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"Those who fail to learn from history are condemned to repeat it." - Winston Churchill.
This article discuss the risks of investing in REITs – specifically
due to extremely dilutive rights issues – by looking at how the Global Financial
Crisis (GFC) in 2007 to 2009 unfolded. I believe it is good for us to
understand the worst case scenarios that may play out again, be it over the next
few months or sometime in the future. I would be taking a macro perspective in discussing
the property cycles, and how debt can be a double edged sword – and linking
these to the REIT sector. I would also take a look back into history, and
summarise the key developments for REITs during the GFC period. Specifically, the
rights issues undertaken by REITs during the GFC period are of great interest
to me – and I have complied a few examples below as well.
Why have REITs been popular?
REITs are favoured by investors due to their steady dividend
payouts, as well as their simple and straightforward business model which many
investors can understand – buying properties and renting them out. REITs also
provide leverage and liquidity for investors who may not have the capital to
invest in physical properties. And indeed, the past decade had been incredibly
rewarding for REIT investors, as low interest rates propped up asset prices
while allowing REITs to borrow cheaply, and the hunt for yields resulted in
more and more capital being poured into REITs.
With the past few weeks being extremely volatile, having witnessed
prices of certain REITs swinging by more than 10% in a single day, I would like
to better understand the worst case scenario that REITs may face in the event
of a huge decline in asset prices and tight liquidity due to panic in the
financial system.
How do rights issues work?
First of all, I would like to discuss the effects of a
rights issue. A rights issue occurs when the REIT wants to raise equity capital
from its shareholders. Typically, the intention of raising equity would be for acquisition
purposes or to pay down debt. New units are usually issued at a discount to the
last traded price, to entice shareholders to apply for the rights units. The discount
to the last traded price can be anywhere between c.10% in good times, to even c.50%
in the event that the REIT desperately needs to raise cash. In good times, rights
issues are usually yield accretive, and shareholders may view the rights issue
favourably, if it supports and acquisition of assets that increase DPU.
However, in times of desperation, a rights issue results in a double whammy of
shareholders being diluted and having to cough up cash to purchase the rights
units.
Let’s illustrate an example of a rights issue for a REIT with
1 billion shares trading at $2 per share today. That gives us a current market
capitalisation of $2 billion – a mid sized REIT. Assuming this REIT is in desperate
need of cash, and due to a financial crisis, banks are unwilling to extend further
credit to the company. Hence, the only option would be to raise equity capital
via a rights issue. Given the depressed mood of the market, a huge discount to
the last traded price would be required, in order to draw investors to subscribe.
Let’s say that the discount in this case is 50% to the last traded price – a very
steep discount – but very possible during a GFC situation. Let’s also say that
the REIT is doing a 1-for-1 rights issue, which means you’re entitled to 1
rights share for every share you hold. Again, this is extreme, but not uncommon
during the GFC, when large REITs like CapitaMall Trust did a 9-for-10 rights
issue, while Starhill did a 1-for-1 rights issue.
Accordingly, this would be the calculation for this hypothetical
example: The newly issued units are issued at $1 per share, and 1 billion new
units are issued. For simplicity of calculations, we assume that the dampened market
outlook means that the over allotment option is not exercised. Based on the
enlarged number of outstanding shares, the theoretical ex rights price (TERP)
would be $1.50 per share. Of course, this is only assuming that the REIT’s
price does not decline after the announcement of the rights issue. Generally,
the REIT prices decline after a rights issue is announced, especially if the
rights issue is dilutive to shareholders. Hence, the TERP may be lower than
$1.50. This would represent a paper loss of 25% for the shareholder who held
the shares at $2, and would be slightly offset if the shareholder subscribes to
the rights issue units at the discounted price of $1. But so long as the TERP
is less than $1.50, the existing shareholder would have incurred a capital
loss, notwithstanding that he or she would have to cough up a significant
amount of cash to subscribe to the rights units.
Rationale for rights issues
Now that we are clear on the effects of a rights issue, let’s
look at some actual examples of rights issues by REITs during the GFC. The overarching
theme for carrying out a rights issue then was 1. To pay down debt; and 2. To build
up cash for opportunities to acquire real estate at distressed prices.
I’ll address the Point 1 first. As we are well aware, REITs are
leveraged vehicles which use a combination of equity and debt to acquire properties.
Currently, the leverage limit for REITs is a 45% gearing ratio. Most REITs have
gearing ratios of around 30 to 40%, which provides them with ample debt
headroom should they require extra credit. In a GFC scenario, real estate
prices would have declined sharply, due to distressed asset sales, falling
rents and reduced occupancies, tenants going bankrupt and so on. This gives
rise to the possibility that the real estate assets held by REITs would decline
as well. In order to maintain the regulatory gearing limit of 45%, REITs may
have to do a rights issue to raise equity capital.
A second scenario for Point 1 would be in the situation when
the REIT has to pay off existing debt. In usual circumstances, REITs would
simply refinance their existing loans with a new loan, and roll over the entire
debt outstanding. However, in a financial crisis, banks may be less aggressive
in lending, and may not be willing to extend as much credit to the REIT. In
this case, the REIT may opt to sell perpetual securities, which might be costly
as the yield would have to be attractive to entice investors during a financial
crisis. Additionally, even though perps are classified as equity, there are
more like debt instruments as they incur interest expenses as well. Hence, given
the circumstances above, the REIT may look to raise equity via a rights issue
or a private placement as a last resort.
As for Point 2, some REIT managers have cited the need to
increase their warchest in anticipation of distressed opportunities that may
arise. This is definitely a more positive outlook than point 1, and
shareholders would have to place a lot of faith in the managers to identify
good opportunities. If the REIT is indeed able to pick up real estate assets at
distressed prices, then in the long run, shareholders still stand to benefit
even though there is some short term pain. Again, this would benefit those who are
able to come up with the cash to subscribe to the rights, to minimise dilution
to their holdings.
Actual Examples during the GFC
Now that we’ve understood the rationale for carrying out rights
issue, let’s look back into history and see real examples of highly dilutive
rights issues during the Global Financial Crisis.
1. CapitaMall Trust (CMT)
CMT undertook a 9-for-10 rights issue in Feb 2009, raising $1.23
billion at a discount of 43% to the closing price of $1.45 per unit. The rights
were priced at $0.82 per unit. The rationale stated was to “Strengthen CMT’s
Balance Sheet and Enhance Financial Flexibility”, reducing aggregate leverage
from 43.2% to 29.1%. The manager also indicated that it would be able
capitalise on opportunities and secure debt on more competitive terms.
The announcement can be found here:
2. CapitaCommercial Trust (CCT)
CCT undertook a 1-for-1 rights issue in May 2009, raising
$828 million at a 44.3% discount to the closing price of $1.06. The rights units
were priced at $0.59 per unit. The rationales stated were to have a “Reduction
of Borrowings consistent with the Manager’s proactive and prudent capital
management strategy” and to “Strengthen CCT’s balance sheet, enhance financial
flexibility and improve credit profile”.
The announcement can be found here:
3. Mapletree Logistics Trust (MLT)
MLT undertook a 3-for-4 rights issue in June 2008 to raise $606
million, at a 21.4% discount to the closing price of $0.98. The rights units
were offered at $0.73. The rationale was to “(i) Strengthen MapletreeLog’s
balance sheet and capital structure; (ii) increase financial resources and
flexibility for future acquisitions to capitalise on growth opportunities in
logistics-related real estate in Asia; and (iii) provide Unitholders with
pro-rata entitlement to Rights Units.”
The announcement can be found here:
Summary
Notwithstanding the possibility of a dilutive rights issue
during a financial crisis, I still like the business model of REITs and am
still looking to invest in them. Quality REITs have delivered strong returns which have
outperformed the STI in recent years, and provide stable income to shareholders
as well. As a general point, I target REITs with strong sponsors, and
established track record, and owning quality properties.
As with every real estate investment, the three most important
things are location, location and location.
I hope this article has been informative with regard to
understanding REITs better. Do note that I am still looking to invest in REITs;
I simply want to prepare for the worst case scenario.
If you're keen to learn more, I have written a follow up article on the factors driving a REIT's valuation here:
http://alpacainvestments.blogspot.com/2020/03/how-do-we-analyse-reits-detailed-look.html
If you're keen to learn more, I have written a follow up article on the factors driving a REIT's valuation here:
http://alpacainvestments.blogspot.com/2020/03/how-do-we-analyse-reits-detailed-look.html
Follow me on Instagram at @AlpacaInvestments
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