ESR REIT - RHB Invest 2019-02-12: An Industrial Giant In The Making; Initiate BUY

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ESR-REIT (SGX:J91U)

ESR REIT - An Industrial Giant In The Making; Initiate BUY

• Initiate at BUY, high-end of Street SGD0.61 Target Price, 18% upside, 8% yield.
• ESR-REIT is a pure play on the Singapore industrial sector turnaround with a well-diversified portfolio of 57 assets located across the island. The REIT has been on a transformational path from the time ESR Group (ESR) became its sponsor (Jan 2017), with a more than twofold increase in asset value – it is currently the fourth largest listed Industrial S-REITs.
• We believe the market is yet to recognise the full potential of the economies of scale from its growth and sponsor strength as it trades at an attractive FY19F yield of 8%. This is 170bps higher than that of its industrial peers and the S-REITs average.

Company Background & Structure

• ESR-REIT (SGX:J91U) (formerly known as Cambridge REIT) has been listed on Singapore Exchange Securities Trading (SGX-ST) since 25 Jul 2006.:
  1. Post the recent acquisition of Viva Industrial Trust (SGX:T8B) and its manager, sponsor ESR has a 67.3% stake in the REIT manager and 100% stake in the property manager. It also holds about a 9.3% stake in the REIT;
  2. Mr Tong Jinquan holds a 25% stake in the REIT manager and the remaining stake is held by Mitsui & Co;
  3. RBC Investor Services Trust Singapore (Trustee) acts as the REIT’s trustee.
• Diagram illustrates the relationship between ESR-REIT, the manager, trustee, property manager, and unit holders available in the attached PDF report (Figure33).

Investment Highlights

Transforming into an industrial giant.

• ESR-REIT (SGX:J91U) has been embarking on a steady transformation into a major industrial player in Singapore since ESR came on board as sponsor in Jan 2017. Over the last two years the REIT has more than doubled in portfolio size through acquisition and most recently through the merger of Viva Industrial Trust. It is now the fourth largest Industrial S-REITs.
• The key reasons for its growth pursuit have been to:
  1. Better compete with other industrial players via scale;
  2. Diversify its asset mix;
  3. Lower funding costs;
  4. Reap operational synergies;
  5. Gain better investor traction.
• We see merits in all the points above as historically, larger Industrial S-REITs in Singapore have benefitted from a wider pool of tenant base, better cost management and lower funding costs – and as a result, have traded at a premium to the smaller industrial REITs. ESR-REIT has a portfolio of 57 industrial properties, all in Singapore, with total asset size of SGD 3.1bn (see Appendix A, for individual property details).

A well-diversified industrial portfolio with strategically located assets.

• ESR-REIT has a good mix of assets across various industrial segments:
  1. Business parks (three assets);
  2. High-specs industrial (seven);
  3. General industrial (25);
  4. Light industrial (12);
  5. Logistics/ Warehousing (10).
• Post completion of its recent merger with Viva Industrial Trust, the proportion of total assets comprising business parks and high-specs sectors has more than doubled to 45% for ESR-REIT. Among the industrial sub-segments, we are most positive on these two segments, due to Singapore’s push towards high-end manufacturing, their ability to consistently command high rental rates and because they are low in supply in Singapore for the next three years (refer to the Industry Outlook, page 13 in the attached PDF report). Thus we see room for occupancy increase and rental improvement in its portfolio in the near-term.
• Additionally, about 22 of its 57 assets are located near the Tuas Mega Port, which is to be completed by 2040. This cluster of assets may stand to benefit from the new port, which will house all of Singapore’s container activities. We believe the consolidation of the container port activities, that run on emerging technologies, automation and data analytics, will provide economies of scale and increase demand for industrial, warehouse and logistic properties around the area.

Unlocking value from AEIs – next leg of growth.

• After growing rapidly through acquisitions in recent years, management’s focus has now shifted on unlocking its portfolio value via asset enhancement initiatives and asset rejuvenations. On this front, ESR-REIT has identified about seven assets where it plans to enhance value over the next three years.
• The value unlocking plan includes tapping of c.1m sqf of unutilised plot ratio at two of its properties – 7000 Ang Mo Kio Avenue 5 (7000 AMK) and 3 Tuas South Avenue 4. Management is in talks with authorities for building an extension wing at 7000 AMK with likely plans of building a data centre. The capex estimated for such a development is c.SGD50m, with works likely to begin in 3Q19 after obtaining necessary approvals.
• In terms of asset rejuvenation, a recent example has been the conversion of 30 Marsiling Industrial Estate Road 8 into a niche food logistics factory. Other asset rejuvenation works would be mainly focused on converting the cargo lift warehouses, which are currently in low demand, to ramp-up warehouses. Management’s targeted yield on cost for AEIs is 8.5-9.5% and 7.5-8% for asset rejuvenation. Considering the management team’s strong past track record of adding value from AEIs we believe the above plans will result in strong value creation for unit holders.

Long-term potential to become a strong regional player from sponsor’s strength.

• ESR-REIT’s sponsor ESR is a merged group between e-Shang Cayman Ltd (e-Shang) and the Redwood Group Asia (Redwood). It is an APAC-focused logistics real estate platform that develops and manages institutional-quality logistics facilities with AUM of > USD 14bn (see page 16 of attached PDF report for sponsor details).
• The sponsor has a 67% stake in the REIT manager, 100% stake in the property manager, a 9% stake in the REIT, and has fully underwritten the recent preferential offering demonstrating its long term commitment and alignment of interest. With ESR-REIT being the sponsor’s only listed arm, it has the rights to a “first look” at assets for acquisition, which provides it excellent opportunities to grow its portfolio in the future.
• ESR also provides ESR-REIT with development expertise and an extensive network for a strong regional tenant base.

The US-China trade tensions: limited impact on industrial demand for now.

• From our recent discussions with industrial landlords, we understand that there has been some slowdown in industrial demand as a result of the recent trade tensions. Specifically, tenants are a bit uncertain about signing up long-term leases and there has also been some downsizing due to uncertainties.
• Our base case view is that this demand uncertainty is a short-term phenomenon. We expect demand to stabilise and get better in 2H19, in line with a higher GDP growth expectation. We also see the possibility of some high-end industrial demand from the region being shifted to Singapore if trade tensions lengthen, with the recent shift of Dyson’s headquarters from the UK to Singapore being a prime example. Additionally, the industrial supply slowdown should also help in buffering some of this impact.

Hyflux – tenant default risk?

• We understand that one of the concerns the market has is in regards to the REIT’s acquisition (Dec 2017) of 8 Tuas South Lane from Hyflux Membrane Manufacturing (S) (subsidiary of HYFLUX LTD (SGX:600)).
• The property accounts for 3.5% of total rental income and was acquired on a long-term (15-year) lease, with the majority (70%) of the space taken up by Hyflux. With Hyflux undergoing a restructuring process, there have been concerns regarding rental payments. Management, however, has clarified that Hyflux has been prompt in rental payments so far and it believes rental payments will continue, as the property is essential for the continued operation of the latter’s business. It has three months of security deposits for the rental payments.
• We understand that the building is not purpose-built for Hyflux, thus we believe that in the worst-case scenario of tenant default ESR-REIT would still be able to re-let the building to other tenants. The property is also currently leased to Hyflux on two different lease terms, which lends itself well to being multi-tenanted.

Potential cost savings from economies of scale.

• Moving ahead, ESR-REIT will be clustering its assets by region for better on-site management and shifting towards self-management of properties for more cost savings, faster response time and better service quality for tenants.
• The enlarged portfolio also creates economies of scale and gives ESR-REIT stronger bargaining power with service providers. ESR will also be using bulk tender contracts for property services to reduce operational maintenance costs.
• Management conservatively expects 2-3% in cost savings pa over the next few years from these efforts.

Diversified tenant base.

• Over the years, ESR-REIT has reduced its reliance on master leases, with about 70% of the rental income coming from multi-tenanted buildings (previously c.50%). It has about 350 tenants in its properties with trade sectors across various categories and no specific trade sector accounts for more than 15% of its total rental income.
• There is also no concentration risk, with no tenant accounting for more than 5% of income, while its top 10 tenants account for only 30% of total rental income. The top three rental contributors for FY18 were AMS Sensors Singapore (4.6%), United Engineers Developments (subsidiary of UNITED ENGINEERS LTD ORD (SGX:U04)) (4.1%) and Hyflux Membrane Manufacturing (3.5%).

Poised to benefit from rising rents and tapering industrial supply.

• The weighted average lease expiry (WALE) by rental income of the portfolio is 3.8 years with 21.2% and 18.7% of the leases expiring in 2019 and 2020 and 24.6% of the leases expiring in 2024. No more than 21.2% of leases are expiring in any given year over the next three years.
• While longer term leases provide ESR-REIT with a more stable source of income, the shorter term leases put ESR-REIT in a better position to take advantage of rising rents. With industrial supply tapering for the next few years, ESR-REIT should be able to replace tenants with greater ease.

Fee structure in line with that of its industrial REIT peers.

• ESR-REIT’s management base fees are set at 0.50% pa of portfolio value, similar to most fees of peers (refer to Figure 11 in the PDF report attached). Its performance fees are well aligned to unit holders’ interest of generating higher returns. The trustee’s fees are at the lower end at 0.03% of property value, while acquisition and divestment fees are comparable with those of industry peers.

Financials

Forecasting a 3-year CAGR DPU growth of 4%.

• We expect ESR-REIT’s FY19 revenue and NPI to jump by 69% and 74% y-o-y on the back of the completion of its merger with Viva Industrial Trust. We forecast NPI margin to expand by 2ppts over the next three years owing to higher NPI yields of acquired assets and cost savings expected from the merger.
• Our forecast assumes a slight improvement to its current portfolio occupancy of 93%, a positive rental growth of 1-3% and a 100% payout ratio. Our forecast currently doesn’t assume any uplift from asset enhancements or rejuvenation plans, pending more details.

Expecting flattish debt costs.

• About 22% of its total debt is due for renewal in FY19. We assume the overall interest cost to remain at 3.81% pa, owing to the more dovish interest rate outlook from the US Federal Reserve.
• For 2020-2021, we have factored in a slight 5bps increase in overall interest cost. The REIT has a well spread-out debt maturity profile with no more than 27% of debt expiring in any single year and with weighted average debt expiry (WADE) of 2.7 years.
• About 83% of its debt is also hedged for a 3.0 year term thus limiting the impact from any sharp spikes in interest rates. Additionally, 100% of the portfolio debt is unencumbered, providing more flexibility in refinancing.

High gearing level limits debt-funded acquisitions.

• ESR-REIT’s current gearing of 41.9% (FY18) is among the highest in the S-REITs sector (maximum allowable limit is 45%) and it has limited debt headroom in terms of acquisitions. The increase in gearing from 30.3% last year was mainly due to acquisitions and the recent merger.
• Management is not too concerned with the gearing, as it has a strong support from its sponsor and the banks are comfortable with its asset quality. The high gearing level, however, limits the accretion effect from potential future acquisitions.

Payment of fees in units.

• Our DPU forecast assumes 50% of management fees to be paid in units, similarly to 4Q18. If management chooses to receive a higher proportion of management fees in units it will result in a further DPU upside and vice versa.

Distribution frequency.

• ESR-REIT declares and distributes dividends to unit holders on a quarterly basis.

Valuation

Initiate coverage with BUY and SGD0.61 Target Price, 18% upside, with 8% yield.

• Our 5-year DDM-based Target Price is derived with an 8% CoE (risk-free rate: 3%, terminal growth: 1%). We have assumed a 100% payout ratio, taking into consideration the REIT’s near-term capex requirements and 50% of the management fees being paid in units.
• Our Target Price implies 1.25x FY19F P/BV, which is the average P/BV of Industrial S-REITs (Figure20). We believe the premium to book value is justified, considering the positive industrial sector outlook, increased scale and management capabilities.
• Our sensitivity analysis looks at changes in Target Price that correspond to a 1ppt change in the COE assumptions and every 0.5ppt change in terminal growth assumptions.

Valuations are attractive with FY19F yields of 8%.

• ESR-REIT’s FY19F-20F yields of 7.9% and 8.3%, are a good 170bps above the average yields of Industrial S-REITs. The REIT is trading at 1.1x P/BV currently, a 10% discount to the Industrial S-REITs average of 1.23x.
• With a well-diversified portfolio of industrial assets across all segments in Singapore, coupled with growth potential from asset enhancements and acquisitions, we believe it is a value buy among Singapore-focused industrial REITs.

Vijay Natarajan RHB Securities Research | https://www.rhbinvest.com.sg/ 2019-02-12

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