We are keeping our NEUTRAL stance on the MREITs sector. Against a still challenging backdrop where persistent oversupply continues to weigh on particularly the office and retail sub-sectors, selected MREITs with niche exposure in the industrial segment (which is seeing resilient demand) and retail space (in prime locations) are still enjoying steady rental income streams. Meanwhile, the retreat in the 10-year MGS yield from the recent peak, if it continues, may provide valuation support for MREITs. Within the sector, our tactical stock pick is PAVREIT (OP; TP: RM1.42), which offers potential total return of 22.4%.

Seeing no light at the end of the tunnel yet. The overhang story that is weighing on the Malaysia REITs (MREITs) sector – particularly in the office and retail segments, as previously highlighted in the1HCY22 Property Market Report by the National Property Information Centre (NAPIC) – is broadly shared by industry pundits. This follows the NAPIC half-yearly report (Chart 1, based on data as of end-June 2022 for the whole of Malaysia), which tabulated: (i) an occupancy rate of 77.7% for purpose-built office space, totalling 24.2m sq m with an additional 2.6m sq m of incoming supply, and (ii) an occupancy rate of 75.7% for retail space in shopping complexes (amounting to 17.4m sq m as another 1.9m sq m of space is expected to come onstream in the future).

Consistent with the NAPIC findings, recent media articles reported that: (i) Knight Frank (an independent property valuation and consultancy services provider) has estimated the supply of office space in the Klang Valley, which totalled 111.37m sq ft (10.35m sq m), would see an increase of 9.28m sq ft (0.86m sq m) (+8.3%) over the next 2½ years. Another independent property advisory company CBRE|WTW has separately projected the average occupancy rate of purpose-built offices would decline to 75.1% in 2023 (from 80.8% in 2019) as the new supply comes into the market, and (ii) Knight Frank is forecasting the cumulative supply of retail space in the Klang Valley to climb from 68.4m sq ft (6.35m sq m) in 2022 to 71.9m sq ft (6.68m sq m) in 2023 and 73.7m sq ft (6.85m sq m) in 2024, representing a year-on-year rise of 5.1% and 2.5%, respectively.

Has MGS yield peaked? Since our last sector update on 11 October, the 10-year Malaysian Government Securities (MGS) yield reached a high of 4.55% on 21 October before slipping thereafter to 4.02% currently (as of 2 December) (Chart 2). This is not far off from our existing assumption of 4.5% for the 10-year MGS yield, a risk-free benchmark we use as a valuation reference to impute the corresponding yield spreads in deriving our individual target prices (Chart 3). Notwithstanding our unchanged 10-year MGS yield assumption, the receding 10-year MGS yield has somewhat eased the pressure on share prices of MREITs (as tracked by the tiny 1.2% increase in the Bursa REIT Index during the period), which could provide valuation support in the event of an extended pullback as inflation pressure may be peaking soon.

NEUTRAL sector call maintained. We are reaffirming our NEUTRAL sector stance. As the tough industry fundamentals continue to be weighed by the demand-supply imbalance, we still prefer MREITs that derive resilient rental income streams particularly from industrial and retail property assets in prime locations. Backing our investment thesis, industrial-focused REITs like AXREIT (MP; TP: RM1.89) and retail-centric REITs such as KLCC (MP; TP: RM6.60) and PAVREIT, have shown steady sequential quarterly earnings performance since 4QCY21 (following the post Covid-19 transition into Phase 4 of the national recovery plan in October 2021). Separately, the recently released Malaysia Retail Industry Report is projecting an average growth rate of 13.9% in retail sales for 4QCY22 after witnessing a strong jump of 96% year-on-year in the third quarter of 2022.

Based on our existing target prices, our tactical stock pick in the sector is PAVREIT (OP; TP: RM1.42), which offers potential total return of 22.4%. We remain cautious on SENTRAL (UP; TP: RM0.79).

Risks to our call include: (i) risk-free rate eases/hikes, (ii) higher/lower-than-expected rental reversions, and (iii) higher/lower-than-expected occupancy rates.

Source: Kenanga Research - 20 Dec 2022