Fundamentals intact despite weak market sentiment (RHB Research property sector update March 18,2011)

Property

? Sector not in favour in a volatile market. While we remain positive on the sector, we are not bullish particularly in the coming 2Q11 considering the choppy volatile market ahead driven by the ongoing political upheavals in the Middle East countries and natural disasters. The property sector is known for its cyclical and high beta nature, and it is not a heavy weight component in the FBM KLCI. We hence do not expect the property stocks to perform well in 2Q. For sector exposure, we advise investors to go for low beta property stocks such as Paramount (with attractive dividend angle) as well as Mah Sing, where valuations are still relatively undemanding. REITs also could turn in favour due to their defensive yields.

? More exciting in 2H11. We think it is appropriate to go for selective high beta stocks only if there is a strong project flow. More news flow is likely to materialise in 2H, and key events to watch out for is the results for the tenders by developers for the Rubber Research Institute land parcels in Sg Buloh, MRT’s “rail plus property” that Prasarana will develop with JV partners for the commercial development surrounding the stations, and the official award and equity structure of the development of land parcels in Singapore. The biggest (potential) beneficiaries for these projects are MRCB, Ekovest (for the land along its river cleaning project) and UEM Land, which share price, to a certain extent, has priced in and will be supported. The key surprise will be the JV winners in particular for the RRI land, which we think are likely to be the GLC-linked reputable developers.

? M&A stories still exist. We believe the M&A catalyst for the sector still exists, which should hence keep the sector warm. Speculation will be centered on “who is next” to merge with MRCB, after the deal to merge with IJM Land lapsed. Similar to ULHB/Sunrise (a property arm of Khazanah), MRCB is the “so-called” construction/property arm of EPF, but MRCB is lagging behind in its property development and brand name. In addition, by merging with a reputable developer, its valuations are expected to normalise to a reasonable level in hopes of better fundamental grounds.

? Risks. 1) Regulatory risks; 2) Rising construction cost; and 3) Country risks.

? Maintain Overweight. Our picks for 2Q are: Mah Sing (OP, FV = RM3.03) and Paramount (OP, FV = RM5.92). High beta with strong news flow such as ULHB could provide some short-term trading angle.

? Sector not in favour in a volatile market. While we remain positive on the sector, we are not bullish particularly in the coming 2Q11 considering the choppy volatile market ahead driven by the ongoing political upheavals in the Middle East countries as well as the recent natural disasters. The property sector is known for its cyclical and high beta nature, and it is not a heavy weight component in the FBM KLCI index that investors would normally position themselves during market selldown. We hence expect the property stocks will only have a mediocre performance in 2Q. For sector exposure, we advise investors to go for low beta property stocks such as Paramount (with attractive dividend angle) as well as Mah Sing, where valuations are still relatively undemanding. Both stocks have a beta of less than 1, and their 1-year and 6-month total returns (inclusive of dividend) are rather respectable (See Table 3).

? REITs are in favour. MREITs could turn in favour again in a down market, given their defensive nature and sustainable yields of 6-8%. We continue to like Axis REIT and both retail REITs – Sunway REIT and CMMT. We expect Axis REIT to continue with its assets expansion plans this year, potentially by another RM300m. In the pipeline, potential assets include: (i) Axis Technology Center 2 (from the promoter); (ii) one logistics warehouse in Johor; (iii) one warehouse in Pasir Gudang Johor; (iv) one warehousing/logistic and manufacturing facility in Shah Alam/Klang; (v) two brand new logistics warehouses in Klang Valley for a MNC; and (vi) two new office buildings in Cyberjaya. Total size of these potential assets is worth about RM400m. As for the two retails REITs, yield performance will continue to be underpinned by higher rental reversion as well as consumer spending.

? Has sector fundamentals changed? Although developers continued to report strong sales in all recent new launches, we see limited upside for developers to raise property selling price further particularly for the property hotspots within the Klang Valley region (but prices in suburbs such as Kajang, Melawati and Rawang are still catching up). Having increased sharply over the past 1-2 years (15-16% in KL and Selangor state as reported by JPPH, but could be higher in selective locations), property price increase is expected to slow down this year possibly with a growth of 5-10%, as prices in certain townships are reaching an “optimal” level whereby further increase in selling prices will not be able to be fully absorbed by sufficient demand. In selective phases of townships such as Bandar Kinrara and Setia Alam, the phenomenon of “fully sold on the first day of launch” is not seen anymore in some recent new launches. Having said that, this could also be partially due to the impact of the
70% loan-to-value ratio cap that was imposed by BNM effective from Nov last year, which was targeted to clamp down speculative buying. To note, loan application and approvals for the purchase of residential properties declined for three consecutive months as at Jan 2011.

? Impact of rate hike. While RHBRI’s economics team had earlier expected interest hikes in 2H2011, given the heightening concern on inflation and the monetary tightening measures undertaken by the central banks in the region, interest rate hike could come in earlier, either in May or July this year. Impact on property demand is unlikely to be significant, as based on our checks with developers, many are still offering attractive packages such as “interest free/no installment during construction period” that significantly lower the upfront entry cost to a property. Historical data has also shown that the negative relationship between property prices (as measured by ARPP – average residential property price) and interest rate (Average Lending Rate and Base Lending Rate) is not as strong except during the 1997/98 Asian Financial Crisis period. That said, the increase in interest rate could dampen market sentiment as property demand is typically perceived to be sensitive to changes in mortgage rates.

How effective is the regulatory measures in regional markets?

? Yes, there is an impact. Countries in the region such as Singapore, Hong Kong and China have started implementing various tightening regulatory measures to cool the “overheating” property markets since two years ago. Due to the influx of liquidity in the Asian region coupled with low interest rates, property prices were stubbornly high at the initial stage but after rounds of tightening, the stringent measures have begun to take effect. The increase in property prices has become mild lately with China reported a +0.3% mom growth in Dec 2010 (same growth in Nov) for top 70 cities and Singapore registered a 2.7% qoq growth in 4Q10 (vs 2.9% in 3Q10).

? Malaysia – anymore tightening? We believe some gestation period is still required after the imposition of the 70% cap on loan-to-value ratio for buyers with more than two outstanding mortgage loans effective from 3rd Nov 2010. Considering that loans approved for residential property have declined for three consecutive months as at Jan 2011, we think Malaysia is still relatively safe from further tightening. If any, we think higher real property gain tax (RPGT) is more likely in 2H2011, which is a more effective way to control speculative buying. Since the announcement of Budget 2010 in end 2009, RPGT has been kept at 5% for properties sold within five years of purchase. If the Government decides to further clamp down speculations, we expect RPGT to be raised but progressively lower with higher tax rate for properties sold within the first two years of purchase.

Key news flow to watch out

? News flow in 1Q11 – MRT project. News flow thus far in the year has been centered on the potential MRT beneficiaries. While we concur that the MRT project generally has a positive impact on the property sector due to better connectivity, we think the actual impact will not ormalize  e at anytime soon as it all depends on how soon the developers ormali the values (i.e. turnaround of landbank) and considering that the MRT will only be completed in 2016. In addition, the extent of which a developer can extract the highest values from the MRT (via higher GDVs) is highly dependant on how the MRT will change the population profile/traffic flow in that area as well as the design of the properties to integrate with the stations. YTL Land is a good example. Over the years, launches of the commercial development have been slow largely due to the influx of massive supply of office space in the KL city centre area. With the MRT circle line passing through the Sentul area, YTL Land’s land in Sentul is said to be the crown jewel due to the expected higher land values. However, unless the development plan is changed, the MRT network may actually change the population/traffic flow profile and hence value enhancement may not be that significant for the 186-acre Sentul West, which is designated for high-end commercial development as the MRT project may increase the flow of low-middle income group in that area. All in all, we believe the MRT network will only benefit specific projects on a case-by-case basis and the impact is only meaningful for developers if it actually translates into their earnings over the intermediate term.

? What else in the pipeline? We think 2H2011 will be more exciting and it is appropriate to go for selective high beta stocks only if there is a strong project flow. More news flow is likely to ormalize e in 2H, and key events to watch out for is the results for the tenders by developers for the 2,680-acre Rubber Research Institute land parcels in Sg Buloh, and MRT’s “rail plus property” that Prasarana will develop with JV partners for the commercial development surrounding the stations. It was reported that of the 35 stations along the MRT line, 5 to 10 of them could be turned into developments with plans (“rail plus property”). Apart from these, the official award and equity structure of the development of land parcels in Singapore are also much anticipated. The biggest (potential) beneficiaries for these projects are MRCB, Ekovest (for the land along its river cleaning project) and UEM Land, which share price, to a certain extent, has priced in and will be supported. The key surprise will be the JV winners in particular for the RRI land as well as the “rail plus property” developments, which we think are likely to be the GLC-linked reputable developers. This is hard to pinpoint, but we think the best bets are still the big players such as SP Setia, IJM Land and Mah Sing, with common shareholders held by key institutional fund – EPF.

? M&A activities stories will still excite. Although 1Q2011 has been quiet thus far except for some landbanking deals by SP Setia – 266 acres of land in Johor, 40 acres MOH land in Bangsar and 268 acres of land in Cyberjaya, M&A stories are still brewing within the sector. Key catalysts will be centered on the next potential candidate to merge with MRCB, after the deal to merge with IJM Land was failed end of last year. The reason that we think MRCB still needs a partner is that, similar to ULHB-Sunrise, which is essentially a property arm of Khazanah, MRCB is the “so-called” construction/property arm of EPF – with a shareholding of 41.5%. However, apart from being a contractor/developer for the renowned KL Sentral, MRCB is lagging behind in its property development and brand name, and hence it needs a strong partner to enhance or strengthen its property division. In addition, by merging with a reputable developer, its valuations are expected to ormalize to a more reasonable level in hopes of better fundamental grounds. The stock is currently trading at 26x forward PE. In our view, potential target companies should have sizeable landbank in strategic locations as well as high shareholdings held by EPF, either direct or indirectly via a listed parent company (See Table 5 for potential candidates). Apart from MRCB, we do not rule out the possibility that UEM Land may embark on an acquisition trail again, as the company has continuously looked out for opportunities to diversify its landbank. Diversification could be achieved either via an outright acquisition of landbank, or a property developer with attractive landbank location. It is reasonable for target companies to have a strategic exposure either in the Klang Valley region or Penang, which UEM Land currently does not have a wide presence. Having said that, we believe this (if any) will only happen at a later stage, as currently the company has an important priority to integrate its operations with Sunrise, which acquisition was only completed in Feb this year.

Key Risks for the sector

? Risks. Key risks for the property sector are: 1) regulatory risk; 2) rising costs of building materials; and 3) country risks. Valuations and Recommendations

? Valuations back to +1 stdev of PE. In terms of PE, most of the property stocks are currently trading at around +1 stdev of historical PE mean. In tandem with the market, most stocks have retraced by 12-24% from their peak achieved in Jan 2011. The most resilient stock, as expected, is Paramount. In terms of PB, most stocks are still trading at between +1 and +2 stdev of historical PB mean. Although valuations are not cheap, we think these developers are well

? Go for lower beta; Maintain Overweight. In our opinion, apart from the key catalyst on news flow as well as M&As, we think the sector has roughly priced in the fundamentals. To re-iterate, in view of the choppy equity market ahead, for investors who would like to have or maintain exposure to the sector, lower beta stocks with cheap valuations are recommended, such as Mah Sing and Paramount. We think investors should also be selective to bet on the potential beneficiaries from the RRI land, and again, big players such as SP Setia, IJM Land and Mah Sing, with GLC fund backing (as major shareholders) are the best candidates. UEM Land will still provide some trading angle in late 2Q11 in anticipation of the news flow coming from the development of Singapore land. Meanwhile, we believe catalysts for the small cap property stocks are limited after a short rally in early 2011. As such, we lower our fair value for the small cap stocks under our coverage – Glomac and YNH (See Table 7 for changes in fair value and rating). As for KSL, the stock is still largely undervalued (at 60% discount to RNAV) considering that it has just received its approval for its Bandar Bestari township project in Klang. With this sizeable development (GDV RM2.5bn) in hand, KSL’s property development income from bread-and-butter projects will be more substantial and sustainable, in addition to its maiden rental income contribution from KSL City shopping mall from FY11. Overall, as we are keeping our calls on big cap stocks, we therefore maintain our Overweight rating on the sector. Our top pick is Mah Sing.