ESR-REIT - OCBC Investment 2018-12-14: New Kid On The Block

SGinvestors.io

ESR-REIT (SGX:J91U)

ESR-REIT - New Kid On The Block

• Largest SG-focused industrial REIT. 
• Trading at discount to large portfolio peers. 
• Initiate with a S$0.59 fair value.  

Largest Singapore-focused industrial REIT priced at small-cap multiples 

• After completing a merger with Viva Industrial Trust (VIT) on 15 Oct, ESR-REIT is the fourth largest industrial REIT listed in Singapore, and the largest with an entirely Singapore-focused portfolio. Post-merger, ESR-REIT’s portfolio size has increased from S$1.7b to S$3.1b (including 15 Greenwich Drive).
• Despite its new portfolio size, the REIT is still trading at valuation multiples closer to small-cap peers. According to our forecasts, ESR-REIT is trading at 0.9x FY19F P/B and offering a 7.8% FY19F dividend yield. In comparison, peers with large portfolios ( > S$2b in valuation) are trading at an average P/B of 1.19x and an average dividend yield of 6.5%.

Merger synergies yet to be fully appreciated

• We see three main benefits to the merger that we believe have yet to be fully appreciated by the market. 
  • First, the sheer size of the enlarged portfolio would mean that the merged entity is less affected by events such as sudden tenant defaults, master lease conversions, and any fall off in income support. 
  • Second, there is the potential to refinance at lower costs and access to a greater pool of financing options. 
  • Third, as ESR-REIT now enjoys greater liquidity and boasts a larger market cap over US$1b, we believe a significantly greater number of institutional investors will considerable it an investable asset.

Demand-supply dynamics to improve for SG industrial land owners

• We believe it is an opportune time to gain exposure to the SG industrial space through the REIT. While we are wary of the back-end loaded supply injection expected in 4Q18 (518K sqm of new industrial space), we believe the relatively slower pace of supply increase from 2019 to 2022 will lead to a better demand-supply situation as well as a further improvement in rents. To put things into context, the average annual demand and supply from 2015 to 2017 were 1.2m sqm and 1.6m sqm respectively, while the average annual supply coming up for 2019 to 2021 is 1.0m sqm. We derive a fair value estimate of S$0.59 for ESR-REIT using a dividend discount model (cost of equity: 7.5%, terminal growth rate: 0.5%). Initiate coverage on ESR-REIT with a BUY.

COMPANY BACKGROUND

Overview of ESR-REIT

• ESR-REIT is a Singapore-focused Real Estate Investment Trust (REIT) which primarily invests in industrial real estate assets. The REIT completed a merger with Viva Industrial Trust (VIT) on 15 Oct, by way of a trust scheme of arrangement. Under the merger, ESR-REIT acquired all of VIT’s stapled securities in exchange for S$9.60 in cash and 160 new ESR-REIT units for every 100 VIT’s stapled securities. As a result, assets of both REITs have come under the portfolio of an enlarged ESR-REIT.
• Post-merger, ESR-REIT’s number of assets has increased from 47 to 56 (or 57, if we include 15 Greenwich Drive which was acquired post-merger on 25 Oct 2018), while total GFA has increased 40.2% to ~13.6m sq ft (or 14.1m sq ft including 15 Greenwich Drive).
• ESR-REIT’s portfolio size has increased from S$1.7b to S$3.0b (or S$3.1b including 15 Greenwich Drive), making it the fourth largest industrial REIT listed in Singapore, and the largest with an entirely Singapore-based portfolio. See Exhibits 1-3 for more details.
• The properties are classified according to five types: General Industrial, Light Industrial, Logistics/Warehouse, Hi-Specs Industrial, and Business Parks.

INVESTMENT MERITS

Merger synergies to be harnessed

• There are positive synergies from the merger which we believe will take time to be appreciated by the market, and thus have yet to be priced in. See below for elaboration.

Large portfolio & diversified tenant base post-merger

• Having a larger portfolio provides greater diversification and adds resilience to ESR-REIT’s operational performance. For instance, specific cases of sudden tenant defaults and master lease conversions would likely be less significant against a larger portfolio.
• ESR-REIT also enjoys diversification through its large base of ~350 tenants. The REIT’s top 10 tenants post-merger are expected to contribute ~28.7% of rental income, with no single tenant accounting for more than 5.0% of portfolio gross revenue.
• In particular, the fall-off of a significant amount of income support from an asset previously under Viva Industrial Trust (VIT) – UE BizHub (UEBH) will matter less for a few reasons:
  • The fall-off in income support will be less significant against the dramatically increased NPI base that has resulted from the merger.
  • The fall-off in income support will look less severe optically (i.e. on a y-o-y basis), given that
    1. less than a quarter’s worth of UEBH’s income support will be captured in ESR-REIT’s FY18F figures, and
    2. FY19F’s y-o-y comparisons will be made against ESR- REIT’s FY18F numbers instead of VIT’s FY18F numbers (which would have included 9M18 worth of income support).
• The latter point is perhaps better appreciated by VIT shareholders who now hold ESR-REIT shares as a result of the merger. UEBH’s income support came up to S$9.5m in FY17 and S$5.4m in 1H18. The income support arrangement for UE BizHub expired in Nov 2018, and we expect ESR-REIT’s 4Q18F and FY18F financial results to include roughly S$0.4m of income support since the merger was only completed mid-Oct.
• Under the UEBH rental arrangement, the vendor of UEBH agreed to pay VI-REIT for the rental differential where the actual net rental income derived from UEBH (excluding the Hotel Leased Premises) is less than an agreed amount of S$26m per annum for each of the first two years, with a step-up of 5% in each of the third and fifth year for a duration of five years from VIT’s Listing Date on 4 Nov 2013.

Better credit profile

• The enlarged ESR-REIT portfolio is expected to be 100% unencumbered compared to 8% encumbrance for VIT’s portfolio as at 31 Dec 2017. We expect access to improved interest costs as a result of the larger fully unencumbered portfolio as well as a broader network of banking relationships following the merger.

Higher market capitalization and free float increases ease of investment for existing and potential unitholders

• Since the merger, ESR-REIT’s market capitalization has increased from S$742m as at the end of 2017 to >S$1.5b currently. Given that having at least a US$1b market cap is an explicit mandate for several institutional funds, we believe the REIT’s market cap post-merger has made it an investable asset to a wider pool of institutional investors.
• Furthermore, we note that the larger market capitalization could also potentially lead to index inclusions for the REIT.

Large REIT trading at small cap valuations

• We believe the advantages that the larger ESR-REIT stands to enjoy have yet to be reflected in its share price. Below is a table showing the dividend yields and price-to-book of other industrial S-REITs. According to our forecasts, ESR-REIT is trading at 0.9x FY19FP/B and offering a 7.8% FY19F dividend yield. In comparison, its large cap peers are trading at an average P/B of 1.19x and an average dividend yield of 6.5%.

Expecting better demand-supply dynamics for industrial sector

• While we are wary of the back-end loaded supply injection expected in 4Q18 (518K sqm of new industrial space), we believe the relatively slower pace of supply increase from 2019 to 2022 will lead to a better demand-supply situation as well as a further improvement in rents. To put things into context, the average annual demand and supply from 2015 to 2017 were 1.2m sqm and 1.6m sqm respectively, while the average annual supply coming up for 2019 to 2021 is 1.0m sqm.
• On the demand side, Singapore’s GDP growth as well as Manufacturing and Electronics PMI have each deteriorated in the past few months, though they both remain the positive territory. Overall, while noting the ongoing macroeconomic risks (see pg 14), we are still expecting an improvement in the demand-supply dynamics in 2019 driven by the moderation in supply injection relative to 2017.
• The operating metrics for industrial REITs shows a mixed picture for 3QCY18 rental reversions, though we note that occupancy rates and degree of negative rental reversions have generally shown an improvement over the past quarters. 

High exposure to business parks and high-spec assets

• Of the total portfolio, business parks account for ~30% of ESR-REIT’s portfolio valuation while high-specification buildings account for 16%.
• Business park rents have been largely stable, especially in comparison with the other asset types in the industrial space. 3Q18 city fringe rents increased 1.8% q-o-q to S$5.80 psf/month (five consecutive quarters of q-o-q growth), while rest of the island business park rents improved 1.3% q-o-q to S$3.80 psf/month (two straight months of q-o-q growth).
• Beyond commanding higher average monthly rents, business parks are also expected to enjoy better demand-supply dynamics in 2019.
• In terms of upcoming supply, we note that according to JTC data, there is 317k sqm of business park supply from 4Q18 onwards, representing 14.8% of the current stock. However, only 77k sqm and 17k sqm are expected to come on-stream in 4Q18 and 2019, respectively.

ESR is a strong sponsor

• ESR is a pan-Asian logistics real estate developer, owner, and operator that was co-founded by Warburg Pincus. The platform spans across Mainland China, Japan, Singapore, South Korea, Australia and India. As at 30 Jun 2018, the company’s assets under management has reached ~US$13b, and the GFA of projects owned and under development stood at over 10m sqm.

Potential NPI increase resulting from AEIs, and capital recycling

• Up to seven ESR-REIT assets have been identified for AEIs over the next three years. This includes creating ~1m sq ft of additional GFA out of unutilized plot ratio (~20% of portfolio GFA) – spread out between 7000 Ang Mo Kio Avenue 5 and 3 Tuas South Avenue 4. AEI plans also include the rejuvenation of assets through
  1. the upgrading and improving of building specifications,
  2. the change of building use to align with current market trends, and
  3. redevelopment and amalgamation of adjacent sites to enjoy economies of scale.
• AEI works are currently undergoing at 30 Marsiling Industrial Estate Road B, to upgrade the asset to a High-Specs Industrial Building. Estimated completion is in 1Q19.
• Alongside ESR-REIT’s AEI plans, the manager has also pursued active capital recycling, having divested four non-core assets above valuation, using the proceeds to (partially) fund three accretive acquisitions. 

KEY RISKS

Ongoing macroeconomic uncertainties

• We note the ongoing macroeconomic uncertainties focused around the US-China trade war and its implications on global growth. The US and China reached a 90-day trade truce at the start of December, but this was complicated by the arrest of Huawei Technologies’ CFO soon after. We note that businesses may become more cautious and leasing activity may slow down should the trade tensions re-escalate.

Supply injection in the fourth quarter of 2018

• Furthermore, we do note that the supply injection for industrial space is significant in 4QCY18. We do expect the demand-supply situation to improve in 2019, but it is possible that rental reversions could worsen first before getting better.

Interest rate hikes

• Interest rates affect REITs in two ways:
  • Operationally. As interest costs increase, the amount available for distribution to unitholders decreases.
  • Valuations. As generally high dividend yielding instruments, REIT valuations are compared to risk-free rates and other yield alternatives in the market (e.g. bonds). With a higher risk-free rate, investors will demand higher dividend yields from REITs, which may in turn place pressure on their unit prices.
• While interest rate hikes are still a concern for REITs, Federal Reserve chair Jay Powell’s speech earlier this month was noted for his relatively more cautious tone on future interest rate hikes, prompting speculation that the Fed may pause rate hikes next year.
• As at 30 Sep 2018, 91.2% of ESR-REIT’s interest rate exposure was fixed, the weighted average all-in cost of debt (%) p.a. stood at 3.76%, and the proportion of unemcumbered investment properties came to 100%. Post-merger, the weighted average debt expiry stands at 2.4 years.

Fall off in rental support

• UE BizHub’s (UEBH) rental support has expired in Nov 2018. We currently forecast S$0.4m of rental support to be recorded in FY19 given the 0.5 months between the completion of the merger to the expiry of the rental support. That said, we currently expect ESR-REIT to show positive DPU growth in FY19F despite the absence of this rental support.

FINANCIAL ANALYSIS AND FORECASTS

Forecasting stable DPU performance in FY19 and FY20

• Looking ahead, we expect the organic growth in ESR-REIT’s gross revenue in FY19F and FY20F to be driven by primarily by the rental reversions and occupancy changes in its multi-tenanted properties.
• Our revenue forecasts of S$154.5m, S$252.5m and S$257.6m in FY18F, FY19F, and FY20F translate into growth of +40.8%, +63.4% and +2.0%, respectively.
• The strong top-line growth in FY18 is largely driven by the acquisition of 7000 Ang Mo Kio Avenue 5 as well as a 2.5 month contribution from VIT’s assets; that for FY19 is driven by the full-year contribution from VIT’s assets. As a result, we project ESR-REIT’s distributable income to increase +35.5% y-o-y to S$68.3m in FY18F, +64.5% y-o-y to S$112.3m in FY19F, and +2.6% y-o-y to S$115.2m in FY20F.
• Due to the enlarged share base following the merger, DPU is expected to show a much milder trend. We expect DPU to dip 0.9% in FY18F, before growing +1.7% in FY19F and +2.3% in FY20F.

PEER ANALYSIS AND VALUATION

Initiate BUY on ESR-REIT with a S$0.59 fair value

• We value ESR-REIT using the dividend discount model (DDM) as it is expected to pay out stable rental income (net of expenses) generated from its assets at regular intervals. DDM is also a commonly used metric to value REITs. See PDF report attached for the details on DDM model.
• We derive a fair value estimate of S$0.59 for ESR-REIT after inputting our financial forecasts and CAPM assumptions (cost of equity: 7.5%, terminal growth rate: 0.5%) in our model.
• Refer to the PDF report attached for the S-REITs peer comparison table. 

Deborah Ong OCBC Investment Research | https://www.iocbc.com/ 2018-12-14

SGX Stock Analyst Report BUY INITIATE BUY 0.59 SAME 0.59