All eyes on the west. US Fed‟s QE tapering has came in earlier than expected. Market will continue to interpret the implications of US economic data (i.e. inflation) to gauge the momentum and quantum of QE tapering over the next months. While interest-sensitive M-REITs are likely to be laggards in 1H14 against a volatile yield environment, a large portion of the taper-related selloff is already factored in their unit prices, we believe, hence, we maintain our NEUTRAL stance on the sector. Our top pick is CMMT.
Glory days have passed. 1H13 was the best year on record for M-REITs with the listing of Malaysia‟s first ever stapled REIT, KLCCP (largest by market value and asset size) in May, further supported by yield-seeking/risk-averse investors accumulating the M-REITs pre-13GE in May 2013 as they turned defensive and shunned political ambiguity. However, the M-REIT sector has been severely sold down since the Fed hinted at QE tapering on 22 May 2013.
The bears overtake the bulls. The 10-year MGS yield has surged to 4.0% (+98bps) while average gross yields of the M-REITs have risen to 6.6% (+67ppt) since 22 May 2013. The yield spread between M-REITs and MGS is now 258bps, below the average of 355bps since 2006 and 314bps between 2012-May 2013 (peak), suggesting that there could be further downside for M-REITs. M-REITs are no longer defensive, with average beta having jumped to 0.5-0.9 from 0.5-0.7 in 2011-12.
Rising rates curtail deals, make yield stocks less appealing. Rising rates and stubbornly high property values would dampen acquisition activities, making fundraising difficult, with acquisitions having been a meaningful driver of earnings growth under a low interest-rate environment over the past few years. We also see weaker demand for yield stocks. Berjaya Sports Toto Bhd has cancelled the listing of its gaming business trust on the Singapore Stock Exchange.
Cost pass-through depends on bargaining power. Electricity tariff and potential assessment rate hikes in 2014 are negative for M-REITs. While many commercial leases include rent escalation clauses and cost pass-throughs to the tenants, their execution is still dependent on market conditions, with tenant retention a top priority. In our view, the presently oversupplied office market makes it difficult to pass on the extra costs. Higher rentals on KL properties due to assessment fee hikes could encourage decentralisation.
The time is not ripe to be bold, as the repricing of the REITs could continue especially in 1H14. We may see M-REIT yields moving towards the historical average spread over 10-year MGS yields of 314bps (+50bps), which implies 6-8% downside in unit prices. The re-entry point will be when the bond market/yields start showing signs of stabilisation, probably in 2H14 as uncertainty over the US Fed‟s monetary policy subsides.
Our preference is for REITs with solid fundamentals, visible asset pipelines from their sponsors, and that have good valuation buffers to cushion the impact of a sudden surge in bond yields. We have cut our TPs by 3-19% on higher beta and cap rate assumptions. We remain BUYers of CMMT and PavREIT.
Fed taper sooner than expected. The Fed will start trimming its monthly bond purchases by USD10b to USD75b from Jan 2014 onwards to unwind the stimulus put in place since 2008. This came in earlier than expected as we had anticipated it to happen sometime in Mar 2014. Markets could continue focusing on the implications of US economic data (i.e. inflation rate) over the next months to gauge the momentum/quantum of QE tapering. Overall, the yield uptrend remains very much intact.
Lack of sector catalysts – we expect property deals to slow down amid rising rates. M-REITs have done extremely well over the past two years amid a low interest rate and „risk-off‟ environment. Low interest rates and strong demand for stable, income-producing investments have made it much easier for REITs to acquire new assets due to cheaper cost of funds/equity. Yields were further compressed with the listing of giant REITs – PavREIT (2011), IGB REIT (2012) and KLCCP (2013) that have made the M-REIT sector more investable and appealing to international investors.
Conversely, rising rates and weaker demand for yield stocks would dampen acquisition activities and could discourage asset owners from REIT-ing their assets due to unfavourable pricing. PNB was earlier reported to have appointed bankers to structure a merger of its property assets valued at around MYR15b and list them as a property trust in 2014. This (a re-rating catalyst) may not happen if demand for yield investments is weak. Meanwhile, Berjaya Sports Toto Bhd recently cancelled the listing of its gaming business trust in Singapore due to the current weak demand for yield instruments.
Rising operating costs – to pass on or not. A rising rate environment typically reflects a recovering economy and should translate into better bargaining power for rental hikes for asset owners. However, we think this will be no easy task for the M-REITs in an environment of rising costs. Next year will see higher fuel bills, electricity tariffs and potential assessment fee hikes. 2015 will see the implementation of GST.
While many commercial leases include rent escalation clauses and cost pass-through to the tenants, tenant retention remains a top priority and REITs may have to absorb part of the additional costs. Also, slower consumer spending (due to higher living costs) may affect turnover rent at retail malls. Currently, turnover rent accounts for 3-5% of the retail REITs' total gross income (except for IGBR's 12%). However, Visit Malaysia Year 2014, which targets significant growth in tourist arrivals and spending (benefiting the retail sector), could cushion the blow.
Rising interest cost risk but still manageable. Most REITs under our coverage have been proactively managing their capital and have tilted towards fixed instead of floating rate loans to reduce overall interest cost risk to their portfolio income. In the event of a 25bps hike in interest rates, QCT, PavREIT and IGB REIT will be the least affected as close to 100% of their debts are fixed rate, while we estimate downgrades of 0.6% in our FY14 net profit forecast for Axis REIT, 0.4% for CMMT, 0.4% for SunREIT and 0.2% for KLCCP.
Rental outlook. Rents for offices may continue to be under pressure due to the office supply glut (huge incoming supply of 16.2m sqft in the Klang Valley by 2015, from 89.3m sqft in 1Q13, according to CBRE). As a result, the office market would have relatively lower bargaining power to pass on the additional operating costs as compared to the retail asset owner. As for strategically-located retail malls such as Pavilion KL Mall, Mid Valley Megamall, Suria KLCC, Sunway Pyramid shopping mall, rental growth should stay strong at 8-10% in 2014 although turnover rent could be affected from Apr 2015 onwards on slower consumer spending post the implementation of GST.
Earnings downgrades. We lower our FY14/15 earnings forecasts by 0.2% to 0.9% to factor in electricity tariff hikes from Jan 2014. REITs under our coverage are able to pass on the majority of these increases to their tenants via higher service charges/rent escalation clauses, we understand. We however have not factored in potential assessment fee hikes for KL property owners, pending further clarifications from KL City Hall (DBKL; public hearings will be in end-Mar 2014). Based on our back-of-the-envelope calculations, we estimate an additional cost of 0.2-1.3sen/unit. Losers include KLCCP, IGBR and PavREIT who have 100% of their assets in KL, while Axis REIT has no exposure in the KL area.
Maintain NEUTRAL; TPs cut. We roll over our base year for valuations and lower our TPs by 3-19% after imputing higher betas of 0.75-0.85 (from 0.55-0.8) and higher cap rates of 7-8% (from 6-7%) amid a volatile bond market. While we think a large portion of the taper-related selloff is already factored into prices, there could be 6-8% downside in unit prices as yields are still below its historical average of 314bps.
Our strategy. We favour the less interest rate-sensitive high-yield REITs (e.g. QCT; HOLD) as we think they can hold up better in a rising rate environment. We also like REITs with solid fundamentals and sponsored REITs with visible asset pipelines. We are BUYERs of CMMT and PavREIT. CMMT offers an attractive gross yield of 7% (2014) after the recent selldown, while PavREIT‟s low gearing allows the trust to acquire assets without the need to raise equity.
Publish date: 23/12/13