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Morningstar | Corporate Action: We Recommend Arena Securityholders Subscribe to the SPP

As foreshadowed in our note of May 22, 2019, we recommend Arena REIT securityholders subscribe for new units under the security purchase plan, or SPP. The SPP subscription price of AUD 2.67 is close to our fair value of AUD 2.63, which implies the offer price is fair. The appeal of the offer is enhanced by the 7% discount to the current market price of AUD 2.87. The offer is open to security holders who were on the security holder register at 7:00pm on May 20, 2019 and the offer closes on June 25, 2019.

We had previously updated our financial model following the acquisitions and capital raise in May and our fair value increased by 3% to AUD 2.63, indicating the transactions are slightly value-accretive. Management provided distribution guidance for fiscal 2019, of AUD 0.135 per security, and fiscal 2020, of AUD 0.143 per security, both of which are in line with our revised forecasts. Our fair value implies a fiscal 2020 price/earnings ratios of 18, and an unfranked distribution yield of 5.4%

Arena REIT’s decision to raise capital is a sensible move which exploits the improvement in investor sentiment towards the childcare sector and falling interest rates. The security purchase plan, or SPP, will raise up to AUD 5 million, enabling securityholders to invest up to AUD 15,000, also at AUD 2.67 per security. Arena will use the new funds and existing debt facilities to acquire three childcare centres, three disability accommodation centres, and five development projects for a total cost of AUD 62 million. However, the disability centre acquisitions were announced in February 2019 meaning the new capital is arguably to replenish the balance sheet as part of the ongoing strategy to grow the portfolio.

Arena’s capital raising isn’t particularly surprising and is consistent with the trust’s strategy of gradually adding high quality social infrastructure assets to its portfolio. It’s also logical for Arena to continue to acquire development and established assets considering developments and acquisitions have comprised around 50% of annual EPS growth on average over the past four years. The latest acquisitions will also be accretive to EPS and net asset value per share, and extend the weighted average lease expiry, or WALE.

Following the capital raising and acquisitions, Arena will still have around AUD 100 million in undrawn debt facilities, which mature in around three years, meaning the trust has ample capacity for further acquisitions. In this regard, management said they are conducting due diligence on a further AUD 30 million worth of new opportunities. Importantly, management is avoiding the temptation to borrow against declining cap rates and rising asset values which would potentially risk overleveraging the balance sheet.

Pro forma gearing as at Dec. 31, 2018, calculated as drawn borrowings divided by total assets, excluding the SPP will be 25% following the transactions, versus reported gearing of 26%. The pro-forma loan to value ratio, which is similar to gearing and calculated as total borrowings divided by investment property value, is 26% and well within the covenant of 50%. The trust also remains well within the interest coverage ratio of 2, with interest coverage of around 6 as at Dec. 31, 2018.

Even after the additional healthcare acquisitions, Arena will remain highly exposed to the childcare sector, which comprises 85% of the portfolio by asset value. However, we continue to believe that the childcare sector has a strong outlook. Aside from positive long term industry trends, such as population growth and rising female workforce participation, we expect the recently introduced childcare subsidy, or CCS, to significantly increase the value of subsidies available to families and increase demand for childcare services. A Labor victory in the recent federal election would have been particularly positive for the childcare sector but we expect both main political parties to continue to support long-term growth in childcare subsidies.

The oversupply of childcare centres, which caused falling occupancy rates for childcare operators in 2018, appears to have abated, in part due to tighter lending standards. With the CCS now in place, demand and childcare centre occupancy rates appear to be improving and we expect this to continue. Although the childcare REIT’s are less exposed to fluctuations in childcare centre occupancy rates, improvement provides support and stability for the broader industry and reduces tenant credit risk for the landlords. Although we’re comfortable with Arena’s strategy, diversification of childcare tenants towards smaller operators potentially increases tenant risk. However, we are comfortable that management is addressing this risk via due diligence, tracking tenants operating data, and using cross guarantees.