We reiterate our NEUTRAL stance on the REIT sector due to rising oversupply in office and retail spaces coupled with a narrowing yield spread between REITs and the 10-year Malaysian Government Securities (MGS) with interest rates on the uptrend that could more than offset the positive prospects of Malaysia’s reopening of international borders.
Retail sales and footfall recovering since the relaxation of movement restrictions. Based on the Department of Statistics Malaysia (DOSM), retail trade rose 7.3% MoM to RM49bil in January 2022 (vs. RM48.5bil in December 2021). Retail sales in non-specialised stores increased 10.1% MoM to RM18.2bil, mirroring an upward trend in consumer spending in retail since the relaxation of movement restrictions. Shopping centres that are highly dependent on tourism are expected to benefit from the reopening of international borders. However, we do not expect the recovery in retail sales and footfall to translate into a significant improvement in rental reversion rates for malls in the near term.
Rental reversion in retail sector is unlikely to recover to the pre-pandemic level in the immediate future. Although the outlook on retail sales is improving, we expect rental reversions for malls in prime locations to remain muted in the near term as tenants will still require some time to recover back to their pre-pandemic sales level. Nonetheless, rental assistance for travel-related tenants is expected to gradually cease with the reopening of international borders. According to the National Property Information Centre (Napic), the performance of shopping complexes continued to moderate in 2021. The occupancy rate of malls in Kuala Lumpur remained in a downtrend on the back of rising total retail spaces (Exhibit 3). Based on the DOSM, the index of retail sales over the internet for January 2022 rose 20.5% YoY, which reflected the trend of consumers continuing to shift their spending towards e-commerce. While we foresee more stable rental renewal rates for popular malls located in key areas, rental reversions for less established malls are likely to turn negative. For these smaller malls, increasing occupancy rates through attractive rents will be imperative.
Occupancy and rental reversion rates in the office segment are expected to continue facing downward pressure. We believe that the pressure on rental reversions for old office buildings in Kuala Lumpur city centre will persist given the growing oversupply of office space on the back of office decentralisation and flexible working arrangement trends. The performance of offices in Kuala Lumpur continued to soften as overall occupancy rate fell further to 73.3% in 2021 (Exhibit 6). In 2021, total office space in Kuala Lumpur rose 5.8% YoY to 9,817.7mil square metres (sqm) (Exhibit 4). Hence, we believe that management will either need to offer more competitive rental rates or embark on asset enhancement initiatives to retain existing and attract new tenants to improve occupancy rates in aging offices buildings.
Gradual recovery in the hospitality segment from the reopening of international borders on 1 April 2022. We foresee the removal of quarantine measures for arrivals from Singapore and Thailand to be positive for hotels’ occupancy rate and revenue per available room (RevPAR). Singapore and Thailand were the top 5 contributors to Malaysia’s tourism and hospitality industries before the pandemic, accounting for 46% of Malaysia’s total international tourist arrivals in 2019 (Exhibit7). We do not anticipate a significant recovery for the hospitality segment in the distant future. Tourists may remain skeptical about entering Malaysia on the back of daily infections rate at above 10,000 and the emergence of a more contagious Omicron sub-variant, the BA.2. The sub-variant is currently dominant in the US and has caused new waves of infection in China and major EU nations.
Declining yield spread between REITs and 10-year MGS in an accelerating interest rate environment. On 16 March 2022, the US Federal Reserve raised the interest rate by 25bps and alluded to more aggressive rate hikes to 1.75% by the end of 2022. This has resulted in the 10-year US Treasury yield rising to 2.55% as of 5 April 2022. Meanwhile, our in-house economists anticipate a 25bps rate hike by BNM in 2H2022 to combat rising inflation in Malaysia. 10-year MGS rose to 3.94% as of 5 April 2022, reflecting a potential interest rate hike and the rising trend in 10-year US Treasury yield. This resulted in a narrowing yield spread between REITs and 10-year MGS. We believe market sentiment will remain lacklustre on REITs in the near term as it is not appealing to yield-seeking investors. The average DPU yield for stocks under our coverage is 4.1% (Exhibit 1).
Our top BUY is Sunway REIT (fair value RM1.66/share) underpinned by: (i) its diversified investment portfolio which encompasses retail malls, hotels, offices, a university, and hospitals that spread across Malaysia; and (ii) strong occupancy rates which have exceeded 90% in retail assets. The group launched Sunway eMall to mitigate the ecommerce disruption by converging the online and offline shopping experience. The platform offers delivery and an instore collection for online shopping across its physical malls. Customers can earn and redeem points via Sunway Pals, its loyalty programme for purchases on Sunway eMall or participating stores in Sunway malls.
Downside risksto our forecasts are: (i) a deeper contraction in yield spread of DPU against the 10-year MGS with a faster-than-expected interest rate hike to curb rising inflation (Exhibit 9); (ii) a slower-than-expected recovery in hospitality and retail REIT due to the reintroduction of international border restrictions with the emergence of more contagious Covid-19 variants; and (iii) a lower-than-expected tenancy renewal rate.
