The risk of further narrowing of yield spreads in the REIT sector is now reduced as the MGS bond yields seem to have normalised at current levels. Acquisition activities could see a pickup, with Quill Capita Trust leading the pack. Earnings growth for some REITs will likely be boosted by the completion of refurbishment works this year. With all negatives priced in, we upgrade the REIT sector to NEUTRAL (from Underweight).

• Still cautious over the short-term.We believe that the short-term outlook for REITs will remain unexciting. The start of the quantitative easing tapering by the US Fed has resulted in a rise in the 10-year Malaysia Government Securities (MGS) bond yield to about 4.09-4.30% YTD vs 3.43-3.54% in the same period last year. As such, the net yield spread for larger REITs is still fluctuating at a relatively unattractive level of about 0-200bps. Nonetheless, the MGS bond yield seems to have normalised at the current level, thus limiting the risks of a further narrowing of yield spreads.
• Acquisition activities could be picking up.Among the REITs under our coverage, so far only Quill Capita Trust (QUIL MK, NEUTRAL, FV: MYR1.25) has announced a proposed asset acquisition. Axis REIT (AXRB MK, NEUTRAL, FV: MYR2.93) has also indicated that it is likely to acquire several assets in FY14. Axis REIT is currently negotiating on a few industrial assets in the Klang Valley, Penang and Johor valued at MYR380m in total. Although further acquisitions could help to boost earnings, we are cautious over the financing prospects for the upcoming acquisitions.
• Reaping the benefits of asset enhancement initiatives (AEI). Axis REIT has completed its major AEIs on several assets and this is expected to yield double-digit ROIs. Hektar REIT’s (HEKT MK, NEUTRAL, FV: MYR1.46) refurbishment of its Central Square shopping will likely result in a doubling of the mall’s rental rates. Pavilion REIT (PREIT MK, NEUTRAL, FV: MYR1.45) will also be embarking on some AEI works to reconfigure some of its under-utilised retail spaces, and the works are expected to be completed by May 2014.
• Negatives priced in, upgrade to NEUTRAL (from Underweight).At this juncture, we believe that all negative factors like the fear of rising bond yields and rising expenses have already been priced in, thus limiting the sector’s downside risks. Having said that, its upside potentialwill probably be limited, as concerns over the anticipated interest rate hike still remain. A potential catalyst could come from acquisition activities, which should be incremental to yields.
• Valuations are still unexciting at present
• Asset acquisitions could see a pickup
• Asset enhancements will start to bear fruit for some REITs
• Subsidy rationalisation initiatives could lead to flattish earnings growth for the smaller REITs, but the larger REITs could mitigate these risks through imposing higher service charges on tenants
• Negatives priced in. Upgrade to NEUTRAL.

Still cautious over the short-term 
We believe that the short-term outlook for REITs will remain unexciting. The start of the quantitative easing (QE) tapering by the US Fed has resulted in a rise in the 10-year Malaysia Government Securities (MGS) bond yield to about 4.09-4.30% YTD vs 3.43-3.54% in the same period last year. As such, the net yield spread for larger REITs, ie those with a market cap of above MYR2.5bn, is still fluctuating at a relatively unattractive level of about 0-200bps. By comparison, the spread for its Singapore peers remains above 200bps against the Monetary Authority of Singapore’s 10-year bond yields. Nonetheless, the MGS bond yield seems to have normalised at the current level, thus limiting the risks of a further narrowing of yield spreads.

Acquisition activities could be picking up 
Among the REITs under our coverage, so far only Quill Capita Trust has announced a proposed asset acquisition. It has entered into a heads of agreement (HOA) with MRCB (MRC MK, BUY, FV: MYR1.82) for the acquisition of Platinum Sentral office blocks in KL Sentral. A formal sales and purchase agreement is expected to be signed soon. MRCB, which major shareholder is EPF, is likely to emerge as a major unitholder in Quill Capita Trust. This could help to propel the REIT to the next level and put it back on investors’ radar screens, given the lack of positive news flow in recent times.

On the same note, Axis REIT has also indicated that it is likely to acquire several assets in FY14. Management believes industrial assets will provide more stable growth vs commercial assets. Hence, the focus is on buying assets in this segment. Axis REIT is currently negotiating on a few assets in the Klang Valley, Penang and Johor valued at MYR380m in total. It could also be disposing more of its matured assets with a holding period of five years or more, given the limited upside to the asset values. It has recently completed the disposal of Axis Plaza in Shah Alam. The asset’s disposal price of MYR34.0m is almost 50% above Axis REIT’s initial investment cost of MYR22.7m. The disposal has resulted in a net gain of MYR10.9m, which will be distributed back to unitholders in the form of a special dividend of 2.37 sen per unit.

Although further acquisitions could help to boost earnings, we are cautious over the financing prospects for the upcoming acquisitions. As we have highlighted before, the REIT sector is highly sensitive to any interest rate movement, as borrowing costs typically account for more than 50% of total trust expenses for REITs. Our economics team expects the central bank to increase the overnight policy rate (OPR) by 25bps towards late 3Q2014 to 3.25% from 3.0% currently. While newer borrowings may come at a higher rate, the REITs have progressively locked in lower rates for their existing debt, thus reducing their exposure to future interest rate fluctuations.

Reaping the benefits of AEI 

We believe that the impact of AEIs announced over recent months will start to kick in. Axis REIT has completed its major AEIs on several assets, such as Axis Business Park and Axis Business Campus, and this is expected to yield double-digit ROIs. Hektar REIT’s refurbishment of its Central Square shopping centre is due for completion by end-2QCY14, and will likely result in a doubling of the mall’s rental rates. Pavilion REIT will also be embarking on some AEI works to reconfigure some of its retail spaces on Levels 2 and 7, and the works are expected to be completed by May 2014. Given Pavilion REIT’s previous success with its Fashion Avenue precinct, where it was able to double the rental rates in the precinct, we believe that this AEI will contribute positively to future earnings.

CapitaMalls Malaysia Trust (CMMT MK, NEUTRAL, FV: MYR1.35) will also be wrapping up its 22-month AEI by end-2014, which will help to sustain its overall earnings growth at 5% annually. This will offset the expected flattish contribution from Sungei Wang Plaza, which has struggled to record meaningful growth over the last 18 months due to its high rental base of MYR12-13 psf and disruptions from the ongoing MRT construction works.

Subsidy rationalisation measures could dent earnings further 
The positive earnings impact from the AEI works, to some extent, may be offset by the adverse impact arising from the on-going subsidy rationalisation initiatives by the government, especially over the short term. Largely due to the electricity tariff hikes, the impact on the smaller REITs will be more severe and, as such, Hektar REIT and Quill Capita Trust are already guiding for flattish organic growth in FY14, as they will have to absorb all the incremental costs.

The larger REITs will also be feeling some pinch in earnings over the short term, although most of these REITs, such as: i) Sunway REIT (SREIT MK, NEUTRAL, FV: MYR1.39), and ii) Pavilion REIT plan to pass on some of the incremental costs to their tenants through higher service charges. Furthermore, Kuala Lumpur-based REITs like Pavilion REIT and IGB REIT (IGBREIT MK, NEUTRAL, FV: MYR1.27) could also see their earnings affected by the Kuala Lumpur City Hall (DBKL)’s recent hike in assessment rates, although this risk will also be imputed into higher service charges to tenants. Do note that KLCC Stapled Group (KLCCSS MK, BUY, FV: MYR6.96) will be the least affected by these measures, as it has entered into triple net lease agreements (TNLA) with most of its master tenants such as Petronas. Under the TNLA, most expenses, such as utilities and assessment expenses are borne by the master tenants. Upgrade to NEUTRAL

We upgrade the MREIT sector to NEUTRAL (from Underweight). We believe that, at this juncture, all negative factors like the fear of rising bond yields and rising expenses have already been priced in, thus limiting the sector’s downside risks. Having said that, its upside potential will probably remain limited as concerns over the anticipated interest rate hike will remain. A potential catalyst could come from acquisition activities, which should be incremental to yields.

Source: RHB