Sunway REIT

Size matters
• A township REIT. Sunway REIT (SunREIT)’s RM3.79b portfolio assets are in retail, hospitality and office segments. Notably, 87% of FY09’s revenue is derived from properties in Bandar Sunway. Retail is SunREIT’s main earnings driver as it accounts for 67% of net property income, followed by hospitality (21%) and office (12%) real estate.

• Assets located in master planned township fuels organic growth. Bandar Sunway township is still growing and enjoys high population traffic flow given crowd drawers (e.g. Sunway Pyramid) and high accessibility via 5 highways. Being in a master planned township ensures there is no competition of similar asset but more importantly complementary development of properties to improve the business (increase shoppers/pedestrian traffic footfall) for the properties in an integrated holistic manner.

• Largest Malaysian-REIT (M-REIT). SunREIT is expected to have RM2.68b market capitalization or 2.6x larger than Starhill REIT, the next largest M-REIT. It is also expected to have the highest free float value and largest portfolio size.

• Size matters. SunREIT size is expected to change perceptions of M-REITs, which suffered illiquidity and lacklustre interests from large funds, as SunREIT has greater visibility amongst local and foreign institutional funds. With a market capitalisation of RM2.7b, cash-calls for acquisitions via placements are more meaningful as regulations cap placements at 20% of approved fund size.

• First right of refusal to acquire parent’s properties. It is beneficial because SunREIT will have a strong stream of assets for injection that has higher likelihoods of aligning with its investment criteria. We understand the parent has RM2.6b worth of local investment properties for potential injection over next 5-7 years. Retail and hospitality should continue to be main features of SunREIT as these assets better benefit from growing township synergies.

• Expecting FY10-11E GDPU of 6.6sen-6.8sen or 6.8%-7.0% yields; assuming 100% payout. We opine SunREIT’s large portfolio size, market capitalization and free float warrants the lower than average yields.

• Recommending fair value of RM1.05 (8% upside to retail IPO price of RM0.97), based on GGM valuations (8.8% required rate of return, 3.0% terminal growth, FY11E NDPU of 6.1sen). Our valuations are also supported when applying Axis REIT’s 1.1x PBV to SunREIT’s BV/share of RM0.97, implying SunREIT could be valued at RM1.07.


Background & Business
Realizing values. Sunway City (SCITY) is spinning-off their property investment assets into Sunway REIT (SunREIT) to fully realize embedded values which were largely discounted under SCITY. SunREIT initial portfolio comprises of real estate in retail, office and hospital sectors in Peninsula Malaysia worth RM3.79b, of which 85.5% of total asset value are located in Bandar Sunway or Sunway Group’s flagship integrated development. The acquisition by SunREIT will be satisfied 30:70 debt-equity funding.

SunREIT to be managed by SCITY. Suncity REIT Management Sdn Bhd, a subsidiary of SCITY, will be the REIT manager of SunREIT. The following diagram is SunREIT’s structure post completion of IPO and highlights and illustrates key relationships between Leasess, Trustees, SCITY, Manager and Unitholders.

Mostly a retail play. Retail makes up 62.7% of SunREIT’s portfolio combined GFA of 8.1m sf, followed by hospitality (27.3%) and offices (10.0%). Contribution is also strongest from retail assets.


Listing details
Main Market listing. The IPO offering comprises of 1.65b units for public issue. Indicative retail price is the lower of RM0.97 or 97% of institutional price, subjected to book building exercise, which should be completed on 24/6/10. The IPO should raise RM1.65b which will be used to partly satisfy purchase consideration of target acquisitions and defray IPO expenses. Listing date is expected on 8 July 2010.

5 cornerstone investors. SCITY will have 35%-38% stake of the listing units (depending on overallotments). Second largest stake will be the Government of Singapore Investment Corporation (GIC) with 5% as part payment of assets for sale; recall GIC owned 48% each of Sunway Pyramid Shopping Mall and Sunway Resort Hotel &Spa. Employees Provident Fund (EPF), Permodalan Nasional Bhd (PNB) and Great Eastern Life Assurance (Malaysia) Bhd (GE) will collectively have 9% stake. These cornerstone investors are known for their long-term holdings and instill confidence for other investors.

Highest free float amongst M-REIT. SunREIT’s free float is 48%, assuming SCITY’s stake is 38% and cornerstone investor’s combined holdings of 14%. Amongst M-REITs, SunREIT has the highest free float in terms of value amongst M-REITs


Investment Case
SunREIT is a township REIT. Unlike ‘pure play’ REITs, SunREIT has multiple exposures to three property segments in different regions, providing diversified income. Notably, majority or 87% of FY09’s revenue is derived from Bandar Sunway. The assets are located in master planned townships enabling the properties to tap on the natural advantage of the portfolio mix of properties which has synergistic effect of providing shoppers / pedestrian traffic footfall) between these properties. More importantly there is no direct competition given that the type of properties approved to be built is already predetermined in the masterplan. This is an advantage that is not apparent with ‘pure play’ REITs.

Assets located in growth areas… Bandar Sunway township is still at a growth stage with a residential catchment of >600,000. It has high population traffic flow given crowd drawers like Sunway Pyramid or one of the largest malls in Klang Valley, colleges/universities, entertainment (e.g. Sunway Lagoon) and business centers, as well as, high accessibility via 5 highways. Other assets are located in KL city center and growing population areas like Ipoh and Seberang Jaya, Penang.

…fuels organic growth. Yield enhancements in Bandar Sunway assets are inevitable as population size continues to expand in Bandar Sunway, and hence is not solely dependent on major CAPEX to achieve organic growth. Guided maintenance CAPEX is RM6m-RM7m p.a. for the next 3 years.

Strong branding… The Sunway branding is well established in Malaysia which attracts quality tenants for SunREIT; this is a critical success factor as it minimizes bad debts and high tenant turnovers as quality tenants tend to 1) be good paymasters 2) have longer lease terms or have higher likelihood of extending lease tenures 3) attract other quality tenants. SunREIT’s top 10 tenants by revenue include Parkson Corporation, AEON-Jusco, Giant-GCH Retail, etc.

…and proven assets. All its assets have >3 year track records and have demonstrated steady growth in rental and occupancy rates. Even during recent economic downturns, most of its asset performance have held steady. (Refer to Appendix for historical asset performance).

Largest Malaysian-REIT (M-REIT). Upon listing, SunREIT is expected to have a market capitalization of RM2.68b, based on average IPO price of RM1.00/unit, and will be 2.6x larger than the next largest REIT, namely Starhill REIT.

Size matters… Although M-REIT provides attractive average yields of 8.6%-8.9%, lack of market capitalization size have resulted in lackluster interests from institutional funds, and consequently, the illiquid reputation of M-REITs.
SunREIT size is expected to change perceptions as it has greater visibility amongst local and foreign institutional funds. The market also anticipates it to have the largest free float amongst M-REITs, in terms of number of units and value, which bodes well for liquidity.

….especially when making way for acquisitions. Cash-calls via placements is preferred by M-REITs because REITs approval time for rights issuance vs. non-REITs, is much longer, making the exercise unfeasible as prices may run away from proposed rights issue prices. But under SC guidelines, M-REITs placement of new units must not exceed 20% of the approved fund size based on a rolling 12-month period. The restriction dwarfs fund raising activities and hence, portfolio growth, resulting in general muted interest in M-REITs.

But 20% placement of approved fund size is meaningful to SunREIT 1 given its size. It could potentially raise RM485m in the next 12 months (based on 20% of SunREIT’s approved fund size of 2.78b units or 556.0m new units and assuming placement price of RM0.873 or 10% discount to retail price of RM0.972). Hence, gearing can be pared down to make room for new acquisitions.

1. The number of units to be issued, when aggregated with the number of units issued during the preceding 12 months, must not exceed 20% of the approved fund size.

2. SC guidelines states new units must not be placed at more than 10% discount to the 5-day VWAP prior to the price-fixing date.

Healthy gearing of 29%, upon inception. Under SC guidelines, M-REITs gearing (defined as total borrowings / total assets) must not exceed 50% of total asset value. So SunREIT could raise RM783m cash from new borrowings for new acquisitions. SunREIT is likelier to gear-up for new acquisitions instead of placing out given current cheaper cost of debt vs. equity.


Outlook
We understand SCITY has RM2.6b worth of local investment properties which could be injected into SunREIT in the next 5-7 years time. Retail and hospitality should continue to be main features of SunREIT as these assets better benefit from growing township synergies. Typically, new injections must be 1) minimally dilutive to the existing portfolio 2) have organic growth opportunities 3) relatively stable income over long periods.

First right of refusal to acquire SCITY properties. It is beneficial because SunREIT will have a strong stream of assets for injection that has higher likelihoods of aligning with its investment criteria; e.g. assets within Bandar Sunway or areas with SCITY led developments. Many of SCITY developments are also located within Bandar Sunway allowing SunREIT to further leverage on township synergies.

Overseas investment is possible, but in the longer term; more time is required to study foreign markets unless SCITY has established presence there. To date, SCITY has new/on-going developments in India and China.


Risks
Largely dependent on Sunway Pyramid Shopping Mall (SPSM). As mentioned earlier, SPSM makes up 60% of FY11E net property income (NPI). Hence any unforeseen events which are negative for SPSM will significantly lower dividend yields.

Managing an extensive portfolio of tenants. Retail and office space already account for 88.4% of FY11E NPI and these spaces have largely fragmented tenants (916 tenants); its top 10 tenants only make up 11.5% of 8MFY10 revenue. Higher number of tenants tends to entail more of management’s time and cost, unlike single-tenant properties.

Retail and office leases mainly short to medium term. Most of SunREIT’s retail and office tenant’s lease profiles are on a 3-year term basis with option to renew for another term; although SunCity Ipoh Hypermarket is a single-tenanted asset with long-term lease with GCH, the operator of Giant Hypermarket, it only accounts for 1.5% of FY11E NPI. Tenants of single-occupied properties tend to lock-in lease terms over longer periods (>5 years) providing income stability for longer periods.

Susceptibility to economic downturn? Retail and hospitality real-estate segments are especially sensitive to economic activities which could cause yield compressions. Potential downsides from economic slumps include the following;

• Retail space could experience high tenant turnover, lower occupancy rates or may need to offer rental rollovers to maintain occupancies. However, most of its tenants are of non-discretionary businesses, making them more resilient against economic downtimes.

• Hospitality space may need to lower Average Room Rate (ARR) to maintain break-even occupancy rates. However, some of this risk is mitigated by the master lease agreement over a 10+10 year master lease between the hotel operators and SunREIT, which is based on the higher of the predetermined guarantee rent and variable rent. (Refer to Appendix for details).

Rising interest rates could shave-off yields. 44% borrowings are based on variable rates (cost of funds + 1.25%). Our analysis shows a 50bps-100bps increase in effective interest rates lowers FY11E GDPU by 3.1%-6.2%.

Spill-over effects from SCITY. There is a possibility of any potential SCITY negative news to affect SunREIT’s share price performance. On the flip-side, SunREIT could also benefit from SCITY upswings.

Financials, valuations and recommendations
Expecting FY10-11E GDPU of 6.6sen-6.8sen or 6.8%-7.0% yields; assuming 100% payout. We are expecting 100% payout and distribution should be on a quarterly basis.

Estimating 2-yr CAGR of 4.8% underpinned by organic growth; we have not imputed for new asset injections. Our assumptions are as followed;

• Retail and office: 1%-3% organic growth assumptions for non-expiring tenancies and 3%-10% for tenancies up for renewals (refer to Appendix). Occupancy rates increases incrementally by 0%-1% each year.

• Hospitality: We have assumed 1%-3% step-up in ARR while occupancy rates increases incrementally by 1% each year.

SunREIT yields are lower than peers. We have selected M-REIT peers with similar asset profiles, although we do note true comparatives are lacking. Closest comparative in terms of real-estate segments mix is Amanahraya REIT, although its market capitalization and portfolio size is significantly lower vs. SunREIT. We opine SunREIT’s large portfolio size, market capitalization and free float warrants the lower than average yields.

Recommending fair value of RM1.05 (8% upside to retail IPO price of RM0.97), based on GGM valuations (8.8% required rate of return, 3.0% terminal growth, FY11E NDPU of 6.1sen). Our valuations are also supported when applying Axis REIT’s 1.1x PBV to SunREIT’s BV/share of RM0.97, implying SunREIT could be valued at RM1.07.

Axis REIT 1.1x PBV is a 22% premium to 0.9x peer averages even though its market capitalization is a 77% discount to SunREIT. Axis REIT’s PBV premium can be attributed to it having the highest free-float and has strong track record of aggressive acquisitions amongst currently listed M-REITs.


Hospitality: Master Lease agreements
• Sunway Resort Hotel & Spa and Pyramid Hotel: Guaranteed rent is based on 80% of the projected FY11E income plus RM144,000 for first 2 years. Remaining term’s guaranteed rent is based on 60% of the projected FY11E income. Term is based on a 10+10 year lease.

• Sunway Hotel Seberang Jaya: Guaranteed rent is based on 80% of the projected FY11E income for first 2 years. Remaining term’s guaranteed rent is based on 60% of the projected FY11E income. Term is based on a 10+10 year lease.

• Sunway Resort Hotel & Spa, Pyramid Hotel, Sunway Hotel Seberang Jaya: Variable rent is based on base rent (20% of revenue) and 70% of the gross operating profit (GOP). GOP is defined as revenue less operating expenses, FF&E Reserve (2.5% of revenue), fees paid to the
Hotel Manager (5% of Sunway Resort Hotel & Spa and Pyramid Hotel GOP till June 2013; 1.5% of Sunway Hotel Seberang Jaya revenue plus 8% of corresponding GOP).