SINGAPORE (Mar 6): On the morning of March 11, at 10 am, unitholders of Frasers Logistics and Industrial Trust (FLT) will be voting by a scheme of arrangement to merge with Frasers Commercial Trust (FCOT). It is more or less a foregone conclusion that FLT’s unitholders will vote in favour of the merger.
FLT’s independent financial adviser (IFA) has recommended to its independent directors to vote in favour of the resolutions. They, in turn, recommend FLT unitholders vote in favour of three resolutions. Resolution 1 is for the merger to be approved; Resolution 2 is to approve the issuance of new units as part payment for FCOT and Resolution 3 is to approve the acquisition of the remaining 50% interest in Farnborough Business Park from Frasers Property that FCOT does not own.
Resolutions 1 and 2 are interdependent while resolution 3 depends on Resolutions 1 and 2 being passed.
In the same afternoon, FCOT unitholders will get to vote on two resolutions. These are related to the merger, and subsequently, the amendment of the trust deed. The IFA has recommended FCOT directors vote in favour of the two resolutions. In turn, the directors have recommended FCOT unitholders to vote in favour of the resolutions too. If the resolutions go through, FCOT will be an approved sub-trust of the enlarged REIT and will be delisted.
It is clearer why FLT needs the merger rather than FCOT with its office properties. Despite having to pay $1.680 per FCOT unit comprising cash of 15.1 cents and 1.233 new FLT units priced at $1.24 per unit, FLT unitholders would be better off in the long term. Although the accretion to FLT’s DPU post-merger is miniscule, it rises to 2.2% with the injection of 50% of Farnborough Business Park. Post-merger, FLT can also expect a 9.5% accretion to NAV. This is because FCOT’s portfolio includes Singapore, Perth, Canberra and Melbourne office property, while FLT owns largely warehouses.
FLT’s largest tenants in Australia and Europe are CEVA Logistics, BMW and Coles. Each of these tenants are facing challenges, and could see consolidation.The Australian dollar has put FLT’s DPU under some slight pressure.The DPU for the 12-month period ended September 2017 (FY2017) was 7.01 cents and the DPU for FY2019 was 7 cents.
As of December 31, 2019, in terms of valuation, 57.7% of FLT’s portfolio is based in Australia, 34.6% in Germany and 7.7% in the Netherlands.In Australia, most of its properties are located in Melbourne, followed by Sydney, and Brisbane.
Merger lowers concentration risk
In a briefing last year, the advantages of a merger were well articulated by Robert Wallace, CEO of FLT’s manager. This was again reiterated in a circular issued on Valentine’s Day this year. The enlarged REIT platform will manage approximately 2.6 million sq m of space with approximately 300 tenants in 98 properties spread across five countries, and will have a broadened investment mandate to invest in a wider spectrum of asset classes across logistics, industrial, office, business park and commercial properties.
The merger is expected to create one of the larger S-REITs, with total market capitalisation of approximately $4.2 billion. The larger scale of the combined portfolio will enhance the merged entity’s visibility within the S-REITs universe and increase its relevance amongst the investor community. It is expected that the larger market cap and free float will increase the enlarged REIT’s weightage within the FTSE EPRA/NAREIT Index and potentially lead to further index inclusion.
As evidenced by other mergers, a larger REIT is likely to have higher liquidity with a wider investor base and broader analyst coverage, resulting in a potential re-rating which will benefit all FLT unitholders. This should allow the enlarged REIT to benefit from better access to competitive sources of capital and enjoy greater funding flexibility.
When FLT was first listed, it had a wider analyst and investor following but this has dwindled as it reported its a decline in DPU early last month."While there were invariably some fluctuations due to movements in forex, our SGD DPU has been generally stable in the past quarters, and has in fact increased over the past quarter," an FLT spokesman says. The spokesman adds that five analysts continue to cover FLT and its investor following has increased since being included in the FTSE EPRA NAREIT Developed Index last year.
An enlarged FLT should also benefit from less concentration risk. After the merger, FLT will have a diversified asset base of logistics & industrial assets and commercial assets, with the split between logistics and industrial, office and business parks and CBD commercial at 58.6%, 19.8% and 21.6% respectively. In terms of geographical diversification, concentration in Australia will reduce from 57.7% to 48.2% (see pie charts).
Stress from tenant concentration is also likely to be alleviated. BMW is one of FLT’s top three tenants. The budding trade war between the US and European Union has been all but eclipsed by that between the US and China and Covid-19. The US is the top destination for EU-built cars, accounting for 29% of the total value of all EU car exports in 2018 which is estimated at EUR37 billion ($57.3 billion). The EU’s largest car makers are Volkswagen, BMW and Daimler-Benz and account for half of the exports to the US. Over the long term, tariffs of 25% could halve the number of German cars shipped to the US, the Munich-based Ifo institute has predicted.
Elsewhere, CEVA Logistics’ corporate family rating was downgraded by Moody’s Investor Service to B2 from B3 because of “continued weak profitability, which results in leverage metrics and a negative free cash flow generation, which is below the requirements for the previous B2 rating category”. Coles has also announced a consolidation programme which has yet to crystallise so its effects on FLT is still unclear.
Mark-to-market issues?
FLT’s portfolio has a long WALE of 6.31 years with annual step-up rents. Leases in the Australian portfolio generally incorporate fixed rate annual adjustments averaging 3.1% and a majority of the European leases benefit from CPI-linked indexation, thereby providing stability in earnings growth.
FLT’s lease expiry profile is spread-out, and should provide minimal disruption. In general, no more than 15.7% of the portfolio’s leases by gross rental income (GRI) will expire in any single financial year. However, in 2022, 16.1% of leases by GRI are likely to expire.
The merger with FCOT will bring this down to a lower portion of leases. Notably, in 1QFY2020, its portfolio had a negative rental reversion of 0.9%, in part due to a 12.1% negative rental reversion due to a modestly-sized property in Melbourne Airport.
Like other REITs which have annual escalations attached to long weighted average lease expiries (WALE), these annual escalations set a high bar above market rents. When rents are marked to market, the rental reversions show a decline.
Ascendas REIT suffered a 9.9% negative reversion for a small logistic warehouse in Brisbane, in its 4QFY2019 ended December 2019. However, its large and diversified portfolio ensured that Ascendas REIT was able to record a 6% rise in rental reversions because of positive reversions in its Australian suburban office and Singapore properties.
Elsewhere, Manulife US REIT reported a negative 12% decline in rental reversions for one of its office buildings, moderating total rental reversions down to +0.5% in FY2019 ended December 2019. An anchor tenant, Hyundai had rental step-ups of 3% a year for 10 years, and hence rentals had risen by 30% during that period. When the REIT manager renewed at mark-to-market levels, it caused a negative reversion for that building.
Similarly to FLT’s expiring leases in Australia — its assets in Australia are warehouses — could present challenges when they are marked-to-market.
Wilson Ng, executive director at Morgan Stanley, explains, “Rent reversions tend to be negative in Australia as spot rents have grown slower than in-place escalations, and we think this is likely to continue. Even in a better performing city like Sydney where spot rents have grown at a 10-year CAGR of 2.6%, growth tends to be below rent escalations clauses of typically 3%. That said, we believe any negative rent reversions in Oz will likely be offset by positive rental escalations, resulting in positive revenue growth for FLT. Each year, leases, that make up just 2-16% of revenues, are due for renewal, while the rest of the portfolio benefits from in place escalations (of around 3% in Australia).”
In a results review last month, Lock Mun Yee, analyst at CGS-CIMB Research, says, “FLT completed four leasing transactions, including a five-year lease with Amazon in Perth, leading to a 100% portfolio occupancy rate; the other three leases were renewed at an average reversion of minus 0.9%. As at Dec 31, 2019, FLT has four leases, representing 2.2% of GRI up for renewal in FY2020. We understand that FLT is confident of renewing the majority of its expiring leases. FLT generally expects a slight uptick in reversions for Europe, but continued negative reversions in Australia as the growth in passing rent from rental escalations exceeds the growth in market rents.”
The other challenge for FLT is the weakening Australian dollar. Hence, despite reporting an 8.1% gain in NPI in Australian dollars in 1QFY2020, FLT announced a decline in DPU for the fifth consecutive quarter.
On the other hand, in 1QFY2020, FCOT reported NPI of $26.71 million, up 27% y-o-y and 23% q-o-q, on progressive recommencement of business at China Square Central’s retail podium, higher rental income and lower utilities at Alexandra Technopark, higher rental income at 357 Collins Street in Melbourne, and a rebound in sterling. FCOT owns a 50% stake in Farnborough Business Park. FCOT’s DPU was unchanged y-o-y and q-o-q at 2.4 cents for its 1QFY2020.
FCOT’s properties appear to have better visibility (than FLT’s) with its Singapore assets filling up. The committed occupancy of FCOT is 95.2% versus its actual occupancy of 79.7%. This is probably due to Alexandra Technopark where Google will take up around 344,100 sf of space in the first quarter of this year, for five years. The space represents approximately 33.3% of the property’s current total net lettable. As rents rise, FCOT’s properties could be revalued at higher valuations.
Interestingly, CGS-CIMB has downgraded FLT to a hold rating following the release of its 1QFY2020 results.
“As we update our A$ and EUR FX rates based on assumptions from CIMB Treasury, lower our cost of debt assumptions due to the declining A$ cash rate, and tweak rental rates to account for renewals, our FY20-22F DPU estimates decline [by] 0.2% to 1.6%. We have not incorporated any impact from the FCOT merger in our estimates. We downgrade FLT to ‘hold’ based on valuations as we see limited upside and downside due to the ongoing merger and limited upcoming expiries. FLT said it does not have any acquisitions in the pipeline until after the merger completes in end- Mar/Apr 2020,” Lock of CGS-CIMB explains.
No surprise then, that FLT needs the merger and its unitholders are likely to vote for the resolutions with a resounding yes. “We think the proposed merger helps diversify both asset class as well as FX exposures, and helps alleviate concerns over a depreciating AUD,” says Ng of Morgan Stanley.
On March 11, FCOT’s unitholders have to decide whether they want to be part of a larger REIT, as they are likely to get a modest cash element from the merger.
