ESR-REIT - CGS-CIMB Research 2020-11-19: Larger Is Better

ESR-REIT (SGX:J91U) | SGinvestors.io ESR-REIT (SGX:J91U)

ESR-REIT - Larger Is Better

  • We view the potential merger of ESR-REIT and Sabana REIT positively as it paves the way for long-term growth on larger market share, wider pool of capital and lower financing cost.
  • Minimal impact from COVID-19. We expect a stable outlook for ESR-REIT.
  • Reiterate ADD. ESR-REIT is trading at 7% yield and 0.91x P/BV.

ESR-REIT + Sabana REIT: A merger to pave the way for stronger long-term growth

  • ESR-REIT (SGX:J91U) and Sabana REIT (SGX:M1GU) will be seeking shareholders’ approval in an EGM scheduled for 4 Dec 2020. For ESR-REIT, the merger requires > 50% of the total number of votes cast by ESR-REIT’s unitholders voting by proxy at the EGM for the approval of
    1. the merger, and
    2. issuance of approximately 989.9m new shares to Sabana REIT’s unitholders.
  • For Sabana REIT, > 50% by headcount vote and at least 75% of the value of such Sabana REIT units are required to approve the scheme. If approved, the merger will be effective on 31 Dec 2020 and be completed by 1Q2021.
  • Both ESR-REIT and Sabana REIT’s independent financial advisers (IFA) are of the view that the financial terms of the merger are fair and reasonable, hence both IFAs recommend unitholders vote in favour of the merger.
  • While the implied price of S$0.36 per share is at a 29% discount to Sabana REIT’s NAV/share of S$0.51 as at Jun 20, we note that the gross exchange ratio of 0.94x is at a premium to the two-year average of 0.84x and in line with its 5-year historical P/BV of 0.74x.
  • In addition, as part of a larger REIT, Sabana REIT would have more flexibility to undergo AEIs and improve asset occupancy. More importantly, the merger will allow it to gain a wider pool of capital, lower cost of capital, and allow it to pursue acquisitions more aggressively.

A merger that is beneficial for both ESR-REIT and Sabana REIT

  • We reiterate our positive view on the merger; if approved, it will create a relatively large S-REIT with AUM of S$4.1bn, placing it as the 5th largest industrial REIT in Singapore. This brings it closer to an inclusion into the FTSE EPRA Nareit Developed Asia Index which would allow it to access to a wider pool of capital and potentially a re-rating.
  • The top 4 industrial REITs in Singapore are constituents of the index and are trading at 1.1x to 1.8x P/BV. Assuming ESR-REIT re-rates to 1.1x P/BV post inclusion, the share price would be S$0.475 (based on proforma NAV post-merger), or 23% upside from the current ESR-REIT share price.
  • Based on the merger reference price of S$0.401 and 3,543.2m new shares to be issued, ESR-REIT’s free float market cap would increase by 42% to S$1.26bn post-merger which is only slightly below FTSE EPRA Nareit Developed Asia Index inclusion threshold of S$1.4bn. If the proposed merger is approved, the REIT hopes to join the index in 1-2 years.
  • A rerating would in turn lower its cost of capital and allow more financing flexibility to pursue organic and inorganic growth. We believe the acquisition is important for both ESR-REIT and Sabana REIT to overcome the structurally short land lease tenure of industrial properties in Singapore. ESR-REIT’s asset valuation excluding divestments and acquisitions has been declining over the years, mainly due to the declining land lease tenure. The same also applies to Sabana REIT which has seen valuations declining over the past four years. One of the potential markets that ESR-REIT is keen to expand into is Australia where its sponsor, ESR, already has an established presence.
  • In addition to a potential rerating, AUM size and backing of a strong sponsor is also important in determining the financing cost of a REIT. Despite the fact that Sabana REIT’s gearing is lower than ESR-REIT and that 93.8% of its assets are encumbered, its financing cost of 3.8% (as at Jun 20) is still higher than ESR-REIT’s financing cost of 3.54%. Post-merger, being part of a much larger entity (S$4bn AUM versus S$837m pre-merger) and with strong sponsor backing as well as more evenly-distributed and resilient debt maturity profile post-merger, Sabana REIT’s financing cost is expected to reduce to 2.5% and all of its assets will be free from encumbrance.

DPU-accretive merger; more room for DPU improvement post-merger

  • On a proforma basis, the merger is expected to be 3.5% DPU-accretive for ESR-REIT and a substantial 12.9% for Sabana REIT. Post-merger, we see more room for DPU improvement as the enlarged REIT could step up AEI activities given that each asset would have lower weighting in the merged entity and any AEIs would have less of an impact on the bottomline. This is especially true for Sabana REIT which we believe faces more difficulties in conducting AEIs due to its higher asset concentration with its top 3 assets accounting for 47% of the REIT’s gross rental income in 2019. There would be more flexibility to move tenants around for AEIs post-merger, an option which may be less available to Sabana REIT on its own. Construction cost for AEIs could also be reduced due to better bargaining power for the enlarged REIT with market share of ESR-REIT and Sabana REIT increasing from 2.8% and 0.8% to a combined 3.6%, respectively.
  • Sabana REIT has 1.2m of unutilised GFA (29.3% of Sabana REIT’s total GFA) for ESR-REIT to tap into. Together with ESR-REIT’s 1m sf of unutilised GFA, the merged entity has up to 2.2m of additional GFA from unutilised plot ratio. Through this merger, the enlarged REIT could develop up to 2.2 million square feet of additional GFA at a lower cost of capital with lower leasing risks as it gains access to a larger pool of potential tenants through ESR Group's and ESR-REIT's existing tenant relationships and network, thus unlocking property value and increasing its overall industrial GFA market share.
  • There will also be economies of scale across operations, leasing and marketing. Sabana REIT’s average occupancy was lower at 80% versus ESR-REIT’s 91% as at Jun 2020. The merged entity could improve this by leveraging its own and ESR’s network to cross-sell assets. Close proximity of assets within each cluster could lead to potential cost savings and lower property expenses arising from the integration and optimisation of property management services.
  • In the immediate term post-merger, ESR-REIT will benefit from higher income contribution from “future-ready” high-specs properties and resilient logistics/warehouse assets which have a more favourable rental outlook versus the older/dated general industrial assets of which contribution would decline to less than 30% of total income post-merger. With a larger portfolio and tenant base, the enlarged REIT will also have stronger bargaining power with service providers and tenants.

What if the merger does not materialise?

  • It will be business as usual for ESR-REIT, although it would take longer for it to be included into the index. We expect a stable outlook for ESR-REIT with business park, high specs and logistics warehouse (except cargo lift warehouse) rental to post flat to positive rental reversion, offsetting the potential negative rental reversion from general industrial and cargo lift warehouse assets.

ESR-REIT's ongoing AEIs.

  • ESR-REIT is undergoing AEI for its asset on 19 Tai Seng Avenue (capex of S$9m) and resumed rejuvenation works at UE BizHub East (capex S$8m-9m). The AEI at 19 Tai Seng involves converting the building from general industrial to a high spec building while enhancement works at UE BizHub entailed a reconfiguration of public areas to improve accessibility and traffic circulation, refurbishment of building façade and upgrading of public facilities. The common areas within the property will be improved in order to attract and retain quality tenants.
  • 19 Tai Seng Avenue and UE BizHub East AEIs are expected to be completed in 2H21 and 1Q21, respectively. While UE Bizhub accounted for 11% of total revenue in 2019, we understand that the property will remain operational during the AEI, and thus have a minimal impact on the bottomline. 19 Tai Seng Avenue on the other hand took up only 1.2% of total revenue in 2019.

More AEIs in the pipeline.

  • It is also planning for the redevelopment of a new building onsite at 7000 Ang Mo Kio Avenue 5 (capex of S$45.7m funded via equity fund raising in 2019) which will increase its plot ratio from 1.7 to 2.1, adding approximately 270,000 sf of brand new high-specification industrial space. The property has another 225,000 sqft of GFA remaining for future development. The AEI is expected to commence as soon as regulatory approval is granted and is targeted to be completed in 18 to 24 months after commencement. 7000 Ang Mo Kio accounted for 9.8% of ESR-REIT’s total revenue in 2019 but yield on cost is expected to be high at > 9%.
  • ESR-REIT is currently looking at 2-3 more AEIs to convert the assets into high specification buildings. If they commence this year, the AEIs would only start contributing in 2Q22. The AEIs are estimated to be about S$70m-80m and yield on cost would be 6-7%. These AEIs could be funded by asset divestments.

DPU impact from ESR-REIT's AEI can be cushioned by divestment proceeds.

  • While AEIs are likely to impact income in the near term, ESR-REIT has total divestment proceeds of S$60m which can be used to buffer the impact of AEIs on distribution.

20.1% of ESR-REIT's leases by income will be up for renewal in 2021.

  • Of the 5.3% leases expiring in 4Q20, approximately 4.4% of such leases are in advanced negotiations where ESR-REIT’s tenants have given indications of plans to renew. 20.1% of leases by rental income will expire in 2021. Of these, 4.1% are single-tenanted assets. ESR-REIT has been receiving healthy leasing enquiries and expects overall rental reversions to be flat to slight positive.

Substantial rental rebates are unlikely going forward.

  • Rental collection in 3Q20 is approximately 94% of gross rental income, which is consistent with 1H20 and pre-COVID-19 levels. There are only 22 out of 346 tenants that have requested rental relief. ESR-REIT has previously estimated that S$10.1m of rental rebates may be required for tenant support. As at 30 Sep 2020, S$3.8m of rental rebates have been given to eligible tenants and another S$3.2m has been recognised.
  • Barring unforeseen circumstances, ESR-REIT does not expect substantial rental rebates to be given out going forward. Thus, it has released 50% or S$3.5m of its income retained from 1Q20.

Expecting lower interest expense.

  • There is no more refinancing requirement in 2020. In 2021, ESR-REIT has S$193m of loans (16.2% of total debt) due. The REIT is looking to reduce its interest cost from the current 3.5% to 3.2% in 2021F in view of the lower interest rate environment. Also, 40% of ESR-REIT’s loan is hedged with fixed interest rate which can be reduced to further lower financing cost.

Reiterate ADD on ESR-REIT

EING Kar Mei CFA CGS-CIMB Research | LOCK Mun Yee CGS-CIMB Research | https://www.cgs-cimb.com 2020-11-19
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