• ESR REIT’s 1HFY20 DPU of 1.162 Scts came in below expectations.
• We see more operational synergies and potential inclusion into NAREIT as the main benefits of the proposed ESR REIT-Sabana REIT (SGX:M1GU) merger.
• We reduce our FY20-22F DPU by 8-9% as we had earlier underestimated its operating expenses. Maintain ADD with a lower Target Price.

ESR-REIT's 1HFY20 Results Impacted by Covid-19 and Lease Conversion

• ESR REIT (SGX:J91U)’s 1HFY20 revenue declined 11.5% y-o-y to S$113.8m, while NPI dropped by a larger 16.8% y-o-y to S$80.2m. The NPI decline was mainly due to lease conversion from single to multi-tenancy for certain properties, non renewals and downsizing by certain tenants, as well as rental rebates of S$4.6m for tenants affected by Covid-19.
• ESR REIT's 1HFY20 DPU of 1.162 Scts (-42% y-o-y) made up 40% of our FY20F forecast, mainly due to income retention of S$7m in 1Q.
• ESR REIT's occupancy improved slightly to 91.1%, with retention ratio in 1HFY20 at 86-87%. Rental reversion was -4.3% in 2Q20, mainly due to the renewal of one anchor tenant. Excluding this, rental reversion would have been -0.2%. Rental collection rate remained high at > 90%.

ESR-REIT and Sabana REIT Plan to Merge

• In a separate announcement, ESR REIT announced that it was planning to merge with Sabana REIT (SGX:M1GU) by way of a trust scheme arrangement with ESR REIT acquiring all units of Sabana REIT.
• Post-merger, Sabana REIT will be a wholly-owned sub-trust of the enlarged REIT and delisted, while the sponsor ESR is expected to hold approximately 12.2% of the enlarged REIT.
• The deal requires approvals from the unitholders of both REITs and is expected to be completed by Oct-Nov 2020.

Proposed Merger Will be DPU Accretive for Both REITs

• On a proforma basis, the proposed merger is expected to be DPU accretive for both ESR REIT (+3.5%) and Sabana REIT (+12.9%). The merger will solidify ESR REIT’s position as one of the top 5 industrial REITs in Singapore. Free float market cap would also increase by 42% to S$1.26bn, slightly below the EPRA Index Inclusion threshold of S$1.3bn.
• Operational benefits are
  1. higher exposure to high-specs and logistics assets,
  2. more diversification,
  3. increased economies of scale in operations, leasing and marketing,
  4. access to lower cost of capital, and
  5. improved flexibility to undertake AEIs.

Reiterate ADD

• While the proposed merger will benefit both REITs, we think Sabana REIT is the larger beneficiary.
• We reduce our ESR REIT's FY20-22F DPU by 8-9% as we had earlier underestimated its operating expenses. Our rolled-over FY21F DDM-based Target Price is reduced to S$0.49.
• Downside risks include no repayment of the retained income in 1Q.

Source: CGS-CIMB Research - 16 Jul 2020