Maintain OVERWEIGHT. We are mildly positive on the Securities Commission (SC)’s new Guidelines on Listed REITs with main amendments being the inclusion greenfield development, and allowing of private lease arrangements. We like the fact that it enables more avenues for earnings growth at cheaper entry levels. However, we do not expect strong near-term earnings growth while longer run earnings and DPU accretion is still dependent on asset yields and funding structure. SC also introduced additional steps to minimise construction risk post allowing greenfield development (i.e. fixed borrowing limit of 50%, limiting construction cost, and higher threshold for real estate and recurring income). All in, we do not expect share prices to re-rate immediately from the guidelines as most additions have been widely anticipated in SC’s Consultation paper (2016). Separately, we also taken the opportunity to; (i) trim PAVREIT, AXREIT and CMMT’s earnings by 5-11%, (ii) assume a temporary risk premium (+50 bps) on MREITs’ spreads to address investors’ concerns of an OPR hike. Note that our in-house view is that the probability is low for another 25 bps OPR hike this year while we observe that the 10-year MGS did not react to the recent 25 bps OPR hike earlier this year. Maintain OVERWEIGHT as most MREITs are attractive at current levels, warranting an OUTPERFORM call (save for AXREIT and KLCC), backed by stable gross yields of 4.8-8.0%. CMMT is our preferred trading pick on attractive yield of 8.0%.

MREITs guidelines providing more growth opportunities, a mild positive. Most of the additions to the Listed REITs guidelines were a positive, with the main highlights being; (i) ability to undertake property development activities (i.e. greenfield development), and (ii) allowing REITs to acquire real estate through lease arrangements. We are mildly positive on these proposals as it allows MREITs more avenues for earnings growth in light of the low cap rate environment which makes it tough for MREITs to acquire assets from third parties, which are DPU accretive. However, this proposal may not translate to strong earnings growth in the near term during the construction phase (between 2-4 years), while earnings and DPU yield accretion in the longer run is also dependent on the structure of the deal (i.e. asset NPI yields vs. portfolio yields, and funding structure).

Prudent steps to minimise greenfield risk. To limit the REITs exposure to construction risk (i.e. development cost overruns) and impact to earnings, the guidelines require; (i) a fixed borrowing limit of 50% of total asset (yes; no more exemptions), (ii) property development costs and real estate under construction is limited to 15% of total asset value (TAV) which is fair considering that REITs embarking on greenfield development will have higher construction cost, and (iii) a higher threshold for minimum investments in real estate and recurring income of 75% of TAV vs. 50% previously. This increases safeguard of recurring income and dividend stability over the longer run. (Please refer to APPENDIX on our comments of the proposals.)

No surprises. Although we view the new guidelines positively, we do not expect share prices to re-rate immediately as most of the proposals, primarily for greenfield development, have been largely expected by the market as stipulated in SC’s Consultation paper back in 2016. Since the SC’s Consultation paper, and prior to this new Listed REIT guidelines; (i) AXREIT has embarked on two greenfield developments, and (ii) SUNREIT has one greenfield project, which is the development of the second phase of Sunway Carnival slated for completion by FY21, both upon seeking exemptions from SC. The measure will allow MREITs to capitalize on the current weak property market and secure bargain greenfield opportunities. However, it may not be as straight forward. Although there is no impact to the REIT’s earnings as interest cost is capitalised, but such deals would have cash flow implications, which could affect DPU payout capabilities, especially for REITs with already flattish DPU. Additionally, MREITs embarking on greenfield projects may face leasing risk as pre-committed tenants may be tough to come by given the oversupply situations in the office and retail segments. On the flip side, a single tenant model (i.e. industrial) could work as it would be easier to secure pre-committed tenants before construction.

MREITs’ share prices YTD losses of 3-30% unwarranted, possibly due to investor concerns on; (i) widening yield spreads in light of a second OPR hike which typically indicates bond yield expansions and rising financing costs, and (ii) concerns of an oversupply of retail and office spaces. We believe the recent sell-down has veered into the irrational territory driven by investor’s fears. Note that the OPR hikes have minimal effect on MREITs’ earnings as most MREITs borrowings (>70%) are on fixed rates, save for PAVREIT, MQREIT and AXREIT (<30% borrowings on fixed rates), while a 50bps hike to PAVREIT, MQREIT and AXREITs’ borrowings would only lower earnings by 1-2%, which is minimal.

Valuation-wise, OPR hikes have little correlation with MGS rates (<20%) making it more elastic to other macro factors (i.e. US interest rate hikes, dollar carry-trade story). Notably, the 10-year MGS yields remain stable at 3.90-4.00% post the first OPR hike in Jan 2018, and despite expectations of three US interest rate hikes in 2018. The 10-year MGS was also unfazed when the Ringgit depreciated from RM3.30 to RM4.45 (by 35%) in 2014 to 2015, but MGS yields were declining during the same period, on the back of high foreign holdings (of 44-48%). Even with all the volatility, the MGS has maintained its high foreign holdings at 45% currently.

Yes, there is an oversupply of office and retail spaces, but we think landmark assets and quality MREIT managers will survive. We believe that MREITs with landmark assets, such as Pavilion Shopping Mall (PAVREIT), Mid Valley (IGBREIT), Sunway Pyramid (SUNREIT) and Suria KLCC (KLCC), will prevail in this oversupply situation. These landmark retail assets tend to have better than average occupancy (90-100% vs the market of 80%), and office assets under our coverage (i.e. MQREIT and KLCC) have above-average occupancy (95-100% vs. the market of 81%) due to long-term lease structure. Furthermore, landmark MREITs assets are able to command positive reversions despite tough market conditions vs. smaller neighbourhood malls and offices located outside the greater KL area. Quality REIT managers such as CMMT and AXREIT, which have smaller asset sizes, stand a better chance at tenant retention on facilities management, AEI abilities and tenant mix (particularly for retail) as these MREIT managers actively engage their tenants to create vibrancy for retail business.

Downward earnings adjustment to account for delays. We are lowering PAVREITs’ FY18-19E earnings by 5-1% due to delays in the acquisition of Pavilion Elite Mall along with the 7.2% placement of 218m shares which we initially expected by end FY17-1Q18, but is now likely postponed to 2Q-3Q18 as the Group just sought a 6-month extension. Additionally, we are lowering the indicative placement issue price closer to current levels of RM1.40 (from RM1.70), implying that PAVREIT would require additional borrowings to fund the placement, increasing borrowing cost. Additionally, we are lowering AXREIT’s earnings by 11% for FY18E as we had previously expected the 2nd tranche of the placement in FY18 to pare down the Group’s borrowings. However, we believe that the placement is likely to be pushed to end 2H18 as its prerequisite is new asset acquisitions, with lower revenue contributions from Axis PDI from Jun 2018 (vs. our expectations from 2Q18).

Lower CMMT’s earnings by 8% each in FY18-19E post meeting with management, refer to our report dated 19th March 2018, "Preferred Trading Pick on Attractive Yields". We are assuming more conservative reversions, and lower occupancy for all assets in light of CMMT’s ongoing AEI’s in FY18-19.

We believe other MREITs’ fundamentals remain intact. Most MREITs have consistently met expectations in FY17, save for AXREIT, KLCC and PAVREIT in 2Q17 which we have already accounted for in our estimates. 3Q and 4Q17 results were well within expectations, save for PAVREIT, (which missed consensus earnings in 3Q17). Going forward, FY18 is expected to be a stable year with; (i) a small portion of leases expiring (14-30% of NLA for MREITs under our coverage), save for CMMT at 45%, and (ii) unexciting reversions, with mid-to-high single-digit reversions for retail MREITs assets under our coverage, and low-tomid single-digit reversions for office and industrial assets. As such, we believe we have accounted for most foreseeable downside risks.

MREITs’ spreads rising to record highs in CY18. Backed by stable fundamentals and MGS outlook, the recent MREITs’ share price declines have caused REITs’ spreads (against the 10-year MGS) to spike, surpassing record highs for CMMT and PAVREIT, while other MREITs under our coverage are close to historical high spreads. Currently, MREITs’ spreads are close to or have exceeded 5-year highs at 0.96-4.07ppt (refer to chart).

Assuming a temporary risk premium to address rate hike risks. As mentioned, we believe such high MREIT spreads to the 10-year MGS, due to share price declines, are unwarranted. However, to address investors’ concerns of another potential 25 bps OPR hike this year, we are assuming a temporary risk premium of an additional 50 bps for all MREITs under our coverage. Our in-house view is that the probability of a second rate hike is low, and hence we may look to lower this premium upon further certainty.

Still an OVERWEIGHT after applying higher risk premium and more prudent estimates. All in, post increasing our spreads and adjusting for earnings, we lower MREITs’ TPs by 6-21%. Additionally, we downgrade our calls for KLCC and AXREIT to UP (from MP). Even so, quite a number of MREITs under our coverage are still commanding strong OUTPERFORM calls. We believe that this is a good opportunity for bottom-fishing on selected MREITs, primarily CMMT and MQREIT in light of the overdone sell-downs.

CMMT (OP; TP:RM1.35) our preferred trading pick due to attractive valuations at current levels. We like CMMT as although it is not comprised of landmark malls, it is commanding attractive total returns with gross yields of 8.0% currently, even post accounting for foreseeable downside risk (refer to our report dated 19th March 2018, “Preferred Trading Pick on Attractive Yields”). We believe CMMT’s share price declines (-30% YTD) have been overdone, retreating below IPO price.

MQREIT (OP; TP:RM1.30) is our preferred long-term pick due to its stable asset profile and attractive dividends, commanding attractive yields of 7.8% vs. other MREITs of 4.8-6.5% (save for CMMT). We like MQREIT’s 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 26% expiring in FY18, while (iii) tenants are unlikely to move out in the near 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. Note that offices situated on the borders of KL and Petaling Jaya have fared better in terms of demand compared to other areas of Klang Valley due to the connectivity play while KL Sentral is a preferred destination for many multinational firms.

Risks to 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 - 19 Mar 2018