Maintain NEUTRAL. MREITs’ results continued to meet expectations in 1Q18, similar to 3Q17 and 4Q17. Meanwhile, REITs’ share prices under our coverage are recovering from March 2018 YTD lows (of -9% to -31%) to +3% to -15% YTD, in tandem with the KLREIT Index recovery (-5% YTD vs. March low of -13%). The fundamental outlook remains stable, but unexciting. Concerns of ongoing oversupply as well potential OPR hikes continue to linger but these have been accounted for in our valuations through wider spreads. We maintain our 10-year MGS target of 4.20%, which is close to current level of 4.22%. However, we remain cautious and will continue to monitor the MGS should there be; (i) higher- thanexpected US interest rate hikes, or (ii) more debt-related news that may lead to potential downgrades of Malaysia’s credit rating, which would precipitate an increase in the MGS yield, leading to weaker MREITs’ share prices. Till then, we are comfortable with our valuations and maintain our wide spreads of +1.4ppt to +3.3ppt (+0.5SD above historical averages) to be conservative. We believe MREITs are commanding decent yields of 5.0-7.1%, but our valuations are conservative due to the uncertain macro fundamentals. We also upgrade SUNREIT to MP (from UP) as yields are decent at c.6%, on par with MREITs’ average.

REITs’ share prices under our coverage are recovering from March 2018 YTD lows (of -9% to -31%) to +3% to -15% YTD, in tandem with the KLREIT Index recovery (-5% YTD vs. March low of -13%). To recap, we believe the sell-down on the sector was unwarranted as the recent 1Q18 reporting season came within expectations, similar to previous reporting seasons, while most MREITs’ fundamentals are intact with downsides already priced in. We reckon that the selldown in 2018 may have been due to perceptions of; (i) a growing oversupply of office and retail spaces in the Klang Valley, and (ii) expectations of negative impact from an OPR hike, which we believe are unsubstantiated. Meanwhile, the recent recovery may have been due to investors gaining some confidence post positive performance in recent quarters (note that 3Q17, 4Q18 and 1Q18 results have all met expectations), while investors may also be looking for flights for safety in MREITs in light of market volatility post the general election (GE).

Stable but unexciting fundamentals. We expect minimal earnings risk in FY18 due to: (i) unexciting reversions, with up to midsingle-digit reversions for retail assets, flattish to low single-digit reversions for industrial assets and flat to mildly negative reversions for office assets, and (ii) minimal lease expiries of 14-30% of NLA for most, save for CMMT (45%) which we have accounted for in our estimates. We believe we have accounted for most foreseeable downside risks, while our FY18-19E average DPU growth of 2-3% YoY is modest.

Despite oversupply fears, most MREITs with landmark assets will fare better than the market with above-average occupancy and positive reversions due to well managed 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 enables such 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. Additionally, Dewan Bandaraya Kuala Lumpur (DBKL)’s 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 2017 is a long-term positive as it helps address the oversupply situation which bodes well for existing MREITs.

Maintain our 10-year MGS target at 4.20% as the 10-year MGS is stable currently, range bounding between 4.10% and 4.20% since we increased our target in May 2018 from 4.00%. Going forward, we do not expect significant fluctuations to the MGS as most of the upward pressure could have been priced in (i.e. upcoming US interest rate hikes). However, a more bullish than expected trend in the US interest rate, OPR hikes or negative news flow could put upward pressure to the MGS, which in turn may cause downward pressure on MREIT TPs. Assuming a +0.2ppt increase to the 10-year MGS to 4.40% (from 4.20%) currently, we do not expect any significant changes to our calls, save for SUNREIT, which would be downgraded to UP, while all our TPs will be lowered by 3-4%.

Maintain NEUTRAL. We are comfortable with our valuations as the 10-year MGS target of 4.20% is close to current levels, and maintain our wide spreads of +1.4ppt to +3.3ppt which is +0.5SD above historical averages to serve as a buffer for near-term fluctuation to the MGS. We remain cautious of the MGS which has risen 8% YTD, especially post GE14 and will continue to monitor Malaysia’s credit rating due to the slew of debt-related news post elections. At current levels, we believe MREITs are commanding decent yields of 5.0-7.1%, but our valuations are conservative due to the uncertain macro fundamentals. We also upgrade SUNREIT to MP (from UP) as yields are decent at c.6% on par with MREITs’ average.

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 - 5 Jul 2018