by David Fick and Martin Mitsoff
REITs can generally select from four types of capital to fund their operations, which they continually juggle to match capital requirements, financing costs and investment opportunities. The four sources are public common shares, private equity, public preferred shares and debt.
Because every REIT has unique characteristics and investment opportunities, there is no formula that applies in every situation. Each of the capital sources experience market cycles wherein capital availability may be restricted or unlimited, and costs may be prohibitive or reasonable.
Real estate investors routinely throw around the phrase weighted average cost of capital (WACC). Although it is discussed often, many companies underestimate their WACC. The most common mistake is underestimating the true cost of common equity. Generally speaking, the current cost of any capital is the rate of return that the investor expects to receive from the security.
Equity costs come in two forms. First, there is the transaction cost, or discount that the issuer must pay to issue the stock. This is generally around 7 percent for a common share IPO, and about 5 percent for a follow-on common share offering, plus out-of-pocket expenses. Then there is the long-term "cost" measured by the investor's expected internal rate of return. Although we hear many arguments on this, it is logical that the investor's return on a security equals the company's long-term cost of issuing that security. The investor's return is what the company "pays" to issue the security.
Common Equity—An Expensive Game
Issuing equity involves a delicate dance around the built-in tension between investors and company issuers. Equity that's expensive for companies is ultimately costly to investors, no matter how cheap or pricey the shares look to either party when issued. REITs, analysts and investment bankers are often faced with the dilemma that the best time to issue shares is when the company's stock is most expensive. This helps assure both earnings accretion as well as added net asset value for existing shareholders. On the other hand, issuing common stock below net asset value almost always dilutes net asset value, and depending on use of proceeds, may dilute earnings.
Real estate stocks raised $101 billion of new equity in 1,107 common and preferred issuances from 1992 through 1998, including $82.9 billion through 899 common equity IPOs and follow-on offerings. In 1999 and 2000, due to depressed share prices REITs went to the common equity market only 42 times, raising $3.4 billion. For the 12-month period ended August 2000, there were virtually no common equity deals. In fact, more than half of all REITs either exercised or instituted common stock buyback programs during this period.
REIT Preferreds— Equity or Debt?
Preferred securities are shown, for accounting purposes, in the shareholder equity portion of the balance sheet and are thus considered—for legal and for some formal and practical purposes—to be equity. In the same way that a company's liabilities are shown before that company's shareholder equity, preferred shares are shown before common stock, whence preferred shares get their name. Preferred shares come before common shares with respect to the payment of earnings-related distributions (fixed-rate dividends) and to the distribution of assets or associated cash in the event of the liquidation, dissolution or winding up of the REIT.
Like common equity, preferreds are typically issued as perpetual securities, without a known maturity date. Preferred securities are also, like equity, subordinate to a company's debt because preferred shareholders risk the elimination of dividends if the company's financial situation deteriorates sufficiently and have no recourse to the company to reinstate dividends. Unlike common equity, preferred shareholders do not have the right to vote on company matters except in very limited circumstances but are compensated with a higher dividend yield than that available to the common stockholder.
Preferreds have debt-like characteristics, in that the securities either have a fixed rate or a floating rate similar to a debt coupon, but in either case with a known dividend that is typically due on a quarterly basis. Unlike the interest payment on debt, however, the preferred dividend has no tax advantage to the issuer. Because preferred issuers must pay this known dividend regularly, debt and equity covenants often include preferred dividends in the calculation of the fixed charge coverage ratios that routinely impact a company's ratings and cost of additional capital.
Another debt-like feature of many preferred stocks is that they have been evaluated by credit rating agencies for the likelihood of dividend payments or face-value repayment based on the credit quality of the issuer. Furthermore, the yield and pricing characteristics of most preferred securities are more similar to debt than to equity. As it relates to convertible preferreds, analysts and managers will evaluate the financial impacts as if the security has been converted into equity, for one perspective, as well as if it has remained outstanding as a straight preferred security.
Investor Considerations Regarding Preferreds
Common equity is traditionally associated with the highest overall yield (dividend income plus price appreciation) among the four types of capital available to fund a REIT's operations. This highest yield is logical: the most risk is taken by equity holders, and after debt service and other fixed charges have been paid it seems fair that common shareholders should be the beneficiaries of whatever upside can be generated. Preferred shares generally come next in line in yield terms because of their status as equity and their consequent subordination to all the forms of true debt but with no real ability to provide otherwise unlimited upside associated with equity.
Most real estate preferred securities tend to be issued in distinct series with a somewhat limited number of preferred shares being issued at any one time. On average, about 3 million to 4 million shares are offered, most often with a face and redemption value of $25. While that may seem like a significant number, it typically pales in comparison with the tens or even hundreds of millions of issued and outstanding tradable shares that make up the common stock of some real estate companies. Furthermore, because preferred shares are viewed by some investors as fixed income securities with steady income streams, many of these investors have little interest in the secondary trading of their preferreds. These factors and considerations affect the marketability of preferred shares.
Like fixed-rate debt securities, a fixed-rate preferred share's price is likely to fall when interest rates rise because the holder will now receive a contractual yield (the dividend) that is lower than what the revised market will offer. The converse is also true, but the cap on the preferred's price will be driven by the issuer's desire to call or redeem the security.
Preferreds Offer Financial Flexibility
Aside from tax considerations, the main issues for companies evaluating whether to proceed with a preferred share offering include the cost of issuance, the number of shares that can be offered, and the extent to which the offering provides financial flexibility consistent with the projected market acceptance of the new issue. Part of this financial flexibility lies in the right of the issuing company to omit or otherwise defer the fixed charge associated with preferred securities; another part of it lies in the fact that issuing preferred shares does not dilute the existing common shareholders' equity base. In the case of rated preferred share issuance, the issuer must also factor in the cost of credit ratings, but with a view to determining whether this cost is outweighed by a generally greater marketability of the rated preferred share relative to an unrated issue.
Real estate stock issuers should view preferred securities as another source of financial flexibility. Preferred shares provide a complimentary market source for capital, but with a different investor base whose focus is more on stable income than on earnings or payout growth, coupled with a desire for yield greater than that sought by the company's lenders.
David M. Fick, CPA, is managing director of Legg Mason Wood Walker's Equity Research-Real Estate Group. Martin Mitsoff is principal and senior research analyst of Legg Mason Wood Walker's Fixed Income Capital Markets credit research effort.
