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The pros and cons of rights issues in Reits

From our research, investors who opted not to participate in the rights issues have come out ahead

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I RECEIVED quite a number of e-mail and text messages in response to my article last week which talked about how it is a myth to expect real estate investment trusts (Reits) to be a steady income yielding instruments. The fact is, Reit managers are always on the lookout to expand their portfolio under management. The bigger their portfolio, the more transactions they carry out, the higher their fees. But there is no denying that some managers do have the contacts and expertise to bag the right acquisitions at the right price, hence benefiting unitholders who chose to pump in more money to participate in the continued expansion of the Reits. One of the most common questions that I received in response to last week's article was: What would the return be if I don't subscribe to the rights?

Does it pay to subscribe?

I decided to tabulate all the cash flows of the Reits with at least four years' track record. For one set of cash flows, I assumed that the investor subscribed to his or her entitlement of rights shares. For the other set, the assumption was that the investor didn't subscribe and didn't sell the rights shares in the market as well. Some rights shares have market value, and some, like the recent K-Reit rights have zero market value. That's because the exercise price for the rights is almost equivalent to the market price of K-Reit, hence there is no privilege to owning the rights. Based on the cash flow stream, I then calculated the internal rate of return (IRR) for each strategy. This is the definition of IRR from Wikipedia: 'The IRR on an investment or project is the 'annualised effective compounded return rate' or 'rate of return' that makes the net present value of costs (negative cash flows) of the investment equal to the net present value of the benefits (positive cash flows) of the investment.

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'Internal rates of return are commonly used to evaluate the desirability of investments or projects. The higher a project's internal rate of return, the more desirable it is to undertake the project. Assuming all projects require the same amount of upfront investment, the project with the highest IRR would be considered the best and undertaken first. 'A firm (or individual) should, in theory, undertake all projects or investments available with IRRs that exceed the cost of capital. Investment, however, may be limited by availability of funds to the firm and/or by the firm's capacity or ability to manage numerous projects.' So how did the Reits do when we take into consideration additional capital injections? And would investors be severely punished for not taking up their rights entitlement? Out of the 18 Reits, 13 chalked up positive IRRs, but some just barely. Seven managed to reward investors with IRRs of more than 10 per cent. Ascott Residence and Ascendas Reit are among the top performers. And curiously, it is investors who opted not to participate in the rights issues who have come out ahead. And if these investors managed to sell their rights entitlement in the market, their return would have been even higher. By not participating in the rights, an investor in Ascott since its IPO days would have registered a 17.2 per cent IRR. For those who forked out additional cash to take up their rights issues, their IRR worked out to 13.4 per cent. I reckoned that this happened because the appreciation of Ascott's share price has not been as steep since its latest round of cash call last year. And also, very importantly, Ascott's rights issues weren't that dilutive in that the exercise price of its rights was only a slight discount to the then market price of its units. This was similar for Ascendas Reit, although the difference wasn't that great. The cash calls of Ascendas Reit have been relatively small.

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But for most of the other Reits, it was a clear disadvantage if existing unitholders gave up on their entitlement to rights issues which were offered at a heavily discounted price to their then market price. If unitholders don't have the money to meet the cash calls, they can try to sell their rights shares in the market. This is of course conditional upon the fact that the market is relatively happy with the proposed acquisition of the Reit, and that the market price of the Reit remained higher than the rights exercise price. If the acquisition is seen as bad for the Reit, perhaps because the price agreed upon for the particular acquisition is too high for the benefits that it would accrue, then the market would sell the Reit causing its price to fall. Sometimes the decline is so big that the market price of the Reit approaches the rights exercise price, or even lower. In that case, the rights issue would most likely not be able to raise its intended amount of money. So the thing is, as long as the interest of unitholders and the managers are not aligned, there will always be the very real risk that a Reit will enter into transactions which are less than favourable to the minority unitholders. For example, the sponsor may try to offload not so attractive assets to the Reit.

Other cash generating stocks

How about some of the cash generating businesses out there? How do they stack up against the Reits? Well, not too badly it seems. I tallied up the cash flows of StarHub, SingTel and SPH since 2002. StarHub has just been a mean cash-generating machine since its IPO in 2005. An investor who invested at its IPO would have chalked up an IRR of 30 per cent, beating all the Reits out there, and with no risk of any cash calls to beat. SingTel has not fared too badly with an IRR of 13 per cent since 2002. Despite its constant cash distribution, SPH - which is perceived to lack

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growth and hence chalked up little capital appreciation - has managed an IRR of only 5 per cent since 2002.

Advice from fund manager

For investors who are keen on Reits and other business trusts, here is some advice from a fund manager friend on how to go about picking the right ones. 'Industrial properties usually have 30-year leases, or 30+30. Assuming a 30-year lease, it means it depreciates at a rate of 3.3 per cent pa, versus one per cent pa for a 99-year lease for a retail or commercial building. So the yields for industrial Reits have to be up to 2.3 per cent pa higher than retail or commercial Reits. Usually however, it is less due to the time discount factor. 'Ships are usually scrapped after about 25-30 years. I think typically they are depreciated over 15 years or so. Even if ships are scrapped after 30 years, shipping trusts should command a higher yield than industrial Reits because the ship lessee can 'disappear' with the ship, but not the industrial building tenant. 'Hospital Reits like Parkway Reit is a rare breed as its revenue is based on a consumer price index formula. You can think of it as having zero vacancy rate (but the main issue is counterparty risk). So given the same counterparty risk, it should trade at a lower yield than retail Reits, which should trade at lower yields than commercial Reits, given the same tenure (because it's easier to lease out retail units). 'In turn, commercial Reits should trade at lower yields to industrial, which should trade at lower yields to hospitality (as vacancy rates of hotels/service apartments can be quite high during recessions). 'Hospitality Reits should trade at lower yields to shipping.

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'But note that industrial can trade at higher yields to hospitality as the former has shorter tenures. 'As for Hutchison Port Holding Trust and SP Ausnet, I would value them as companies rather than Reits, as usually the rates they charge are prone to fluctuations - unlike Reits and shipping trusts which usually lock customers up for years. 'SP Ausnet is not structured even as a business trust and pays its dividends out of net profit rather than cash profit. I think every year, it pays out the same dividend per share even though its earnings fluctuate. I would value it the same way I value SingPost.' So here you have it. I hope that we all are now a little clearer about the nuances of the various instruments out there.