ESR-REIT - OCBC Investment 2019-04-10: Forecasts In Flux

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ESR-REIT (SGX:J91U)

ESR-REIT - Forecasts In Flux

• Hyflux Membrane is a concern.
• ESR-REIT unit price rally since initiation.
• Fair value decreased to S$0.55.

Total returns of 9.8% since our initiation

• Since our initiation on 14 Dec 2018 (see report: ESR-REIT - New Kid On The Block), ESR-REIT (SGX:J91U) has posted total returns of 9.76%, vs. the Straits Times Index’s 7.41%. 
• ESR-REIT continues to trade at a discount to industrial REITs that also have large industrial portfolios, but this has narrowed significantly since our initiation. As at 9 Apr’s close, ESR-REIT is currently trading at 1.17x P/B (versus the 1.33x average of its large portfolio peers), and a dividend yield of 7.0% FY19F yield (vs. the 5.7% current yield of its large portfolio peers).

Hyflux Membrane issue is a concern, but there are mitigating factors

• We note that Hyflux Membrane is one of ESR-REIT’s top 10 tenants, accounting for ~3.5% of the total rental income for Dec 2018 and ~7.2% of distributable income for 4Q18. In recent months, exposure to this tenant has become a concern given Hyflux’s filing for bankruptcy protection.
• While we continue to monitor the situation, we identify a couple of mitigating factors for ESR-REIT:
  1. Hyflux Membrane has not defaulted in its rental payments,
  2. should HYFLUX LTD (SGX:600)’s business remain intact after the restructuring, we believe there is still a good chance that Hyflux Membrane will continue to rent its current premises (8 Tuas South Lane),
  3. the asset is within an established industrial area and ESR-REIT has been receiving leasing interest and enquiries for the space, and
  4. ESR-REIT presently holds security deposits worth three months of rental income, which have yet to be drawn down.
• That said, in the case of a default, we believe the asset will be subject to JTC anchor tenant rules which may be onerous to fulfill.

Adjustments made to fair value

• We update our property forecasts to account for a potential Hyflux Membrane rental default.
• Having assumed a Hyflux Membrane default after 1Q19, a full drawdown in the security deposit and a gradual recovery in occupancy thereafter, our fair value drops from S$0.575 to S$0.55.
• Looking ahead, we look forward to a bottoming in industrial rents in 2019, though towards the latter half of the year given the backend-loaded supply injection last year. As mentioned in our last report (see report: ESR-REIT - Good First Steps), we remain a little wary on ESR-REIT’s relatively high gearing ratio of 41.9%, which we believe increases the risk of a dilutive equity financing.
• Given the ESR-REIT share price rally since our last update, we downgrade ESR-REIT from Buy to HOLD.

Deborah Ong OCBC Investment Research | https://www.iocbc.com/ 2019-04-10

SGX Stock Analyst Report HOLD DOWNGRADE BUY 0.55 DOWN 0.575