Downgrade to NEUTRAL (from OVERWEIGHT). MREITs’ results have continued to meet expectations, similar to 3Q and 4Q17. Meanwhile, REITs’ share prices under our coverage are recovering from March 2018 YTD lows (of -9% to -31%) to +5% to -16% YTD, in tandem with the KLREIT Index recovery (-6% YTD vs. March low of -13%). Fundamentals remain stable, but unexciting in our view. Investors’ concerns of ongoing oversupply in the market as well potential OPR hikes continue to linger and have been accounted for in our valuations previously, through wider spreads. However, we are cautious on the rising 10-year MGS, at 4.24% currently (vs. our target of 4.00%) after remaining range bound between 4.00-4.24% in the recent months. We lower all our TP’s by 3-4% and downgrade all our calls, save for KLCC and MQREIT. At current levels, MREITs are commanding decent yields of 4.8-7.3%, but our valuations are conservative due to the uncertain macro fundamentals.

Results within expectations. All MREITs’ results were within our and consensus expectations in 1QCY18, similar to 4QCY17 when most REITs were within expectations, save for IGBREIT, which was slightly above. YoY-Ytd, top-line was mostly positive (2-11%), save for CMMT and MQREIT, which were marginally lower at 3% each on; (i) slightly lower reversions and occupancy due to refurbishments for CMMT, and (ii) rental incentives for MQREIT, both of which were within our expectations. This translated to bottom-line growth for most (3-15%), save for CMMT (-2%) and MQREIT (-9%). QoQ, bottom-line was mostly flat to mild positive (0-6%) on stable occupancy and mild reversions, save for slight decline for KLCC (-3%) and MQREIT (-2%). All in, we made no changes to our earnings and TP’s, but we downgraded our call for KLCC and MQREIT as our valuations have been reflected with recent share price appreciations.

Share prices recovering from March lows. MREITs under our coverage recorded YTD gains/losses ranging from +5% to - 16%. However, this is a recovery since March 2018 when MREITs saw YTD lows of -9% to -31%. The KLREIT Index had also since recovered, down 6% YTD vs. March low of -13%. To recap, we believe the sell-down on the sector was unwarranted as the recent 1Q18 reporting season was within expectations, similar to previous reporting seasons, while most MREITs’ fundamentals are intact with downsides priced in. We reckon that MREITs sell-down in 2018 may have been due to investor perceptions of; (i) a growing oversupply of office and retail spaces in the Klang Valley, and (ii) expectations of a negative impact from an OPR hike, which we believe are unsubstantiated. Meanwhile, the recent recovery may have been due to investors looking for flights for safety in MREITs in light of market volatility post the general election (GE).

Our top picks CMMT and MQREIT have done well since our OUTPERFORM call, with CMMT gaining 20% (since our report dated 19th March 2018, ‘Preferred Trading Pick on Attractive Yields’) and MQREIT (up 11% since our report dated 30th March 2018, ‘In an Era of Oversupply, Who Survives’). We believe the sell-down was overdone at those levels which were suitable for bottom fishing, while recent 1Q18 results have done well by meeting expectations.

Even so, CMMT remains a laggard with attractive yields of 6.7% vs. retail MREIT peers’ average of 5.8%. Despite the strong bounce back in CMMT’s share price (+20%) since our report, we believe there is still value in attractive yield play such as CMMT, which remained the top loser YTD (-16%), which we reckon is due to investors’ perceptions of weak reversions at Sungei Wang Plaza (SWP) and The Mines (TM), as well as potential rental downtime in FY18-19 due to asset enhancement initiatives (AEI) at SWP, TM and Tropicana City Mall (TCM). We have accounted for rental downtime as well as lower reversions going forward post meeting with management in 1Q18. It is also important to note that CMMT’s reversions are finally back into the black at +2.2% improving significantly from -12.4% in 1Q17, and -1.3% in 4Q17 on the back of fairly stable occupancy of 93.7% in 1Q18 vs. 95.0% in 1Q17. To reiterate, we believe the oversupply situation is not overtly negative to MREITs with landmark assets. We believe MREITs with contributions from landmark malls (i.e. PAVREIT, IGBREIT, KLCC, SUNREIT) will continue to remain stable from higher footfall traffic (vs. neighbourhood malls). This allows these assets to retain close to maximum occupancy of 95-100% vs. domestic retail occupancy of c.80% and command positive reversions, albeit at a slower growth rate which we have accounted for. This is similar for landmark office assets (i.e. KLCC and MQREIT) which fare better than the industry average with close to full occupancy 96-100% vs. the Klang Valley average of c.80%. Oversupply issues over the past three years have made strong rental reversions tough to come by, but most MREITs under our coverage have held up well, recording flattish to mild GDPU growth during those periods. However, CMMT has seen GDPU declining marginally due to weakness at Sungei Wang Plaza, most of which had been priced into earnings.

Furthermore, Dewan Bandaraya Kuala Lumpur’s (DBKL) previous decision to freeze approvals for new applications to build shopping centres, offices, service apartments and luxury condominiums in the capital city following a directive from the Cabinet in Nov-17 is a long-term positive as it helps address the oversupply situation which bodes well for existing MREITs.

Stable but unexciting fundamentals. 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 (45%) which we have accounted for in our estimates, and (ii) unexciting reversions, with up to mid-single-digit reversions for retail assets, flattish to low single-digit reversions for industrial assets and flat to mildly negative reversions for office assets. As such, we believe we have accounted for most foreseeable downside risks, while our FY18-19E average DPU growth of 2-3% YoY is modest.

However, valuations are volatile with the MGS creeping up to 4.24% currently (+9% YTD) vs. our target of 4.00%. We expected some knee-jerk reactions to the 10-year MGS surrounding the general elections (GE) on 9th May 2018. However, going forward, we believe that market participants especially foreign investors may be concerned of potential near-term risk from downgrades to Malaysia’s credit rating due to the slew of debt-related news post elections, which may put pressure on Malaysia’s credit rating in coming months. So far, Fitch has reaffirmed it’s A- rating for Malaysia post elections (as reported in The Edge on 11th May 2018), while Moody’s have implied that removing (GST) will be ‘credit negative’ unless its new government takes steps to offset the loss in revenue (as reported in The Sun Daily on 22nd May 2018). We will continue to watch this space closely in light of constant updates on Malaysia’s current debt situation. As such, we are increasing our 10-year MGS target to 4.20%, which is closer to current levels, while our above-average spreads (+0.5std deviation above historical averages) serve as a buffer for near term fluctuations to the MGS.

Maintaining wide spreads to the MGS to account for investors’ concerns. We do not believe MREITs warrant to trade at historical high spreads of +1.6 to +4.3ppt as seen in March 2018, (between +1.0 to +2.0SD), and surpassing record highs for CMMT and MQREIT. To recap, we increased our spreads to 10-year MGS (refer to our 2Q18 Strategy report dated 4th April 2018) to +1.4ppt to +3.3ppt (+0.5std deviation above historical averages) from -0.5SD to its historical mean, to encapsulate investors’ concerns (i.e. oversupply issues and OPR hikes). We may look to remove this going forward provided there are consistency in MREITs’ earnings and valuations. Additionally, we are comfortable with our wider spreads for now as it may serve as a cushion to our valuations considering the potential volatility surrounding the 10-year MGS as a prolonged rising MGS may put upward pressure on MREITs’ spreads.

Downgrade to NEUTRAL (from OVERWEIGHT). We lower all our TPs by 3-4%, and downgrade all our calls, save for KLCC and MQREIT, which were previously downgraded in the recent results season (refer to table on MREITs Valuations). We opt to take a conservative view on our valuations by increasing our 10-year MGS target to 4.20%, closer to current levels (from target gross yield of 4.00%) on concerns of potential near-term risk to the MGS which would have a negative impact to MREITs’ valuations. Furthermore, we exercise caution that a prolonged rising MGS may put upward pressure on MREITs spreads and as a result we maintain our wide spreads of +0.5SD above historical averages. We will continue to monitor the impact of news flow and updates to Malaysia’s credit rating and the 10-year MGS. At current levels, we believe MREITs are commanding decent yields of 4.8-7.3%, but our valuations are conservative due to the uncertain macro fundamentals.

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 - 30 May 2018