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Axis REIT (ECM Libra Reserach) buy; target price RM2.90

The preferred buy-and-hold investment

Initiate coverage on Axis REIT
We initiate coverage on Axis Real Estate Investment Trust (REIT) with a Buy recommendation and target price of RM2.90. Axis REIT (Axis) is not only our preferred play on investment properties in Malaysia but also our preferred buy-and-hold investment vehicle within our coverage. Despite its defensive quality with beta of just 0.5, Axis’ average annual total return of 23% since its listing in 2005 outperform the equity market as represented by the total return of the benchmark FBMKLCI over the corresponding period. Another plus point is its distribution visibility as Axis commits to distribute 99% of its earnings on quarterly basis.

Yield accretive acquisitions lead to superior returns
Axis has the most enviable acquisition track record among M-REITs as it has grown its asset under management (AUM) from 5 properties with AUM of RM260.4m to 27 properties with AUM of RM1.4bn now. Its property portfolio comprises of commercial, office, industrial properties and logistics centres located mostly in Petaling Jaya and Shah Alam. Its strategy of undertaking yield-accretive acquisitions is the prime reason for its superior total return to its investors. This was further underpinned by high occupancy rate (95%), and rental reversion.

FY11 earnings to grow 19.6%
We expect a massive 19.6% earnings growth in FY11 due to contribution from four recently acquired properties: (1) PTP D8, (2) Axis Technology Center, (3) Axis PDI Center, and (4) Tesco Johor as well as its proposal to acquire an office building in Cyberjaya for RM51.3m which will be completed in 1Q2011.

More acquisitions to come
We expect more acquisitions going forward. We understand that management is working on the acquisition of an office warehouse in Petaling Jaya, a logistics warehouse in Johor and a warehousing/logistic and manufacturing facility in Shah Alam/Klang.

Recommend BUY with a RM2.90 TP
Our target price of RM2.90 is derived using Gordon Growth Model assuming cost of equity of 8.3% and long-term growth rate of 2.0%. The target price implies CY11 P/BV of 1.6x and net yield of 6.4%. Catalysts include (1) yield-accretive acquisitions, and (2) higher than expected rental reversion. Risks include (1) oversupply of commercial space, (2) increase in interest rate, and (3) diminishing acquisition opportunities.

The first M-REIT

Axis REIT (Axis) is the first real estate investment trust (REIT) to be listed on Bursa Malaysia Securities Berhad on 3 August 2005. Its diversified portfolio focuses on office, industrial properties and logistics centres located mostly in Petaling Jaya and Shah Alam. Axis is also the country’s first Islamic office/Industrial REIT since its reclassification in December 2008. Properties within its portfolio and its financing instruments comply with the Syariah requirements and the Securities Commission’s guidelines on Islamic REIT.

Most acquisitive REIT

Axis had 5 properties within its portfolio with asset under management of (AUM) of RM260.4m when it was listed in 2005. Since then, Axis has acquired 22 more properties, with the recent ones being PTP D8, Axis Technology Center, Axis PDI Center and Tesco Johor. On 30 December 2010, Axis announced that it is looking at acquiring a building in Cyberjaya. Total AUM as at 30 September 2010 (excluding the four new acquisitions) was RM1,097m and this is expected to reach RM1.4bn by end-2010. Meanwhile average occupancy rate for its portfolio is 95%. (Refer to Appendix for further details on the properties.)

Balanced mix of tenants from diverse sectors

Axis has a well-balanced mixture of tenants from diversified industries such as retail, automotive, financial services and logistics. These tenants consist of multinational companies, local firms and government-linked companies (GLC) with an average tenancy period of 3 years. Given its diversified tenant base, the risk of over-reliance on a single corporation or sector is relatively low, hence providing Axis with a stable income stream. As at 30 September 2010, Axis has 105 tenants. The top 10 tenants listed below contributed 47% to FY09’s gross income.

Equal number of multi and single-tenanted properties

Current portfolio also features an almost equal mix of single (45%) and multi-tenanted (55%) properties. Single-tenanted properties tend to be leased over a longer tenure on a “triple net” basis i.e. periodic maintenance, quit rent, assessment, insurance and major refurbishment will be borne by tenant. As such, triple net leases will yield lower gross rent as compared to conventional leases but will also benefit from lower operating costs, and most importantly offer a “hands-off” approach to property management. The latter feature is increasing important to Axis given its ever increasing portfolio of properties. Multi-tenanted properties, on the other hand provide a more current and vibrant tenant base with tenants leasing smaller spaces that can quickly reflect any movement in the rental market.

Well-distributed lease expiries

The leasing terms for Axis’ properties are typically three years and lease renewals are well-staggered over the upcoming years. Based on the committed leases as at 30 September 2010, 12.8% and 10.4% of the total net lettable area is due for renewal in FY11 and FY12 respectively.

Impeccable track record

Axis has been actively expanding its portfolio since its listing. Total properties under portfolio grew from 5 to 27 within 5 years, while total AUM is expected to expand from RM260.4m (2005) to RM1.4bn (2010). Axis’ strategy is to only acquire properties which are yield accretive i.e. acquisition which will enhance distribution yield after taking into account additional units issued to finance the acquisition. This has not been an issue for Axis given management’s impeccable track record in the past in sniffing out deals which generate decent gross yield of 8.0% - 9.5%.

Although distribution yield for Axis (6.8% for FY10F) is lower than average yield for Malaysian REITs (M-REITs) of 8.1% (excluding CapitaMalls and Sunway), we believe this is a reflection of investors’ confidence in the management’s ability to continue adding yield accretive properties into its portfolio going forward.

However, Axis boasts the highest historical total return among M-REITs and even outperforms the average FBMKLCI’s total return over the last 5 years. Its internal rate of return is 21% as compared to FBMKLCI’s average return of 18% during the period of 2006-2011.

Reputable property managers

Axis is managed by Axis-REIT Managers Berhad which comprise of a team of experienced professionals led by chief executive office/executive director, George Stewart LaBrooy. Labrooy is also the vice president of the Asia Pacific Real Estate Association (APREA), and the protem chairman of the Malaysian REIT Managers Association (MRMA). In November 2003, he spearheaded a project to identify suitable properties owned by common shareholders of Axis Development Sdn Bhd to be injected into Axis. Besides Stewart Labrooy, Dato’ Abas Carl Gunnar bin Abdullah, Stephen Tew Peng Hwee, and Lim Kian hiam were also among those instrumental in setting up as well as injecting the initial assets into Axis. Both Dato’ Abas and Stephen Tew are currently directors of Axis-REIT.

Growth strategies

In terms of organic growth, Axis is committed to manage its portfolio proactively via rental revisions and tenant mix enhancement. The property managers have developed close relationships with the tenants. Emphasis has been put into the maintenance of the buildings and quick responses to tenants’ requests. For example, Quattro West (formerly known as Nestle House) was completely refurbished in April 2010. Previously served as headquarter for Nestle Malaysia, the building was given a new look in order to enhance valuations and increase rental rates. As a result, Quattro West has been fully leased out to four tenants with earnings contribution coming in from 1 August 2010.

Meanwhile, for its acquisition growth strategy, Axis REIT plans to acquire additional properties that will provide yield enhancement to the portfolio. The focus will be on Syariah-compliant properties in the Klang Valley, and in secondary locations such as Penang and Johor.

On 30 December 2010, Axis announced its plans to acquire a four-storey building in Cyberjaya from FSBM Holdings Berhad (Fujitsu Systems Business Malaysia) for a cash consideration of RM51.25m. The building has a NLA of 116, 288 sq ft and houses a diverse mix of tenants such as SCICOM (MSC) Berhad, Wolter Kluwer Enterprise Service Partners Sdn Bhd, Multimedia Development Corporation Sdn Bhd, Telebiz BPO Sdn Bhd, Media Monitor Sdn Bhd and FBSM Holdings Berhad. The proposed acquisition is expected to be completed on or before 31 March 2011.

Potential asset acquisitions

At the moment, Axis has a few properties in its pipeline. This includes Axis Techpoint, an office warehouse in Petaling Jaya which would potentially be developed into an “Axis Business Campus”, housing the largest commercial developments in Petaling Jaya.

At the same time, Axis is currently assessing the following assets to acquire:

• a logistics warehouse in Johor; and,
• a warehousing/logistic and manufacturing facility in Shah Alam/Klang.

Prospects

Low earnings volatility

Axis earnings have been fairly stable backed by a large pool of leases with average tenure of 3 years. The occupancy rate for its properties averages at 95%.

Steady EPU and DPU growth

Axis is poised to enjoy steady earnings per unit (EPU) and distribution per unit (DPU) growth in the next few years from increased rental rates upon tenancy renewals. We understand that Axis typically raises its rental rates by 15% upon renewal of the 3-year contracts, which suggests an average increase of about 5% p.a.

Attractive distribution yield

Average yield for Axis since listing is 8.3%. In FY09, Axis paid out total distribution per unit (DPU) of 15.8 sen (100% payout), translating to an attractive annualised yield of 10%. Axis is committed to a payout of at least 99% of distributable income (to be paid quarterly in arrears). For 9M10, Axis has paid out a total of 11.7 sen of DPU, and we estimated total DPU payable for FY10 of 16.2 sen. Current gross yield of its asset stands at 10.3% based on book value compared with industry’s average of 7.4-8.2%.

Axis is our preferred play on investment property due to its superior returns to 10-year Malaysian Government Securities (MGS), 12-month fixed deposit rates, as well as bigger cap investment property companies, KLCC Property and IGB Corp. Its average yield spreads against 10-year MGS, 12-month fixed deposit, KLCC Property and IGB Corp are 370bps, 300 bps, 518 bps and 590 bps respectively.

Investment risks

Oversupply of commercial space

There is risk of oversupply of commercial space especially in the office sub-segment which may put occupancy rate and rental reversion under pressure going forward. However, this is mitigated by Axis’ limited exposure to pure office space. Furthermore, most of Axis’ properties are located in Petaling Jaya where rental rates are much lower than in Kuala Lumpur, hence will likely face lesser competition.

Increase in interest rates

In the event of an interest rate hike, diminishing spread over fixed income investments may render REITs less appealing to investors. However, we view that the Overnight Policy Rate (OPR) hike is not expected to be aggressive in 2011. Our economist has forecasted a possible rate hike in 2H2011 by 50 bps to 3.25%. As such, Axis is still expected to deliver superior returns over fixed income investments.

Diminishing acquisition opportunities

Axis may face the risk of diminishing yield-accretive acquisition opportunities due to competition with other REITs as well as property investors. This may result in declining average annual total return to its investors. However, we take comfort from management’s track record in the past in sniffing out acquisition opportunities as well as potential asset injections by some of its sponsors who remain as major shareholders of Axis.

Financials

For 9MFY10, Axis posted core earnings of RM36.4m, an increase 16.5% y-o-y partly contributed by new acquisitions made during the nine-month period, and positive rental reversions. Expenses incurred for the period amounted to RM9.5m—mostly for the refurbishment of Quattro West and Menara Axis. Axis paid out a total of 11.7 sen of distribution per unit (DPU) during the period.

Gearing

Current net gearing stands at 31.3% (of total asset value), lower than its optimum rate of 36%. On 15 September 2010, Axis completed it third private placement where it issued 68.8m units to institutional investors. The exercise raised RM135m of cash proceeds which was used to reduce its borrowings. As a result, current units in issuance increased by 22% to 375.9m units. As M-REITs are allowed to borrow up to the maximum of 0.5x debt / asset, Axis will have sufficient financial capacity to fund future acquisitions.

Key assumptions

For FY10-11, we forecast Axis net property income (NPI) to grow at 20% and 23%, respectively, due to the contribution from (1) Quattro West, (2) the four newly acquired properties in FY10, and (3) rental reversions. We assumed NPI to sustain from FY12 onwards pending new acquisitions.

Recommendation and valuation

We initiate coverage on Axis with a BUY and target price of RM2.90 using Gordon Growth Model with cost of equity of 8.3% and long-term growth rate of 2%. Our target price implies CY11 P/BV of 1.6x and net yield of 6.4%. Catalysts include (1) yield-accretive acquisitions, and (2) higher than expected rental reversion.

Market overview

The properties under Axis’ portfolio are concentrated in Selangor, mostly in Petaling Jaya (PJ) (41%), followed by Shah Alam (23%) and Klang (13%). In 3Q10, 42% of Axis’ net property income is derived from its office and warehouses in PJ. Its PJ offices have an occupancy rate of between 88% and 100%, which is above the area’s average market rate of 73%. Meanwhile, its warehouses have a 100% occupancy rate. This is mainly attributable to the properties’ strategic locations near or next to main infrastructure links such as LRT stations and the Federal Highway.

Recent decentralization from city centres to other areas in the Klang Valley such as PJ has led to a revival in terms of commercial office development in the area. Being located closer to working class suburbs, recent years have seen completion of new commercial buildings offered at affordable prices in the area. These help establish PJ as a cheaper alternative to Kuala Lumpur where average rental rates are in the range of RM3-RM4.20 psf/month compared to Kuala Lumpur’s RM5.09 psf/month (RM7.10 for Prime A buildings).

Latest 3Q10 data from the National Property Information Centre (NAPIC) showed an improved occupancy rate within PJ where it rose by 3.4 ppt y-o-y to 72.8% due to high leasing activities in the area. Out of the 10.0 million sf of space available, 7.3 million sf was taken up. PJ is looking at an incoming supply of 299,011 sf of office space.

On the other hand, the occupancy rate in the Kuala Lumpur city centre dropped by 9.2 ppt to 69.5%. According to a report by CB Richard Ellis (CBRE), a number of companies have shown willingness to move out of the city centre primarily due to concerns on congestion and in order to achieve possible cost savings. The current supply of privately-owned purpose-built office space in Kuala Lumpur amounts to 68.0 million sf, of which 53.8 million sf of space is occupied. An additional 10.4 million sf of space is coming on board on top of the 839,377 sf of office space completed in 3Q10.

Going forward, we expect the office rental market to remain stable. Although the oversupply of office space in Kuala Lumpur may push rental rates down, we believe this would not affect demand in the PJ area, especially those of Axis’. This is backed by Axis’ tenancy agreement and pre-agreed rental increases which will cushion Axis from downside risk in the medium-term. Furthermore, Axis’ rental rates are competitive compared to Kuala Lumpur and the upcoming new office buildings.

These features also apply to its industrial properties, i.e. warehouses. The properties are mostly single-tenanted with longer-term leases (as opposed to offices) and are designed according to tenants’ specific requirements, which further protect Axis from future risks. About 67% of the trust’s industrial properties are located in PJ, Shah Alam and Klang. Axis has two warehouses/manufacturing facility (in Shah Alam and Johor) under its acquisition pipeline.

Industrial REITs are set to benefit from increased manufacturing activities planned for 2011. In 2011, the Malaysian Government expects the economy to expand between 5% and 6%, where growth will be supported by private investment, expanding 10.2%, private consumption 6.3% and exports 6.7%. The manufacturing sector will continue to spearhead growth, expanding 6.7% and the services sector 5.3%.



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