By guest contributor Calvin Yeo (reproduced with permission from his blog www.investinpassiveincome.com)
There was an article published in Business Times a while back by The Hooi Ling titled ‘The REIT Myth Busted’. I read the article with great interest as I have significant holdings of REITs. Basically, the article is saying that if you held most of the Singapore REITs from day 1, you would have paid more for the rights issue than what you received from the dividends from the REIT.
It uses CapitaMall Trust in a hypothetical situation where the unit holder holds a unit of the REIT since IPO and subscribes to all the rights regardless of the subscription price and the reason for the rights issue. By the end of November 2011, the unit holder would have received $1,264 in dividends and paid $1,549 for rights subscription, a net cash outflow of $284 per lot. Now, there is nothing factually wrong with this analysis, however, there are some assumptions made which a savvy investor normally wouldn’t have done. Before we begin, let’s first discuss what rights issues are and the impact of rights issues.
What Are Rights Issues and the Impact of Rights Issues
Rights issues are a way for the company or corporate entity to raise equity by selling shares. Capital can either be raised by debt or equity and rights issues are a way for shareholders to inject additional capital into the Company. Simplistically, imagine you are one of the partners of a Company and it needs funds to grow, so all the partners are asked to pump more money into the Company in return for shares.
The impact of rights issues to the Company are an enlarged shareholder base and increased assets from the capital injection. For the shareholder, if he decides to invest capital by subscribing to the rights, he will retain his existing ownership percentage of the Company. If he chooses not to invest, somebody else will take over the new shares and his ownership percentage in the Company will be reduced.
Example of the Impact of a Rights Issue
The following is a hypothetical Scenario:
Company Alpha has 100 shares outstanding with an asset base of $100. Net Asset Value per share = $1.
Shareholder B owns 10 shares in Alpha, so Shareholder B has 10% of the total Company and owns $10 in total asset value.
Alpha announces a 1 for 1 rights issue with a subscription price of $1 each.
Post the transaction, Alpha would have $200 outstanding with an asset base of $200. Net Asset Value per share remains at $1.
If B subscribes fully to the rights, B will pay $10 for the rights issue. B will now own 20 shares in Alpha, so ownership remains at 10% of the total Company and he now owns $20 in total asset value.
If B does not subscribe, B will now have only 5% ownership left, however, total asset value remains at $10 (5% * $200).
So we can see that in the hypothetical situation, B does not really lose out by not subscribing, neither does B gain anything extra by subscribing to the rights.
Why Are Rights Issued?
Now that we have an understanding of rights mechanism, we would want to know why Companies issue rights, especially for REITs. There are a few reasons, some being good reasons, some being not so good reasons:
1. Acquisition of Properties – If the properties to be acquired are at an attractive valuation and have a return on investment above that of the capital cost, it would make good sense.
2. Paying Down Debt – the Company might be paying high interest rates and decides that it is more efficient to reduce debt by raising equity. Normally this would reduce returns by deleveraging, but will put the balance sheet in a stronger position.
3. Unable to Refinance Debt – During a credit crunch, many independent REITs get shut out from the debt capital markets and cannot refinance maturing loans. It usually happens at the worst time when stock prices are low and existing shareholders may get diluted at a low price.
4. Cash Call Due to Asset Devaluation – This is the worst reason, where the properties have dropped in value, causing leverage ratios to rise to unsustainable levels or hitting leverage caps, and cash need to be raised to increase the asset base.
Rights Are an Option Not Obligation to Invest
The article states that at each rights issue, the shareholder should subscribe regardless of the offer price or the reason stated. Now if the subscription price was overvalued, does it make sense to subscribe? Probably not, especially in the article’s example of the CapitaMall Trust issue in 2004 where the exercise price was considered high at $1.62. By not subscribing to the rights, the shareholder does not necessarily lose out as shown in the above, i.e. B still holds $10 worth of share in net asset value. In fact, if the rights are issued at a high price, the current shareholder can benefit from the increased net asset value of the shares he is holding without having to pay a single cent.
If the rights were for the purpose of acquisition, the shareholder should study if the property purchased is a good performing asset, whether the purchase price is right, and whether it fits in the overall strategy of the REIT. If none of these factors are fulfilled, the shareholder can choose not to participate in the rights issue or may even choose to dispose of the stock in disapproval of the transaction. For example, the recent Keppel REIT transaction of Ocean Financial Center is what I would consider a bad acquisition.
If the acquisition is a good one, the shareholder can choose to participate by subscribing to the rights. In the event that the shareholder has insufficient funds, he can sell the rights for cash and his existing shares will still benefit from the increased net asset value per share and even increased dividends assuming the income from property outweighs the cost involved with the acquisition.
If the rights were for reasons number 3 or 4, it either implies bad capital management on the part of the REIT management or lousy acquisitions at high prices after which the asset values were written down later. As an astute investor, one would have to determine the quality of the REIT management, a very important part of fundamental analysis. Especially for lousy acquisitions, a savvy investor would have seen the disaster coming from miles away. For refinancing, it is important to study the debt maturity profile of the REIT, debt rating and available credit markets to the REIT to ensure it will not be hit by a credit crunch.
Rights Are an Entitlement
The article also mentions that other REITs such as Fraser Centerpoint Trust and CapitaRetail China Trust never had a cash call. That’s a misrepresentation, just because these other REITs never issued rights doesn’t mean they never did other forms of equity raising. CapitaRetail China Trust issued shares to the manager for acquisition of the Mingzhong Le Yuan Mall, while Fraser Centerpoint Trust did a private placement for the acquisition of Bedok Point.
Issuance of shares to managers or private placements have the same effect of diluting the existing shareholder base. The only difference is that for Rights, you get to choose whether you want to participate in the capital raising and benefit from the transaction while a private placement is done directly to institutions and you do not get participate. So implying that these other REITs never had any sort of equity capital raising is a gross misrepresentation.
Personally, I would prefer if Rights were issued versus Private Placements as I would definitely be interested in investing more capital into both Fraser Centerpoint and CapitaRetail China Trust at a discount.
I believe there is some truth to be derived from the article regarding the net cash flow. However, it is skewed in that it does not take into account the analysis and groundwork an investor can do to avoid such problems.
It also does not consider the fact that an investor can choose to subscribe to the rights or not based on his views of the REIT. Saying REIT investments are no good in such a manner is almost the same as saying stock investments don’t make sense as many people continually buy high and sell low. It is the importance of understanding the nature of REITs, valuation of REITs, the properties within the REITs, and the mechanics of capital raising that will make one a successful investor in REITs.
However, it’s good to know that most REITs have yielded positive total returns, including CapitaMall Trust in the example which gave a total return of 127% on capital. A take away from this article is to always have sufficient cash ready if you intend to continue to participate in the growth of a REIT. That’s because REITs grow mainly through acquisitions of high yielding assets and capital raising through debt and equity are to be expected.
Guest contributor Calvin Yeo is the founder of the Making Passive Income blog. He graduated with a Business Major in Finance and Accounting and spent a few years working in an investment bank. The knowledge from his studies and working experience serve as a good base for him to grasp the ideas for passive income generation.