Of rights issue and REITs (Part 1 of 3)

My recent encounters with rights issue exercise

I have went through one rights issue exercise raised by one of my investments, CapitaCommercial Trust in June this year. Before I can barely take a breather from such fund raising exercise for retail investors like me who have participated in the exercise, then comes another potential rights issue raised by another of my investments, MacArthurCook Industrial REIT (MI-REIT). Wow, rights issue has become a fashion trend embraced by many local public listed companies so far this year! I am personally not prejudiced against rights issue though we heard of the dilution effects of rights issue to shareholders.

However, it really gets on my nerves as I have to pore through the terms of a rights issue and it means extra time spent for me. If I don't do so, it also means I may not be able to understand and come to an informed decision whether to subscribe to the rights units of a company. Blindly putting my money into a rights issue just in order to purchase more rights at discounted price to current traded share price may not mean a good bargain. It is akin to blindly buying shares of a company that has dropped in it's share price significantly. What makes one think that he is getting a good bargain and not end up instead inheriting a failing company due to permanent deteroriation of a company's fundamentals? There is always a reason why a company's shares are undervalued. Not all cheap stocks are value stocks. Some cheap stocks may be worthless (no worth) stocks!

I view the recent announcement of one of my investments, MacArthurCook Industrial REIT (MI-REIT) that it has proposed plans for refinancing it's debts due in December 2009 through equity fund raising. It's debts consisted of term loans of S$ 226 million and JPY 1500 million (S$23.7 million). Earlier in the year, MI-REIT has already encountered problems refinancing some of these loans which were due in earlier part of the year, and it has managed to extend the loan settlement date to December this year through negotiations with the various lenders. This has at least given it time to plan for a recapitalisation exercise to deal with these loans. In addition to these loans, MI-REIT also has a contractual obligation to purchase an industrial property in Singapore (1A International Business Park) which it requires around S$90 million to complete the purchase also by December 2009. Looking at the debts profile, MI-REIT has a current gearing of 44.7% (on the high side for a REIT investment).

To deal with these few pressing issues at hand, MI-REIT is holding an EGM this month to seek unitholders' approval to a few matters to deal with these debts refinancing and also acquisition of the International Business Park. There are also other additional matters to seek unitholders' approval including further acquisiton of another 4 more Singapore industrial properties etc.

As the EGM has not been convened, I shall not share my opinion about the terms of the equity raising exercise as I do not wish to influence any unitholder's decision. I believe each retail investor has his own investment objectives and his decision may differ from another investor's decision. Even if investment decisions may differ, it may not necessarily mean one investor's decision is better than another (as each may have his own unique investment objectives affecting his investment decisions, and also unique judgments to the fundamentals and terms of a rights issue from another). Thus, I hold the view that investing is both a science and an art. Quantitive measures of a company are obvious (based on financial statements) while qualitative measures of a company (based on perceptions of the business model and competitive strength) are at best anyone's guess. Also, there is nothing absolute. A company that has excellent economics can also turn sour along the way in future.

Some points for consideration when looking at REITs

Though I do not wish to comment on MI-REIT at this moment, such equity raising exercise (e.g. by rights issue) has got me pondering over my investment in REITs of which I have two in my portfolio (MI-REIT and CapitaCommercial Trust).

REITs are leveraged investments with ongoing risk of not being able to refinance it's loans?

Real estate investment trusts also known as REITs operate on purchasing properties and leasing the properties to tenants, and so receive rental income from it's tenants. There are different types of REITs namely commercial, retail, industrial, healthcare, mortgage, residential, infrastructure, etc. As the names suggest, a commercial REIT owns mainly commercial properties, a retail REIT owns mainly retail properties, etc.

No matter which type of REIT, REITs need to purchase properties to grow it's portfolio of properties. This ensures the growth of a REIT through constant growth in it's portfolio size by purchasing properties, apart from other organic means such as rental income escalation. To purchase properties, REITs have to raise funds through loans or equity. Loans and other means of raising funds (e.g. convertible bonds) carry interests that REITs have to pay for. No lenders or investors will provide funds for free to REITs. There is no free lunch in this world. To get loans, a REIT has to pay interests to the lender over the loan period or distributions to investors for their invested equity. In addition, it must not be forgotten that paying interests does not mean paying debts of the loan. The original loan still remains to be settled upon the expiry date of loan.

The way REITs function is unique. It has to provide at least 90% of it's rental income as distribution to it's unitholders in order to receive income tax rebates by regulation. It is not difficult to see that since most of a REIT's income is distributed to unitholders, what remains after paying off it's interests on loans and other expenses is just a palty sum certainly not enough to pay off even a small fraction of it's loans. Thus, there is also regulation to the amount of gearing a REIT can take. A gearing in the 40 plus % range is certainly towards the high end of gearing for REITs considering that it is impossible for REITs to have enough retained cash earnings to pay off loans. If it were to be a normal company, it can decide to retain more of it's earnings as cash reserves since there is no such mandate to disburse 90% of it's earnings to shareholders.

So, constant refinancing of it's loans is always one of the ongoing concern for REIT to remain viable. It is like an owner of credit cards keep borrowing from one credit card to pay off the credit loan of another card and he keeps doing that again and again rotating among different credit cards to clear credit loans that seem forever difficult to clear unless he stops spending on credit (unless a REIT stops acquiring any more properties). Of course, REITs can choose to raise funds through equity from it's unitholders of which there is no interests requirement to pay. However, there is a limit of equity that can be provided by unitholders. Therefore most REITs adopt raising funds through combination of both equity and loans from lenders (e.g. banks or financial institutions).

So, REITs can be highly leveraged operations with a hidden risk that it's loans may not be able to be refinanced. If such problems arise, a REIT can dispose some of it's properties to clear it's loans. However, the problem with properties is that there may not be a ready buyer all the time. So, gearing of a REIT and it's ability to refinance it's loans remain a going concern not just for the REIT, but also it's unitholders.

I learnt this lesson the hard way about REITs being leveraged investments with hidden risk of not being able to refinance it's loans after encountering equity raising exercises (through rights issues) all from two of my investments (both REITs), which are MI-REIT and CapitaCommercial Trust. So, be prepared as unitholders of REITs for more encounters with rights issues from REITs than other companies in general.

Looking at a REIT's portfolio of properties

Another important consideration after assessing the gearing level and track record of the ability to refinance loans by a REIT, is to look at the portfolio of properties of a REIT. Properties are the backbone of a REIT. I will only discuss REITs that function on rental properties here (e.g. commercial, retail and industrial REITs). Properties that are high income yielders benefit a REIT and if the income yields on all properties of a REIT are higher than market rate, the properties are doing well to generate higher income. To identify such high income yielding properties, one may look at the net property income divided by the initial cost of purchase for the particular property as a %. For example, assuming one bought a house for $300k and rent it out at $2k per month. Assuming other expenses and taxes to be paid on the property is negligible, the  income yield is 8% per annum.

As such, income yield depends on the initial cost of purchase for properties in a REIT. The cheaper the cost of purchase for properties in a REIT, the better the income yield. The income yield also depends largely on the amount of rents a property owner gets on the property. So, the ability to secure higher rents than market rate for it's properties is important for a REIT. The amount of rents that can be secured depends on market demand of tenants to rent similar properties in the market. Rents can also be affected by the exact property in question, it's location, age and quality of it's infrastructure. Rents is usually expressed as rents per square foot. So, one can also compare the rents per square foot for individual properties in a REIT compared to the average rents per square foot in the market for similar properties to get an idea of how much rents a REIT is getting from it's properties compared to market.

Another consideration is occupancy rate for individual properties of a REIT. It is good for all properties in a REIT to have 100% occupancy rate. This means all properties are fully leased out to tenants which makes all properties very productive. Any property in a REIT that has low consistent occupancy rate over years may suggest that such property is not productive for the REIT especially when other similar properties in the market have higher occupancy rate over the same time period. Occupancy rate may depend on many factors such as demand and the qualities of the property in question.

In a nutshell, the higher the income yields and occupancy rates for all properties in a REIT, the better the portfolio of properties of a REIT. When looking at any metrics, it is important to examine them over a good number of years to look for consistent trend of high income yields and occupancy rates.

Type of tenants and rental lease period to expiry

The ability of tenants to pay for rents without delay or default is important. Big name tenants that operate large businesses are generally more stable than small name tenants. I am not stereotyping here. Larger businesses that have longer operating history generally have better consistent cashflows and there maybe lesser chance of delay or default in payment of rents. So, the more big name tenants found in a REIT's profile, the better the stability of rental income.

Also, the ability for tenants to accept rental escalation over the rental lease period means a REIT can secure increasing rents over the rental lease period. The longer the average rental lease period to expiry for a REIT the better it will be because the REIT can likely continue to receive rental income for a longer period (especially when rental escalation is built into the rental lease period). The rental lease expiry profile for various properties in a REIT should preferrably not fall significantly at same future year but should be well spread out over various future years. This ensures no potential risk for rental income to fall significantly over any single year should the REIT failed to renew the expired rental leases or secure new rental leases.

Also, it maybe better not to have an over contribution of rental income from any one single tenant. This is because should the tenant pull out from the rental lease, it will dampen the rental income of a REIT too significantly. Over here, balanced contributions of rental income from many tenants may ensure lesser risk to sharp decline in rental income at any time.

Sometimes, there is security deposit required to be paid by tenants. This ensures the landlord is protected against any premature termination or breach of rental lease agreement.

More discussion on REITs and rights issue in future posts....to be continued

Disussion points:- When looking at investing in REITs, consistently rising distribution income received by unitholders over a long period (see financial statement of REITs for amount of distribution income) is more important than the annualised distribution yield per unit (since distribution yield depends on unit price fluctuations which is everchanging and misleading).

Amount of distributions income paid to unitholders depend largely on income yield of properties in a REIT, the higher the average income yield of properties in a REIT, the potential for more distributions to be provided to unitholders. Managers of REITs that can consistently secure low cost of purchase for properties (lower than market valuations) and also higher rents per square foot than market rate is securing better income yields on it's properties for unitholders.

Check for high consistent occupancy rates (best to have 100% occupancy rates) on all properties of a REIT to look out for ability for REIT to fully lease out all it's properties which makes the properties productive.

Check for consistent track record for a REIT to refinance it's loans on time. Be wary of REITs having high gearing in the 40 plus % range.

Check for any big name tenants in a REIT, rental escalation built into rental lease agreement, security deposits received on rental leases, long average rental lease period to expiry, no large number of rental leases expiries falling over any single year, and preferably no overcontribution to rental income from any single tenant.