, vs. other MREITs’ average of 5.8%. Top losers were AXREIT (-8%) and CMMT (-7%) likely on earnings weaknesses and a lack of strong re-rating catalyst, while other MREITs saw flattish to positive YTD gains between - 1% to 8%. All in, MREITs’ share prices in CY17 appear to have stabilised, with average share price virtually unchanged for all MREITs, compared to the strong run-up in CY16 (9% average gains) when investors were chasing for dividends due to market volatility.

Fundamentals intact with minimal earnings risk going forward as FY18E will see; (i) minimal lease expiries (14-30% of NLA for MREITs under our coverage), and (ii) unexciting reversions, with 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. We do not expect further earnings risk in coming quarters as we have; (i) trimmed AXREIT, KLCC and PAVREIT’s earnings estimates in the recent 2Q17 results review by 7-14% for FY17-18E and 3-6% for FY18-19E, and (ii) trimmed CMMT during 1Q17 results review by 4-4% for FY17- 18E to account for weaker reversions ahead, while other MREITs’ results came in within expectations YTD. Thus, we believe we have accounted for most foreseeable downside risks going forward. Additionally, we are expecting a modest 2-year forward average DPU growth of 0-6% YoY for MREITs under our coverage, implying that our estimates are neutral, at best.

MREITs’ share prices yet to play catch up, likely on additional perceived risk by investors. Most MREITs share prices have yet to play catch up, (-8% to 8% YTD loss/gains) despite the 10-year MGS declining 8.7%. To recap, a declining MGS will cause MREITs’ share prices to revert upwards as MREITs are viewed as a less risky option to the MGS. Although we believe we have priced in foreseeable earnings risk for MREITs under our coverage, valuations appear sticky as investors may likely perceive additional earnings risk for REITs due to on the ground sentiment from the; (i) supply glut of office spaces in the Klang Valley, and (ii) influx of retail space entering the market over the next 2-3 years. As such, we are taking a more conservative approach and increasing all our MREITs’ spreads to the 10-year MGS by 5%, and thus lowering our TPs by 1-2% to account for investors’ negative sentiment on MREITs’ valuations. We widen our spreads by 5% based on the additional perceived earnings risks by an additional 5% on top of what we have trimmed from our earnings.

The MGS has remained stable at 3.90%. The 10-year MGS has remained range bound between 3.80% and 4.00% since our upgrade on the sector in June 2017 (refer to report dated 8th June 17, Upgrading on a Lower MGS Yield). Going forward, we do not expect significant fluctuations in MGS as most upsides have been priced in (i.e. upcoming interest rate hikes). Additionally, foreign holdings of the MGS are also stable at 40%, in line with the Malaysian Ringgit improving against the greenback to RM4.21 currently, up 6% YTD against the USD. As such, we maintain our 10-year MGS target of 4.00%, which is slightly more conservative vs. current levels of 3.90%.

Maintain OVERWEIGHT. Despite the MGS compressing 8.7% YTD (declining since April 2017) to 3.88% yield, MREITs’ share prices under our coverage have not reacted with yield spreads now at 1.3ppt-2.7ppt (vs. its YTD average of 1.1ppt-2.5ppt). At current levels, most MREITs are commanding attractive total returns of 13-19% (save for AXREIT and KLCCSS), and is backed by 5.4-6.5% dividend yields, providing security to investors. We believe this is a good opportunity for investors to hold MREITs with attractive valuations, while we are selective on MREITs with above-average yields such as MQREIT with of 6.5% yields (vs. peer average of 5.5%) and believe this stock is due for a re-rating given that its market cap is now above RM1b.

Our Top Pick is MQREIT (OP; TP:RM1.38) as it is backed by stable assets and attractive dividends, commanding the highest yield among MREITs under our coverage (6.5% yield) vs. its peers at 5.5% yields. We like MQREIT for its earnings stability, with minimal downside risk due to its; (i) long lease expiry profile (WALE of 5.6 years, which is long compared to retail MREITs of 2-3 years, (ii) minimal lease expiries with 14-26% expiring in FY17-18, while (iii) tenants are unlikely to move out in the future due to the MSC status of most of its buildings (c. 80% of GRI has MSC status) vs. other office MREITs under our coverage which do not own any MSC status assets. As a result, occupancy has been strong at 97%, (>90% historically) vs. other office assets under our coverage of 69-96%. MQREIT also has the best yields under our coverage at 6.5% gross yields vs. large cap MREITs’ average of 5.5%, while we believe it warrants to trade at similar gross yields vs. its large cap peers having graduated into a big cap MREIT (>RM1b market cap) post the placement in 4Q16.

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, (iv) weaker-than-expected occupancy rates, and (v) further decline in oil prices and weaker MYR, which may increase pressure on the 10-year MGS.

Source: Kenanga Research - 4 Oct 2017