Taxes have an enormous impact on investors' long-term results. However, nominal tax rates are often unhelpful in understanding the real tax implications of transactions. For example, Warren Buffett's famously self-disclosed 17.7% tax rate counterintuitively indicates his income bears a higher tax rate than his secretary's. The tax impact of dividends is especially worth considering when the company declaring them is regulated as a REIT and subject to taxation at rates that do not depend on the "qualified dividend" rate cap of 15%.
American Capital Ltd. (ACAS) is the external manager of two publicly-traded mREITs. American Capital Agency Corp. (AGNC) was launched in 2008 and invests exclusively in agency-backed mortgage investments. American Capital Mortgage Investment (MTGE) was launched in August of 2011 and is permitted to invest in mortgage products without guarantees by an agency of the U.S. government. Both funds pay a dividend of approximately 16%, and each has grown not only through reinvestment of income but through the issuance of additional common shares at prices at or above net asset value (and in the case of American Capital Agency, the issuance of a preferred).
A Real Estate Investment Trust ("REIT") is able to avoid paying income taxes on income paid to shareholders as dividends if it distributes at least 90% of its taxable income to shareholders. Wouldn't it be grand if REITs could reinvest that last 10% tax-free? Alas, it's not that easy. Although there is no penalty on retaining SEC-reportable GAAP "earnings" that are not taxable income, taxable income retained by a REIT is subject to taxation in the hands of the REIT. Given the potential application of a 35% tax rate, why would an investor want income to be retained by a REIT? Is growing NAV by retaining earnings tax-inefficient?
The Effect of Post-Earning Issuance
The secret is that a REIT's dividend obligation is not a per-share obligation but an obligation of the entity. Suppose that in a certain period, an mREIT having a $10 NAV and 10 million shares earns $0.10 of ordinary taxable income ($1,000,000 of ordinary income the entity must distribute to avoid taxes). In the name of tax efficiency, the mREIT anticipates paying this ordinary income to shareholders and therefore (correctly) makes no provision on its books for an accumulated tax liability. Before declaring a further dividend, therefore, the mREIT momentarily has a NAV of $10.10 ($101m over 10m shares). To avoid entity-level taxation, one would expect the period's ordinary income to require a $0.10 dividend, fully taxable to recipients as ordinary income, leaving the entity to a NAV of $10.00.
Now imagine that the mREIT instead of immediately declaring a dividend issues another 10 million shares for $10.10. The net assets per share remain $10.10 after the transaction. The taxable income the REIT must distribute to avoid entity-level taxation remains $1,000,000. The only difference is that share count has doubled to 20 million. What effect does this have?
To distribute the required $1m, the required dividend is $0.05 per share for each of the 20 million shares, leaving a NAV of $10.05. The extra nickel of NAV isn't taxed - not to the entity, and not to any shareholder.
Indefinite Partial Deferral of Income Possible in mREITs
The issuance of 10 million shares at $10.10 didn't change NAV, but it increased the fraction of equity in each share and reduced the undistributed taxable income per share. From the perspective of shareholders from before the $10.10 issuance, they have traded $0.10 of immediately taxable ordinary income for a combination of $0.05 of ordinary income payable now plus $0.05 of NAV increase that won't be taxed unless and until the shareholder disposes of the shares (and which will be subject to taxation at capital gains rates if and when any tax is applied). The shareholder still gets "$0.10", but the deferred $0.05 of NAV is arguably much more valuable than the $0.05 of immediately-taxable ordinary income, particularly considering that the investor was not obliged to allocate scarce resources in a tax-advantaged account to obtain this indefinite deferral. Moreover, the deferral is subject to no penalties in the event the investor chooses to access the capital prior to retirement age.
Under some circumstances, two nickels may be worth more than a dime.
Deferral: Fact or Fiction?
A look at the American Capital Agency Corp. NAV per share graph shows that while it was paying a hefty double-digit dividend over its life it was also adding over $10 per share in equity from the $17.50 it posted in the summer of 2008:
This NAV increase amounts to $10.21 - over 53% - a point reached when NAV apparently plateaued in the middle of 2011. To achieve this result in three years requires nearly 17% in compounded annual returns. This is atop the substantial dividends the company was paying over the period, frequently exceeding 20% of NAV. Sometimes, it paid yields in excess of 20% of share price:
When rate spreads were in the range of 3% and leverage was 8.5x, that dividend wasn't hard to pay from pretax dollars. Since the company was frequently issuing new shares at or above NAV (which can generate its own NAV increases), the company was able to divide the taxable earnings across more shares and thus enable in-effect tax-free reinvestment to shareholders who held through successive issuances. Take the last quarter of 2011, for example.
At the end of 2011, American Capital Agency disclosed a book value of $27.71 and an undistributed taxable income of $0.80 per share, following a fourth quarter in which the company earned $1.61 per share. Page 3 of the 4Q2011 highlights is an outstanding guide to the effect of issuance over the quarter. The $0.80 in undistributed taxable income per share is a function of company's total undistributed taxable income (which grew from $156,000,000 at the end of 3Q2011 to $180,000,000 at the end of 4Q2011) and the company's growing outstanding share count - the growth of which decreased undistributed income per share by $0.05 from $0.85 to $0.80 over 4Q2011. The company thus grows undistributed taxable income while reducing the undistributed taxable income on which each share will ultimately be taxed by the federal government. Investors over the quarter didn't just get an immediately-taxable double-digit dividend, but indefinite deferral of additional income that was silently replaced with nontaxable equity contributions of subsequent investors.
At present, American Capital Agency has so many shares outstanding that changing the denominator substantially will require an enormous number of new shares. Moreover, management must obtain authorization to issue more shares, as the existing authorization hasn't enough shares left in it to support an issuance of common that is the same size as the last issuance. These are not insurmountable barriers: the company's manager American Capital Ltd. has a history of orchestrating 10-figure equity issuances (as recently as last month) for American Capital Agency, and the success enjoyed by American Capital Agency shareholders in the wake of multiple accretive issuances is likely to dispose them favorably to authorizing actions favored by the manager and recommended by the Board. Moreover, the new preferred issue enables American Capital Ltd. to earn more for American Capital Agency at the company's regular rates or return than it is obliged to pay the holders of the new 8% preferred. This difference can be reinvested for the benefit of the common shareholders - and as more non-dilutive equity is issued, more of that reinvestment will turn into perpetually deferred income.
American Capital Ltd. is, of course, also the manager of American Capital Mortgage Investment . Its 4Q2011 presentation is also instructive. At the end of 2011, American Capital Mortgage's debt:equity ratio was 8:1 and it enjoyed net spread income of 2.38%, for a gross profit exceeding 20% of NAV. While the company earned $1.07 per share in taxable income over the fourth quarter, it declared $0.80 in dividends and grew undistributed taxable income 27¢ from $(0.03) to $0.24. Adding $0.27 to $0.80, one discovers that there is no hidden deferral over 4Q2011 - a quarter in which there was no issuance of shares. However, in 1Q2012, American Capital Mortgage Investment more than doubled it share count. The current 90¢ dividend could probably be raised on the basis of the company's return on NAV: $0.90 amounts to about 17% of the company's year-end NAV of $20.87. However, the tax-deferring effect of post-earnings issuance may cause American Capital Ltd. - a major shareholder - to keep the dividend "safely" below actual earnings per share in order to enjoy not only a more stable dividend but indefinite tax deferral in a major investment. Since American Capital Mortgage Investment's net interest spread is higher than AGNC's, and its share count is lower, it has greater potential to benefit from the hidden deferral enabled by post-earnings issuance.
Identifying tax-efficient investments can help investors magnify returns over time without undertaking risks one might otherwise expect to assume in pursuit of similar after-tax returns in a less tax-efficient investment. Tax characteristics can also help explain the difference between returns that are impressive but sustainable, and returns that raise alarm. Both American Capital Mortgage Investment and American Capital Agency have issued shares at non-dilutive prices under circumstances that reduce the tax burdens of shareholders who held over the period of the issuance, and each can be expected to engage in similar transactions in the future. American Capital Mortgage Investment's smaller size and higher net spread make it a likelier candidate to benefit from the deferral-effect enabled by non-dilutive secondary offerings. Every time undistributed taxable income per share drops while undistributed taxable income for the company does not, shareholders will enjoy effective deferral of income taxes until disposition of the investment.