by: Tam Ging Wien
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ESR-REIT and Sabana Shari'ah Compliant Industrial Real Estate Investment Trust (Sabana REIT) made a joint announcement on 16-Jul-2020 (Thu) proposing a merger which could result in the enlarged entity maintaining a dominant 4th largest industrial S-REIT by GFA market share, behind Ascendas REIT, Mapletree Logistics Trust and Mapletree Industrial Trust.
Back in 2018, ESR-REIT completed a merger with Viva Industrial Trust (Viva) paying a 26.3% premium to NAV for Viva. This time, the merger with Sabana REIT could potentially close at a discount to Sabana REIT’s latest NAV per Unit of 51c. In addition, unlike the merger with Viva, this deal is a pure share exchange without a cash component.
After this deal is complete, it appears that ESR-REIT may have other targets in mind. ESR-REIT is a Warburg Pincus-backed Singapore REIT and will likely to continue its consolidation strategy of smaller industrial REITs in a fragmented industrial REIT market.
In this article, we discuss the benefits of the merger and what could be on the cards in the coming years.
Through the proposed merge, ESR-REIT would acquire Sabana REIT in an all share deal based on a gross exchange ratio of 0.94x. This means that for every 1,000 units of Sabana REIT, unitholders will be receiving 940 new ESR-REIT shares.
For the proposal to become effective, the proposers would need to convene the Extra Ordinary General Meeting (EOGM) and secure >50% in number of Sabana unitholder’s votes with a representation of >=75% of the units. Common shareholders of both REITs such as Mr. Tong, e-Shang Infinity Cayman Ltd and ESR Cayman Ltd as well as Sabana REIT’s manager shall abstain from voting.
The EOGM is expected to take place in October 2020 and if approved, the effective date of the merger is expected to be in October or November 2020.
If the deal completes as expected, Sabana REIT will become a wholly owned sub-trust of ESR-REIT with a structure as illustrated in the diagram below. The Chinese businessman Mr. Tong Jinquan who controls Shanghai-based Summit Property Development, will be the largest shareholder of the merged entity with an 18.5% stake while ESR Cayman – the sponsor, is expected to hold about 12.2% stake.
The enlarged REIT will have a market capitalisation of about $1.8bil and a free float of some $1.3bil. Combined, it will have an expanded network of 75 assets with a total GFA of about 19.2mil sqft across Singapore.
This proposal should end the conflict of interest that was highlighted in November last year by activist fund Quarz Capital Management (Quarz). In an open letter, Quarz argued that ESR's substantial overlapping investment mandates of both ESR-REIT and Sabana REIT can potentially result in corporate governance concerns and proposes a merger to close the gap.
Both ESR-REIT and Sabana REIT unitholders stand to potentially benefit from the enlarged market cap and free float. With this enlargement, trading liquidity is expected to increase, investor base is expected to widen, potentially increase research coverage, and potential inclusion into prominent indexes.
Overall, these benefits could translate to a better realisation of value and potentially positive re-rating for unitholders of the enlarged entity.
With the increase assets under management, certain synergies and economies of scale could be achieved, for example through:
While these are expected to benefit unitholders in the long term, investors should not expect these benefits to be realised instantaneously as it would take time to fully amalgamate the processes, software, management systems, talent pool and sponsor’s leverage.
Based on the slides of the proposed merger, the management highlights that the resulting enlarged entity will be more diversified in terms of the industrial sub-sector exposure, trade sector exposure as well as dilution of the proportion of gross rental income derived from the top-10 tenants.
With an increased size and support of a sizable sponsor comes increased negotiation leverage with the banks during the refinancing of credit. This could in the longer term lower the total cost of capital for the enlarged entity. The management illustrates an example that it expects that post-merger, the loans for Sabana REIT will be refinanced with a new loan reducing its all-in interest cost from 3.8% to 2.5%.
According to the management presentation slides, they expect to realise up to potentially 1.2mil sqft of unutilised GFA from Sabana REIT’s portfolio. Additionally, ESR-REITs portfolio could potentially realise another 1.0mil sqft of GFA giving a total AEI potential of 2.2mil sqft.
This allows the enlarged entity to undertake future AEIs to power its organic growth yet lower its risk with a wider tenant base, increased flexibility, and increased financing at a lower cost of capital.
As the share swap formula has been established and agreed upon, it means that going forward both ESR-REIT and Sabana REIT shares will likely trade lockstep with one another with any arbitrage opportunity in the divergence in the exchange ratio to be quickly closed.
We mapped the historical unit prices of both REITs and found that post-announcement on 16-Jul-2020, the conversion difference had become marginal while it was more significant historically in 2019.
According to announcements by both REITs, the merger will be DPU accretive to unitholders of both REITs. It’s interesting how they have managed to engineer this, lets take a closer look at some important assumptions.
The secret to achieving DPU accretion for both unitholders lie in the assumptions made to modify the structure to achieve cost savings, amongst them are:
In simple terms, after the merger is over, Sabana REIT manager’s fee structure will be changed to match that of ESR-REIT’s manager with a higher proportion of the fees paid in units. Further with the added economies of scale, the management expects to reduce the cost of financing for Sabana REIT’s debt from the present 3.8% to 2.5% which would achieve significant cost advantages.
This refinancing package is delivered through a consortium of banks including Malayan Banking Berhad (Singapore Branch), RHB Bank Berhad, Sumitomo Mitsui Banking Corporation (Singapore Branch) and United Overseas Bank Limited.
With just these 2 changes alone are the likely significant reason for the ability to push DPU higher for unitholders of both REITs.
But refinancing of debt will take some time, do expect the accretion to take place gradually over a few quarters post-merger.
A quick check of all the remaining REITs with asset sizes smaller than ESR-REIT, AIMS APAC REIT is the only REIT where the sponsor ESR has a significant stake in the REIT.
According to the latest disclosure of interest of AIMS APAC REIT dated 17-Mar-2020, an entity known as “ESR HK Management Limited” has disclosed that it has purchased 1,583,100 units in AIMS APAC REIT for $2,089,692.00 or about $1.32 per unit via market transaction. In the same document, post-transction the entity “ESR HK Management Limited” would hold a 7.1% interest in AIMS APAC REIT.
This move is similar to the moves made by the sponsor prior to the merger with Sabana REIT where the sponsor was aggressively acquiring control of both Sabana REIT units and shares in Sabana REIT’s manager. If we were to hazard a guess, it is most likely that ESR has larger plans for ESR-REIT and is strategically aiming to increase its presence and dominance through mergers with smaller competitors in the industrial REIT space.
If our guesses are right, this could play out in the next 1 to 2 years after the completion of the Sabana REIT merger. Could there be another round of dilution for unitholders then? It remains to be seen.
After reviewing the proposal, we can see much long term benefits of the merger including economies of scale, increased synergies, lowering cost of capital, realising additional unutilised GFA, increased diversification and reduction of risk and finally a potential of re-rating of the enlarged entity.
However, we wish to highlight that we see many of these benefits to be medium to long term in nature and investors are not likely to enjoyed them immediately post-merger. Therefore, investors should take a long-term view of ESR-REIT.
We also observe that the DPU accretion for the unitholders of both REITs are a result of cash flow savings from reduced cost of capital and increasing of management fees paid in units.
Finally, we believe that ESR-REIT is not likely to stop in its pursuit for growth and the next potential acquisition target could potentially be AIMS APAC REIT in the coming 1 to 2 years post-merger with Sabana REIT. It seems the consolidation in the fragmented industrial REIT space is likely to continue in the near future.
As a concluding remark, specifically, for this merger, it does on the surface seem like Sabana REIT unitholders did not get a full realisation of the REIT’s 51c NAV per Unit. Giving the illustrative example based on the 0.94x exchange rate at 37.7c per Sabana REIT unit with no cash component, the acquisition P/B is only 0.74x, which is much much lower than the deal that the Viva Industrial Trust unitholders got.
Even if ESR-REIT’s share price normalised to the 55c range pre-COVID-19 sell-off by the effective date of this merger, Sabana REIT unitholders would only be getting a realised value barely at 1.01x P/B ratio compared to the 1.26x P/B that Viva Industrial Trust unitholders got. Perhaps, this was a move to take advantage of the suppressed stock price of Sabana REIT?
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