Did ESR Overpay To Acquire Viva?

by: Tam Ging Wien


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Our regular readers are well aware that ProButterfly attended the REITs Symposium 2018 where we had the opportunity to interact with the management of various REITs.

During the symposium, we approached ESR-REIT management as we had burning questions with regards to the recent announcement of the proposed merger between ESR-REIT and Viva Industrial Trust.

For those who are unfamiliar, just the day before the REIT Symposium 2018, both ESR-REIT and Viva Industrial Trust (VIT) made a joint announcement on the details of the proposed merger.

Brief Background of the Merger

According to the details of the merger, VIT unitholders will receive S$0.96 per Stapled Security. Therefore, for every 100 units of VIT Stapled Security, unitholders will receive:

  • S$9.60 in cash
  • 160 new ESR-REIT Units at S$0.54 per unit


Source: Respective Quarterly Report Announcements and Merger Announcement (Pro-forma)

We summarise the in the above table the pertinent metrics comparing the individual trusts before the merger and the resulting pro-forma of the enlarged trust after merger.

From the perspective of the VIT unitholders who had gotten their units at a good price, the S$0.96 offer does certainly look enticing. It’s no doubt clear that VIT unitholders have much to benefit from this offer.

However from the perspective of the ESR unitholders, it will result in further dilution in their unitholdings. Notice that in terms of NAV per Unit, this merger will result in fall from 58.35c to 49.14c as the total NAV increase is only 68.11% while the unit increase was greater at 99.63%. To make matters worse, an earlier S$0.54 per unit preferential offering exercise was just conducted in February/March-2018 already diluting unitholders just months before.

In pro-forma terms, the gain in DPU is also not significant at only 5.58% DPU accretive which translates to a 0.215c gain; this comparatively unfavorably to the NAV per Unit which fell 9.2c. This resulted in the immediate increase in the Price/NAV per Unit based on the current trading price. Furthermore, the ESR unitholders would be holding a more significant risk of an increased gearing from 29.8% to 38.9%. Therefore it was not surprising that unit prices corrected from 52.5c to close 51c this week. The markets obviously reacted negatively to the announcement.

So having understood the terms of the merger, naturally when we visited ESR-REIT’s booth – the focus of the discussion would be around this seemingly poor deal for ESR unitholders. VIT unitholders meanwhile while there is significant emphasis on the benefits to VIT unitholders.

Greater Benefits of a Real Estate Developer Sponsor

We started off the discussion with the IR representatives in order to understand the longer term strategy with respect to this proposed merger. We decided to let the management do the talking.

The management started off by sharing that e-Shang Redwood Group (ESR) is a developer, owner and operator of modern logistics real estate in countries such as China, Japan and South Korea. They have also recently ventured into new markets like Australia, India and Malaysia.

Compared to National Australia Bank (NAB) who was the major shareholder of the former entity Cambridge Industrial Trust (CIT) – ESR is better able to value-add to the REIT with their real estate domain expertise.

They further added that with a strong developer sponsor, it gives the market confidence that ESR-REIT has the ability to raised funds and acquire good quality assets. Citing the example of the recent acquisition of 15 Greenwich Drive (a modern ramp-up logistics facility) and 7000 Ang Mo Kio Avenue 5 (consisting of a 6-storey high-spec block and a 5-storey multi-tenanted office block), ESR as a recognizable sponsor is able to attract sellers and deal makers early when an asset becomes available for sale.

Doesn’t Rule Out Overseas Expansion, Singapore Still the Focus

We went on to ask if ESR-REIT would ride on its international sponsor to gain exposure to overseas assets.

The management doesn’t rule out the possibility of overseas expansion plans, however they emphasised that Singapore will remain their primary focus for the foreseeable future.

They elaborated that with the ESR-REIT and VIT merger in the pipeline, there is much effort needed to ensure the merger achieves the desired synergies and benefits from the increase in portfolio size. They estimate that it would take approximately 3 to 6 months of integration efforts to achieve an aligned cohesion and fully realise benefits of the enlarged portfolio.

Benefits of an Enlarged Portfolio

Naturally, the flow of conversation led to a detailed discussion on the benefits of the enlarged portfolio to ESR-REIT unitholders.

According to management, as a result of the merger, ESR-REIT would become the 4 largest industrial REIT listed on the SGX with a combined assets of ~S$3.0bil. To reiterate, ESR-REIT would be backed by sponsors who are also developers which will immediately bring strong real estate domain and expertise to the REIT.


Source: ESR-REIT & Viva Industrial Trust Merger Announcement Presentation Slides

A larger entity would potentially lead to an increased trading liquidity, greater analyst coverage and in the future the possibility of inclusion in indexes as their marketcap grows leading to increase demand for the units.

Besides these points, the management added that an enlarged portfolio would potentially lead to a lower overall cost of financing. They shared that various lenders have already approached them to discuss the financing needs of ESR-REIT and are willing to offer more competitive rates. Management estimated that they could achieve interest savings of 20 to 30 basis points compounded over a longer term. The margin compressions entails lower financing cost which would lead to increased overall DPU.

A larger portfolio would also benefit from economies of scale as cost could be spread out, common operational services could be shared and management benefit from an integration of the software management systems.

Specifically to VIT’s portfolio which is presently 92% encumbered; the enlarged entity will be structured such that the portfolio will be completely unencumbered. This is achieved by refinancing VIT existing $525.0mil secured debt into unsecured debt with lower interest cost to and increase the flexibility of managing the portfolio.

A larger portfolio also gives a more diverse negotiation options to the REIT manager which could lead to more favorable contract negotiations with the aim of achieving rental uplift.

We certainly can appreciate the qualitative comments from the management and see the synergies and benefits a larger portfolio could bring.

Going forward, we as investors would need closely follow the progress once the merger is approved. Benefit and value extraction from a merger certainly will take time to realise and trickle down to the bottom line.

Was the 26.3% Premium to NAV A Fair Price to Pay?

Next, our initial queries centered on the seemingly high price ESR paid for VIT’s portfolio. Prior to the acquisition, VIT’s latest announcement shows an NAV per share of 76c and VIT’s shares closed at 89c just prior to the announcement.

The acquisition price of 96c implies a 26.3% premium to NAV and 7.9% premium to the last traded price prior to the announcement.

The IR representatives explained that during the acquisition of real estate assets, there will always be some amount that needs to be paid as the assets are physical and command a certain valuation in the market.

They also added that when acquiring an entire portfolio, there will most certainly be premiums compared to acquiring assets individually. We can appreciate this comment since acquiring a portfolio comes with some inherent intangible benefits to the new owners; for example the homogeneity and fit of the portfolio, additional cost efficiency benefits through economies of scale, ability to deploy capital or a much larger scale at a single moment and lowering their cost of financing.


Source: ESR-REIT & Viva Industrial Trust Merger Announcement Presentation Slides

Next, they further elaborated that the VIT portfolio consist mainly of business parks and high-specs industrial assets. These assets are also higher yielding with stable rentals. There is limited supply for these class of industrial assets in the market and acquiring a ready portfolio of such a class of limited supply assets will certainly come at a premium.


Source: Viva Industrial Trust Annual Report FY2017

While in-principal, we agree with the pointers shared by the management with regards to the acquisition, we also note that VIT’s portfolio has significant amount of income support. According to VIT’s latest annual report Note 22, declared DPU for the year is 7.473c but would have been only 6.442c without the income support. Therefore the income support boosted the DPU by approximately ~16%. These income support is expected to expire in Q4-2018 with some offset from potential rental revision. We can assume that the asset valuations on VIT books are likely also boosted correspondingly by ~16%.

So it is possible that ESR may have paid more than just a 26.3% premium as VIT's NAV may not be truly 76c if the income support was factored into that valuation amount.

The merger would entail the enlarged entity of ESR absorbing these income support which are due to expire end of this year. It would certainly be worthwhile for investors to monitor the performance going forward and whether the rental revisions and benefits of the enlarged entity can be realised to negate the effects of the loss of income support.

We also wouldn’t discount the possibility that during negotiations, it is likely that the premiums were required get the significant shareholders such as Mr Tong Jinquan and Ho Lee Group Trust to agree to the merger. The premiums would also be required to ensure that minority unitholders in VIT would more likely vote in favour of the acquisition since the interested parties would be required to abstain from voting.

Premiums Paid Comparable to Past Mergers?

Acknowledging the comments from the management, we proceeded to compare the premiums paid in past merger and acquisitions within the REIT space.

In late-2015, Triangle TMK – the Japanese affiliate of Lone Star Funds; had acquired the entire portfolio of Saizen REIT at an offer price of $1.172 per unit; Saizen REIT owns a portfolio of Japanese residential real estate assets. The offer price represents a 36.9% above the closing price of S$0.855 per unit and a 40.9% premium above the one-month volume-weighted average price per unit. From an asset value perspective, this offer was a 3.4% premium to the appraised value. Source: https://www.businesstimes.com.sg/real-estate/saizen-reit-to-sell-all-japan-assets-to-triangle-tmk-for-447b-yen

In early-2017, ARA Asset Management was taken private by a consortium led by founder and group CEO John Lim. The offer of $1.78 a share was approved at a premium of 26.24% to the stock's closing price of $1.41. Compared to the one-month volume-weighted average price (VWAP), the offer is a 29.6% premium. Source: https://www.businesstimes.com.sg/real-estate/ara-founder-leads-consortium-in-buyout-at-26-premiumhttps://www.straitstimes.com/business/companies-markets/minority-shareholders-approve-ara-buyout 

In Sep-2017, US private equity giant Blackstone Group led a buyout of Croesus Retail Trust with a $1.17 per unit cash offer. The offer was approved by the unitholders which represents a premium of approximately 38% to the 12-month volume weighted average price per unit excluding the 4.06c dividends declared. From the perspective of NAV, the offer for Croesus was at 1.23x NAV. Source:https://www.businesstimes.com.sg/companies-markets/blackstone-makes-offer-for-croesus-retail-trust-at-s117-per-unithttps://www.straitstimes.com/business/companies-markets/croesus-retail-trust-unitholders-approve-blackstone-buyout-offerhttps://www.stocksbnb.com/reports/croesus-retail-trust-blackstone-privatisation-offer/ 

Our personal view is that Lone Star got a great deal on Saizen’s portfolio which was severely undervalued by the market. The ARA buyout was severely undervalued and ARA was taken private much to the displeasure of minority shareholders. The Croesus buyout by Blackstone was fairly valued in our view.

Looking at the precedence of past portfolio acquisition, we see that the premiums were between 23% to 40.9% - some against NAV and some against the last traded price.

It does seem to us that the 26.3% premium seems aligned (even if income support was factored in) with historical deals made within the REIT segment in Singapore.

Risk Going Forward

While there could be many benefits of the merger, as investors we should also not overlook risk in our investments. Besides the risk of loss of income support in Viva’s portfolio come year end, here are a few (non-exhaustive) other risk that investors may want to take note.

1. The Little 6.8% Hyflux Issue

Just last week, news emerged that Singapore-based water treatment firm, Hyflux Ltd, has applied to the High Court to seek court protection to reorganise its business and debts. This issue does not come as a surprise to us as Hyflux poor cash flow situation has long been on our radar. We have even written about it last October-2017 to in our article entitled Hyflux’s Worrying Cash Flow Situation.

What does Hyflux have to do with ESR-REIT and VIT merger you ask? Well, let me point you to the following:

Source: ESR-REIT Quarterly Results Presentation Slides

Recall that SoilBuild REIT ran into problem with its master tenants Technics Offshore Engineering, NK Ingredients and KTL Offshore. In ESR-REITs case, Hyflux is the second largest tenant in ESR-REITs portfolio and accounts for 6.8% of their rental income. There is uncertainty around what could emerge from the Hyflux business and debts restructuring exercise and until more information is known, it is still a risk to investors.

ESR-REIT released a public statement in relation to Hyflux which can be accessed at the following link:

According to the announcement, there are currently no arrears due from Hyflux and payments have so far been prompt. ESR-REIT also holds a 3 month security deposits which mitigates the risk should Hyflux default.

Looking back at the history of “8 Tuas South Lane”, the asset was actually a sale and leaseback agreement with Hyflux for 15-years. According to the proposed acquisition announcement in October last year, the asset was valued at $115.0mil but acquired at $95mil – at 17.4% discount to valuation!

Experiencing cash flow issues, it was likely that Hyflux had to raise funding through the sale of its assets. Seizing the opportunity to acquire a quality asset below valuation was very astute of management.

While we cannot discount the risk that Hyflux brings to ESR-REIT, it does seem to us that some level of the risk is mitigated with the presence of a 3 month security deposit and the comfort that the asset was purchased at a discount.

We also applaud management for releasing a statement quickly quickly with regards to the status of Hyflux as a tenant.

2. Low Occupancy of Viva's Business Park and Jackson Square

Some of VIT’s assets such as the Viva Business Park and Jackson Square have relatively shorter leases compared to the other assets. The occupancy rates are also a lower relative to the other assets. Would occupancy rates be boosted post-merger to compensate for the shorter land lease?


Source: Viva Industrial Trust Annual Report

3. Risk of Converting Assets from Single-Tenancy to Multi-Tenancy at an Unfavorable Rental Revision

Historically, many industrial REITs such as ESR (or rather the former Cambridge Industrial Trust), Sabana and Cache Logistics all have experienced a fall in rental income after their master leases assets were converted into multi-tenancy.

Since the days of Cambridge Industrial Trust (CIT), a number of master leases have been converted to multi-tenant leases at an unfavorable rental revision.


Source: ESR-REIT and Cambridge Industrial Trust Results Announcements

The chart above shows the plot of the DPU Trend overlaid with the trend of Single-Tenancy Percentage. It does appear to show a correlation between falling single-tenancy percentages and falling DPU.

We want to be cautious here in order not to confuse causation and correlation. There is likely to be multiple factors at play resulting in the fall in DPU such as unit dilution or divestment of assets. But we also cannot exclude the factor and impact that the conversion from single-tenancy to multi-tenancy also carries the risk of lower rental revisions.

There is probably many possible reasons for this observation. We suggest a few possible reasons:

  • When a master leasee vacates an asset, it will take time for the manager to secure leases from multiple tenants to back-fill the vacant spaces. During this transition period, the vacancy rates could be lower resulting in lower rental income
  • Poorer rental revision during the business cycles
  • Manager accepting lower rentals to back-fill the vacant spaces as quickly as possible which favours the tenants
  • Management and agent cost may have increase due to the need to manage multiple tenants instead of one single tenant resulting in lower total income


Source: Comparison of Multi-Tenanted vs Single-Tenanted Income Source from Cambridge Industrial Trust Slides as of 31-Dec-2012 and ESR-REIT Slides as of 31-Mar-2018

Cache Logistics similarly experienced the same decline. The case of Sabana REIT needs to introduction, starting with a portfolio of 20 out of 21 master lease assets at IPO, it is now down to 8 out of 19 assets with master leases.


Source: ESR-REIT Quarterly Results Presentation Slides


Source: Cache Logistics Trust Results Presentation Slides

Going forward, will the enlarged ESR-REIT with a strong sponsor be able to successfully engineer an improved rental revision? Will upcoming master leases be renewed or converted to multi-tenanted leases favorably? What is the ratio of master-leases vs multi-tenanted leases within Viva Industrial Trust’s portfolio and the eventual enlarged ESR-REIT?

These are some questions which investors may want to consider.

4. Operational and Integration Risk post-Merger

As with any merger, as investors we are reliant of management to perform with the best possible outcome for investors. However post-merger, there are bound to be many operational and integration risk which may result in the delay in the realization of the benefits of an enlarged entity. We cannot discount possible operational risk which may drag the integration risk beyond the estimated 3 to 6 months.

5. Merger Not Finalised

Finally, at this stage, the merger is still not concluded yet as both ESR-REIT and VIT unitholders would need to vote in favour of the merger. Failing to garner the necessary votes may result in the merger being aborted or renegotiated.

Concluding Remarks

Personally, we found that the ESR-REIT management and investor relations representatives to be very friendly, open to hearing our views and very willing to share. They would have liked to share in greater detail, but we appreciate that they are also restricted in what they can freely share due to market sensitive information as the proposed merger is still on-going.

We certainly had some tough questions for the management, and they handled them in a very professional manner. They took much time and care to ensure that we understood the finer details of the proposed merger.

In summary, ESR’s vision is to merge 2 smaller industrial REITs to reap the benefits of an enlarged portfolio by achieving economies of scale, reduced financing cost, rental uplift and increase visibility. Going forward with this strategy in place, ESR-REIT is more likely to be able to accretively grow their asset base at a faster pace.

However, the enlarged entity as with any merger is not free from risk, due diligence lies with us investors to manage those risk within our portfolio allocation and exposure before investing.

If we could sum up the message that ESR-REIT management is trying to convey, perhaps it would be to build a REIT where the whole is greater than the sum of its parts.

 

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