We maintain  our NEUTRAL call on the REIT sector  going  into 2015, as we believe that overall earnings will start to normalise after being hit by higher  expenses  in  2014.  The  lowered  risk  of  an  OPR  hike  should mitigate the REITs’ exposure to interest rate volatility. We still prefer the retail segment,  given its stable  annual  rental growth of about 5-7% and because we expect the GST to have minimal impact on sector earnings.

Worst  could  be  over  for  the  REITs.  The  outlook  for  REITs  looks brighter in 2015, as earnings start to normalise after being hit by higher utility and assessment expenses in 2014. Some of the REITs are likely to see  some earnings boost from  either  the injection of new assets or the extensive  refurbishment  of  existing  portfolio  assets.  We  do  note, however,  that  with the goods and services tax (GST) kicking in from 1 Apr  2015,  future  acquisitions  could  prove  to  be  challenging.  This  is because all purchases of commercial assets will be subjected to the 6% GST – potentially causing assets’ yields to become less attractive.

Lower interest rate risk to be favourable to REITs.  The REITs could take a breather next year,  given  that the risk of further  overnight policy rate  (OPR)  hikes  has  been  substantially  reduced  as  economic  growth weakens. This should be favourable to the REITs, given the steady yield spread and also stable interest costs  on borrowings. We believe that the sector’s average cost of debt will stay at around the 4-5% level. We  also expect the REITs’ gearing levels to remain stable going forward. 

Retail segment still the best.  We  believe  retail REITs will continue to outperform their peers, given their relatively stable average annual rental rate growth of ~5-7% vis-à-vis 2-3% growth in the industrial segment and flattish  annual  growth  for  the  office  sector.  Nonetheless,  retail  REITs could  still  be  susceptible  to  the  expected  slowdown  in  consumer dscretionary spending. That said, the turnover rent portion only accounts for  <5%,  as  most  retail  REITs  rental  incomes  are  fixed.  As  such,  any short-term slowdown in sales should have minimal impact  on the overall REITs’ earnings. We also believe that the possible cannibalisation effect from  the  incoming  supply  of  new  retail  space  will  be  minimal ,  as  the malls  under  the  REITs  are  typically  more  mature  and  have  wellestablished positions in the market given their sizes. 

Maintain NEUTRAL.  Although our expectation of a zero-rate hike next year is favourable to the REITs, upside potential will be limited.  This is because the  sector continues to lack re-rating catalysts and excitement, with  our  expectation  of  only  a  low  single-digit  sector  earnings  growth. Sunway REIT  (SREIT MK, NEUTRAL, TP: MYR1.55)  is our pick for the sector.

 

 

Worst could be over for the REITs

We  believe  that  the  outlook for the  REITs  is  looking  brighter  in  2015,  as  earnings start to normalise after being hit by higher utility and assessment expenses in  2014. Some of the REITs are likely to see some earnings boost, either  from the injection of new  assets  or  the  extensive  refurbishment  of  existing  portfolio  assets.  Both  Quill Capita Trust  (QCT)  (QUIL MK, NEUTRAL, TP: MYR1.25) and Axis REIT (AXRB MK, NEUTRAL, TP: MYR3.55) are expected to wrap up their respective asset acquisitions sometime towards the end of 4Q14 or early 1Q15. Sunway REIT has also announced some small injections recently. We expect Sunway REIT,  CapitaMalls Malaysia Trust (CMMT)  (CMMT  MK,  NEUTRAL,  TP:  MYR1.41)  and  Hektar  REIT  (HEKT  MK, NEUTRAL, TP: MYR1.43) to  start reaping the fruits of their labour,  as the extensive refurbishments of their malls are due to be completed before end -1H15. We do note,however,  that  with  the  GST  kicking  in  from  1  Apr  2015,  future  acquisitions  could prove to be challenging, as all purchases of commercial assets will be subjected to the 6% GST – potentially causing the assets’ yields to become less attractive.

We  expect  no  significant  changes  on  the  sector’s  organic growth. We  believe  that even if electricity tariffs  were to increase again during the next review in mid-2015, the  impact  will  be  largely  manageable.  This  is  because  some  REITs  like   Pavilion REIT  (PavREIT)  (PREIT  MK,  NEUTRAL,  TP:  MYR1.48)  and  KLCC  Stapled  Group(KLCCSG)  (KLCCSS  MK,  NEUTRAL,  TP:  MYR6.96)  have  started  raising  their tenants’  service charges, hence,  cushioning the impact of higher tariffs. At the same time, we also think that the GST is unlikely to dampen the REITs’ organic growth.

Lower interest rate risk expected next year
The REITs could take a breather next year,  given that the risk of further OPR hikes has  been  substantially  reduced  as  economic  growth  weakens  following  the  fall  in CPO  and  crude  oil  prices.  As  the  decline  in  commodity  prices  is  expected  to adversely  affect  the  economic  outlook,  the  focus  has,  therefore,  been  switched  to stimulating growth rather than containing inflation. As a result, we believe the OPR will likely remain stable in 2015. This should be favourable to the REITs, given  their steady yields spread and also stable interest costs on borrowings.

We expect the REITs’ gearings to also remain stable going forward. As at end-3Q14, the average sector gearing stood at 31.6% and all the REITs’ gearings are still below the 50% gearing cap set by the  Securities Commission. We expect the REITs’  future acquisition activities  to  be  funded through a mix of debt and equity funding. This is because  most  REITs  would  like  to  keep  their  long-term  gearing  below  40%. Meanwhile, the sector’s average cost of debt will likely stay at around the 4-5% level.

 

Retail still the best – GST impact likely neutral

We believe that the retail REITs will continue to outperform  their  peers, given  their relatively stable average annual rental rate growth of about 5-7% vs 2-3% growth in the industrial segment and flattish annual growth for the office  sector. Nonetheless, retail  REITs  could  still  be  susceptible  to  the  slowdown  in  consumer  discretionary spending,  as consumers turn cautious in anticipation of the higher cost of living  and the uncertainties arising from the implementation of the GST. According to our house view, private sector consumption is expected to register a decent YoY growth of 6.8% for  2014,  with  a  slower  growth  of  5.2%  in  2015.  Our  2015  growth  forecast  is conservative compared with Retail Group Malaysia 2015’s growth forecast of 6%. Although the  current  negative  sentiment  on retail  consumer  stocks  could  spill  over into retail-related REITs due to the GST impact, the turnover rent portion (ie  rental income  based  on  tenants’  sales)  only  accounts  for  less  than  5% .  This  is  because most of rental incomes are fixed. As such, any short-term slowdown in sales should have  minimal  impact  on  the  overall  REITs’  earnings.  We  also  believe  that  the possible cannibalisation effect from the incoming supply of new retail space will be minimal. This is because  the malls under the REITs are typically more mature and have  well-established  positions  in  the  market  given  their  sizes.  According  to  CB Richard Ellis (CBRE) Research, barring any delays, close to 5m sq ft of new retail net lettable area (NLA)  will be completed by end-FY14. This  includes the  1.4m-sq  ft  IOI City Mall, which opened its doors in November.

 

 

Another challenging year ahead for the office segment

The  office  REITs  segment  will  likely  continue  to  face  headwinds  going  into  2015. According to another  report by  CBRE,  there will be approximately 6.8m  sq ft  of new office space coming up in the Greater Klang Valley area next year. Given the influx of supply,  we  expect  competition for new  tenants  and tenant retentions (especially in the  Central  Kuala  Lumpur  area)  to  remain intense.  In  general,  all  the  office  REITs continue to guide for flattish rental growth going forward in a bid to retain tenancies. We  note  that  between  1Q09  and  1Q14,  the  CAGR  for  the  rental  rates  for  Kuala Lumpur’s  investment-grade offices  stood at only  about  4.3%, and we expect  future annual growth to come in slower as more new office space is completed.

 

 

 

We  believe  that  despite  these  challenges,  there  is  still  a  silver  lining  for the  office REITs under our coverage.  KLCCSG will continue to be insulated from this risk, as the  leases  for  most  of  its  offices  are  based  on  long-term  triple  net  master  leases. 

QCT  will  potentially  have  some  future  growth  prospects  through  the  injections  of Malaysian Resources Corp’s (MRCB) (MRC MK, NEUTRAL, TP: MYR1.40) premium assets going forward. Sunway REIT’s earnings exposure to the office segment is only at about 10% of total earnings. Hence,  we believe that the shortfall from the office segment will be made up by the growth in its other segments. For PavREIT, although the  revenue  for  Pavilion  Tower  declined  by  10.4%  YoY  in  9M14,  we  are  not  too concerned, as the asset only contributes about 2.7% to its overall topline.

Industrial segment should see no surprises
Although  the  industrial  production  index  (IPI)  YoY  growth  has  moderated  to  about 4.1% in 3Q14  (2Q14: 5.9%), we still expect the  rental rates growth in the  industrial segment to remain stable going into 2015.  This is mainly due to the  absence of new industrial  assets  available  in  the  market  as  well  as  the  long-term  leases  for  most tenants. As such, we expect Axis REIT, which is the only REIT under our coverage with exposure to the industrial segment, to still record a stable annual growth of about 2-3%  from this  sector.  We note that the growth in the industrial segment is typically not as exciting as the retail segment, given that most tenants  are on long-term (five years and above) leases, while the tenancy period for retail REITs  is  typically  three years only.

 

 

Key risks

We believe that the key risks to the sector include: i) the  increasing competition  for tenants  from  the  influx  of  new  assets,  ii)  unexpected  interest  rate  hikes  that  could cost newer borrowings to come in at higher rates,  and iii)  GST impact on purchases of new assets that could dilute the assets’ yields.

Maintain NEUTRAL
We maintain our NEUTRAL stance on the sector. Although our expectation of a zero rate hike next year is favourable to the REITs, upside potential will be limited as the sector  continues  to  lack  re-rating  catalysts  and  excitement,  especially  with  our expectation  of  only  a  low  single-digit  sector  earnings  growth.  Sunway  REIT  is  our pick for the sector, given the potential earnings upside stemming from the reopening of Sunway Putra Place in 2Q15 as well as from more sizeable asset injections from its sponsor, Sunway (SWB MK, BUY, TP: MYR3.90).

Source: RHB