ESR-REIT and VIT plan merger as REITs race to grow bigger

“Size does matter for REITs,” Chui says. “This enlarged REIT will benefit from a larger market cap of $1.7 billion and larger free float. A higher liquidity and free float will provide us with the opportunity for inclusion into indices that are tracked by institutional investors and [that could lead] to a positive rerating change, which in turn will benefit all unitholders.” With the merger, the enlarged ESR-REIT will have assets of $3 billion and become the fourth largest industrial REIT after Ascendas REIT, Mapletree Logistics Trust and Mapletree Industrial Trust.

Inclusion into indices tracked by institutional investors is likely to result in a lower cost of capital and cost of debt. The larger a REIT, the more access it has to the leasing market. Eventually, acquisitions can be funded with placements — which tend to be yield-accretive — rather than equity fundraising or rights issues, which are generally dilutive. And, the lower the cost of capital, the more likely an acquisition will be accretive.

Let’s look at these advantages one by one.

REIT managers are focused on the yields at which their units trade on the market. “A potential index inclusion will result in a rerating of our stock,” says Wilson Ang, CEO of VIT’s manager. A lower cost of capital is useful to REITs if they want to grow — and this year, several REITs are expanding their portfolios. This is partly to mitigate declines in their distribution per unit (DPU).

For instance, shortly after Keppel DC REIT reported a 4.8% y-o-y decline in DPU to 1.8 cents for 1QFY2018, it announced the acquisition of a data centre in Singapore, along with income support. Its pro forma DPU including income support could be as much as 4.3% accretive if certain conditions are met. As at March 31, Keppel DC REIT had assets under management (AUM) of $1.7 billion from its deposited properties.

Of course, ESR-REIT and VIT are not the only REITs gunning for size. Earlier this year, Frasers Logistics & Industrial Trust announced the acquisition of a $1 billion logistics portfolio that has expanded its AUM to $3 billion. Manulife US REIT announced in February that it plans to double its AUM from US$1.3 billion ($1.7 billion) to US$2.6 billion in two years. Keppel-KBS US REIT said in a results statement that “to capture further upside from improving office market conditions, the manager will also seek acquisition opportunities in key growth markets it currently has a presence in, as well as other US cities with similar growth characteristics”.

Keppel-KBS US REIT had assets of US$861 million as at March 31 and its market cap is just US$557 million, putting it at a disadvantage compared with Manulife US REIT in terms of size. In addition, Manulife US REIT is attracting a lot of attention with its spate of acquisitions. It is only a matter of time before Keppel-KBS US REIT announces some acquisitions.

Who funds the growth?

Unitholders and investors have to fund a ­REIT’s growth. Because of tax transparency granted to the “trust structure”, REITs have pay out at least 90% of their cash earnings. That leaves them with a capital structure devoid of retained earnings. To buy a property, the REIT has to use debt such as bank loans or bonds, perpetual securities or equity. This is why investors prefer REITs with strong sponsors. In the Singapore context, the sponsor owns a significant stake in the REIT and supports it when the REIT needs to raise equity.

Last year, ESR-REIT — formerly Cambridge Industrial Trust and without a sponsor — found itself with a strong sponsor in e-Shang Redwood (ESR), a pan-Asian logistics property developer, owner and operator. ESR’s co-founders are ex-Prologis executives, as are some members of its management team. Prologis is the world’s largest logistics property developer, owner and operator. ESR owned and managed more than US$12 billion in AUM as at Dec 31. It is also a member of the Global Real Estate Sustainability Benchmark. In February this year, a client of State Street Global Advisors and various StepSone funds together invested US$140 million into ESR. Separately, ESR itself has acquired a 9.05% stake in Sabana Shari’ah Compliant Industrial REIT.

The enlarged ESR-REIT’s future growth will be supported by ESR, Chui confirms. “In April, when ESR-REIT called for a preferential equity fundraising of $142 million, ESR back stopped $125 million; and it was back stopped to acquire third-party assets and not their own assets,” Chui says in reference to the acquisition of 7000 Ang Mo Kio Avenue 5. “This is an example of how ESR can support this vehicle.”

Unitholders of VIT appear to be winners. “We will be able to have our unsecured assets rise from 8% to 100%,” Ang says.

REITs need different sources of debt and capital, and with an unsecured portfolio, they can access capital markets better. The enlarged ESR-REIT will be availed of further pools of capital and more competitive costs for capital with all the assets being unencumbered (see Chart 1). “You can go out to the market and access perps, the US dollar bond market, longer-tenure bonds, and once you have the scale and market presence, you have reverse enquiries. Bondholders come to you,” Chui says.

Potential for AEIs and attracting higher-value tenants

Chui says another advantage of a larger size is the potential for asset enhancement initiatives. AEIs provide REITs with more attractive returns on investment than acquisitions. ESR-REIT’s portfolio is dated and some properties need to be rejuvenated. ESR-REIT undoubtedly wants to be part of Singapore’s Smart Nation initiative as this is where the future of REITs is likely to be tied to.

“I’ve identified three to four AEIs, but at an AUM size of $1.7 billion, if I close down a property, I get a hit on my DPU. But at $3 billion in AUM, I’m able to undertake two to three AEIs because the impact on DPU is not so great,” Chui says.

Size will also increase the enlarged ­ESR-REIT’s visibility for leasing agents. “If you go to a leasing agent, and you have $3 billion in AUM, your product suite appears on the third page. Today, we are on the fifth and sixth pages because [agents] want to deal with landlords who are bigger and can make decisions fast,” he remarks.

According to Chui, the acquisition will raise “high-spec” property and business parks to 46% of AUM. These properties are in high demand and will be able to attract higher-value industries as tenants, he adds.

All this comes at a cost, though. ESR-REIT has to put the transaction to unitholders or a vote. To fund the acquisition, it will have to issue 1.585 billion new units at 54 cents per unit to VIT unitholders.

Separately, sponsor ESR will be paying $62 million for VIT’s manager. Tong Jinquan, who owns a stake in VIT’s manager, will use his portion of the monies to subscribe for a 25% stake in the enlarged ESR-REIT manager. ESR will own a 67.3% stake in the ESR-REIT manager, and Mitsui 7.7%.

Going abroad

Chui is hesitant about expanding overseas in the immediate future. “We will still be very much a Singapore-focused REIT. We don’t want to suddenly change our risk profile too much. And if we go overseas, it will be in a geography where ESR has a presence. Real estate is a local game and we’re not thinking that far yet.”

Going overseas brings with it more risk, both operational risk and foreign exchange risk.

Recently, CapitaLand Commercial Trust (CCT), formerly a Singapore-focused REIT with a very low cost of equity, decided to go into Frankfurt, Germany — a totally new geography in which sponsor CapitaLand has a limited presence. Concomitant with this move is likely to be a higher cost of equity. In other words, its DPU yield will probably expand to counter the new risk.

What was surprising was that Kevin Chee, CEO of CCT’s manager, said the focus of the REIT was “to provide sustained distribution growth”. Subsequently, a CCT spokeswoman said “there is no change to CCT’s strategy. Consistently, it has been to deliver sustainable distribution growth in the long term”. The previous management had articulated that REITs are required to provide stable DPU to their unitholders.

Whatever the case, some investors prefer growth. And, with a larger size, it is easier for REITs such as CCT to fund acquisitions with an overnight placement. These are quick and relatively painless, and unitholders get their distributions before the placement, so they are usually not dilutive. It is like a virtuous circle — because bigger REITs are on the radar screens of institutional investors and analysts, it is easier for them to undertake placements and grow AUM.

Since REITs give most of their returns through their yield, investors looking for distribution growth should focus on REITs that have announced clear growth strategies in recent months — CCT, Manulife US REIT, Keppel-KBS US REIT, Mapletree Greater China Commercial Trust and Keppel DC REIT.

While rights issues and preferential equity fundraising provide unitholders with the opportunity to invest further in the REIT should they wish to do so, some retail investors may be unable to fund REITs with a very strong growth profile. Retirement money, for instance, is just looking for yield. At some point in the future, there could be demand for REIT-like products that prioritise

DPU stability over growth.

For investors looking for the next merger or corporate action, it might be worth examining the smaller REITs, where major unitholders are unable to provide the support needed for equity fundraising. Independent REITs with market capitalisation of below $1 billion and AUM of below $2 billion could now be looking for sponsors and new investors. Some of these are featured in Chart 2 and the table on the right.

Merger good for VIT security holders

The ESR-REIT–Viva Industrial Trust merger is looking increasingly positive for VIT. VIT’s unitholders will receive 96 cents per stapled security, 10% of which will be in cash. More importantly, two properties, Viva Business Park and Jackson Square, have land leases set to expire within the next 15 years. According to the merger announcement, the land lease of some 37.7% of VIT’s portfolio expires in the next 20 years. This will fall to 23.1% of the portfolio should VIT’s security holders vote to change their trust deed and vote in favour of the merger.

Also, around 40% of VIT’s assets under management are in single-tenanted buildings or on master leases. A larger REIT will mitigate the risk of converting these leases to multi-tenanted buildings. Moreover, income support provided by the vendor United Engineers for UE BizHub East expires in November.

Prior to the announcement of the merger, OCBC Investment Research was expecting VIT’s distribution per unit to fall, from 7.475 cents for FY2017 to 6.794 cents for FY2018, and to 6.101 cents by FY2019. With the merger, the fall-off in income support will be “spread” across a larger base of distributable income, OCBC says.

What a scheme of arrangement entails

ESR-REIT will acquire all stapled securities of Viva Industrial Trust via a trust scheme of arrangement in accordance with the Singapore Code on Take-Overs and Mergers. The consideration payable to VIT’s stapled security holders is 96 cents per security, on an ex-distribution basis, with an implied equity value of $936.7 million that will be satisfied by 10% in cash and 90% through the issuance of new ESR-REIT units or 160 new units for every 100 VIT units held. This indicates a gross exchange ratio of 1.778 times, assuming an issue price of 54 cents per ESR-REIT unit.

For VIT unitholders, the merger will require the approval of unitholders to (1) amend the trust deeds (with at least 75% of votes cast) at a meeting scheduled for August; and (2) vote in favour of the proposed scheme of arrangement (more than 50% in numbers representing at least 75% in value of unitholders).

Upon completion by 3QFY2018, VIT will be a sub-trust of ESR-REIT and will be delisted.

ESR-REIT will separately need to obtain approval from 50% of unitholders by proxy or present in an extraordinary general meeting, and by 75% of votes cast by unitholders for the issuance of new units.