Myriad headwinds for M-REITs

From The Edge Malaysia
19th Aug 2013

Prospects for real estate investment trusts
(REITs) listed on Bursa Malaysia are likely to stay muted for the foreseeable future.

Whilst REITs had fared well previously, when excessive liquidity and historic low interest rates pushed investors into seeking higher yields in these investments, the trend has reversed in recent months.

Even though unit prices for most of the larger, more liquid trusts have corrected over the past month, their expected returns do not appear any more attractive, given that risk-free returns on government bonds have risen in tandem.

Indeed, yields on the 10-year Malaysian government securities (MGS) have risen quite sharply over the past few weeks, breaking above 4.1% at end-July, after having averaged around 3.5% in the first six months of the year, before retreating to the current 3.8%.

The year-to-date yield increases for the MGS — of about 0.33% — are still lagging comparative increases for the benchmark 10-year US Treasury notes, which are up by well over 1%. It is thus conceivable that there could be more catch up risks for local bonds.

Looking further ahead, interest rates will likely trend higher with the gradual normalisation of monetary policies, led by the US Federal Reserve. Currently, the market expects the US Fed to start pulling back on its bond purchase programme as early as in September.

Rising interest rates will cap any near-term gains for REITs — indeed, they raise downside risks, especially for those currently offering yields at the lower end of the range.

Furthermore, earnings outlook for REITs may turn more challenging.

Prevailing yields offer litle buffer against rising interest rates
Income for office-focused REITs has long been viewed as the most vulnerable, based on prevailing forecast for incoming supply of space over the next few years. On the other hand, earnings for retail REITs are widely thought to be among the most resilient.

Indeed, most of the listed retail trusts on the local bourse are still registering good rental reversion. For example, CapitaMall Malaysia Trust (CMMT) reported rental reversion of 7.9%, on average, in the first half of 2013 (1H13).

Over the same period, Pavilion REIT is believed to have renewed about one-third of total net lettable area (NLA) for its flagship mall at a rate of between 10% and 15%. The trust expects the remaining one-third of NLA, to be renewed by end third quarter (3Q) of 2013, to enjoy similar reversion rates.

Strong rental reversion this year will drive the trust's income growth — in the absence of new acquisitions. We estimate distribution per unit for Pavilion REIT to expand some 6.7% and 5.8% in 2013 and 2014 respectively.

Nonetheless net yields are still modest — at 4.8% and 5.1% over the two years — at the current price of RM1.37,implying a spread of just about 1% to 1.3% against risk-free MGS. This does not provide much buffer against further rate increases.

Slower GDP growth may cap future rental increases
Importantly, the pace of rental increases may slow going forward.

Rental reversion for shopping malls in prime locations has been strong over the past few years on the back of robust domestic consumption. Retail sales grew 8.1% in 2011, 5.5% last year and 7.5% year-to-year (y-o-y) in 1Q13 — bolstered, in part, by government handouts in the long run up to the general election.

However, debt-fuelled consumption is unsustainable over the longer-term. Indeed, Bank Negara Malaysia has started to clamp down on rising household debt in earnest. Malaysia's household debt to GDP, of 83%, is among the highest in the region.

At the same time, the government is also expected to tighten fiscal spending, what with public debt to GDP rising above 53%, worryingly close to the self-imposed limit of 55%. Fitch Ratings' recent downgrade of our country's ratings outlook from "stable" to "negative" serves as a warning call against further deterioration in public finances.

Measures under discussion such as rollback in subsidies and service tax levy would help boost government revenue but will eat into disposable incomes and consumer purchasing power even as households have to find ways to deleverage. Additionally, the binge on cheap credit will strain household finances when interest rate starts to go up.

Reining in spending by both the public and private sectors could herald a period of slower economic growth for the country.

Rental outlook for the office sector is already bleak on the back of expectations of oversupply. In a similar vein, new retail space coming into the market could moderate the pace of future rental increases against a backdrop of slower economic growth. Sunway REIT estimates 5.2 million sq ft and 7.6 million sq ft of new retail space in Kuala Lumpur and Selangor in 2013 and 2015 respectively.

High property prices make yield accretive acquisition more difficult
High property prices also make it difficult for REITs to expand via acquisition of yield accretive assets.

Case in point, despite significant debt headroom — relatively low gearing of 25% — it appears unlikely that IGB REIT would add to its existing portfolio of two shopping malls in the foreseeable future.

As such, its income growth too remains heavily dependent on rental reversion. Expectations for rental increases for the Gardens Mall are still upbeat given that rates are still lower than that of the adjoining Mid Valley Megamall. Just over half of Gardens Mall's NLA is up for renewal in September. Rental reversion will likely be strong, for now.

However, like Pavilion REIT, IGB REIT's prevailing net yields are not compelling either — estimated at roughly 4.8% and 5% at the current price of RM1.29.

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