PavREIT’s 3Q NPI margin falls short

Pavilion Real Estate Investment Trust (Oct 28, RM1.74)

Revise to hold rating with a target price of RM1.85: We have cut Pavilion Real Estate Investment Trust’s (PavREIT) financial years ending 2016/17/18 (FY16/17/18) earnings by 8%, 7% and 6% respectively as net property income (NPI) margin was lower than expected in the third quarter of FY16 (3QFY16) at 68.7% compared with our estimate of 70.4%.

This was due to higher operating expenses allocated towards promotional and marketing initiatives for the da:men USJ Mall and the Intermark Mall. We downgrade our recommendation on PavREIT to “hold” due to lower-than-expected distribution per unit (DPU) accretion from the two malls in FY16 and FY17.

We believe the NPI margins will improve once management has rebranded and realigned the assets. PavREIT’s core asset is the Pavilion KL mall, with net lettable area (NLA) of 1.3 million sq ft (120,774 sq m). The premium tenant profile and location have led to strong average rental rates of above RM20 per sq ft.

The da:men USJ Mall in Subang Jaya, Selangor, opened its doors on Jan 8, 2016 with more than 50% occupancy. The acquisition was completed in 1QFY16 and management is positive on the mall’s prospects as occupancy has since reached 85%. The Intermark Mall, which was acquired for RM160 million, was also completed in 1QFY16.

With contributions from 2QFY16 onwards, we estimate that both the da:men USJ Mall and Intermark Mall will generate NPI of RM31.1 million in FY16 and RM42.4 million (+11.1%) in FY17. In our view, PavREIT is likely to continue on its acquisition trail with the soon-to-be-completed Pavilion Extension, on which it has the right of first refusal (ROFR).

The two remaining ROFR assets are the 250,000-sq ft NLA Pavilion Extension and 300,000-sq ft Fahrenheit88 Mall, currently held by PavREIT’s major shareholders. Both could see valuations around or above the RM600 million to RM700 million range due to their prime location near Pavilion KL, which can support rental rates of more than RM20 per sq ft a month.

We have imputed the Pavilion Extension acquisition in FY17, though we conservatively forecast that initial DPU accretion is low at less than 1%.

The 3QFY16 distributable income of RM62.1 million (-0.5% year-on-year [y-o-y]) was below our and the consensus estimates. The negative growth was due to higher operating expenses of RM36.8 million (+24% y-o-y) due to the new malls acquired, mitigated by a 15% increase in rental income to RM118 million. — AllianceDBS Research, Oct 28

This article first appeared in The Edge Financial Daily, on Oct 31, 2016. Subscribe to The Edge Financial Daily here.