Blog
The rationale of merging two real estate funds: 1 + 1 > 2
Hereby I will take the opportunity to highlight main keywords and considerations why we have decided to propose to the annual general meetings of two EfTEN real estate funds to merge the funds into a single, exchange-listed real estate fund:
- Real estate business is primarily a business of volume where size matters. The merger of two funds will create a fund with assets worth about EUR 350 million, comprising a total of 29 commercial buildings across the Baltics. The equity of the joint fund will be about EUR 175 million, which means the fund is expected to enter the TOP 10 of the companies in Nasdaq Baltic Main List. For example, Merko Ehitus has a total market capitalization of EUR 164 million, while the corresponding value of Tallinna Vesi is EUR 230 million. EfTEN Real Estate Fund III has traded 5-15% above book value so far.
- From the investor’s perspective, the merger ensures better diversification of underlying assets. While 60% of the third fund’s portfolio is today invested in commercial properties in Lithuania, 75% of the assets of EfTEN Kinnisvarafond AS are in Estonia. The Baltic economic area is so small that all three economies are following a similar macroeconomic trend. In our opinion, geographical diversification is not as important as dispersion between different buildings – in the joint fund, the share of each individual property is in overall, smaller than it would be in two separate funds.
- Both funds have been created with identical investment strategy, being of opportunistic and value adding kind. EfTEN Kinnisvarafond AS was EfTEN’s first fund, which started investment activities in 2008 and stopped investing in new commercial buildings in 2014 when the fund’s target volume was reached. Since its inception in 2015, EfTEN Real Estate Fund III AS has followed an opportunistic and value-added strategy as well. The commercial terms of the third fund were essentially overlapping with those of the first fund. Two funds are of uniform nature because they are created by the same team, with the same investment philosophy. Simply the time horizon of investments has been different.
- With its higher market capitalization, a joint fund would achieve a greater visibility among foreign investors as well. This development provides a better basis for increasing the liquidity of the joint fund, which is a clear priority for the Management Board. While our third fund is today almost entirely owned by private investors, the first fund’s investor base includes institutions, primarily LHV pension funds. The merger will also contribute to the diversification of the investor base. Potential new institutional investors will contribute to the development of corporate governance and would be anchor investors in new issues of securities, be it in raising equity or, for example in bond issues under appropriate conditions.
- The underlying assets of both funds are performing flawlessly: the vacancy rate of 18 properties of EfTEN Kinnisvarafond remains under 2%, similar to the vacancy rate of EfTEN Real Estate Fund III. With assets of the two funds no major capex investments are expected in the near future, except for the office property at Kadaka tee 63, Tallinn, which will be rebuilt to meet the needs of smaller tenants after Elektrilevi leaves the building. These activities fall into the category of day-to-day management of real assets – similar issues are managed on a daily basis by our 55-member Baltic team.
- The dividend policy of both funds has been identical – at least 80% of the free cash flow earned in the previous financial year is paid out as dividends. We have paid dividends every year and will continue this good tradition in the future. EfTEN Real Estate Fund III positions itself as a dividend stock and we do not plan any changes in this respect.
- EfTEN Kinnisvarafond has sold a total of 10 commercial buildings to date, earning to investors between 20% and 46% return on equity per year, depending on the project. We have exited rather smaller than larger investments, which has fortified the overall composition of EfTEN Kinnisvarafond’s assets.
- Based on recent investment pace, it would take at least five years for the listed EfTEN Real Estate Fund III AS to achieve the assets volume that is comparable with the scale of the joint fund. Through the merger, we would receive a clear boost in business growth. The joint fund would continue to raise capital and make new investments, being an indefinite – evergreen -, as it is called in financial market terms.
- The merger will be completed on the basis of EPRA NAV as of March 31, 2020, which determines the share swap ratio. EPRA (European Public Real Estate Association) NAV differs from ordinary NAV only in terms of deferred tax liabilities and the accounting of the fair value of interest derivatives, meaning interest swap contracts, which are eliminated. When assessing the true value of a real estate business, EPRA’s recommendation is to eliminate from the accounting equity liabilities that are unlikely to be recovered. The tax systems of different countries are very different. This is also the case in the Baltics. While the Lithuanian tax system imposes a deferred tax liability, the Latvian and Estonian tax systems do not. In addition, Lithuanian deferred tax liability would be only imposed if the real estate investments are sold, but the funds do not intend to do so in the near future. In the balance sheet of the funds, interest derivatives are taken into account at fair value, but this liability is eliminated against interest expense on the maturity date of the derivative contracts, so the reflection of this liability is also only temporary. Therefore EPRA NAV provides a clearer picture of the real value of the funds than the book value of the equity. In the transaction, the acquiring fund is EfTEN Real Estate Fund III AS, listed on the stock exchange, and the fund being acquired is EfTEN Kinnisvarafond AS.
- Real estate investments account for over 85% of the total assets of both funds (other assets are mainly cash on accounts). So the most important question in the merger is how are the assets of both funds valued? Since 2013, the assets of all EfTEN funds have been valued by Colliers International. Some other funds are using different valuation companies for different assets, which we do not consider as good practice. In the context of both regular comparability and current merger, it is particularly important that all assets of both funds are valued on the basis of a common approach and the same methodology. At the moment, it is not so important whether another appraiser is more optimistic or more pessimistic about the assets of both funds, the similar basis and approach of valuation of the two funds is important, which also ensures a fair exchange ratio for the merger.
- The joint fund has greater opportunities than before to engage in real estate development or in its forward financing. The third fund has developed Laagri Selver as well as Hortes Gardening Center in Tallinn. In the first fund, the joint Building of Police and Rescue Department in Rakvere has been completed on the basis of forward financing. In addition, first fund’s development portfolio encompasses UKU Center in Viljandi, RAF Center in Jelgava, as well as extensive reconstruction work for Mustika Center and Palace Hotel in Tallinn. Historically, the objects of the development portfolio have been the most productive for investors.
- The idea for merger comes from the management of the fund management company. In 2018, EfTEN Kinnisvarafondi AS received from a world-renowned fund management company a takeover bid, which was rejected by our fund shareholders at the time. Instead, it was decided to extend the fund’s term by five years, until 2027. Given the fund’s similar investment profile, fund managers proposed to the Supervisory Boards of both funds to merge the funds into a single exchange-traded fund, which was supported by the Supervisory Boards of both funds.
Viljar Arakas
CEO, EfTEN Capital AS