Industrial REITs - DBS Research 2018-01-30: Size Really Matters!

Industrial REITs - DBS Vickers 2018-01-30: Size Really Matters! Singapore Industrial REITs ESR-REIT J91U.SI VIVA INDUSTRIAL TRUST T8B.SI SOILBUILD BUSINESS SPACE REIT SV3U.SI

Industrial REITs - Size Really Matters!

  • A giant awakes in the industrial mid-cap space.
  • Short the acquirer, long the acquired? Not this time.
  • Size matters as the combined entity could see further re-rating on “liquidity“ premium.

A giant awakes in the industrial space.

  • The proposed merger of ESR-REIT (ESR) and Viva Industrial Trust (VIVA) puts the M&A spotlight back into the mid-cap industrial REITs, which have been struggling to grow meaningfully through acquisitions. 
  • We remain excited about prospects of the combined entity (ESR-VIVA) as we see both sets of unitholders able to benefit and ride together with a potentially fourth largest industrial REIT (S$1.7bn mkt cap, S$3.1bn AUM) in Singapore, backed by a reputable sponsor in E-shang Redwood, which offers a sizeable pipeline of acquisition prospects and deal flow.

Short the acquirer; long the acquired? Not this time.

  • With the target “VIVA” trading at a premium to NAV of 1.24x vs 1.0x for ESR, we see limited upside to play the “acquired” theme. 
  • In fact, VIVA’s implied portfolio yield of 5.7% is already lower than ESR-REIT’s portfolio yield of 6.0%, meaning that to bring about a win-win solution to both unitholders, a delicate balance must be sought. 
  • We estimate that a share swap at current price for VIVA (S$0.95/share) and at NAV (S$0.59/share) for ESR-REIT is appropriate as the post consolidated entity will result in
    1. higher dividend yields for both sets of unitholders,
    2. minimal dilution to NAVs, and
    3. lower gearing, implying ample capacity to still expand through debt-funded acquisitions.
  • Our call is to BUY ESR-REIT with Target Price of S$0.63; with potential further re-rating upon completion of this M&A.

Size matters! ESR -VIVA could re-rate by 15%-20% upon completion.

  • Investors have historically accorded large-cap REITs (1.36x P/NAV) with premium valuations compared to mid-cap industrial REITs (1.05x P/NAV), while ESR-REIT trades at the lower end of 0.96x P/NAV. 
  • Upon potential combination of both REITs, we see that ESR-VIVA may trade higher towards the higher multiples that the larger cap industrial REITs are trading at.

Who is next?

  • We believe that other mid-cap industrial REITs will be accorded an “acquisition premium” post this M&A as investors speculate the next target. 
  • On that front, Soilbuild REIT is an interesting targets given similar Sponsor and shareholder structures respectively. However, the timing and certainty of any deal is tough to identify.

Our thoughts on the proposed merger

What’s news? A proposed merger between ESR-REIT and VIVA.

  • Both ESR-REIT and Viva Industrial Trust (VIVA) requested for trading halt on Friday, 26 January. Immediately after, Bloomberg reported that, according to a source from ESR- REIT, the two REITs are in merger talks, the terms are under negotiation and with no certainty that this will lead to a transaction. 
  • On Monday, 29 January, announcements from both ESR-REIT and VIT confirmed talks on the proposed merger. According to both managers, the proposed merger will be effected by ESR-REIT acquiring all the issued and paid-up stapled securities of VIT via the issue of new ESR-REIT units.

Potential to be the fourth largest industrial S-REIT.

  • With mid-cap industrial REITs struggling to deliver inorganic growth over the past years, the consolidation of ESR-REIT and VIT enable two mid-sized REITs to leapfrog onto the “big stage”; closing the gap in terms of asset under management (AUM) with the larger cap industrial REITs like Ascendas REIT (A-REIT), Mapletree Logistics Trust (MLT), and Mapletree Industrial Trust (MINT).
  • ESR-REIT’s market capitalisation was ~S$742m based on the closing price on Thursday, while VIT was valued at ~S$912m. The combined portfolio will potentially be the fourth largest industrial S-REIT, with a market cap of S$1.5bn with an AUM of close to S$3bn. 
  • Meanwhile, the post-merger portfolio will increase ESR-REIT’s exposure to business parks from 2% to 30%.

Multiple expansion; combined ESR-VIVA REIT could trade at lower yields.

  • Support of a larger Sponsor (e-Shang Redwood) implies better access to debt and capital markets coupled with a visible acquisition pipeline and sourcing capability. This will empower the combined ESR-VIVA with additional firepower to pursue inorganic growth opportunities.
  • In fact, investors tend to accord a lower cost of capital for REITs with “growth” as seen in the valuation gap between larger cap industrial REITs and mid-cap industrial REITs. 
  • On a P/NAV basis, large cap industrial REITs are trading at an average multiple of 1.35x P/NAV, which is a 0.30x premium to the mid-cap industrial REITs, and higher than the long term average of 0.23x. 
  • ESR-REIT, which currently trades at a P/NAV of close to 0.96x, could potentially trade closer to the larger cap industrial RIETs, implying potential upside of up to 15%- 20%.
  • On a yield basis, the larger cap industrial REITs are trading at an average yield of 5.9%, which is more than 1.5% lower than the mid-cap industrial peers, implying there is potential for the post consolidated ESR-VIVA REIT to close that gap in the medium term.

Potential synergies and benefits

Potential synergies.

  • While qualitative benefits of having a combined portfolio size of S$3bn and potential market cap of S$1.7bn will certainly put ESR-VIVA up against the big boys, we believe the management team has to work towards gaining investor confidence that they are able to execute and deliver value to unitholders in the medium term.
  • We note that portfolio matrices are fairly similar; we note that VIVA’s portfolio is more concentrated with valuations at close to S$1.3bn over 9 properties while ESR REIT’s S$1.7bn portfolio is diversified over 48 properties. Occupancy rates are also fairly high at north of 90% with fairly long weighted average lease expiries (WALE). VIVA’s WALE is shorter with potential for ESR to negotiate and reposition some of the properties upon expiry of master leases.
  • While no forecasts are provided at this moment, we believe that potential synergies will hinge on the ability to extract operational cost savings through having 2 portfolios in close proximity, allowing the manager to better manage tenancies and potentially extract savings through better negotiations on maintenance contracts going forward. The immediate savings in our view is to re-finance VIVA’s cost of debt, which as of 30th Dec’17, is c.0.45% (45 basis points) higher than ESR- REIT’s. 
  • We estimate that every 0.5% reduction in interest rate will lead to a 2% improvement in the combined ESR-VIVA REIT’s net property income.

The start of more to come?

  • We are positive on this potential merger & acquisition (M&A) if it comes to fruition, as we believe this is only the first step for a larger, more capable and more liquid industrial S-REIT in Singapore to emerge. 
  • To recap, ESR-REIT also has a 5% stake in Sabana REIT. A series of further M&A steps could emerge if ESR-REIT and Warburg Pincus’ partner Mr Tong Jinquan (a significant unitholder of ESR-REIT, Sabana REIT, VIVA and Soilbuil REIT) consolidate their stakes. Please find details in the report published in March 2017: Catalyst Abound

How does the combined REIT look like?

  • Based on our back of the envelope calculations, we estimate that the combined entity (ESR-VIVA) could potentially see higher distribution yield of c.7.5% and lower combined gearing of 35.6% implying headroom to acquire further. This based on the assumption that the equity share swap is priced at 
    • VIVA’s current market price and 
    • ESR REIT’s NAV.
  • The acquired (VIVA) is trading at a higher P/NAV multiple than the acquirer (ESR) - limits upside to VIVA. VIVA, by virtue of having a portfolio with a higher weighting to business park assets - which are valued higher among industrial asset classes in Singapore - is trading at a P/NAV multiple of 1.25x, or at an implied yield of 5.7% (net property income / enterprise value). This is slightly lower than ESR REIT’s implied yield of 6.0%, and the stock is trading at a slight discount to its NAV.
  • Therefore, for the deal to be accretive to both sets of unitholders, we believe that a swap price could potentially be close to current prices in order for the math to work. 
  • To prevent dilution, the minimum price for ESR-REIT will be likely be set at the REIT’s current NAV of S$0.59/unit as of 31st Dec’17, representing an upside of c.4.4% from the last close of S$0.565/unit.

Derek TAN DBS Vickers | Mervin SONG CFA DBS Vickers | Singapore Research Team DBS Vickers | http://www.dbsvickers.com/ 2018-01-30
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