Downgrade to NEUTRAL. FY22 will be a recovery year as business operations and earnings are expected to normalize closer to pre-Covid levels. The retail segment’s earnings are improving steadily in recent quarters in line with the reopening of the economy, with prime malls expected to do better than suburban malls post the country entering the endemic phase. The Industrial segment remains fundamentally stable on low single-digit reversions, while the Office segment may see flattish reversions for now and we remain cautious of its long-term outlook. Despite earnings improving, we are cautious of a rising 10-year MGS yield which has put a dampener on MREIT’s valuations. All in we increase our 10-year MGS target to 4.5% and lower our sector call to NEUTRAL from OVERWEIGHT.

FY22 a year of recovery for MREITs business. Going forward, we believe business disruption for malls will be minimal compared to FY20 and FY21 as the country has entered the endemic phase, while most malls are reporting increased shopper traffic but more importantly tenant sales returning closer to or on par with pre-Covid levels. As such, earnings are expected to normalize in FY22 and improve in FY23. We are currently expecting YoY earnings growth of 25% in FY22 and 10% in FY23 which is on track to meeting expectations thus far.

Prime malls to benefit the most. As shopping and spending habits change, it appears that prime malls would fare better due to two reasons; (i) their shopper demographic is less affected by the impact of Covid as demand for luxury goods has been increasing post-pandemic, and (ii) they attract tourist – which would also be keen to spend in prime malls with the reopening of international borders this year. As such, earnings for these malls have been normalising closer to pre-Covid levels as the economic situation continues to return to the old normal. That said, we do not completely discount the possibility of further economic disruptions from potentially new Covid variants, but believe the probability of this happening is low for now.

The industrial segment will continue to remain stable. This segment is known for its minimal organic growth (of 2-3% p.a.) but during the pandemic, it has been a fortitude of stability within the MREITs space. On top of stable organic growth, AXREIT, the only industrial REIT is also actively acquiring more industrial assets, targeting an additional RM120m worth of industrial asset

acquisitions, focusing on Grade A logistics located in Selangor, Penang and Johor and a net yield of c.6.5-7.0%.

Not overly optimistic about the office segment, save for KLCC. Over the medium to long run, we believe the office segment may see a decline in demand vs. the pre-Covid era, either from shorter lease terms or tenants requiring less office space. This is because most companies were able to function seamlessly through work-from-home arrangements during the pandemic. This may also further exacerbate the pre-existing oversupply of offices in the Klang Valley. That said, our pessimism for the office segment does not apply to KLCC even though it is primarily office space driven as it is well protected by its secured long-term leases (>10 years vs. retail of 2-3 years) and with an easy to manage triple-net-lease (TNL) structure.

The rising 10-year MGS a downside risk to valuations. Despite expected earnings improvements this year, it is unfortunate that MREITs are now bogged down by a rising 10-year MGS yield. To date, the MGS has climbed from 3.5% at the beginning of the year, rising to a peak of 4.4% in April, and is currently at 4.28%. This is in line with recent surge in US Treasury yields and expectations of the US Feds sizeable rate hikes going forward. As such, we have increased our internal 10-year MGS target during the results seasons, and we are pegging MREITs under our coverage to a 4.50% 10-year MGS target (from 4.15%-4.4% previously).

Downgrade to NEUTRAL (from OVERWEIGHT) as earnings improvements are not enough to outweigh rising bond yields. We are comfortable with our 10-year MGS target of 4.50% for now, in line with our in-house risk-free rate, and as the 10- year MGS appears to be trending sideways in the near term. Our valuations have been rolled forward previously to FY23E to better encapsulate a new normal to earnings as 2022 is poised to be a recovery year, especially for the ailing retail and hospitality segments. We are more optimistic on MREIT’s earnings potential going forward, and thus have pegged MREITs to marginally lower spreads to the 10-year MGS target.

Industrial based AXREIT has the thinnest spread (+0.8ppt) under our coverage due to; (i) extremely stable earnings profile and the ability to weather the pandemic, (ii) positive single digit rental reversions which is better than the retail and office segment, and (iii) an active acquisition trail allowing for strong YoY growth of 10% p.a. vs. organic growth of 2-3% p.a. and (iv) for its high yielding acquisitions of 6.5-8% (higher than retail and office of 4-6%). Additionally, we like AXREIT and one of two Shariah compliant MREITs under our coverage.

Retail MREITs applied spreads are between +1ppt to +2ppt, slightly higher than the industrial segment and lower than office segment. This is because; (i) the retail segment is more susceptible than the industrial segment to negative earnings impact from the pandemic, (ii) has lower rental reversions than industrial (flattish vs. low single digit positive reversions), (iii) minimal acquisitions due to the low yielding nature of retail asset acquisitions (c.4-6%). The only outlier for the retail segment is CMMT at +4.2ppt spread due to its challenging asset profile which commands negative reversions and struggles with fluctuating occupancy, while FY22 is expected to be challenging due to the high amount of leases up for expiry of 40%.

The office segment is spilt between KLCC and SENTRAL. KLCC warrants a low spread of +1.0ppt, closer to AXREIT due to; (i) its stable earnings from its office segment (55% of earnings), and long term lease expiry profile (>10 years), which is also Covid-proof (ii) positive low single-digit rental reversions on stable occupancy for the office segment, although the retail and hospitality segment are still susceptible to earnings risk from the pandemic on flattish reversions and high occupancy cost, and (iii) we also like KLCC for its Shariah-compliant status. SENTRAL on the other hand warrants a higher spread of +3.6ppt as it operates like a typical office asset which has; (i) earnings variability from tenant movements due to an oversupply of office spaces in the Klang Valley, (ii) shorter lease expiry terms of 4-7 years (vs. KLCC >10 years) and (iii) flattish to mildly negative rental reversions due to the competitive nature of this segment which we are long term negative on.

Risks to our NEUTRAL sector call include: (i) stronger/weaker-than-expected consumer spending, (ii) stronger/weaker-than expected rental reversions, (iii) U.S. Fed increasing interest rates aggressively, and (iv) stronger/weaker-than-expected occupancy rates.

Source: Kenanga Research - 21 Jul 2022