By iFAST Research Team
THE unprecedented COVID-19 pandemic affected many parts of the Malaysian economy and real estate investment trusts (REITs) were not spared, with retail and hospitality the worst hit subsegments.
After falling -13.4% in 2020, things were starting to turn better for Bursa REIT Index in 2021, as it appreciated 3.1% by early-April 2021. However, the index subsequently retraced as much as -6%, as the REIT sector suffered another blow due to the latest and biggest wave of COVID-19 infections which ravaged through the country and forced the Government to impose lockdowns again.
That said, we believe that most of the negativity has already been priced in, and the REIT sector could be in for a turnaround due to the following factors:
Reopening of lockdown and interstate travel a near term catalyst
One of the key catalyst for the turnaround in REITs is the nationwide vaccination which has been underway since end-February 2021. Despite a slow start, the vaccination has picked up across the country. The vaccination should further accelerate with the opening of more mega vaccination centres, aka Pusat Pemberian Vaksin (PPV), and if private hospitals and clinics are allowed to provide vaccinations.
We believe that as more people are vaccinated, the number of cases would decline, which mirrors the trends seen in the US and UK, where the vaccination rate has an obvious negative correlation with the number of new cases. Once COVID-19 becomes more manageable, the lockdown and interstate travel will be reopened in order to resuscitate the badly hit economy.
The Government has laid out the National Recovery Plan – a four-phase exit strategy from the COVID-19 crisis. In the plan, the Government targets to gradually resume social activities in Phase 3 (September to October). Subsequently, the government targets to reopen all economic sectors, allow more social activities, interstate travel and domestic tourism permitted in Phase 4 (November to December).
Subsequently, we expect the pent up demand of consumers to be unleashed, in a similar fashion to 3Q 2020 where we saw a huge spike in consumerism upon the reopening of MCO 1.0. Private consumption, which contracted -22.9% quarter-on-quarter (qoq in 2Q 2020, rebounded strongly by 28.7% qoq in 3Q 2020 while consumer confidence also improved with the Retail sales improving from the -19.4% qoq contraction in 2Q 2020 to rebound by 26.4% qoq in 3Q 2020.
Despite the advent of e-commerce, brick and mortar retail stores will still remain relevant for consumers that still want the physical shopping experience. Furthermore, we should see a boom in domestic travel due to pent up demand from local Malaysians who have to resort to local trips to satisfy their travel itch as international travel is still unavailable.
Additionally, the Government recently announced initiatives, such as the extended exemptions from service tax and tourism tax for hotels and extended income tax relief on domestic travel, would provide the well needed jump start to the domestic tourism industry.
Retail REITs which own prime retail malls at strategic locations and have unique product or experiential offerings are likely to recover faster. Meanwhile, hospitality REITs should see improved occupancy from domestic tourists.
Eventual reopening of international borders the longer term catalyst
In the near term, the retail and hospitality REITs industry will likely continue to be dependent on domestic travellers until the longer term catalyst kicks in which is the eventual reopening of international borders. The reopening of international borders is dependent on the progress of the global vaccination programme and active COVID-19 cases.
However, we believe that the reopening of international borders would be much sooner than that, possibly in early 2022. We should see international borders open to fully vaccinated travellers first, and eventually for everyone. Similarly, we are expecting an eventual pickup in international tourist arrivals due to pent up demand and this would bode well for retail and hospitality REITs in the longer term.
REITs to benefit from the prolonged low interest rate environment
REITs, due to its income paying nature, tend to have bond-like characteristics. In other words, as interest rates go up, REITs typically tend to come down and vice versa. Additionally, REITs tend to perform in low interest rate environments as the asset class attracts yield seekers, while benefitting from lower interest expense, which could boost earnings.
That being said, we saw this correlation break down in 2020 as the Bursa REIT Index fell -13.4%, despite Bank Negara Malaysia (BNM) cutting rates to record lows. The reason why it is different this time is because revenue and earnings for typically resilient retail and hospitality REITs were disrupted by the unprecedented COVID-19.
Going forward, we anticipate BNM to prolong the accommodative stance and maintain the low interest rate environment at least until 3Q 2022 in order to aid the domestic economic recovery, before hiking rates gradually from 4Q 2022 onwards.
REITs with a higher ratio of floating vs fixed debt can continue to benefit from lower cost of debt thanks to immediate interest rate adjustments for their floating rate borrowings. With rates expected to remain low until at least 2Q 2022, we expect REITs to lock in favourable fixed rates at longer tenures now, including opportunities to hedge through interest rate swap contracts, before rates start to rise again in the future. We believe that the locking in of low fixed rates could help cushion REITs hedge from future increases in rates should they occur from 4Q 2022.
Additionally, REITs are offering a forward dividend yield of 5.2% pa which is around the same level as before the pandemic. Meanwhile, since the start of 2020, the risk free rate (here we have used yields for five-year Malaysia Government Securities) fell by around 600 basis points (bps) to the current 2.5% per annum. The current spread between REITs’ forward dividend yield over the risk free rate is about 2.7%, significantly higher than the pre-pandemic average of 2.0%, which could indicate that REITs are undervalued relative to the risk free rate (refer to Chart 1).
Chart 1: Bursa REIT Index Dividend Yield vs Risk Free Rate
Earnings to recover back to pre-pandemic levels by 2022 but prices are still -14% below pre-pandemic levels
Taking the factors above into account, we expect earnings for the Malaysian REIT sector to rebound 48.7% in 2021 and 10.6% in 2022, to recover back to pre-pandemic levels by 2022 (refer to Table 1).
However, Bursa REIT Index is trading at around the same levels as the start of the year, which is -14% below pre-pandemic levels, indicating that markets are still undermining the potential reopening. On the other hand, its Global and Asia Pacific peers have already recovered to pre-pandemic levels (refer to Chart 2).
With the Bursa REIT Index now trading at PER2023 of 16.57x (below the historical average P/E of 21x) there is still potential upside should valuations re-rate closer towards the historical average (refer to Table 1).
Further to this, the dividend yield offered by REITs is an attractive proposition for investors looking for high dividend payouts. The projected dividend yield for REITs over the next three years range from 4.76% to 5.72% per annum which would add to the total return to investors on top of the capital gains should valuations re-rate upwards.
Chart 2: Malaysia vs Global and Asia Pacific REITs
Table 1: Valuations and Earnings Estimates
We believe that at current valuations markets have already priced in most of the negativity and uncertainty arising from the risk of delayed vaccination progress domestically and internationally as well as the political uncertainties. In addition, we opine that the current generous spread and rising dividends could help cushion against rising interest rates should it occur from 4Q 2022.
As a conclusion, we opine that the Malaysian REIT sector is an undervalued but potential reopening play with good upside potential amidst recovering earnings, undemanding valuations and attractive dividend yields. With that, investors should consider adding some exposure into the sector. However, investors should be selective and go for leading names in the sector. – June 23, 2021
iFAST Capital Sdn Bhd provides a comprehensive range of services such as assisting in dealing, investment administration, research support, IT services and backroom functions to financial planners.
The views expressed are solely of the author and do not necessarily reflect those of Focus Malaysia.
