Link REIT (00823) announced its first pre-emptive equity raise since its initial public offering (IPO) in 2015. The subscription of new shares will be opened between March 9 and 16. The management team says the proceeds amounting to HK$ 8 -10 billion will be used to repay upcoming debt maturities in 2023 and 2024. The balance is expected to fund future acquisitions.
What is a Rights Issue, and How Does it Work?
A rights issue is a common way for listed companies to raise capital. Unlike capital raised from an initial public offering, rights issues are open only to existing shareholders. Investors who already own shares in the company are given the option to purchase a specific number of shares (usually in a ratio to the number of shares owned) at a discounted price.
In the case of Link REIT, investors who own Link REIT shares as of Feb. 24, 2023, will be eligible to purchase additional shares at a price of HK$ 44.2, a 29.6% discount to the share price as of Feb 9, the day the announcement was made. The issue is executed in a 1-for-5 ratio to raise a total of HK$ 18.5 billion after expenses. This represents a theoretical dilution of 5% to Link’s unit price.
Investors should carefully review the terms of rights issue and consider their holdings before deciding whether or not to participate. For instance, in Hong Kong, odd lots might arise from rights issues. Odd lots arise when the number of shares do not add up to one standard trading lot size. As few buyers are willing to buy them, odd lots tend to be less liquid, and brokers may charge extra trading and handling fees on them.
For Link REIT, a trading lot is 100 shares. In this offering, an ownership of every five shares will be eligible to subscribe to one new share. If an investor owns 700 shares in Link REIT, or seven lots, through the cut-off date, a full subscription will leave the investor with 840 shares (eight lots and 40 odd shares) in total.
Morningstar Analysts Remain Neutral, Trim FVE by 7%
The market reaction to the rights issue announcement was negative, as it also signals that Link REIT may view its share price as overvalued.
Factoring the impact of the rights issue, Xavier Lee, equity analyst at Morningstar, has lowered the fair value estimate for the REIT to HK$ 77 from HK$ 83. Lee calls the decision to raise capital without balance sheet pressure, and without having a deal on the table a ‘bold move’ and says: “That can only be justified if the right investment opportunities arise in the next 12 months.”
Lee believes the action also implies further weakness in the Hong Kong property market down the road and expects asset pricing to soften further. He remains neutral on the action. “Even considering the adverse property market outlook, our view is rather neutral because this can be a decision followed by huge payoffs. If the real estate market in Hong Kong does continue its correction in the next 12 months, the upfront fundraising could prove well-timed preparing Link REIT for assets at good prices.”
He continues: “Raising equity now would eliminate the risk of unfavorable unit pricing when a good deal emerges and better positions Link REIT to capture these acquisition opportunities. This is especially so for distressed opportunities where interested buyers may be required to make snap decisions or risk missing out on the entire transaction.”
Success Will Hinge On Execution
Other than the macro environment, Lee also factors in the company management’s execution, which is critical when it comes to new capital use. “The management has an exceptional track record when it comes to allocating capital, which earns the REIT our exemplary rating for capital allocations.”
He continues: “Historically, Link has invested in asset-enhancement projects to upgrade its properties. In the first decade since its listing, Link has increased its book value per share by a compound annual growth rate of 19%, partly attributable to net property income growth.
The REIT also earns a narrow economic moat rating for its efficient scale. “On the acquisition side, the REIT has historically performed capital recycling by divesting some of its smaller and lower-yielding assets to consolidate its position in dominance in certain growing districts.”
Despite a 7% trim in fair value estimate, Link REIT continues to trade at a significant discount against the fair value estimate assigned by Morningstar.
Equity Issues Becomes Common as Borrowing Rates Stay High
The massive government stimulus program during the early stages of the pandemic, and the supply chain disruptions from factory shutdowns have both played a big part in driving global inflation higher. This lead to seven rate hikes in 2022 in the U.S., even as Federal Reserve chair Jerome Powell signaled the need for even higher interest rates. The current three-month interbank borrowing rate in Hong Kong, or Hibor, remains high at around 3.5%.
Given that the interest rate may climb further, Lee thinks such upfront equity raising may be more widely used by REITs. Lee says: “REIT investors globally should brace for the consequences amid a rising and high interest rate environment, which either causes refinancing cost to rise and eventually erodes dividend or dilutes unitholders as they issue equity rights to raise capital used to repay debt.”
ESR-Logos REIT (J91U), a portfolio of industrial properties and business parks in Singapore, has also recently did a pre-emptive equity raising. “While we believe that management is exercising prudence in the rising rate environment, the 7% dilution to DPU is a pretty steep price to pay for a slight improvement to its gearing. To put that into context, we think that it may take the trust at least another two years to make up for the dilutive effect of this equity fundraising exercise.” The no-moat REIT fair value estimate is lowered to SGD 0.38.
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