Analysts' Recommendation

Macquarie: Starhill REIT 'OUTPERFORM'; target price RM1.14

Macquarie Research, 7 April 2006


Shining Star


Gain exposure to a little piece of Paris… in KL

Starhill (STRH MK) is the only Malaysian REIT that gives investors pure exposure to prime retail (Starhill Gallery and Lot 10, which collectively have 469,122 sq ft of NLA) and hotel assets (the 561-room JW Marriott) in Bukit Bintang, the main shopping district of Kuala Lumpur. Total asset size is RM1.15bn. Starhill Gallery is a niche high-end retail mall with many unique brands/tenants (including the LVMH group) while Lot 10 is positioned in the mid-high end market.


Potential upside to rentals

Starhill REIT offers an annualised DPU yield of 6.4% in FY06 and 3.3% five-year DPU CAGR, excluding acquisitions. We see potential upside to Starhill REIT’s rentals from turnover rents and the ‘novation’ of some subleases (at higher rates) to the REIT. We believe that Pavilion (which is expected to be opened in 2007) can be positive for Starhill’s assets as it can draw more foot traffic to that section of Bukit Bintang. Pavilion is a mixed development located across from Starhill Gallery and is expected to have about 1.3m sq ft NLA of retail space. Based on our sensitivity analysis, every 1% point increase in Starhill REIT’s rentals above our base case in FY07 will improve our DCF valuation by 0.8%.


Acquisition growth opportunities

Investors can buy into potential future growth generated by a visionary management team. There are acquisition opportunities given that the Malaysian REIT industry is still in its infancy. International acquisitions are also a possibility.


Regulatory changes can spur re-rating

Besides organic and acquisition driven growth, Starhill REIT offers investors upside potential from regulatory changes. Currently, there is a withholding tax of 28% on distribution from REITs to foreign investors. We see the possibility of this being reduced gradually to be more in line with other REIT markets. The regulator is keen to develop the REIT industry, as shown by measures taken to revitalise the industry in early 2005. In the meantime, the withholding tax issue can be mitigated by an expected appreciation in the Ringgit vis-à-vis the US dollar. Our economists forecast that the RM/US$ exchange rate would strengthen to 3.30 in 2007 (from about 3.70 currently).


Initiating coverage with Outperform; target price RM1.14

We are initiating coverage on Starhill REIT with an Outperform rating. Our target price of RM1.14 is based on a DCF methodology and a discount rate of 8.8%. Its 12 month total return of 23% based on year one yield plus capital upside to our target price is attractive, on a risk adjusted basis.


Starhill’s DPU yield in FY06-07 translates to a spread of 230-260 bp over the local risk free rate and is attractive vis-à-vis regional valuations. From a size and liquidity standpoint, Starhill is, by far, the most investible REIT in Malaysia.


Organic growth

Starhill REIT’s assets - Starhill Gallery and Lot 10 (retail) and JW Marriott (hotel) - are located in Bukit Bintang, the prime shopping area of Kuala Lumpur. Growth in FY06 is expected to be underpinned by increased occupancy in Starhill Gallery and lease renewals in Lot 10 (36% of leases are expiring in FY06). Meanwhile, the hotel would provide stable income from the lease agreement with Star Hill Hotel, a wholly owned subsidiary of the REIT sponsor, YTL Corp.


Pavilion - Prosper thy neighbour?

Contrary to popular view, we believe that Pavilion could have a positive impact for Starhill Gallery as it would draw more traffic to that section of Bukit Bintang. Pavilion is targeted at the mid-high end retail market and is positioned against Suria KLCC. In our view, Starhill Gallery can continue to thrive as a niche upmarket retail mall with many unique brands/tenants (including the LVMH group) while Lot 10 can also serve a niche mid-high end market, given that it is less than one-seventh the size of Pavilion.


Revenue from YTL Corp – good or bad?

About 55-60% of Starhill’s REIT revenue is ultimately dependent on YTL Corp (through retail lease agreements with Autodome and the hotel lease – Autodome is a wholly owned subsidiary of YTL Corp). With most of its income derived from regulated assets, YTL Corp has high earnings quality and payment ability to Starhill REIT. While Autodome will continue to retain control of the subleases to F&B outlets, the subleases to non-F&B tenants will start expiring from Nov 2007. We believe that the rentals on these subleases are expected to be higher when they revert to the REIT (and not lower as feared by some). There is the possibility that some of these subleases could be novated to the REIT before Nov 2007 and this would be positive for the REIT’s income – this is not factored into our forecast.


When the Autodome subleases to non-F&B tenants roll off, we forecast the revenue from YTL Corp would fall to about 40%. In our view, the hotel lease agreement is positive as it insulates the REIT from potential volatility in the underlying performance of the hotel.


Acquisition growth opportunities

Besides organic growth, we see growth opportunities for Starhill REIT through acquisitions given that the REITs industry is still in its infancy, plus YTL’s visionary management and its underleveraged balance sheet (Starhill REIT’s debt to asset is 15% currently).


Withholding tax a deterrent but…

While we acknowledge that the withholding tax issue is a deterrent for foreign institutions to invest in Malaysia REITs, we see two offsetting factors. Firstly, there could be some mitigation from our expectations of a strengthening in the Ringgit vis-à-vis the US$.


Secondly, we believe that there is a possibility of the regulators relaxing the withholding tax

gradually as they seek to develop the REIT industry.


Target price of RM1.14

We have pegged Starhill’s target price at RM1.14 based on a DCF methodology. This method takes into account the key success factors that drive a REIT. The discount rate is 8.8% (based on a Macquarie beta of 0.76, a risk free rate of 4.2%, and a market risk premium of 6.0%) and the terminal growth rate is 2.5%.


Valuations attractive compared to peers

In our view, Starhill’s valuations are attractive compared to domestic and regional peers. Starhill’s DPU yield in FY06 of 6.4% is about in line with the average in Malaysia but we believe that it deserves a premium due to investibility considerations, asset quality, and strong management. Meanwhile, the DPU yields for regional REITs are trading at a spread of -84 to ~220 bp over their respective risk free rates. Starhill REIT, in comparison, is trading at a 230 bp spread, making it attractive given the growth prospects and potential for positive regulatory changes.

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