Portfolio rejuvenation to drive growth
Maiden entry into Japan; freehold modern logistics facility.
EREIT just received an overwhelming approval (EGM was just held on 12 October 2022) for the proposed acquisition of its ESR Sakura Distribution Centre for S$183.5m (including rental support) from its sponsor. The property is a five-storey logistics property in Sakura City, Chiba Prefecture in Tokyo, and the purchase consideration is c.21.8% lower than the market comparable in the Chiba Prefecture.
The property has a total NLA of more than 877,300sqft and it currently has an occupancy of 75%. The 25% vacancy was due to a tenant that vacated the property to consolidate its operations into its own built-to-suit facility in May 2022. Prior to this, the property has always been fully occupied over the past five years. Given the strong demand-supply dynamics of the logistics market in the Chiba Prefecture, EREIT is confident of backfilling these vacancies in the near term. We understand that the manager is currently in discussion with prospective tenants to lease the space, and the 12-month rental support from its sponsor will come in handy.
DPU-accretive acquisition. Although EREIT provided two possible scenarios to fund the acquisition, we firmly believe that the manager will fund the acquisition entirely on debt, given its current high cost of capital which makes an equity fund raising scenario to be tough to execute, in our view. Given how the share prices of S-REITs have corrected in recent weeks, we believe EREIT will not proceed with the alternative scenario that requires equity fundraising to raise c.S$75m and lead to significant NAV dilution.
With the debt-funded option, the acquisition is projected to generate a c.2.9% accretion to DPU. Concurrently, gearing is expected to inch up to c.42%, and we believe that it can be brought down gradually with the future divestment of non-core and lower yielding assets, which will be value accretive to the REIT. Since its successful merger with ARA LOGOS Logistics Trust in April 2022, EREIT has already divested three lower yielding assets to raise more than S$132m. EREIT has also identified several other non-core assets that they could potentially divest to raise a further S$400m.
Decaying land tenure of EREIT’s portfolio. Previously, EREIT benefitted from being a pureplay industrial S-REIT that appeals to investors looking to gain exposure to Singapore’s industrial sector. However, the short land tenures of Singapore industrial properties also meant that its portfolio’s land tenure will decay with time. EREIT began addressing this concern back in mid-2021 through the acquisition of stakes in freehold properties in Australia.
With the acquisition of the Sakura Distribution Centre, the proportion of freehold assets in EREIT’s portfolio will increase to c.8.2%. The remaining land lease tenure of EREIT’s portfolio will also increase by c.6.0% to 40.8 years.
Fears of economic slowdown and impact to industrial sector. Market volatility and slowing growth has sparked fears of an economic slowdown, impacting share price for the REIT. Although EREIT will not be insulated from a global economic slowdown, we believe that its rejuvenated portfolio post merger with ARA LOGOS Logistics Trust, will enable the REIT to be better positioned than before. Historically, based on our observation of occupancy rates, we found that logistics properties tend to remain more resilient during economic slowdowns and outperform other industrial property segments.
Following the merger with ARA LOGOS Logistics Trust earlier in the year, EREIT’s exposure to logistics facilities doubled. Its concentration of logistics facilities will be further enhanced with the acquisition of the Sakura Distribution Centre. Post the acquisition, c.51.8% of EREIT’s portfolio will consist of logistics facilities. The support from its sponsor on this deal and further possible pipeline opportunities also demonstrates its commitment to EREIT and opens the doors for further access to a c.US$2.0bn portfolio of logistics facilities in the pipeline.
Diversifying its footprint into one of the largest logistics markets in APAC, EREIT has the opportunity to ride on the strong fundamentals of the logistics sector in Japan. The strong supply and demand dynamics are expected to drive positive rental growth in the near to medium term. Gross rents in Greater Tokyo continue to be driven by a tighter market environment and low vacancy rates, especially in Chiba Bay, where the Sakura Distribution Centre is located. With Japan having a very limited stock of modern logistics facilities (only c.13% of total supply), modern assets with superior specifications such as the Sakura Distribution Centre increasingly stand out and appeal to tenants.
Over the past few weeks, S-REITs have undergone a correction owing to rising interest rates impacting its returns. Currently, EREIT trades at a P/NAV multiple of c.0.96x, and at a forward dividend yield of more than 8.5%. Looking at its historical trading performance, such levels may not be unheard of, especially during major economic crises such as the Global Financial Crisis, Euro Debt Crisis, Flash Crash in 2015, and most recently, the initial outbreak of COVID-19, we believe that there are key differences this time round, which warrant a higher valuation multiple.
Firstly, given EREIT’s rejuvenated portfolio and transition into a larger-cap industrial REIT, we believe it is currently trading at a very attractive level, especially given its portfolio’s outsized exposure to logistics facilities and potential for further growth through its sponsor’s pipeline. Even when compared to the Taper Tantrum period in 2013, EREIT was still trading just above NAV. Although EREIT’s gearing may seem relatively high at c.42.0%, its capital management metrics are better than before. Its entire portfolio is unencumbered, and c.70% of its portfolio is hedged to fixed rates. Based on our estimates, EREIT also currently has a very healthy ICR of approximately 3x.
We have refreshed our projections to assume that the divestment of 49 Pandan Road and 2 Jalan Kilang Barat will be completed by the end of FY22, and the acquisition of the Sakura Distribution Centre will only begin contributing income in the beginning of FY23. We have also taken the opportunity to assume that EREIT’s all-in cost of financing will creep up by c.55bps over the next three years.
Despite the adjustments and revised estimates, we believe EREIT offers a very attractive yield at the current levels and that there is room for some earnings growth over the next few years, even with higher financing costs. As such, we will be maintaining our BUY recommendation with an unchanged TP of S$0.50.