In the cold light of day, ARA LOGOS Logistics Trust (ALOG) unitholders are not quite overjoyed at the terms of the ESR-REIT offer for its units despite being valued at its highest level this year.
ALOG unitholders are being paid 95 cents, which is the highest price achieved by the REIT in the past 12 months, in a mixture of mainly ESR-REIT units and 9.5 cents in cash. As the ESR-REIT units are priced at 51 cents, ALOG unitholders will receive 1.6765 new ESR-REIT units and 9.5 cents. Since the price is fixed, the two REITs are likely to trade in lockstep. Meanwhile, ESR-REITs unit prices have strengthened.
The merger is 8.2% accretive to ALOG’s DPU based on a pro forma basis for FY2020 and 2.2% accretive to its NAV. For ESR-REIT, the transaction is 5.8% accretive to its FY2020 DPU.
“It’s a fixed price. We are going to issue units at 51 cents. It’s not a ratio. We’ve fixed it and we will pay 10% in cash,” says Adrian Chui, CEO of ESR-REIT’s manager, and CEO designate of the manager of the merged entity, ESR-LOGOS REIT. “Size does matter and now size increasingly matters,” he points out.
The merger is by way of a scheme of arrangement. The EGM will be held in early January and if all resolutions — some of which are interdependent — are passed, then ESR-REIT and ALOG become ESR-LOGOS REIT or E-LOG.
An analyst — and he is not the only one — reckons ALOG’s unitholders have two choices on the ESR-REIT merger: Accept the offer or sell and walk away from ALOG. This is because LOGOS will be part of ESR Cayman after the latter’s EGM on Nov 3.
One of the conditions of ESR Cayman’s acquisition of ARA Asset Management is that ARA Asset Management raises is stake in LOGOS from 52% to 86%. If unitholders persist in voting against the scheme, ALOG could end up as its former self, Cache Logistics Trust, with no sponsor.
LOGOS saved ALOG
ALOG has been the best-performing S-REIT this year. This is because last year, ALOG, which was previously Cache Logistics Trust, had a new sponsor who also owns the manager, in the form of LOGOS. LOGOS acquired both the manager and ARA Asset Management’s 9.82% stake in Cache Logistics Trust in late 2019.
As Cache Logistics Trust, ALOG had a challenging existence. Its manager was a joint venture between ARA Asset Management and CWT. Since CWT sold its warehouses into Cache Logistics Trust, CWT was initially the sponsor. As a result, Cache Logistics Trust’s cost of capital was high, with DPU yield up in the high single digits.
In 2018, CWT was acquired by HNA, a mainland Chinese company. CWT divested its stake in both the manager of Cache Logistics Trust and the REIT to ARA. In 2019, these stakes were shunted to LOGOS, which now owns the manager and is a sponsor to ALOG. The founders of LOGOS are ex-Goodman Group employees. Karen Lee, CEO of ALOG’s manager and deputy CEO designate of E-LOG's manager, was formerly at Ascendas. In the early days of the S-REITs, Ascendas REIT’s manager was owned by Ascendas and Goodman. Ascendas REIT’s manager is now held by CapitaLand Investment.
To show its commitment to ALOG, LOGOS provided a pipeline of Australian assets for ALOG and supported its fundraising to acquire this pipeline in 2020. It also brought in an institutional investor, Ivanhoe Cambridge. It was a challenging transaction because the acquisition amounted to $441 million including expenses when ALOG’s market capitalisation was about $680 million in October 2020. Ivanhoe Cambridge has provided an irrevocable undertaking to vote in favour of the scheme in the January EGM.
Following the completion of the transaction in January, ALOG’s DPU yields were compressed and its cost of capital fell.
As a case in point, its cost of debt as at 1HFY2021 ended June was 2.92%, excluding perpetual securities. In 2018, Cache Logistics Trust’s all-in cost of debt was 3.71%. In 2019, after the LOGOS transaction was announced, Cache Logistic Trust had an all-in cost of debt of 3.84%. As ALOG, in 2020, the cost of debt started falling and was 3.22% for the year to Dec 31, 2020. Without these elements of support from LOGOS and Ivanhoe, ALOG’s cost of capital could have been closer to that of Cache Logistics Trust.
Cheaper debt, lower costs
During a recent interview with Chui, he pointed out that the cost of debt is usually the highest expense for REITs, not fees. And he is right.
ALOG’s interest expense in 1HFY2021 was $12.7 million on net property income (NPI) of $51.5 million compared to its management fee of $4.7 million, 24% higher compared to $3.8 million a year ago.
ESR-REIT’s interest expense in 1HFY2021 was $21.7 million on an NPI of $87 million compared to its management fee of $7.2 million, which was down 1.4% y-o-y. The management fee structure for the combined entity would revert to ESR-REIT’s unitholder-friendly fee structure where performance fee is tied to DPU growth, rather than a percentage of NPI.
If the merger goes through and all relevant resolutions are passed, ESR-REIT has $1.2 billion of ready unsecured funding from banks — priced at 2.25% a year — for four years. This will lower costs for the combined REIT.
“The banks have given us $1.2 billion of debt which we will use for upfront land premium, the cash component of the offer, and to refinance $700 million of ALOG’s debt,” Chui elaborates.
In addition, ESR-REIT’s manager plans to redeem ALOG’s $150 million 5.5% perpetual securities and to replace them with lower coupon perps.
“The cost of funding and access to capital is totally different for a bigger entity,” Chui says. As he sees it, a merged entity accelerates the growth profile.
Accelerating growth profile “I have a pipeline and they have a pipeline. Today, we are a mid- and small-cap REIT. As a mid-cap REIT, I can issue $150 million in equity if my market cap is $1.8 billion,” Chui argues.
Last year, ALOG raised $50 million in an equity fundraising to part-finance its Australian acquisition. Trading at a yield of 5.8% and P/NAV of 1.4 times, ALOG can raise still raise $50 million.
“I have a $1 billion pipeline. For me it takes three years to get to $1 billion assuming I can acquire $300 million a year with equity of $150 million,” Chui estimates.
ALOG has a $1 billion pipeline. But, due to its smaller size, it would take a longer period to acquire the $1 billion, based on a debt and equity mix of 50:50.
“If we come together, with an AUM of $5.4 billion and a market cap of $3.2 billion, we can easily acquire $1 billion in assets a year,” Chui calculates. WIth a general mandate, REITs can issue up to 20% of their units outstanding in a year.
With a lower cost of capital, it would be easier to acquire assets. Logistics assets have been compressing since the start of Covid. The most recent acquisition by CapitaLand China Trust of four logistics assets, two in and around Shanghai, and two in tier-2 cities had a blended NPI yield of 5%.
Access to capital is important. As was demonstrated by ALOG, the LOGOS sponsorship had the ability to bring in new investors in the form of Ivanhoe Cambridge and provided access to cheaper debt.
The merged entity has an improved opportunity to restructure the portfolio to higher-yielding modern properties with longer land tenures.
“A general overview of both portfolios shows we have some short land lease. There are few ways to fix it. The short lease is less than 20% of the portfolio, and we still have 80% long lease assets. So this 20% is manageable. One way is to divest them if they are smallish. We can identify those with potential to get lease extension and do some AEI to justify to JTC,” Lee explains.
“More importantly, the ‘New Economy’ assets of the sponsor, of US$50 billion, is large and these short land lease assets will be diluted within the larger scale,” she says.
A larger portfolio provides more flexibility, in that it allows the REIT manager to divest older properties with shorter land leases, leaving more headroom to acquire modern logistics assets from ESR Cayman.
“The larger REIT will have a greater acquisition potential to tap into sponsor’s initial visible pipeline of US$2 billion with more on the offing, thus offering promising potential to be one of the biggest New Economy focused REITs in the region. In addition, we expect the REIT to benefit from a lower cost of capital and operation synergies resulting in cost savings. The move will allow it to divest some of its older non-core and shorter land lease assets and redeploy the capital into newer ones,” says RHB Research.
Flagship REIT if hurdle is crossed
E-LOG would be ESR Cayman’s flagship REIT if the resolutions are passed. “It’s going to be [our] flagship REIT going forward. The group will support this at scale, and as we look at other markets,” says Jeffrey Perlman, chairman of ESR Cayman. He believes that E-LOG has the potential to reach bellwether status in the same manner as the large US REITs but this requires size and scale. And, in the Asian timezone, E-LOG has the wherewithal to be the preeminent New Economy vehicle, Perlman indicates.
ESR Cayman, following the acquisition of ARA Asset Management, would itself be the preeminent “New Economy” real estate investment manager on a global basis, rivalling the likes of Prologis. ESR Cayman’s founders are originally from Prologis.
As a sponsor, ESR Cayman has a pipeline of more than US$50 billion ($67.24 billion) “New Economy” assets for E-LOG and over US$10 billion work-in-progress assets which represent development value across 10 markets.
However, for E-LOG to achieve flagship status, it has to cross the EGM hurdle. “We believe the rerating story is compelling and could happen if ESR-REIT/E-LOG can come through in tapping the sponsor’s modern pipeline in Asia without eroding DPU and offloading its legacy noncore assets in a timely manner above NAV. Meanwhile, we see modest execution risk in the merger if ALOG minority unitholders cannot see the benefits of the merger,” writes David Lum, Daiwa Capital Markets’ head of real estate, in a recent report.
The upside would be a rerating of E-LOG to bring valuations closer to the largecap industrial S-REITs. Of course, the downside risk is, failure to complete the merger as management credibility would be hit, Lum points out.
“For retail investors, we need to give them more colour. We’re not asking you to sell but we’re rolling [our portfolio] into a bigger entity and platform where there is a clear growth path. We [are giving] unitholders cash in the 90:10 ratio. We want our unitholders to stay with us as we grow into a bigger platform,” Lee explains. “The merger comes with strong sponsor backing and pipeline and we’re moving into a cluster that is very resilient, with logistics, data centres and hi-specs tech buildings,” she adds.
“The potential is there and our current sponsor is still there [in the new platform]. The formula that we’re using to turn ALOG around is a workable formula. We won’t deviate too much on the strategy and we will stay disciplined in acquiring good quality assets,” Lee concludes.
It remains to be seen if retail unitholders buy into this vision.
