We reiterate our NEUTRAL call on MREITs amid the still challenging industry fundamentals. Generally, the sector remains clouded by persistent oversupply (particularly in the office sub sector) but there are bright spots selectively in the resilient industrial segment and strategically located retail space. Moreover, MREITs may face valuation headwinds due to elevated interest rates and a heightened inflationary backdrop, which may limit their share price performance. From a valuation perspective, our sector pick is PAVREIT (OP; TP: RM1.43) while SENTRAL (UP; TP: RM0.79) remains an UNDERPERFORM.

When the going is still tough. The challenging outlook for the Malaysia REITs (MREITs) sector still persists. According to the recently released 2022 Property Market Report by the National Property Information Centre (NAPIC), the supply-demand imbalance continues to weigh especially on the office and retail segments. Extracting the data (as of end-December 2022) for the whole of Malaysia, the latest yearly report unveiled an occupancy rate of: (i) 78.5% for the purpose-built office space (based on an occupied space of 19.1m sq m against total office space of 24.3m sq m), down slightly from 78.9% end-2021, and (ii) 75.4% for retail space in shopping complexes (derived from occupied space of 13.2m sq m on total retail space of 17.5m sq m), sliding further from 76.3% end-2021. See Exhibit 1 overleaf.

More supply in the pipeline. Going forward, we believe the occupancy rates for both the purpose-built office space and retail segment will remain under pressure. Against the already overhang backdrop, more supply is expected to come onstream as the NAPIC report has forecasted: (i) for the purpose-built office space, an incremental 1.53m sq m is under physical construction and another 0.99m sq m attributable to planned supply (where building plan approvals have been obtained), accounting for a combined 10.4% of existing supply, and (ii) for retail space in shopping complexes, 1.38m sq m (from construction in progress) and 0.35m sq m (from planned supply) may be added (representing an extra 9.9% of existing supply).

On the demand side, following the full resumption of economic activities post the pandemic, the take-up rate for office and retail spaces will likely be muted amid the prevailing jittery economic prospects and elevated inflation worries.

MGS yield headwinds ahead. The 10-year Malaysian Government Securities (MGS) yield – a risk-free benchmark used by us as a valuation reference to impute the corresponding yield spreads in deriving our individual target prices – has climbed from a recent low of 3.74% in late January this year to as high as 4.06% in early March before slipping to 3.90% (Exhibit 2). This follows its previous slide from a high of 4.55% in October last year due to initial expectations that global interest rates might have peaked already. Yet, amid the volatile movements, we reckon interest rates could remain elevated in view of the sticky high inflationary environment, prompting us to maintain our 10-year MGS yield assumption at 4.5% for our computation of individual target yields (Exhibit 3).

NEUTRAL sector view. Amid the still challenging industry dynamics, our NEUTRAL sector view stays. We still like MREITs with the following attributes: (i) niche in the right business segments particularly in industrial and retail, and/or (ii) own property assets in prime and strategic locations, which will continue to provide resilient rental income streams. On valuation grounds, PAVREIT (OUTPERFORM; TP: RM1.43) remains our sector pick, offering potential total return of 15.8%. We remain cautious on SENTRAL (UNDERPERFORM; TP: RM0.79).

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

Source: Kenanga Research - 6 Apr 2023