REITs - More Leverage or a Secondary Offering?

[adios]

For REITs, do you prefer a secondary keeping the leverage constant or increasing leverage? Companies that don't have special tax status such as REITs are "encouraged" if you will to take on some debt to lower their cost of capital due the tax advantages of debt. Furthermore my understanding is that the optimal capital structure for companies that don't have special tax status is such that the present value of tax shields should equal the present of value of financial distress costs. I'll leave implications of taxable REIT subsidiaries out of this. Well REITs do have special tax status i.e. that earnings are not taxed (at least 90% of taxable earnings aren't anyway). So there is no tax advantage to taking on debt that I know of. So the capital structure for REITs it would seem to me would be to make the optimal use of leverage to maximize earnings. However, I have my doubts if all REITs actually do this. Certainly one way for REITs to increase earnings is to increase leverage. The other way to increase earnings of course is to obtain more investment capital through secondary offerings and leverage that investment capital if you will. So it seems like REITs have a choice in order to increase earnings either increase leverage or to do secondary offerings. You could say they could do both increase leverage and do a secondary. That would simply state that optimal use of leverage was not being used. Does anybody have any thoughts on how to evaluate the optimal use of leverage for REITs and whether or not a secondary is a better course of action than increasing leverage?


I was thinking about making a decision between increased leverage or a secondary and wondered what was the threshold where it would be better to do one of the other. To complete this probably boring post to most I came up with an equation where the earnings per share increase is the same for applying more leverage as doing a secondary and keeping the leverage constant:

NLF = New Leverage factor multiple. Increasing leverage from 4 times to 6 times yields a leverage factor multiple of 1.5 time the current leverage factor or put another way a 50% increase.

PRMBV = Premium to book value factor. If a company is trading at 2 times book value the factor is 2 , if it's trading at 2.5 times BV it's 2.5, etc.

PNFLT = Percentage of the current number of shares being offered. If a company has a 1000 shares of common stock and they offer 250 shares in a secondary PNFLT = .25.

Therefore:

NLF = ( 1 / ( 1+ PNFLT))* ( 1 + PRMBV * PNFLT)

So if a company is trading at premium to book of 3.5 and did a secondary selling 10 percent of the current number of shares outstanding they increase earnings per share by the same amount as by multiply their current leverage factor by 1.23 without doing the secondary or put another way they would have to increase their leverage by 23% to achieve the same EPS increase as doing a secondary by selling 10% more of the current number of shares. If that company's optimal use of leverage would be 50% higher than it currently is, in my mind it would be much better to increase leverage than do the secondary offering.

[GeorgeF]

Doing a secondary means not being obligated to pay a dividend, while debt finance means being obligated to pay interest. I think the key issue is how soon the extra cash can be invested and producing earnings (Funds From Operations, FFO) from any new aquisitions.

I believe at the current time commercial occupancy rates are about 85%, I am not sure that a REIT could get an immediate FFO increase from new investments. Perhaps things are better on residential side.

I read that leases signed during the tech boom are being renewed for much less and worse terms which will not help FFO. A bunch of REITs are being crushed by the Wal*Martians as they leased to Kmart ect.

Your equation might apply to mortgage REITs. I can't say much about them other than I find their annual statements impenetrable and I own some NLY CMM AXM AHR because I got greedy for yield.

"So it seems like REITs have a choice in order to increase earnings either increase leverage or to do secondary offerings. "

It is not clear that you can get immediate FFO from new investments. I am not sure REITs have a choice. The market offers them one or the other or both, the REIT is really not in control.

[adios]

Thanks for the response. A few comments:

"Doing a secondary means not being obligated to pay a dividend, while debt finance means being obligated to pay interest."

Not sure what you mean here. My experience is that all newly issued shares in a secondary offering (I may be using this term too loosely and vaguely) are eligible to receive dividends.

"I believe at the current time commercial occupancy rates are about 85%, I am not sure that a REIT could get an immediate FFO increase from new investments. Perhaps things are better on residential side."

I agree. I didn't make it clear that I didn't mean an immediate increase and that it would and does take time to see the results.

"I read that leases signed during the tech boom are being renewed for much less and worse terms which will not help FFO. A bunch of REITs are being crushed by the Wal*Martians as they leased to Kmart ect."

Definitely there's some challenges shall we say for some.

"Your equation might apply to mortgage REITs. I can't say much about them other than I find their annual statements impenetrable and I own some NLY CMM AXM AHR because I got greedy for yield."

I think it applies to both but probably more so to MREITS. I've looked at the capital structures of quite a few equity REITs and for the most part they're fairly similar. MREITs on the other hand have capital structures that differ by quite a bit. My top 3 MREIT picks are:

NFI
IMH
FBR

I've also had RWT highly recommended to me.

I think AHR could turn out to be a great investment though. Management has screwed the pooch a couple of times but if they get their act together things migh work out there. I don't like the NLY business model which is leveraging the spread between agency MBS and LIBOR rates. NLY has had to cut their divvy due to massive refis last quarter. NLY is basically subject to interest rate risk. My understanding is that the paper they hold now has a fairly small spread. AHR is involved with CMBS (commercial mortgages) and isn't subject to pre-pay risk. Also they did what's called a Collaterialized Debt Obligation and hold paper that will pay a nice yield. The problems that AHR has had is delving into RMBS (residential mortgages) which has hurt their earnings. AXM has a business model very similar to NLY but management has screwed up in the past. AXM is being acquired by AHMH which is not an MREIT now but AHMH is morphing into an MREIT after the acquisition. I think the divvy is supposed to be around $2.00 a share per year for AHMH. So owning AXM is the same as owning AHMH. Don't know much about CMM but I know the consummate expert on CMM. He's got a handle of the Yahoo boards named hhill51. He posts on the TEI and NFI boards among others.

Now into why I like NFI and IMH. These two MREITS are Alt-A lenders or sub prime mortgage lenders. NFI does conforming loans now too. They do mortgage warehousing and after they've issued enough loans they securiterize the loans by doing what's called a Collaterilized Mortgage Obligation which is specific type of Collaterilled Debt Obligation. They issue bonds of different grades with the majority of the bonds rated AAA. They're rated by the credit agencies such as Moody's. I'll explain CMO's in another post as I can see this is getting a little long. Anyway there are residual, higher risk securities that NFI and IMH retain which will come clearer when I explain CMO's in another post. What NFI and IMH are doing is deferring interest rate risk and taking on credit risk and basically capturing the spread between libor rates and subprime MBS rates. Both of these companies are in the sweet spot now due to the huge spread. FBR is an MREIT who is going to start doing CMO's as well with funds received from a recent secondary. FBR also has a broker-dealer business that is a taxable REIT subsidiary. Kind of a long rambling post about MREITs without enough detail probably but I'll post more on CMO's and how they work.

"It is not clear that you can get immediate FFO from new investments. I am not sure REITs have a choice. The market offers them one or the other or both, the REIT is really not in control."

No it won't happen immediately. Most MREITs anyway have a maximum amount of leverage that they state they will use but they all seem to use a different amount. Again I appreciate the response and your insightful commentary. I'll try to make a more coherent post about MREIT business models when I've got some time to make a detailed post which should be soon.

You might want to check out the following site:

NFI Investors Site (http://www.nfi-infor.com)

Very good discussion of the NFI's business model.

[GeorgeF]

"are eligible to receive dividends."

My point is if you are uncertain about when an investment will start to pay off issuing stock is the best since you can cut/cancel the dividend at any time. If you use debt you are going to have to make the payments even if things are not working out.

I think your equation over emphasised taxes.

You might also look at what smart real estate people, like Sam Zell of Equity Office, are doing.

As far a mReits go I know nothing. Sometimes if I have a few bucks I do a stock screen in high yeilds. Sometimes the ball lands in mReits, sometimes on emerging markets, sometimes on penny stocks and sometimes on royalty trusts. Where the ball lands I buy. I try to keep it diversified. Thus far I have not had a large permanent loss, but I know it will happen at some point.