November 20, 2020

Larger is better

  • We view the potential merger 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 EREIT.
  • Reiterate Add. The stock is trading at 7% yield and 0.91x P/BV.

A merger to pave the way for stronger long-term growth
ESR REIT (EREIT) and Sabana REIT (SREIT) will seek shareholders’ approval in EGMs on 4 Dec 20 for the merger between the two REITs. If approved, the merger is targeted for completion by 1Q2021F. We view the merger positively as it paves the way for stronger long-term growth. Independent financial advisers have also recommended unitholders to vote in favour of the merger. The merger will create a sizeable S-REIT with AUM of S$4.1bn, placing it as the 5th largest industrial REIT in Singapore. This brings it closer to inclusion into the FTSE EPRA Nareit Developed Asia Index which allows it access to a wider pool of capital and potentially rerating. The top 4 industrial REITs in Singapore are constituents of the index and are trading at 1.1x to 1.8x P/BV. Management hopes to join the index in 1-2 years.

Size does matter
A rerating would lower its cost of capital and allow more financing flexibility to pursue growth which is crucial for both EREIT and SREIT to overcome the structurally short land lease tenure of industrial properties in Singapore. We think AUM size and backing of a strong sponsor are important in determining the financing cost of a REIT. This is demonstrated by the ability to lower SREIT’s financing cost from 3.8% to 2.5% and free the assets from encumbrance post-merger. While the deal is proforma DPU accretive for both REITs, we see more room for DPU improvement as the enlarged REIT could step up AEI and redevelopment activities at lower cost with lower leasing risks and DPU impact due to a wider pool of tenants, lower weighting of each assets in the merged entity and larger market share. There will also be economies of scale across operations, leasing and marketing which could help to improve occupancy, especially for SREIT.

Reiterate Add
EREIT has seen little impact from Covid-19 so far. We expect a stable outlook for EREIT with business parks, high specs and logistics warehouses to post flat to positive rental reversion, offsetting the potential negative rental reversion from general industrial and cargo lift warehouse assets. There are two ongoing and three planned AEIs which could enhance its income further. Income disruption due to AEIs can be buffered by S$60m divestment proceeds. Financing cost could be reduced due to the lower interest environment and lower hedging. We reiterate Add with DDM-based TP of S$0.49. The stock is trading at 7% yield and 0.91 P/BV versus its pre-Covid 19 peak of 1.3x. The merger, if approved, will pave the way for stronger long-term growth for the merged entity. Upside/downside risks include stronger/weaker rental reversion.

Independent Financial Advisers recommend voting in favour of the merger
ESR REIT (EREIT) and Sabana REIT (SREIT) will be seeking shareholders’ approval in an EGM scheduled for 4 Dec 2020. For EREIT, the merger require 50% of the total number of votes cast by EREIT’s unitholders voting by proxy atthe EGM for the approval of (i) the merger, and (ii) issuance of approximately 989.9m new shares to Sabana REIT’s (SREIT) unitholders. For SREIT, >50% by headcount vote and at least 75% of the value of such Sabana units are required to approve the scheme. If approved, the merger will be effective on 31 Dec 2020 and be completed by 1Q2021. Both EREIT and SREIT’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 SREIT’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, SREIT 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 REITs

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 EREIT re-rates to 1.1x P/BV post inclusion, the share price would beS$0.475 (based on proforma NAV post-merger), or 23% upside from the current share price.

Based on the merger reference price of S$0.401 and 3,543.2m new shares to be issued, EREIT’s free float market cap would increase by 42% to S$1.26bn postmerger 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 EREIT and SREIT to overcome the structurally short land lease tenure of industrial properties in Singapore. EREIT’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 SREIT which has seen valuations declining over the past four years. One of the potential markets that EREIT 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 SREIT’s gearing is lower than EREIT and that 93.8% of its assets are encumbered, its financing cost of 3.8% (as at Jun 20) is still higher than EREIT’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, SREIT’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 postmerger
On a proforma basis, the merger is expected to be 3.5% DPU-accretive for EREIT and a substantial 12.9% for SREIT. 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 SREIT 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 SREIT on its own. Construction cost for AEIs could also be reduced due to better bargaining power for the enlarged REIT with market share of EREIT and SREIT increasing from 2.8% and 0.8% to a combined 3.6%, respectively.

SREIT has 1.2m of unutilised GFA (29.3% of Sabana’s total GFA) for ESR REIT to tap into. Together with EREIT’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 EREIT’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. SREIT’s average occupancy was lower at 80% versus EREIT’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, EREIT 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 EREIT, although it would take longer for it to be included into the index. We expect a stable outlook for EREIT 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.

Ongoing AEIs. The 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 EREIT’s total revenue in 2019 but yield on cost is expected to be high at >9%.

The 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 AEI can be cushioned by divestment proceeds. While AEIs are likely to impact income in the near term, EREIT has total divestment proceeds of S$60m which can be used to buffer the impact of AEIs on
distribution.

20.1% of 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 EREIT’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 singletenanted assets. EREIT 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. EREIT 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, the 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, the REIT has S$193m of loans (16.2% of total debt) due. EREIT 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 EREIT’s loan is hedged with fixed interest rate which can be reduced to further lower financing cost.

Reiterate Add
Our FY20-22F DPU is adjusted by -0.2% to +0.3% due to a housekeeping exercise. We reiterate Add on EREIT with a TP of S$0.49. The stock is trading at 7% yield and 0.91x P/BV versus its pre-Covid 19 peak of 1.3x. The merger, if approved, will pave the way for strong long-term growth for the merged entity as it will create a sizeable REIT which places it closer to index inclusion and potentially rerating on the stock, providing more flexibility in growing AUM. In the near-term, post-merger, both EREIT and SREIT could look into enhancing assets to generate higher income which is also important to buffer any asset valuation decline due to declining land lease tenure.

ADD by CGS-CIMB. Share price closed at $0.385.