Regulated Investment Companies or RICs are a type of company that has become increasingly popular.
Companies that elect to be RICs are considered "pass-through" organizations by the IRS, meaning that they generally do not pay taxes at the corporate level. Instead, the majority of their cash flow is passed through directly to investors. Among the numerous regulations that go along with the designation, are requirements to distribute over 90% of their taxable income.
This means that RICs generally have higher distributions than c-corporations and that makes them very attractive for investors seeking an income focused investment style. A recent change in tax laws allows most RIC dividends to qualify for the "Qualified Income Business Deduction", which makes them even more attractive.
Many investors might not recognize "RICs", but are familiar with the specific types. Real Estate Investment Trusts (REITs), mortgage REITs (mREITs), and Business Development Companies (BDCs) are all examples of RICs.
RICs are legally obligated to distribute a large portion of their cash flow, and since they are attractive to income investors, most actually distribute more than they are legally obligated to. The result is that most RICs do not have significant retained earnings that can be reinvested into future growth.
Expansion is done through a combination of raising equity and issuing debt. Today, we will focus on the equity side of the equation. Issuing equity can often mean that the company is growing, which can be very beneficial for investors, but it can also dilute the per share results putting the dividend and the share price at risk.
Being able to identify when issuing equity is beneficial and when it is risky is a key part of being able to pick the best opportunities and avoid falling knives.
How Equity Is Raised
There are numerous methods that can be used to raise equity
- Secondary Offering: This is where the company announces that they are issuing a number of new shares. Sometimes the shares are sold in bulk to brokers who turn around and resell them into the market. They could also be sold in a private transaction to a single investor, or used to convert preferred equity and/or debt.
- At-The-Market (ATM): The company will make a generic filing announcing they will issue up to a certain number of shares, that number is usually far more than the company would ever actually issue. Then from time to time, the company will contact the broker and tell them to issue X shares, which are then sold into the open market.
- OP Units: Many REITs are structured as an "UPREIT", this is a structure where the properties are owned by an "operating partnership" and the public REIT owns a majority stake and is the general partner of the operating partnership. These REITs can offer a stake in the operating partnership as full or partial payment for properties. This can have positive tax benefits for the seller, allowing them to take advantage of 1031 exchange rules and defer capital gains taxes. OP Units have limited voting rights, usually receive the same dividend as common shares, and are usually convertible to common shares at a 1:1 ratio.
For the company, secondary offerings have the benefit of providing a large lump sum of cash all at once, great visibility of the price shares will be sold for and of the amount of cash that will be raised. Secondary offerings will typically be used when there is a specific large need, such as paying off debt, redeeming preferred equity, or a large acquisition. They are also more common for smaller companies that have small average daily trading volumes.
When a company announces a secondary offering, more often than not the share price will drop immediately following the announcement. This is where it is crucial to be able to make a quick determination of whether or not the dilution will be beneficial. The drop could be an excellent opportunity to invest at a discount to recent prices. At HDO, we love to take advantage of the temporary drop to build positions in quality growing investments.
When companies are issuing equity using their ATM, or OP Units, it is often undetectable until long after the fact. Shares are slowly sold into the market over a long period of time, blending in with the regular buying and selling. Exactly how many shares the company is selling is unknown until their next 10-Q or 10-K is released. This means that there is no large price shock.
The company will not be able to raise a large lump sum, and is taking on the risk/reward of whether their stock price is rising or falling. A strong company with a generally rising share price will find that using the ATM can provide a solid stream of capital.
For investors, avoiding the large price shocks might seem like a benefit; however, when a company is using substantial ATM offerings, or a large number or OP Units for acquisitions, it is important to keep an eye on dilution. Investors who look only at the headline numbers could be in for a rude awakening when the full impact of dilution is realized.
A Successful Secondary
The concept of issuing equity is straightforward. If you own 1,000 shares in a company that has 10 million shares outstanding, you own 0.01% of the company. If that company issues an additional 3 million shares, your ownership will decline to 0.007% of the company. Your ownership has been diluted (assuming you do not buy additional shares).
This is not necessarily a bad thing, it amounts to a partial sale of all existing assets and increases the amount of cash the company has. That cash can be used to reduce debt or used to fund future investments. What really matters for investors is whether the new capital increases the total cash flow on a per share basis.
Consider Jernigan Capital (JCAP), one of our favorite up and coming REITs. As a young REIT, JCAP is still in growth mode and is aggressively building up their asset base. On June 11th, 2018, they announced a public offering of 3.5 million shares, which was raised to 4 million shares the following day, plus granted an option to the underwriters to buy an additional 600,000 shares. The offering price was $18.50. So shareholders could expect the total share count to increase over 30%.
JCAP's share price quickly dropped over 5% and continued to decline for the next two weeks as 4.6 million new shares flooded the market.
As it turned out, this was a fantastic buying opportunity for JCAP, as the price started rebounding after a couple of weeks.
Investors who bought the dip after the secondary offering have enjoyed 13.76% return on price, plus an additional $1.40 in dividends for a total return over 20% in 11 months.
Since IPO, JCAP has demonstrated that their share issuances consistently lead to improving per/share metrics.
The reason for this growth is clear, the funds that JCAP raised were used to pay off their revolver for investments that were made earlier in the quarter. The increase in cash flow from those new investments were more than enough to offset the 30% increase in shares.
Source: Jernigan Capital
In the 4 quarters leading up to the share issuance, JCAP's revenues ranged from $2.6 to $5.2 million and their bottom line adjusted earnings ranged from $3.25 to $5.49 million.
In the following 4 quarters, gross revenues nearly doubled to the $9 million range, while adjusted earnings increased to $10-$20 million per quarter. Despite the increase in the number of shares, adjusted earnings per share increased dramatically to $2.95/share from Q2 2018 through Q1 2019. Up from $1.49 the prior period, a 98% increase.
This is clearly a case where dilution worked out well for prior shareholders. JCAP has been meeting their current capital needs issuing shares via their ATM program. If they do issue another secondary in 2019, it will likely be an excellent buying opportunity.
There are several REITs which have been negatively impacted by dilution, but perhaps none have been more of a train wreck than Wheeler REIT (WHLR). WHLR stumbled out of the gate, dropping almost 30% their first year.
WHLR isn't the only REIT to stumble initially, and many make a solid recovery to become great investments. It was 2015 when the bottom really fell out and WHLR has continued their downward trend to this day. When we look at the number of shares outstanding, it is no mystery why 2015 was a pivotal year for WHLR.
Coming into 2015, WHLR's common shares were already struggling. The company was overleveraged and had convertible preferred shares outstanding that had less than favorable terms. WHLR attempted to dig out of their hole by issuing a substantial number of common shares, with the common share count climbing from 7.8 million to 66.1 million in just two quarters.
While WHLR did acquire a lot of properties and increased their gross assets from $130 million at the end of 2014 to almost $400 million at the end of 2016, the per share numbers continued to struggle.
In 2017, with shares trading under $2, WHLR did a 1 for 8 reverse split, meaning every 8 shares an investor owned were converted to just a single share. WHLR continued to dilute shareholders issuing over a million common shares and another 1.3 million preferred shares by 2019.
As we noted above, companies that issue shares using an ATM program or offering OP Units to sellers can have dilution that is not immediately apparent and often not reflected in the share price. STAG Industrial (STAG) is an example of a REIT that has made extensive use of their ATM.
STAG continues to issue shares at an accelerated rate, investing heavily in new assets. STAG investors will often cheer the double-digit year-over-year revenue growth and STAG routinely puts up fantastic headline numbers.
Then dilution takes its toll, and as we can see, while the gross numbers are up substantially, FFO/share has only increased by 27%. STAG is raising a lot of capital to pass along only 5-6% annual FFO/share growth. While not a terrible investment like WHLR, we can see why STAG has underperformed their peers over the last 5 years.
When reviewing earnings reports, investors need to keep in mind the impacts of dilution. Investing large amounts of cash almost always increases revenue and FFO, but the impact on the per/share metrics is usually muted.
A Preferred Perspective
One advantage of preferreds is that they are not negatively impacted by common share dilution.
Externally managed REITs have a bad reputation for diluting common shareholders since the manager's pay is usually based on "assets under management". The manager is incentivized to grow the asset base, and has fewer incentives to worry about the common share price.
This leads to situations like Global Net Lease (GNL) or American Finance Trust (AFIN), where the REIT owns high-quality properties, but we fear that dilution will make the common shares an unprofitable investment.
We can see the impact dilution has had on GNL.
Preferred shares have better alignment with external management since for preferred shares we want a large asset base and common shares cannot receive any dividends until the preferred shares have been paid in full. So when capital is raised from common equity, the preferred shares benefit from the larger asset base or the reduction in debt.
While common share investments in GNL or AFIN are at a high risk of dilution, their preferred shares (GNL.PA) and (AFINP) provide a more stable opportunity. Both companies have high-quality properties, but management with a history of diluting common shares.
Dilution at the preferred equity level is also a risk, a company can issue a new preferred series or sell additional preferred shares of a current series. This recently happened with UMH Properties Series C (UMH.PC).
Like secondary offerings with common shares, the initial announcement will lower the price, and it could be a buying opportunity if the new shares do not negatively impact the safety of the existing preferred equity. In this particular case, I believe this is a buying opportunity and UMH.PC will be trading back above par in the near future.
Dilution is a fact of life when investing in RICs. It is going to be a primary source for raising capital and making more investments for growth. Whether the dilution comes all at once in a secondary offering, or if it is spread out over time through an ATM or OP Unit transactions, investors need to be aware of it.
Investors need to stay focused on the bottom line, per/share metrics. Remember that when a company issues new shares, whatever the new capital is invested into needs to have a return equal to or better than the current FFO/share.
For example, if a REIT is producing annual FFO of $1.00/share and they issue a million new shares at $15/share, they will need to invest the $15 million in a way that produces net FFO of at least $1 million. Anything less than that, and current shareholders will see their FFO/share decline. Preferably, the new funds can produce more than $1 million in FFO, improving cash flow for everyone.
It is often difficult to determine whether or not the new capital will produce enough, but we can use educated guesses. Management will usually indicate what the funds will be used for, we can use historical cap-rates to estimate the return and we can look at a company's history. Companies with a history of dilutive issuances tend to keep their bad habits.
It is important to dig into the financials any time one of your holdings or a company on your watchlist issues a significant number of shares to determine if it is a buying opportunity or a warning sign. For RICs, dilution is often the beginning of more growth, but if done irresponsibly, it could leave shareholders wondering why the growth never trickles to them.
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Disclosure: I am/we are long JCAP, AFINP, GNL.PA, UMH.PC, WHLRP. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.