Earlier this week, I was having a conversation where I was
trying to explain how some REITs are able to consistently make acquisitions and
grow their AUM, while other REITs are not. My view is that the difference is
mainly down to their price to net asset value (P/NAV) ratio which the market
assigns to the REITs. REITs with P/NAV greater than 1 are able to take advantage
of this cheaper cost of equity to make yield and NAV accretive acquisitions,
whereas REITs with P/NAV at or below 1 are unable to do the same – acquisitions
would often not be feasible as this would result in NAV and yield being
dilutive.
I illustrate this with the examples below.
Let’s say we have two REITs, Reit A and Reit B. Both have
similar properties valued at 1 mil, and generate a gross yield of 4%. Interest
costs are 2.5%, and the gearing ratio of both Reits are 40% - meaning that the
capital structure of the reit comprises of 40% debt and 60% equity. Both Reits
have 600,000 shares issued, which gives the Reits a net asset value of $1 per
share each. Up till now, both Reits have exactly the same metrics.
Now, let’s assume that as the units of both Reits are traded
on the market, somehow, Reit A’s units are trading at a P/NAV ratio of 0.9x,
with a dividend yield of 5.56% (assuming 100% payout). Reit B’s units are
trading at a P/NAV of 1.5x, with a dividend yield of 3.33%.
What would then happen if both Reits were to look at making
an acquisition?
When evaluating the proposed acquisition, both Reits would
publish the “pro forma” financial impact of the acquisitions. Here, the capital
structure of both reits remain the same (40% debt 60% equity). The gross property
yield remains the same, because we are purchasing a property which gives the
same yield as the existing property portfolio, and the interest cost remains at
2.5%. The pro forma impact on both Reits would be that the acquisition would be
dilutive Reit A’s NAV and yield. NAV will drop to $0.98, while dividend yield,
based on the theoretical ex-rights price (TERP) would be 5.50%, down from 5.56%.
On the other hand, Reit B would see its NAV rise from $1 to
$1.02, and its dividend yield would increase from 3.33% to 3.44% - both NAV and
yield accretive.
What would be the impact of the proposed rights issue for
both Reits?
It is likely that Reit A’s shareholders would not approve
the deal – nobody likes coughing up more cash, only to see their NAV and
dividends get diluted. In fact, the Reit manager for Reit A might not even propose
the deal to shareholders, given that it is likely to fail. On the other hand Reit
B’s shareholders would likely be glad to throw extra cash at the Reit – given that
the deal is NAV and yield accretive.
What can we understand from these two examples?
Fundamentally speaking, there is no difference between the
two Reits, as well as the property that is to be acquired. The only difference
here is that Reit B is trading at a much higher P/NAV ratio, which allows it to
issue fewer shares to make the same acquisition, hence resulting in it being NAV
and yield accretive. The longer term impact would be more crucial. Reit B can
continue to grow its AUM with more yield accretive acquisitions, and reap
benefits such as lower interest costs on its larger asset base, as well as perceived
“stability” from it being a much larger Reit. The market would also view Reit B
as consistently “growing”, thus may be willing to pay a premium for Reit B.
This results in a positive cycle for Reit B, all of which started from the mere
fact that its P/NAV was higher than Reit A.
What can Reit A do to grow?
This is not the end of the road for Reit A. It can still
grow, but it would require different approaches to grow its AUM. Firstly, Reit
A would probably be more selective in its acquisition targets, looking for properties
that yield above market gross yields (in this case, >4%). Reit A can also
consider other financing options, such as issuing perpetual securities, which
count as equity instead of debt. Lastly, Reit A can also consider taking on a
more aggressive financing structure for the acquisition, for example, using a
60% debt/40% equity mix, and play around with the numbers until the acquisition
can be yield and NAV accretive. However, this would increase the Reit’s overall
gearing ratio.
Conclusion
The conclusion here is that simply having a higher P/NAV
ratio can result in tangible long term benefits for a Reit, if the Reit is able
to take advantage of their “cheap” cost of equity to make acquisitions. In fact,
raising equity when share prices are high is what many companies are doing, for
example, fast growing companies such as Tesla or Sea Ltd have taken advantage
of their high share prices to raise equity. Even meme stocks such as AMC have
done the same.
Of course, there are other factors that influence a Reit’s
ability to grow, such as the sponsor strength, pipeline of properties from the
sponsor, capital recycling etc, but this article mainly serves to explain the impact
of having a high P/NAV on acquisitions and rights issues.
Disclaimer: This article is intended for informational and discussion purposes only, and do not constitute financial advice. When in doubt, please contact a licensed financial adviser.
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