Maintain NEUTRAL. MREITs fundamental outlook remains unexciting, but fairly stable on uninspiring reversion rates of mildly negative to low-single-digit reversions due to the oversupply of retail, office and hospitality spaces. We prefer the industrial segment as it commands similar reversions on more long-term leases (6 years vs. 2-3 years). All in, we expect modest average DPU growth of 3-1% YoY in FY19-20. And, the US Fed’s dovish outlook on the economy and interest rates has put downward pressure in the 10-year MGS yield which has declined by 42 bps YTD to 3.65%, putting some upward pressure on MREITs share prices. However, with much of the yield adjustments behind us, we believe the remaining positive impact to be muted going forward. Post 1Q19 results which were slightly better than the previous quarter, we increased TPs by 3-6%, save for CMMT which we lowered by 8%. Note that we trimmed CMMT’s earnings by 8-7% in FY19-20E to be more conservative in light of weaker reported margins. Even so, post lowering earnings, CMMT still commands an OP call on attractive 6.7% gross yields vs. MREITs average of 5.6%. Maintain all calls for MREITs save for MQREIT which we upgrade to OP (from MP), while CMMT is maintained as an OP (TP; RM1.15) from RM1.25.

Results were within expectations. All MREITs’ results met expectations in 2Q19. Overall, they were slightly better than the previous quarter when AXREIT came in above and MQREIT came in below expectations. QoQ, top-line growths were mostly positive (1-9%), save for MQREIT, which was marginally lower by 3% on lower rental, KLCC (-4%) due to seasonality factors, and AXREIT (-9%) on exceptionally higher rental recognised in the previous quarter from back dated rent. These translated to bottom-line growth for most (1-10%), save for KLCC (-1%), MQREIT (-1%), and AXREIT (-20%). YoY, the year-to-date topline grew for most, save for CMMT (-2%) and MQREIT (-6%) on lower rental contributions.

MREITs under coverage up 10% YTD on average (vs. 7% in 1Q19) in line with the KLREI Index (+9.4%) (as at our report cut-off date on 21st July 2019), exceeding the FBLKLCI (-0.5%) but below the FBM Small Cap Index (+14.4%). Almost all MREITs saw positive YTD gains for 1H19 of 0-17%. PAVREIT was the top gainer YTD (+17%) likely due to the fact that results were well within expectations and it is one of the few MREITs with a landmark asset (Pavilion Shopping Mall) that has occupancy stability and can command positive reversions. Meanwhile, MQREIT was the worst performer with a flat share price due to downward rental pressures. Other MREITs saw YTD gains as results continued to meet expectations and on decent yields.

Slow, steady and unexciting fundamental outlook. Oversupply concerns continue to weigh on MREITs’ reversions outlook, which remains sluggish over the near term and longer run. MREITs under our coverage are expecting mildly negative to lowsingle-digit reversions as the oversupply situation is affecting the retail, office and even the hotels market in Malaysia, which make it a predominantly tenant’s market. We do not see any strong re-rating catalyst for the sector in sight and strong reversions will remain challenging as asset owners will prefer to prioritise occupancy over reversions, but the saving grace for these segments are quality landmark assets and/or locations, which can weather oversupply conditions better by being able to attract higher footfall traffic. The industrial assets segment has a better footing as its single-digit reversions are on par with other asset classes (i.e. retail and office), but lease terms are longer at c.6-10 years (vs. 2-3 years for retail and office) providing long terms earnings stability. FY19 will see c. 21-53% leases up for expiry for MREITs under our coverage, with the largest being PAVREIT at 53% of NLA. However, we are not overly concerned for PAVREIT as the bulk of its lease expiries is from Pavilion Shopping Mall (65% of its NLA up for expiry) which we believe would have no issues of securing/maintaining tenants as occupancy is consistently strong at >95% due to strong shopper traffic. All in, we do not expect strong earnings growth, targeting menial FY19-20E average DPU growth of 3-1%.

Oversupply concerns do not phase iconic REIT assets. In light of oversupply fears, we believe MREITs with landmark or iconic assets will fare better with above-average occupancy and positive (amidst low single digit) reversions due to well managed assets. REITs such as PAVREIT, IGBREIT, KLCC, SUNREIT that own landmark malls such as Pavilion Shopping Mall, Mid Valley, Suria KLCC and Sunway Pyramid, will continue to remain stable from higher footfall traffic (vs. neighbourhood malls). These assets are able 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, which are faring better than the industry average with close to full occupancy of 96-100% vs. the Klang Valley’s average of c.80%.

The US Fed looking more dovish. The June 2019 FOMC meeting saw the US Fed maintain the benchmark interest rate within its target range of 2.25% to 2.50%. However, they signalled that they may consider lower rates going forward as risk to the future outlook has grown in light of the recent lack of progress on resolving trade disputes, producing greater uncertainty for the US economy which may miss its inflation target of 2%. The recent June 2019 FOMC meeting saw the Fed removing the word “patient” from its narrative of lowering interest rates, which suggests they may be more inclined to lower rates in the near future, but later highlighted that it is important not to overreact in the short term issues. All in, we believe markets are anticipating at least one rate cut in 2019 for now, which will put downward pressure on the 10-year MGS in the near term.

Lowering our 10-year MGS target to 3.70% (from 3.90%) in anticipation of potential rate cuts. We opt to be slightly optimistic by lowering our 10-year MGS target to 3.70% (from 3.90%) – but this merely places us sligtly above the current 10- year MGS levels that seem range bound between 3.60-3.70%. This means that the ‘falling yield’ effect on MREITs may have largely run its course for now. We believe markets have stabilised in the near-term post reacting to news of a possible rate cut in the near future.

Trimming CMMT’s earnings by 8-7% to be more conservative. CMMT’s recent results as with the past 6 quarters have continued to meet our expectations. However, we opt to be more conservative on our outlook for CMMT’s to test our narrative as to whether the stock still warrants an OUTPERFORM call. Post relooking at our assumptions, we are trimming CMMT’s earnings by 8-7% in FY19-20E to RM147-149m in line weaker margins observed in its recent 1Q19 results on higher operating cost from higher utilities consumption, reimbursable staff cost as well as higher marketing and communication costs for its assets and Jumpa at Sungei Wang Plaza. As a result, we lower CMMT’s TP to RM1.15 (from RM1.25).

All in, we increase MREITs TP’s by 3-6% post lowering our 10-year MGS target to 3.70%, save for CMMT’s TP, which is lowered by 8% after accounting for more conservative earnings. Even so, CMMT still warrants an OP call despite a lower TP of RM1.15 (from RM1.25) on above-average gross yields 6.7%. Our calls are also mostly unchanged save for MQREIT which we upgrade to OP (from MP) given attractive gross yields of 7.3% and decent upsides at current levels even though we have applied the highest yield spread among MREITs under our coverage to account for potential earnings weakness.

Maintain NEUTRAL despite a lower 10-year MGS target. We maintain NEUTRAL on the sector on a lower 10-year MGS target of 3.70% and leave our spreads unchanged (historical average spreads) which we believe is justified given MREITs earnings stability over the past 2 years while most negative news has been accounted for. At current levels, MREITs under our coverage are offering average gross yields of 5.6% which we as deem decent, warranting our NEUTRAL call. However, CMMT stands out on above-average yields of 6.7% even after most downsides have been priced in.

Source: Kenanga Research - 5 Jul 2019