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

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.

'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.

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 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.

'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.

Examining the house that Reits built

Recent property deals rekindle debate over fees, independence, minority protection

Calls for reform in the real estate investment trusts (Reits) market here have taken on fresh urgency, as questions resurface about the possible conflict of interest when Reits acquire assets from their sponsors.

This comes after the Monetary Authority of Singapore (MAS) said last week it may offer more regulatory guidance to the industry and urged boards not to take ‘an overly technical approach’ in following governance rules.

The spotlight has swung sharply on the manager/ trustee model and fee structure that Reits operate under, as well as whether there is enough independence on Reits’ boards.

The murmurs grew louder after the sale of Keppel Land’s 87.5 per cent stake in Ocean Financial Centre to K-Reit Asia for $1.57 billion was approved last month at the shareholders’ meetings, despite criticism from minority unitholders over the price and timing.

Singapore and Hong Kong Reits tend to use the manager/trustee model, which has the Reit manager appointed by the sponsor – and often the controlling shareholder – of the property trust. The directors of the Reit manager are also appointed by the sponsor. Reits are managed by the managers, and managers are paid according to the size of the portfolio they take care of.

An earlier report by CFA Institute had already highlighted that one way to better protect Reit unitholders is to ensure most directors on the boards of Reit managers are independent. It noted that the inter- relatedness between the sponsor and the manager increases the risk that they would act in their own interest, at the expense of minority unitholders.

The bulk of Reits do not have independent directors making up the majority of their board, though this is in line with the practice of most listed firms here.

‘The conflict of interest can be avoided if the sponsor appoints a Reit manager that is not related to the sponsor or its group of companies,’ Lee Kha Loon, head of the Standards and Financial Market Integrity division of CFA Institute for the Asia-Pacific region, told BT in an interview.

The other option is to use a corporation model that has investors voting for the appointment of the directors, including independent directors – a practice that is more common in Australia, he added.

Mak Yuen Teen, associate professor at NUS Business School, called the governance of Reits ‘problematic’, since the board of directors is the board of the Reit manager and owes fiduciary duties to the manager, not the unitholders.

Under recent revisions of the Code of Corporate Governance, a director is not independent if he is or has been directly associated with a substantial shareholder of the company in the current or any of the past three financial years.

Professor Mak noted that K-Reit manager’s chairman Tsui Kai Chong is classified as an independent director, though he has been an independent director of Keppel Land since 2001. Another K-Reit independent director, Lee Ai Ming, is also an independent director of Keppel Land.

At Reits such as CapitaMall Trust, CapitaCommercial Trust and CDL Hospitality Trusts, the chairmen – who have links to the sponsor – are not labelled independent.

BT reader Bobby Jayaraman recently wrote that Reit managers should be paid based on a combination of growth in distribution per unit and market valuation of the Reit.

He argued that current rules are not robust enough to ‘prevent unscrupulous Reits from taking advantage of minority shareholders’. ‘The major culprit is the incentive system for Reits, which does not always align with shareholder interests,’ he added.

Mr Lee noted that in Singapore, the fee structures of S-Reits are skewed towards performance fees paid based on net property income. Of the 22 S-Reits that the CFA Institute reviewed in January, 64 per cent of them used this approach.

‘This excludes interest charges; therefore gearing charges have not been deducted in computing performance fees for the manager,’ said Mr Lee.

‘A more equitable form of compensation would be a combination of factors, based on an index and growth in distribution per unit.’

Also, independent financial letters issued to minority shareholders of both Keppel Land and K-Reit do not express an opinion of future prospects, Mr Lee noted. Analysts have noted the deal came at a time when macroeconomic conditions are turning grim.

In addition, Mr Jayaraman noted that independent valuation reports – done in accordance with MAS rules to safeguard investors’ interests – do not consider potential changes and risks to the commercial property market.

Mr Lee said: ‘If there can be additional information that can help minority shareholders to evaluate the impact of the acquisition, it will be a research report issued by a research house. However, this will likely happen only if there is sufficient institutional ownership.’

An idea to have a tender process for such property transactions has also been mooted. One senior lawyer supported this but cautioned that sponsors could control the timing and know the information better, making it hard for third parties to have the same assessment of the values.

Reits are currently excluded from the annual ranking for the governance and transparency index, which highlights the best and the worst among listed companies in corporate governance standards, noted Prof Mak.

‘They are just a completely different animal.’

• A BT columnist’s piece on Saturday The Reit Myth Busted is interesting, especially amid the K-Reit controversy.

• The CapitamallTrust (CMT) illustration shows a unit holder having to fork out $1549 taking up all of his rights entitlements since the 2002 listing, vs distributions received of $1264, for a net outflow of $285.

• What is however interesting is that total shareholders return since 2002, a far more important metric in our opinion, is 127.2%.

• There is as such no need to consider what if he / she chose not to take up all rights entitlements, by selling their nil-paid rights.

• The weekend piece serves one useful purpose: drawing attention to the need for some tweaking of rules governing the sector, before more damage should be inflicted on the carefully nurtured sector.

• For a start, it is high time the regulators re-looked at how reit managers are compensated, for sure not based on the size of portfolio.

• So have they to re-look at Income Support, which was seen in K-Reit’s latest purchase of Ocean Financial Centre /, and before it (as did Suntec Reit), 1/3 stake of One Raffles Quay, and Marina Bay Financial Centre Towers 1&2 / Marina Bay Mall Link; CapitaCommercial Trust buying One George Street.

• We believe selected S-Reits are attractive, eg Fraser Centrepoint Trust (FCT), Mapletree Commercial Trust (MCT, albeit showing negative 1.8% total return since listing late 2010), Parkway Life. (We also favor City Spring, an infrastructure business trust, probably the worst performer in the sub-sector.).

The Reit myth busted

Whatever Reits pay out in dividends, they will take back a few years later in the form of rights issues

THE high yields of real estate investment trusts (Reits) are tempting. And indeed, they have been touted as a relatively safe and stable instrument to own if one is looking for a steady stream of income. As such, many investors see Reits as a good asset class to have in one's retirement accounts.

But you know what? That Reits are good income-yielding instruments is but a myth. The thing is, whatever they pay out in dividends, they will take back – all and more – a few years later in the form of rights issues.

Here's what I found. Of the 17 Reits which have a listing history of at least four years on the Singapore Exchange, only three have not had any cash calls or secondary equity raising. The remaining 13 have had cash calls, and many had raised cash multiple times. One had a few rounds of private placement of new units which diluted the stake of existing unitholders somewhat.

For many of these Reits, the cash called back far exceeded the cash received. So, the myth of Reits as almost comparable to a fixed income instrument is really busted.

Take CapitaMall Trust (CMT) which was listed in July 2002. Assuming that Ms Retiree bought one lot or 1,000 units at the initial public offering (IPO) for a total sum of $960. For the whole of 2003, she received $57 in dividends. However in that year, CMT also had a one-for-10 rights issue. To subscribe for her entitlement, Ms Retiree would have to cough out $107.

In 2004, she would received $89 for the total number of CMT units she owned. That year, CMT had another rights issue, also one-for-10. The exercise price was higher at $1.62. To subscribe, Ms Retiree would have to fork out $178.

In 2005, CMT again had another fund raising exercise via rights issue. Ms R would pocket $124 in dividends but in that same year, had to return $282 back to the Reit.

In the next three years – 2006 to 2008 – Ms Retiree felt rich and happy. She merrily banked in her quarterly distributions which amounted to $404 for her holdings of CMT. Her one lot, after three rights issues, had grown to 1,331 units.

In the following year, another $175 was distributed. But CMT wasn't going to let Ms R be happy for long. It launched a big one – a 9-for10 rights issue. To fully subscribe for her entitlement, Ms R had to empty her bank account of a whopping $982.

And you know what, the cash call came in March 2009, when the Straits Times Index fell below 1,600 points, and many retirees were dismayed to see their investment portfolios plunge by half or more. Many fret if they would have enough left in the pot to sustain their lifestyle. Having to cough up more money for a Reit was the last thing that they wanted to do!

Negative cash flow

And here's the final tally. Since its IPO until today, a holder of one lot of CMT would have received $1,264 in cash distributions. However, in all, he or she had to return $1,549 back to the Reit so as to subscribe to their entitlement of new issues. That's a net outflow of $284 per lot.

It's the same story with K-Reit Asia, Capitacommercial Trust, Frasers Commercial Trust, Mapletree Logistics, First Reit, Lippo Malls Indo Retail Trust, AIMS AMP CAP and Saizen REIT in that what was taken back from investors was more than what was given out.

K-Reit has been one of the most aggressive fund raising Reits. Had you started with just one lot when it was listed in April 2006, you would have to dish out $8,399 to subscribe to your rights issue. Distributions amounted to $1,110, resulting in a net outflow of $7,289.

For Reits with at least four years of track record, only Fraser Centrepoint, Parkway Life and CapitaRetail China have not had any cash calls.

Instead of a rights issue, Suntec Reit raised funds by issuing new units to some institutional investors at a slight discount. Existing unitholders don't have to cough out additional cash, but they would have their share of earnings diluted somewhat.

Misalignment of interests

Reits are managed by managers, and managers are paid based on the size of the portfolio that they manage. So the incentive is for the managers to continue to raise money and expand the portfolio size. Sometimes this is not done in the best interest of unitholders.

The most recent controversy was over K-Reit's purchase of Ocean Financial Centre (OFC) from its sponsor Keppel Land. K-Reit has launched a 17-for-20 rights issue to pay for the purchase which was deemed by the market to be expensive at a time of uncertain outlook and when office rental is expected to ease.

BT reader Bobby Jayaraman argued that rather than be compensated based on factors such as the value of assets, net property income and acquisition fees, Reit managers should be paid based on a combination of growth in distribution per unit and market valuation of the Reit.

'If Reit managers were paid on the basis of distribution per unit and market valuation growth, would K-Reit have bulldozed its way through the OFC acquisition like they have done?

'The day K-Reit announced the OFC acquisition, its stock price fell close to 10 per cent and has continued sliding. Yet, its Reit manager will take home significantly increased management fees while shareholders would have lost a good chunk of their capital even as they bear significantly more risk in the form of higher leverage and potential property devaluations given the uncertain environment,' he wrote to BT.

Misalignment of interests aside, there are also unitholders who clamour for growth.

But while Reits may not be the perfect income yielding instrument that they are made out to be, they have proven their capacity for capital appreciation. Relative to the capital ploughed in, CapitaMall Trust has rewarded its unitholders with a return of 127 per cent. Most Reits have yielded positive total returns.

Instead of buying Reits for yields, some savvy investors only buy them when they see those with good quality assets trade at sharp discounts to their book value. For example in the first half of 2009, CMT was trading at 50 per cent its book value. Today, it is not as cheap. At $1.755, CMT is now trading at 13 per cent premium to its net asset value of $1.55.

Hence, valuation metrics which apply to a typical asset heavy stock would apply to Reits as well.

MAS weighs in on Reit sector debate

The Monetary Authority of Singapore (MAS) may offer more regulatory guidance to the real estate investment trust (Reit) industry in efforts to boost corporate governance standards, it said yesterday.

MAS did not highlight specific companies but was responding to criticism that current rules governing the Reit sector fail to protect the interests of minority shareholders.

Central to this brewing debate is the $1.57 billion sale of Keppel Land’s entire stake in Ocean Financial Centre to K-Reit Asia – a plan that was criticised by shareholders for both the timing and price. The deal was approved but through a show of hands at the shareholders’ meeting – a voting system that the Singapore Exchange (SGX) is proposing to ban.

Under a show-of-hands system, each person gets a single vote regardless of the number of shares he holds. The alternative of poll voting gives each shareholder voting rights according to the size of his shareholding.

‘The current code on collective investment schemes under MAS, which regulates Reits, is not robust enough to prevent unscrupulous Reits from taking advantage of minority shareholders,’ said reader Bobby Jayaraman in a letter to The Business Times on Nov 16.

‘The major culprit is the incentive system for Reits, which does not always align with shareholder interests,’ he added.

Rather that be compensated based on factors such as the value of assets, net property income and acquisition fees, Reit managers should be paid based on a combination of growth in distribution per unit and market valuation of the Reit, said Mr Jayaraman.

In response, MAS director of communications Angelina Fernandez said in a letter: ‘MAS will consider issuing further guidance to the industry as part of our ongoing effort to enhance corporate governance in Reits and other listed entities.’

The regulator reminded companies and boards to uphold high corporate governance standards. ‘Corporate governance rules and guidelines cannot envisage all possible circumstances,’ Ms Fernandez said.

‘When observing such rules and guidelines, companies and their boards must always bear in mind the interests of shareholders or unitholders; and not take an overly technical approach,’ she added.

MAS highlighted current rules that are in place to safeguard investor interest when it comes to interested party transactions. For example, transactions that represent at least 5 per cent of the Reit’s net asset value are subject to voting by independent unitholders, and two independent valuations have to be obtained – one for the Reit manager, and another for the sponsor.

Limits are also set on the sale and purchase prices, and acquisition fees paid to the manager are in the form of units that can be sold only after a year.