Idea of the Week: ESR Group – Finally seeing the impact of higher interest rates?

ESR Group (“ESR”) is the largest real asset manager within the Asia Pacific region and the third largest listed real estate manager globally. Since the acquisition of ARA Asset Management in early 2022, ESR is currently the largest sponsor and manager of REITs in Asia-Pacific, with a total Asset Under Management (“AUM”) of approximately USD 45b under the REITs. ESR heavily focus on the development and management of New Economy Assets, which predominantly include logistics, e-commerce and data centres – three areas of properties that are deemed to be in a high growth stage.

Financial Highlights

For the half-year ended 30 June 2023 (“1H23”), ESR recorded an increase in revenue and total AUM but saw a drop in earnings against the previous year. Revenue rose by 5% from USD 432m in 1H22 to USD 455m in 1H23, while total AUM had risen by 9% from USD 135b in 1H22 to USD 147b in 1H23. Total AUM was mainly propelled by growth in the New Economy Assets, which the AUM for New Economy grew by 13% year-on-year (“YoY”). This translated to the overall higher fee revenue that ESR observed in 1H23.

However, EBITDA and PATMI both fell YoY in 1H23. ESR’s EBITDA fell by 18% from USD 670m in 1H22 to USD 550m in 1H23, while PATMI fell by 26% from USD 412m in 1H22 to USD 304m in 1H23. ESR had specified that the drop in performance was largely due to (1) lower fair value gains observed in 1H23 at USD 115.3m (versus USD 162.9m in 1H22, mostly due to increased capitalization rates used for valuations) and (2) a stronger comparable in 1H22 due to higher one-off gains (higher distributions from joint ventures and associates and more capital recycling in 1H22). PATMI was further set back by higher interest expenses, which saw a jump in finance costs by more than 50% from 1H22 to 1H23.

On the other hand, ESR recorded lower operational expenses at USD 169m in 1H23, against USD 183m in 1H22. The integration of ARA Asset Management and LOGOS Property provided for USD 25m worth of cost savings thus far, allowing ESR to reduce its operational expenses despite the ongoing inflationary pressure on costs. Moving ahead, ESR continues to expect further cost savings through ‘additional synergies’ created from further integration through 2024, while there remain opportunities for savings in 2H23 with the ongoing recycling of capital.

Outlook for ESR

New Economy Assets have been the core of ESR’s strategy in its development, supported by the projected growth in the areas of e-commerce and data centres. Mordor Intelligence expects to see a compounded annual growth rate (“CAGR”) of 10.7% for e-commerce within the Asia-Pacific markets. Jones Lang Laselle (a global real estate services company) expects the data centre market to grow at a CAGR of 11.3% from 2021 to 2026, with certain key countries like Japan, Hong Kong and Singapore to potentially grow even faster at approximately 20% CAGR. The continued strong demand in these two areas underpins ESR’s current strategy to focus on the New Economy Assets, currently accounting for 61% of its total AUM.

Table 1
Occupancy and Rental Reversion of New Economy Assets by Region

Region	Occupancy Rate	Rental Reversion Rate
Greater China	84%	3.2%
South Korea	98%	19.5%
India	99%	23.4%
Japan	98%	6.0%
Southeast Asia	94%	2.7%
Australia/New Zealand	99%	18.5%
Group Portfolio	92% (total) 98% (ex-China)	10.4% (Weighted Average by AUM)
Source: Company presentation. Data as of 1H23.

Beyond the positive outlook for New Economy Assets, the segment under ESR’s portfolio has shown why it deserved that attention. Looking solely at New Economy Assets within the portfolio (excluding listed REITs and Associates), ESR recorded a weighted average portfolio rental reversion of 10.4% while the occupancy rate is at 98% excluding China.

The New Economy Assets in South Korea, India and Australia/New Zealand also reflect exceptionally strong performance (Table 1) – with the occupancy rates close to 100% and rental reversion of about 20%. Given that demand for such assets will only increase, it provides strong justification for the ESR’s strategic focus on the New Economy Assets, at the very least, in the short term.

We expect New Economy Assets to increasingly take a larger slice of ESR’s AUM given its capital management strategy and development workbook. As of June 2023, ESR identified around USD 750m of non-core assets for divestment and is on track to divest over USD 1b of assets in 2023. Alongside a substantial dry powder of USD 19.3b, of which USD 12.7b is from New Economy vehicles, ESR’s ongoing capital management allows it to have the financial flexibility to tap into opportunities.

In addition, ESR is actively expanding its development in the new economy segments to better capture the high demand for logistics spaces. ESR has estimated USD 13.0b work in progress, an increase of 8% YoY from the past year’s development workbook and currently the largest in Asia. In 1H23, ESR saw USD 3.8b development starts and USD 2.2b development completion, both increasing by 9% YoY and 12% YoY respectively. ESR indicated that >70% of the work in progress is planned for completion between 2024 to 2026.

With good prospects ahead of ESR, we continue to be optimistic about the Group’s outlook underpinned by the positive payoff from its New Economy segment. The immediate challenge for ESR will be the increased financing costs attributable to higher interest rates, which we believe the Group will be able to offset with rent growth considering positive rental reversion.

Credit and Liquidity Profile

ESR reflected that total liquidity inclusive of undrawn debt facilities is about USD 3.0b – more than sufficient to cover current borrowings amounting to USD 394.5m. Total borrowings saw a slight increase from USD 5.5b as of December 2022 to USD 5.6b as of June 2023, while across the same period, the see-through gearing (inclusive of perpetual securities) increased from 29.7% to 34.8%. That said, cash position for ESR had dropped, falling from USD 1.8b as of December 2022 to USD 1.1b as of June 2023. ESR indicated that the cash was mostly utilized to pay off legacy loans in the high 7% range.

ESR sees considerable impact from the rise in interest costs, with the weighted average interest cost rising from 4.2% as of December 2022 to 5.6% as of June 2023. Other than the continued rate hikes since the start of 2023, we believe the increase in weighted average interest cost is largely attributable to the significant proportion of floating rate loans at 81% of total borrowings, while fixed rate loans are only at 19%. Nonetheless, ESR remains in a good position to manage its interest cost, with an adequate interest coverage ratio of~3.5x, while current policy rates are likely close to the peak.

 ESR’s debt maturity profile remains decent, as the majority of debt maturing in 2023 has already been refinanced. Looking ahead, we believe ESR will be able to refinance its debt with a favourable interest rate by tapping on its ‘AA-’ (Stable) rating by Japan Credit Rating Agency. Earlier in 1H23, ESR had debuted JPY 30b issuances with an average rate of 1.38% – significantly lower than the existing weighted average interest cost. We think that ESR is likely to further tap into the JPY market with its strong credit rating and the relatively low interest rates in Japan.

While ESR might seem impacted by the higher interest rates in 2023, its credit profile continues to look decent and capable of containing the damage from the rise in interest costs. We believe that the worst is likely over for ESR, and with prudent capital management, its credit profile should look to improve from here.

Recommendations

Table 2
ESR Fixed Rate Issuances

Issue	Ask Price	Years to Maturity	Yield to Maturity
ESRCAY 5.100% 26Feb2025 Corp (SGD)	100.00	1.36	5.10%
ARASP 4.150% 23Apr2024 Corp (SGD)	99.70	0.51	4.76%
Sources: Bloomberg Finance L.P., Bondsupermart, iFAST Compilations. Data as of 19 October 2023.

Table 3
ESR Perpetual Securities

Issue	Ask Price	Years to Call /Reset	Yield to Call /Reset	Option-adjusted Spread (bps)	Reset Date and Reset Rate
ESRCAY 5.650% Perpetual Corp (SGD)	97.65	2.37	6.74%	282	02 Mar 2026 & every 5 years thereafter Prevailing 5-year SOR + Initial Spread (4.73%) + Step Up Margin (200 bps from 02 Mar 2026)
ARASP 5.650% Perpetual Corp (SGD)	92.83	0.40/ 5.40	25.65%/ 7.74%	2179/ 360	14 March 2028 & every 10 years thereafter Prevailing SGD 10Y SOR + Initial Spread (3.128%) + Distribution Step-up (300 bps)
ARASP 5.600% Perpetual Corp	96.00	2.88	7.17%	326	04 Sep 2026 & every 7 years thereafter Prevailing SGD 7Y SOR + the Distribution Step-up (300 bps) + Initial Spread (4.06%)
Sources: Bloomberg Finance L.P., Bondsupermart, iFAST Compilations. Data as of 19 October 2023.

ESR offers two fixed rate issuances and three perpetual securities (“perpetuals”), inclusive of the ARASP issuances after acquiring ARA Asset Management.

We maintain our recommendation for ESRCAY 5.100% 26Feb2025 Corp (SGD), given the short tenor of 1.36 years with a yield to maturity of 5.10%. While ESR’s credit profile had deteriorated slightly due to the higher interest costs, its outlook remains positive considering the active development within the New Economy segment. A shorter tenor also reduces the risk from increasing interest rates given the backdrop of higher for longer rates, and mitigating the risk from the uncertainty in global growth.

For ESR’s perpetuals, we remain wary of the heightened non-call risk amidst the high interest rates environment. ARASP 5.650% Perpetual Corp (SGD) has currently priced in a non-call on the call date of 14 March 2023, as the yield to call of 7.74% looks more adequately priced to the first reset date of 14 March 2028. As the reset date is much later, ESR is not incentivized to redeem the perpetuals earlier – especially since refinancing with another perpetual on the first call date is likely costlier than the current coupon of 565 bps.

We prefer ESRCAY 5.100% 26Feb2025 Corp (SGD) over the perpetuals. With interest rates expected to remain higher for longer, yields might be insufficient to compensate for the duration risk on the perpetuals. On the other hand, we note that ESR might find it cheaper to refinance its perpetuals before its reset, as they have a step-up margin embedded within the reset rate. Across the perpetuals, if we have to choose, ESRCAY 5.650% Perpetual Corp (SGD) will be preferred given the higher initial spread of 473 bps (versus OAS of 282 bps) among the three.

Declaration: For specific disclosure, at the time of publication of this report, IFPL (via its connected and associated entities) holds a position in ESRCAY 5.100% 26Feb2025 Corp (SGD) and ESRCAY 5.650% Perpetual Corp (SGD), and the analyst who produced this report holds a NIL position in the abovementioned securities.