MREITs - Thriving on a Low MGS Yield

Maintain OVERWEIGHT. We believe the sector fundamentals are intact as we expect modest single-digit reversions on minimal leases up for expiry in FY18 (14%-29% of NLA). With the 10-year MGS consistently trending downwards since Apr 2017, on the back of increased foreign holdings to 42% in May-2017 (from 38% in Mar-2017), we believe investors are looking for yields and flight to safety. We believe the foreign inflow is backed by strong Malaysian economic data, resulting in the Ringgit appreciating against the USD (+5% YTD). We are of the view that there may be more upsides to MREITs under our coverage as the MGS has compressed by 8% YTD, but MREITs’ share prices under our coverage (-3% to 10% YTD loss/gains) have not reacted and yield spreads are now at 1.3ppt-2.7ppt (vs. its YTD average of 1.0ppt-2.4ppt). Based on our recently lowered 10-year MGS yield target of 4.00%, and unchanged spreads, we maintain all our calls and TPs. We currently have an OUTPERFORM call for all MREITs, save for AXREIT. Our top pick is PAVREIT (OP: TP: RM2.02), as we believe it is a laggard since it share price has yet to react to the MGS (-3% YTD), while it is backed by a strong asset profile and acquisition potential. Our other preferred pick is MQREIT (OP; TP : RM1.41) with above average yield of 6.5% (vs. peers’ average of 5.5%), on an extremely stable asset profile.

IGBREIT top performer YTD, up 10%. IGBREIT is the top gainer year to date (YTD) under our coverage, up 10% as of 23rd June 2017, backed by its asset stability from strong occupancy (>99%) and double-digit reversions, evident from a good set of 1Q17 results. This is a follow-through since CY16 when IGBREIT was the top performer as well, up by 19.4% vs. other MREITs (at between -1.8% to +17.1%), due to similar reasons, and superior yields of 6.2%, vs. other MREITs’ average of 5.8%. All in, MREITs’ share prices in CY17 appear to have stabilised, with zero average share price gains for all MREITs, compared to the strong run-up in CY16 (9% average gains) when investors were chasing for dividends due to market volatility

FY18 stable with minimal lease expiries and modest reversions. FY18 will see minimal leases up for expiry for MREITs under our coverage at 14-29% of NLA, which we have already built into our estimates. Additionally, we are forecasting mid-tohigh single-digit reversions for retail MREITs’ assets under our coverage, and low-to-mid single-digit reversions for office and industrial assets to remain conservative due to unexciting take-up rates and office supply glut situation in the Klang Valley. As such, we believe fundamentals are mostly intact as our estimates are conservative.

A declining MGS bodes well for MREITs’ share prices. The 10-year MGS has been consistently trending downwards since 24th Apr 2017, from 4.10% to 3.89% currently. We believe this is on the back of strong economic data (i.e. strong 1Q17 Malaysian GDP growth of 5.6%), which was well ahead of consensus (4.8%) and house estimates (5.0%), driven by domestic demand and broad-based growth, while oil prices have remained range bound since May 17. To recap, a declining MGS is a positive for MREITs’ share prices, causing it to revert upwards as MREITs are viewed as a less risky option to the MGS.

Ringgit appreciating against the USD, signalling foreign investors’ confidence. In line with better economic fundamentals for the Malaysian economy, the Malaysian Ringgit has been improving against the greenback, at RM4.29 currently (vs. RM4.43 in 1Q17). Year-to-date, the Ringgit has appreciated 5% against the USD. Notably, the percentage of foreign investors holding of the MGS has also picked up to 42% in May 2017 (from 38% in Mar-17).

Maintain 10-year MGS target to 4.00%. We had recently on 8th June 2017 (refer to our report title ‘Upgrading on Lower MGS Yield’), lowered our 10-year MGS target to 4.00%, closer to current levels (from 4.20% previously) due to reasons mentioned above (i.e. better economic fundamentals, improving Ringgit and increased foreign holdings in the MGS). Meanwhile, we believe upside risk to the MGS is also minimal as potential Fed interest rate hikes have been priced in. For now, we are targeting a 10- year MGS of 4.00% (vs. current 10-year MGS of 3.89%) in order to remain conservative on our target and MREITs’ share prices. On the flip side, we may look to increase our target 10-year MGS if there are: (i) more-than-expected US interest rate hikes, (ii) significantly weaker economic data in Malaysia, (i.e. below consensus estimates), while we may lower our 10-year MGS target if there are: (i) fewer-than-expected US interest rate hikes, (ii) continuously improving crude oil data, and (iii) improving Ringgit to USD below current levels.

Maintain OVERWEIGHT. Despite the MGS compressing by 8% YTD (declining since April 2017) to 3.89% yield (from c.4.10%), we noticed MREITs’ share prices under our coverage (-3% to 10% YTD loss/gains) have not reacted to the MGS compression and yield spreads are now at 1.3ppt-2.7ppt (vs. its YTD average of 1.0ppt-2.4ppt). At current levels, MREITs are commanding attractive total returns of 11-21% (save for AXREIT), which is backed by 5.2-6.5% dividend yields, providing security to investors. We believe this is a good opportunity for investors to accumulate laggard MREITs like PAVREIT (-3% YTD) which have lagged behind the average YTD returns of sizeable MREITs (+2% YTD) and all MREITs (0% YTD). We also like MREITs with attractive valuations such as MQREIT with above-average yields of 6.5% (vs. peer average of 5.5%). We believe MQREIT is due for a re-rating given that its market cap is now above RM1b.

PAVREIT is our Top Pick. We like PAVREIT for its inorganic growth potential from likely asset acquisition in FY17, which include Pavilion Elite (opened end-Nov-2016), while other potential assets injection are; (i) fahrenheit88, pending the sponsors’ intention to sell, (ii) assets from WCT (i.e. Paradigm Mall, AEON Bukit Tinggi and) of which Tan Sri Desmond Lim and spouse have a 20% stake, while low gearing of 0.26x allows for sizeable acquisitions or greenfield potential. All in, PAVREIT’s gross yield of 5.6% provides security to investors due to its stable assets, mainly Pavilion Shopping Mall, on the back of strong portfolio occupancy at 95%, making PAVREIT an ideal laggard play as YTD share price has yet to react to the recent declines in the 10-year MGS, while upsides for PAVREIT going forward appear attractive due to its visible acquisition path. At current levels, PAVREIT is commanding attractive total returns of 21%. MQREIT is our preferred pick due to its stable assets backed by strong dividend yields of 6.5%. MQREIT’s earnings prospect appears solid due to its stable asset profile as most assets on long-term leases (i.e. 5-15 years), while portfolio occupancy is expected to remain healthy at >97% with minimal lease expiries in FY17-18 of 13.0-26.0%, capping downside risk. At current level, MQREIT is commanding 6.6% yield for FY18, which is far superior compared to MREITs under our coverage, at 5.2-5.8%. Since MQREIT’s market cap is above the RM1b mark, (at RM1.4b), we believe MQREIT’s yield spreads should trade closer to sizeable MREITs’ average, but still at a higher spread to the average given its office asset profile.

Risks to our call. Factors that may affect our call include: (i) worse-than-expected consumer spending, (ii) cost-push factors that result in weaker-than-expected rental reversions, (iii) U.S. Fed increasing interest rates in a more aggressive manner, and (iv) weaker-than-expected occupancy rates, and (v) further decline in oil prices and weaker MYR, which may increase pressure on the 10-year MGS

Source: Kenanga Research - 5 Jul 2017