Credit Update – ESR Group: Are the high yields on its perpetuals worth your time?

While the buy-out remains undecided, the offer thrust ESR into the global spotlight – with heavy speculations on the pending decision. We intend to discuss this potential buy-out by the consortium further (under the discussion of ESR’s perpetual securities), but before that, we will review ESR’s performance for the first half of 2024.

Losses in 1H24 owing to significant non-cash items

For the six months ended 30 June 2024 (“1H24”), ESR reported lower revenue and profit after tax and minority interest (“PATMI”) as compared to a year ago, with the issuer seeing losses for the period. Revenue fell 31.4% year-on-year (“YoY”) from USD 455.4m to USD 312.5m, while PATMI fell from USD 289.0m to USD -218.7m.

The decline in revenue was largely due to the lack of promote fees in 1H24 (none in 1H24 versus USD 136m in 1H23), which led to Fund Management EBITDA falling by 47.1% YoY. ESR previously indicated that promote fees are dependent on the life cycles of the funds and real estate in general. Additionally, there might be select periods where no promote fee income is recognised. With that said, we believe promote fees will average out over time considering ESR’s continued strong pipeline of projects.

Despite lowered expenses in 1H24, PATMI fell significantly owing to non-cash items and the writing down of assets – with more than USD 300m impact coming largely from one-off items such as:

1. USD 97.4m impairment loss of assets associated with the sale of ARA US Hospitality Trust – the sale of the trust largely stems from the issuer’s strategic action to divest non-core assets and focus on New Economy
2. USD 44.6m share of associate’s fair value losses for Cromwell Property Group’s Australia investment portfolio, as well as the sale of Cromwell’s European fund management platform and associated co-investments
3. USD 60.0m from the revaluation losses of three balance sheet assets in China to be spun off to ESR C-REIT, which is a newly approved REIT in China that is ready for listing in 2H24
4. USD 125.5m decline in property fair values in China – oversupply of completed projects in Northern China leading to lowered fair values in the region

ESR reported an adjusted PATMI of USD -57.9m, primarily adjusted for the USD 97.4m impact from the impairment loss of assets and USD 44.6m from the share of associate’s fair value losses. While adjusted PATMI still sees a considerable drop from 1H23 adjusted PATMI of USD 289m, the results reflect a fairer figure given the lack of promote fees.

Despite seeing an overall loss for the period, ESR managed to generate net positive cashflow from operating activities. The net operating cashflow had increased from USD 22m (1H23) to USD 163m (1H24), although a considerable amount came from the change in trade receivables (1H24: +142.7m vs 1H23: -142.0m). Such cash generation ability is crucial for ESR as a real estate company, supporting its ability to make the necessary payments on its projects and their continuity.

Other key performance indicators we wish to particularly highlight include (1) capital raised for the Group, (2) development workbook and also (3) ESR’s New Economy portfolio performance.

1. ESR managed to raise a staggering USD 2.3b of capital in 1H24, +155% YoY and 68% allocated towards New Economy assets. While the ability to raise capital does not directly impact ESR’s top line, we do view strong investor confidence as a good sign. Additionally, its management highlighted a dry powder worth USD 23.7b to be deployed, which would in turn help to grow fee-related AUM. Deployment has been conducted at a cautious pace, but they expect interest rate cuts to reveal opportunities and allow them to “capture the trough” across the New Economy assets.
2. ESR development workbook has steadily grown since its IPO from USD 3.9b in 2019, to the current USD 13.1b as of 1H24. The development workbook is the largest across the Asia Pacific region, while at the same time substantially diversified across the countries. ESR specified that a larger proportion of new developments are data centres (34%), a core focus of ESR’s New Economy strategy. Its management placed rather high expectations on the growth of data centres, with capacity expected to grow at ~20% CAGR through 2028 to more than double its current capacity. We believe ESR shows a clear intent to ride on this potential growth in data centre demand.
3. Portfolio performance remains relatively strong for ESR, with portfolio occupancy and rental reversion at 87% and +10.7% respectively. Excluding the China portfolio, both further increase to 94% and +19.4% respectively. The management noted that rental reversion in China is negative (-11%) due to prioritising occupancy, but expects a gradual recovery in China’s leasing going forward as new supply into the market is now limited.

Chart 1: ESR performance over past half-year periods (in USD m)

Table 1: ESR New Economy Portfolio Performance

Strategic focus and lower interest rates to be beneficial for ESR’s outlook

We do not find ESR’s loss in 1H24 particularly concerning, considering that the impact largely arises from the impairment with divesting non-core assets. The ongoing divestments are part of ESR’s strategic focus on New Economy Assets. In addition to the divestments of ARA US Hospitality Trust and Cromwell’s European platform (both of which resulted in impairments), ESR is selling the ARA Private Funds for a total consideration of USD 270m, pending completion. The proceeds are expected to be utilised towards debt repayment.

The divestments are part of ESR’s ongoing balance sheet optimisation that was initiated last year, allowing ESR to go asset-light. Such a strategy enables ESR to focus more on its Fund Management business as it syndicates its balance sheet assets, which this particular business segment has seen consistent growth and forms the core of ESR’s recurring income. ESR currently expects USD 1.2b from the optimisation to be used towards debt repayment and plans for another USD 1.5b~2.0b of additional balance sheet sell-down in the 12-18 months.

Beyond debt repayment, the extensive capital recycling allows ESR to concentrate on pertinent areas – one of them being the full integration of LOGOS Property Group (“LOGOS”). Recently in July, ESR completed the acquisition of the remaining 13.6% interest in LOGOS from the founders. The acquisition will place ESR as the #2 New Economy Manager across Australia and New Zealand, with ESR having the ambitious plan of being the #1 in the region. ESR expects the data centre business within the Australia and New Zealand region to be a key growth driver for the Group. Furthermore, ESR sees room for another USD 50 million worth of cost synergies arising from the complete integration of ESR and LOGOS.

Concurrently, we believe interest rate cuts will be beneficial for ESR as a real estate company. With lower interest rates likely to support valuations, losses arising from valuation decline would be unlikely moving forward. More importantly, we expect this to benefit ESR in the deployment of capital, enabling growth in its Fund Management business. The management highlighted that lower interest rates are likely to boost transaction activities across the real estate space, providing more opportunities for the Group to capitalise on.

As a result, despite ESR’s relatively poor performance in 1H24, we remain largely positive on the issuer’s overall outlook. Earnings will likely improve with an expected rebound in promote fees given the cyclical nature, on top of lesser impairments and minimal fair valuation losses. Meanwhile, ESR’s credit profile is expected to improve owing to the considerable debt repayment plans.

Chart 2: Planned capital recycling in the next 12 to 18 months (in USD b)

Stable credit profile is expected to get better

ESR’s credit profile remained relatively stable across the half-year period. While it reflected a slight increase in net debt from USD 4,978m (FY23) to USD 5,127m (1H24), the increase stems from a timing spill-over for an asset loan refinancing. The loan drawdown was completed in late June, ahead of the required repayment in early July. Net gearing (net debt to total assets) similarly saw an increase, from 30.7% (FY23) to 32.3% (1H24) – but ESR expects this figure to fall to 30.2% post-repayment with proceeds from ARA Private Funds and formal listing of the approved ESR C-REIT.

We saw a decline in the weighted average interest cost from 5.3% (FY23) to 4.9% (1H24), likely due to its AA- (stable) rating by Japan Credit Rating Agency, and AAA (stable) rating by China Chengxin International Credit Rating Co. ESR previously mentioned that the strong ratings enabled the Group to procure cheaper loans in JPY and RMB, allowing them to reduce the weighted average interest cost.

Excluding the upcoming freed-up capital, we find ESR’s liquidity to be generally decent. ESR has approximately USD 1,029m and USD 564m worth of debt maturing in 2H24 and FY25 respectively. Meanwhile, ESR holds cash and bank balances of USD 1,064m as of 1H24 and a sustainability-linked loan facility of USD 2.5b. We do not think ESR would face any refinancing issues, but we expect ESR to proceed with paying down the upcoming debts in accordance with the capital recycling plans.

We expect ESR’s credit profile to improve considerably from here, given the intended debt repayment from capital recycling measures. ESR remains highly committed towards reducing the Group’s gearing to the lower end of the 20%~30% range. The lower amount of debt will help in reducing ESR’s overall finance costs as well.

Table 2: ESR’s balance sheet and metrics

Our thoughts on ESR’s outstanding issuances

Table 3: ESR’s outstanding SGD issuances

The ESRCAY 5.100% 26Feb2025 Corp (SGD) has been one of our top recommendations for a while, but we see diminishing value for newer investors as the bond is maturing in less than five months. The bond also trades above par which minimises total return for investors and would be further reduced by any potential fees and charges.

While we still like ESR as an issuer, new investors looking at fixed-rate issuances might want to consider the 6-month Singapore Treasury bills (“T-bills”) instead. We believe that the 6m T-bills still offer immense value given the inverted yield curve. As of 26 September 2024, the 6-month T-bills boasting of triple-A credit ratings continue to offer an attractive average daily yield of 2.99% - suitable for conservative investors looking at relatively short duration.

For ESR’s perpetual securities (“perpetuals”), including those from ARA Asset Management, something important to note is the change of control clause found on the two ARASP perpetuals (but absent in the ESRCAY perpetual). The change of control clause requires the issuer to redeem the perpetuals at par, when there is a “Change of Control” event. Should the issuer choose not to call, the perpetuals will have a 300 basis points (“bps”) step-up on the coupon rates.

ARA Asset Management had previously conducted a consent solicitation exercise for the bondholders in October 2021 to (1) change the benchmark rates on both ARASP perpetuals from SGD SOR to SGD SORA-OIS and (2) include ESR with the change of control clause. The article covering the consent solicitation exercise may be found here - ARA Asset Management: Consent the change concerning change of control conditions?

As such, the recent development of ESR being potentially taken private is a critical event for holders of ARASP perpetuals. Prices of the ARASP perpetuals rose after the initial announcement, with buyers likely considering taking advantage of the change of control clause. However, given that there is minimal information on the eventual ownership, we strongly believe that buying into ARASP perpetuals simply for the potential change of control is a gamble. The market appears to be increasingly aware of this as well, with prices on the ARASP perpetuals gradually falling.

The non-call risk of perpetuals continues to be our key concern, especially with interest rates likely to remain elevated in contrast to pre-pandemic lows, despite rate cuts. Given the high rates in recent years, issuers that experienced a deterioration in credit profiles might not be financially incentivised to redeem and refinance their perpetuals on the first call date. As a result, they may opt for a reset in coupon if it is more economically viable for them to do so. In addition to the non-call risk, investors would be subjected to extended duration risk if the perpetuals remain uncalled and coupons on the perpetuals reset.

With that being said, there is a benefit to ESR’s perps – all of its perps have a step-up margin embedded in the reset rate. This becomes beneficial for bondholders, as non-call risk is reduced in the presence of a step-up margin. This step-up margin drastically increases the cost of allowing the perpetual to reset, likely much more expensive than refinancing the redemption with a new series of perpetuals. As such, ESR may be more inclined to redeem the perpetuals on the reset date, given the likelihood of a coupon reset being pricier than refinancing.

For investors considering ESR perpetuals for the high yields, we prefer the ESRCAY 5.650% Perpetual Corp (SGD). Other than the attractive yield to call (7.70%) it offers, we like it for the relatively shorter years to call and a higher initial spread.

At 473 bps, the initial spread on the ESRCAY perpetual is considerably higher than ARASP 5.650% Perpetual Corp (SGD) at 313 bps and ARASP 5.600% Perpetual Corp (SGD) at 406 bps. The higher initial spread will further incentivise ESR to refinance this perpetual as we see a good probability of ESR issuing a new perpetual with lower spreads. With its credit profile set to improve significantly after the debt repayment, spreads are likely to trend lower for ESR in the short to medium term – providing an avenue for the issuer to seek refinancing with ease.

In the event that the perpetual remains uncalled, the coupon would reset based on the benchmark rate (5y SGD SOR), initial spread (473 bps) and the step-up margin (200 bps). Using the 5y SORA-OIS benchmark as a direct replacement of the discontinued 5y SGD SOR (229.5 bps as of 25 September), the coupon could potentially reach ~9% assuming interest rates remain at current levels. This translates to a current yield of ~9.2% based on the ask price of 97.5, an attractive proposition for investors even if the perpetual remains uncalled.

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.