We reaffirm our NEUTRAL sector call on MREITs. While the supply-demand mismatch will continue to weigh particularly on the office and retail segments, selected MREITs with niche exposure in the industrial segment (which is seeing resilient demand) and retail space (in prime locations) will continue to derive steady rental income streams against the challenging industry backdrop. Our sector top picks are PAVREIT (OP; TP: RM1.47, offering potential total return of 22.2%) and SUNREIT (OP; TP: RM1.93 with potential total return of 27.7%). 

Room for occupancy rates to move down. Against a broadly subdued economic climate, the Malaysia REITs (MREITs) sector will still face challenging times ahead, repeating the narratives following the release of the 2022 Property Market Report by the National Property Information Centre (NAPIC) in March this year. To recap, its latest annual report (using data as of end-December 2022 for the whole of Malaysia) reveals the prevalence of supply-demand gaps particularly in the office and retail sub-sectors, showing 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% at end-2021. See Exhibit 1 overleaf.

With that said, the occupancy rates for both the purpose-built office space and retail segments will remain under pressure going forward. Essentially, more supply will be coming onstream as the NAPIC report has forecasted: (i) for the purpose-built office space – an incremental 1.53m sq m which 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).

More supply, less demand in sight. Reaffirming the NAPIC findings, in its 2HCY22 report published recently, Knight Frank (an independent property valuation and consultancy services provider) has estimated an incremental supply of: (i) approximately 5.1m sq ft (0.5m sq m) of office space in the Klang Valley in 1HCY23 – from the scheduled completion of seven office buildings, namely PNB 1194, V2 Corporate Office Tower (Velocity 2), Merdeka 118 Tower, Aspire Tower, Pavilion Damansara Heights Corporate Tower (Phase 1), Tower 5 of PJ Sentral Garden City and Office Towers @ Atwater, adding another 4.5% to the Klang Valley’s existing cumulative office stock of 113.9m sq ft (10.6m sq m), and (ii) a combined retail space of 1.94m sq ft (0.18m sq m) in the Klang Valley during the first half of 2023 – with three shopping centres/supporting retail components scheduled for completion/opening (namely KSL Esplanade Mall, retail component of 8 Conlay and Pavilion Damansara Heights), representing a rise of 2.9% to the overall present supply of retail space of 67.72m sq ft (6.29m sq m) as of 2HCY22.

Meanwhile, from a demand standpoint, even as economic activities are already back to usual post the pandemic, the incremental take-up rate for office and retail spaces will likely be soft in view of the slowing global economic outlook, the rising trend of flexible working arrangements and weakened consumer spending power amid the elevated inflationary pressure.

MGS yield in a range-bound pattern so far this year. 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 been swinging sideways thus far this year, climbing from a low of 3.74% in late January to as high as 4.06% in early March before retracing back to 3.74% currently (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. Against this backdrop, interest rates will probably remain elevated given the still sticky high inflationary environment, prompting us to maintain our 10-year MGS yield assumption at 4.5% for our computation of individual target yields and their respective target prices as we have rolled forward our valuation window to FY24 during the recent earnings reporting season (Exhibit 3).

NEUTRAL sector view. Backed by the still challenging industry dynamics, we are keeping our NEUTRAL stance. Within the sector, 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. From a valuation perspective, PAVREIT and SUNREIT emerge as our top retail-centric picks, offering potential total returns of 22.2% and 27.7%, respectively. We remain cautious on SENTRAL (MARKET PERFORM; TP: RM0.79) given its high exposure to the office segment.

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 - 16 Jun 2023