Apart from debt financing as discussed in the previous post, REITs can also raise capital through EQUITY financing. The 3 main methods of equity-based financing are:
- Private placement
- Rights issue
- Perpetual securities
One of the main reasons a REIT raise capital through equity is because they have hit or is close to hitting the gearing ratio limit of 45%, a regulatory requirement set out by MAS. Gearing ratio can be understood as “The extent of using debt to finance the operations of assets” (Gearing ratio = Total Debt / Total Assets). so MAS is basically saying you can’t borrow more than 45% of the total assets value in the balance sheet. This is to protect investor as the regulation limits REITs companies from borrowing excessively.
If Debt-based financing methods such as borrowing from the banks is used, it would cause Total Debt to increase which directly pushes up the gearing ratio. If a REIT’s gearing ratio is near 40%+, its close to the borders of the danger zone and usually they would do an equity-financing (raising capital from shareholders) and use it to pay off some debts to reduce their gearing, or continue their operations by acquiring properties without increasing the gearing ratio.
Why do i say gearing ratio around the 40% zone is dangerous? That is because REIT’s property assets are revalued on an annual basis. In times of economic downturns, their asset would be revalued LOWER and Total Assets would Decrease. As a result, looking at the formula of gearing ratio, assuming debt remains constant but the denominator decreases, its gearing would increase nevertheless. If it hits the 45% gearing limit, the REIT manager might be forced to sell-off their properties at depressed prices in order to repay their debt obligations.
Equity financing is usually dreaded or frowned upon by existing shareholders due to SHARE DILUTION. As the number of units issued increases, the same pool of distribution income now gets distributed to more people (similar to how a cake is shared by more people, individually each of gets a smaller slice). UNLESS, the management can make use of capital raised through equity to generate higher Distribution Per Unit (DPU) for unitholders. This term is known as “yield-accretive acquisition” (similar to inviting more people into the kitchen, they contribute by baking a bigger cake, and individually each of us gets a bigger slice).
1. Private Placement:
Private placement ISSUES/CREATES new units/shares to a selected group of people usually institutions or high-net-worth individuals at a slight discount relative to the market price. The general public like you and me are excluded from participating in this sort of private placement. An example of a private placement that was done recently this year was Ascendas, a REIT i personally bought.
Ascendas REIT Raised $450 million by issuing 178 million of new units to selected institutions and other investors at a price of between $2.52 to $2.60 It was later settled for $2.54, a discount of approximately 6% from its trading price of $2.70 at that point of time.
Figuring out WHY they did a private placement is also very IMPORTANT. The relevant information can be found under “Use of Proceeds”. What you want to see is a REIT is using a large portion of capital raised to grow/expand its portfolio/assets either through organic or inorganic means. BUT if they raise money just to pay off short-term debts solely, then that might mean they are tight on cash or have poor management in managing cash inflow/outflow. In this example, Ascendas is using the money to expand into new markets, hence its good news!
Ascendas is raising $450 million to partially fund the acquisitions of 26 logistic properties in UK. By the way, it’s Ascendas’s maiden entry into Europe (UK) this year in 2018. Earlier in July this year, they had acquired 12 logistic properties in UK costing $373 million that is fully funded by debt, so actually this is their 2nd round of acquisitions totaling up to a total of 38 logistic properties in UK (Tenants include DHL, Amazon, Aston Martin, Royal Mail, Sainsbury’s Supermarket, 2nd largest chain of supermarkets in the UK.)
Another 25% of the proceeds would fund the development of a build-to-suit facility in Singapore. This is another one of the advantages that Ascendas has over all other industrial, logistic properties. Most of their properties are specifically built to meet the design and needs of the tenant which ensures that they don’t come and go to find the cheapest alternatives available. Lastly, the rest of the proceeds 20% are used to fund debt repayment and cover transaction fees.
And this as we have mentioned, the issuance of new units would cause share dilution and the increase of 178 million of units represents 6.1% of the total units issued. Instead, they phrase it in a nicer way “to improve liquidity of the Units”.
2. Rights Issue
Rights issue is similar to private placement EXCEPT that now instead of issuing new units to institutions and high-net worth individuals, they are issuing new units for sale at a discount to EXISTING shareholders (those who are ALREADY owning units of a particular REIT). Usually it is done based on a Rights to Share Ratio, meaning the more units you own the more you are allowed to buy and the less you own the less you can buy.
In the scenario if you do not have enough money to subscribe for the rights issue, you can also SELL your “entitlement rights” to someone else so that they can buy the units at a discount to market price. But usually, the unit-holders would buy it so as to prevent their shares from being diluted. If it is a solid REIT with strong fundamentals, it can be seen as an opportunity to accumulate more holdings at a discounted price.
HOWEVER, rights issue can have its cons as well as seen in the most recent and infamous news of OUE Commercial REIT. The title of the article is “unabashedly dilutive!” Wow…. let’s take a look at what happened.
In Summary, OUE Commercial wants to acquire the office portion of OUE Downtown along Shenton Way which costs $908 million. I used to come by OUE during lunch hours to buy ice lemon tea at Old Tea Hut during my PwC days. Its method of financing is through a mixture of debt and equity. They wanted to use $361.6 million of debt to fund the acquisition and the remaining $587.5 million through Rights Issue. The Rights to Share ratio is 83-for-100 rights issue and its selling for 45.6 cents, a WHOOPING burger 31% discount from the market price of 66.5 cents. That means for every 100 shares i own, i can buy 83 shares at a discounted price of 45.6 cents.
Rights issue unlike private placement usually offers a HIGHER DISCOUNT because it has to entice all existing unit-holders to subscribe in order to raise that capital of $587.5 million in this OUE case. The consequence of this is that price of OUE commercial REIT would drop. By how much? It depends on the discount given. There is this term called Theoretical ex-rights price (TERP) which calculates what will be the share price assuming all newly issued shares are taken up. The formula can be found in the above image.
For example, if there are 500,000 units issued trading at $2 but additional rights issue of 300,000 are sold to existing unit-holders at a discount for $1.50. The total market cap would be (500,000 units x $2) + (300,000 units x $1.50) = $1.45 million but now instead of 500,000 units there are 800,000 units issued in total. Thus, the theoretical price of the unit should be $1.45 million / 800,000 units = $1.81, a decrease from the price of $2 when there are only 500,000 units. That’s basically what TERP means.
The TERP of OUE C-REIT is calculated to be $0.57 (theoretically speaking) from $0.665 at the last trade price. TERP is a theoretical price because market is imperfect. Every individual has a different perception and if there are more sellers than buyers (negative sentiment), prices would eventually be pushed down. Vice versa, if there are more buyers than sellers (positive sentiment), prices would be pushed up. At date of writing, the closing price of OUE Commercial is $0.465, lower than that of TERP.
Not only that, look at the pro forma DPU, DPU Yield and NAV per unit. All of them decreased. That is why this move is unabashedly dilutive! Not only that, there is income support from its sponsor OUE and its gearing stands close to 40%, but that is another topic of discussion that is beyond rights issue and equity financing.
3. Perpetual Securities
Perpetual securities are like perpetual bonds. But unlike bonds as we have discussed in the previous post on debt financing, it has no maturity date! That means the borrower has NO contractual obligation to return the principal back to you at any specified date. This is the reason why perpetual securities falls under shareholder’s equity of the balance sheet instead of liabilities. In return for this risk, perpetual securities compensates by offering a higher interest payment as compared to regular bonds.
The advantage of using perpetual securities is that it does not AFFECT the GEARING RATIO as total debt in liabilities remains untouched. But, outflow of cash payment still occurs and it would still impact the interest expense in the P/L, cashflow statement, interest coverage ratio as well as income available for distribution to unitholders (DPU). That’s why the term ‘Cash is King’. Because even though you can manipulate performance metrics, cash payments can’t be avoided. At any point of time, the issuer can also REDEEM back all perpetuals meaning pay back all the principal to creditors and cancel the perpetual securities, but whether they want to pay back the principal is still under the discretion of the REIT management not us.
In summary, we have covered the different ways that a REIT can raise capital through equity. They are mainly private placement, rights issue and perpetuals. Generally speaking, private placement and rights issue are share dilutive (more people invited to share the same pie) but if it is yield accretive (more people invited to bake a bigger pie and everyone gets a bigger slice) then it’s beneficial for everyone. Perpetual securities is something to be taken note of because the gearing ratio that is presented in management slides EXCLUDES perpetuals. Hence, a REIT’s cost of debt or interest payment might actually be higher than what management wants you to see on the surface.
Equity vs Debt Financing
So… Is debt better or equity? The cost of debt is generally cheaper than cost of equity. The reason is because there is an obligation to pay back interest + principal in debt but in equity, the only assurance you get is dividend payouts. You might not fully redeem back the capital invested hence the dividend yield is higher to compensate for such risk undertaken.
Generally, you would want the REIT manager to use debt financing since cost of borrowing is lower than equity but it comes with its own sets of dangers that are not to be ignored too.
Firstly, macro economic factors such as the current rising interest rate environment should also be considered in deciding the extent of debt to leverage on. Most REITs would have employed hedging strategies such as interest rate swap to hedge a portion of their interest rate payments.
Secondly, there is a regulatory limit and gearing ratio of 45%. REITs with gearing ratio close to ceiling means there is little debt headroom and limited options to increase borrowings and fund acquisitions fore expansion. On top of that, it might be forced to sell properties at a loss to repay debt as debt is a contractual obligation. On the other hand, REITs with a lower gearing ratio and larger debt headroom has higher flexibility in managing its funding during acquisition, paying off debts during economic downturns and lesser risk of defaulting on payments.
Thirdly, if occupancy rate and rental rates decrease can it meet its debt obligations adequately? The best metric to test for this is interest coverage ratio. Cash is King & having sufficient cash to sustain its debt operations is a key fundamental that any business should have.
Lastly, when using debt-financing it is important to be aware of their debt repayment schedule. If a large portion of debt repayments falls during the same year, then there might be a risk of REFINANCING. A prudent risk should have staggered debt maturity that spreads across the years to minimize refinancing risk.
Credits to Tam Ging Wien for sharing his insightful knowledge in REITs. You can learn more about REITs from www.ProButterfly.com, www.REITScreener.com and his best seller book REITs to Riches: Everything You Need To Know About Investing Profitably In REITs