Sunway Real Estate Investment Trust (KLSE:5176)

Sunway Real Estate Investment Trust (SunREIT) is a diversified REIT underpinned by one of the best performing shopping malls in Malaysia, Sunway Pyramid. The strong performance of this mall has turned this REIT into one of the best performing REITs in the Malaysian REIT (MREIT) space. Unfortunately, the bulk of the other assets have been mediocre at best, with some severe non-performers such as an office building, Sunway Tower which has struggled with an occupancy rate of 20% over the last few years.

Summary of the Investment Thesis

Strengths

1. Sunway Pyramid is a major growth driver as a prime mall in Klang Valley and anchors the REIT's overall DPU growth
2. Sponsor has a pipeline of assets to be injected, which will sustain long term growth

Risks

1. Glut of office and retail assets in Klang Valley- low occupancy and/or falling rental rates of office and non-prime retail assets have been a drag on the REIT's earnings.

What does the company do?

SunREIT is a diversified REIT that is backed by Sunway Berhad, a Malaysian conglomerate involved in construction, property development, hospitality, education, healthcare and etc. Geographically, more than 90% of the REIT's assets by revenue and net property income are located in the Greater Kuala Lumpur region, commonly referred to as the Klang Valley.

SunREIT is heavily skewed towards retail malls, underpinned by its crown jewel, the Sunway Pyramid mall which accounts for 55% of revenue and 58% of net property income. The retail segment (in shades of gray below) accounts for about 70% of  net property income, followed by hospitality at 20% (red) with the balance consisting of a diverse pool of healthcare, office and industrial assets. The management announced on 24th December 2018 that it has acquired from its Sponsor a clutch of education-related assets, which will further diversify the REIT's asset base.

Macroeconomic Analysis

Consumption driven growth remains intact. The Malaysian economy remains a story of rising consumption growth. Income levels in Malaysia has been rising at a steady pace, with official government statistics pointing to an average of 9.1% growth on average between 2009-2016 for Malaysia. In Selangor and Kuala Lumpur, the growth rate has been 7.7% and 10.9% over the 8 year period.

Supply glut of office and retail space in the Klang Valley. Due to supply outpacing demand, rental rates for office and retail space have been impacted, particularly for the less prime properties. Vacancy rates for shopping malls have been rising since 2015 while the office vacancy rates have remained very high over the last few years, with no signs of the situation improving anytime soon.

Klang Valley's Big Five prime shopping malls are Suria KLCC, Pavilion, One Utama, Mid Valley Megamall/The Gardens Mall and Sunway Pyramid (owned by SunREIT). Despite this glut of retail space, the prime shopping malls have seen rental rates rise steadily over the years. Rising vacancy rates and falling rental rates have plagued primarily older and less prime malls.  On a related note, the surge of the T20 (top 20% percentile of income earners) in terms of income and wealth growth has helped support traffic footfall to the prime malls. The steady growth of demand for luxury cars over the last few years versus mid-range Japanese brands paints a very clear picture of the state of each socioeconomic strata in Malaysia.

Company Analysis

Review of Assets

Sunway Pyramid

The crown jewel of the SunREIT. I am of the view that this REIT would have performed better if this REIT only contained Sunway Pyramid as most of the other assets have detracted from performance. As one Klang Valley's Big Five prime shopping malls, this has allowed Pyramid to maintain a close to full occupancy rate and steady rental reversion in spite of the glut of shopping malls in the Klang Valley. This mall has remained the anchor of the REIT since its IPO and the primary source of DPU growth, as can be seen below. In the long run, the addition of new assets into the REIT will gradually erode its contribution to the REIT. The mall has experienced steady growth in traffic footfall (industry jargon for number of mall visitors) over the years, with a reported 5% growth in car count for 2017. The management's active effort to increase the number of parking bays available for visitors has sustained this growth rate, as limited parking bays have been a growth bottleneck for the prime malls of Klang Valley.

Other Assets

SunREIT's hospitality assets have been unsatisfactory in my opinion, though not surprising for its asset class. The contribution of the hotels have been volatile on a quarterly basis, and in the long run, stagnant as hotel room rates have not increased significantly over the years, unlike retail rental rates. The office buildings have been performing even worse, largely due to the office supply glut in the Klang Valley. According to Savills, the office vacancy rate is currently between 20-25% and is expected to persist there until 2022.

On the other hand, Sunway Medical Centre has been a positive acquisition for the REIT as it was done on a triple net lease basis, meaning that all costs are borne by the hospital while the REIT collects a fixed rent with annual escalation of 3.5%. SunREIT's recently announced acquisition of education assets are also fixed rent terms, subject to annual escalation, which I deem to be a positive as this will provide NPI growth and stability to the REIT. As these leases are long term (Sunway Medical Centre's lease was done on a 10 + 10 years basis while the education assets will be leased on a 30 + 30 + 18 years basis), the risk of non-renewal or renewals at lower rental rates is not there.

Income Analysis

Long term DPU growth. SunREIT has demonstrated a steady track record since its IPO in 2010, due in no part to the strong performance of Sunway Pyramid and acquisitions of new assets funded through borrowings. Sunway Pyramid has been able to raise rents successfully while preserving a close to full occupancy rate over the years. Suria KLCC, Pavilion, Mid Valley Megamall and The Gardens Mall have average rental rates of RM 24 psf, RM 26 psf, RM 17 psf and RM 16 psf respectively.

As a result of more acquisitions, the REIT's gearing ratio (total debt to total assets) has been creeping upwards over the last few years years, and will rise to 42.8% following the recently announced acquisition. This is still comfortably below the Securities Commission's prescribed gearing limits of 50%, and will give the REIT some headroom to acquire further assets without needing to raise new equity or issuing perpetual bonds. While most REIT's employ a fair amount of leverage to boost unitholders' returns, SunREIT is unique relative to the MREIT space in that it relies exclusively on short-term financing, which I will discuss further below.

Sensitive to interest rate changes. Unlike most of the other MREITs that rely on medium term financing, SunREIT relies exclusively on short term funding. Implicitly, SunREIT's interest expense is sensitive to changes in Bank Negara Malaysia's (BNM) Overnight Policy Rate (OPR), relative to other MREITs. According to SunREIT's 3Q18 financial report, it has MYR 2.913 billion of short term borrowings, consisting of short term bonds, commercial papers and revolving loans. As a result of relying on short-term financing, SunREIT's cost of debt is approximately 4.0%, somewhat lower than the other MREITs. IGB REIT's borrowing cost is 4.5%, KLCC REIT - 4.8%, CMMT - 4.8% and Pavilion REIT - 5.2%.

On the other hand, the price of relying on short term financing leaves SunREIT vulnerable to liquidity shocks in the banking system and broader financial ecosystem. Under extreme liquidity scenarios such as the Asian Financial Crisis of the late 90s, or more recently the US at the height of the Great Financial Crisis, SunREIT could struggle to roll over its short term debts, or may end up paying exorbitant rates in times of crisis.

Taking into account the new debt of MYR 550 million for the acquisition of Sunway's education assets, SunREIT's new debt load will stand around RM 3.5 billion. A 0.25% reduction in the OPR and corresponding fall in SunREIT's cost of debt translates into a lower interest cost of RM 8.6 million. This translates into a full year DPU boost by 0.29 cents, or about an increase of 3% to the last four quarters worth of DPU. Conversely, an increase of the OPR by 0.25% will directly translate into a corresponding decrease. This is in contrast to the other major REITs that issue 3-10 year bonds with fixed coupons, or take out loans on fixed interest terms, causing the earnings to be less sensitive to short term fluctuations of interest rates.

Conclusion

SunREIT's DPU growth should remain positive despite the challenging situation affecting the retail and office rental markets, owing the strong performance of Sunway Pyramid. I deem the addition of education assets as a strong positive, as it will reduce the volatility of DPU on a quarterly basis as well as provide predictable and stable growth going forward.

As of 31 December 2018, this REIT has generated capital gains of 96.6% since its IPO, and 62.5% of post-tax dividend return for a total return of 159%. This translates into an approximate annualized return of 11.8%. In comparison over the same period, the KLCI has generated 29.5% of capital and 27.6% of dividend returns, for a total of 56.9% or an annualized rate of 5.6%.

For market data on this REIT and comparison against the market, please refer to my compilation of REITs here.

Disclosure: I have been holding this REIT since its IPO in 2010, and have no plans to liquidate my position in the foreseeable future.