SINGAPORE (July 16): Share buybacks are quite common and part and parcel of capital management. If a company has excess capital, it can either pay it out as dividend or repurchase its own shares, or invest in a business or asset that can give shareholders a higher return.
The reason why companies undertake share buybacks is best summed up in a letter to Berkshire Hathaway’s shareholders dated Feb 25, 2012 by Warren Buffett, the company’s largest shareholder and chairman. He said Berkshire Hathaway had bought US$67 million of its own stock in 2011 before the price advanced beyond “our limit”.
“Charlie [Munger] and I favour repurchases when two conditions are met: first, a company has ample funds to take care of the operational and liquidity needs of its business; second, its stock is selling at a material discount to the company’s intrinsic business value, conservatively calculated,” Buffett had written. He acknowledged that he has no way to pinpoint intrinsic value, and indicates that book value per share is a reasonable proxy for it.
At any rate, Berkshire Hathaway had an upper limit on price at 110% of book value for the share buybacks. “It doesn’t suffice to say that repurchases are being made to offset the dilution from stock issuances or simply because a company has excess cash. Continuing shareholders are hurt unless shares are purchased below intrinsic value. The first law of capital allocation — whether the money is slated for acquisitions or share repurchases — is that what is smart at one price is dumb at another,” Buffett says in his letter to shareholders.
Sometimes, companies may buy back shares to support their share prices. Shareholders clearly benefit from this support, but so do company executives, who may desire to have the value of their stock options enhanced. This reasoning may not hold water for real estate investment trusts, as all the S-REITs are externally managed. Hence, the managers of the CapitaLand REITs work for CapitaLand, although they must prioritise unitholders’ interests above their own.
Overseas REITs have obtained unit buyback mandates and have used them. Over the past two decades or so, the three largest REIT markets — the US, Australia and Japan — have seen some of their REITs undertake repurchases of their units. Hong Kong REITs have also bought back their units since 2008. Japan’s first unit buybacks were made last year by Japan Retail Fund Investment Corp, Global One Real Estate Investment Corp and Invesco Office J-REIT.
Why would REITs repurchase their own units?
Very few S-REITs have a mandate to repurchase their own units. This is because REITs here have a weak capital structure with limited cash holdings. Since they are required to pay out 90% of their distributable income in order to qualify for tax transparency, REITs do not have retained earnings.
Without retained earnings, REITs have to lean on their unitholders for cash if they need to buy a building or carry out asset enhancement initiatives (AEIs). Unitholders are usually keen to know whether the acquisition is accretive, and often, they are called upon to help fund the acquisition.
REITs undertake AEIs to refresh, update or modernise their properties and this also requires funding. CapitaLand Mall Trust, for instance, carries out AEIs on a regular basis. As a retail mall owner, CMT has to introduce new retail concepts, align tenant mix with current trends and enhance shoppers’ experience. It has gone further by using technology for marketing and promotional events. CMT also owns around 14% of CapitaLand Retail China Trust, and may retain its distributions from this investment for AEIs. Returns on investment from AEIs are usually accretive.
If local REITs carry out buybacks, they will not be paying dividends. Since unitholders buy REITs for their dividend-paying ability, ideally REITs should not repurchase their own units in lieu of paying dividends.
According to some analysts, REITs may have asked for a unit buyback mandate to counter the impact of rising interest rates. As part of the market cycle, REITs’ unit prices may fall to counter the effect of rising risk-free rates in order to maintain a yield spread. In this event, managers may decide to buy back units to stabilise prices, analysts suggest. Also, analysts reckon that this could be a way for managers and sponsors to gain greater control of the REIT. This is especially so where the manager and sponsor have relatively tenuous stakes.
Companies buy back shares when they expect the investment returns on their own stock to be greater than the returns on any alternative investment or business. If REITs cannot find accretive acquisitions, or at times when capitalisation rates are compressed, unit buybacks may make sense. With capitalisation rates compressing for some asset classes such as office, REITs may suffer from lack of acquisition opportunities. If REITs are trading below their net asset values (NAVs) and at relatively high yields, it may make sense to acquire their own units as it would be difficult to make an accretive acquisition under those circumstances.
DPU growth
In the case of companies, share buybacks result in either a cancellation of shares, or in the shares being transferred to treasury shares. REITs do not hold treasury units, so the units that are bought back are likely to be cancelled. This would result in DPU growth, which is what some REIT investors look for.
On April 19, CMT announced that it received overwhelming approval for the renewal of its unit buyback mandate, with 99.96% of unitholders voting in favour. The mandate authorises the manager to repurchase units not exceeding the 1.5% limit of the total number of issued units as at the date of the annual general meeting (AGM).
According to CMT, the rationale for seeking the unit buyback mandate is that it is a flexible and cost-effective capital management tool to enhance for unitholders return on equity and/or NAV per unit; when exercised at appropriate times, the buyback would help mitigate short-term market volatility, offset the effects of short-term speculative trading of the units and bolster market confidence in the units.
Of course, with this mandate, the manager has to be cognisant of the competing uses of cash — such as AEI — and the REIT’s free float. CMT’s free float is 63.83%, and the liquidity of the REIT is unlikely to be affected.
At their most recent AGMs, held earlier this year, Suntec REIT and Fortune REIT unitholders approved a resolution for a unit buyback mandate. Suntec REIT’s unit buyback mandate allows its manager to acquire a maximum of 2.5% of the total number of issued units as at March 24. Suntec REIT’s manager has also stipulated a maximum price of 105% of the average closing price in the case of buying from the market and a maximum of 10% above the average closing price in the case of an off-market repurchase. Some 18.59% of unitholders voted against this resolution, but it was overwhelmingly carried, with 81.41% voting for the buyback mandate.
What is more interesting was the voting in an unrelated resolution, Ordinary Resolution 3, to endorse the appointment of Chew Gek Khim as director. Chew is chairman of Suntec REIT’s manager. Companies controlled by her hold 21% of ARA Asset Management. Together, the companies controlled by her and ARA Asset Management hold around 19% of Suntec REIT. Yet, some 40.98% of unitholders voted against Resolution 3, although it was carried with 59.02% of the votes.
Office REITs could utilise mandate
JP Morgan believes unit buybacks could be beneficial for office REITs, as their assets have the lowest capitalisation rates and are usually the most immobile. “From a financial standpoint, we think it makes most sense for the office S-REITs to buy back shares, given that they are the only sector S-REITs which trade at a discount to latest book values. On average, office S-REITs trade at [a] P/B of 0.84 times, compared to industrial (1.23 times), retail (1.18 times ) and hospitality (1.02 times). As S-REITs seldom trade their physical assets, we think unit buybacks would help to unlock value, particularly given that office S-REITs own 53% of Grade-A office stock, which is rarely available,” the JP Morgan report says.
So far, none of the S-REITs have undertaken unit buybacks. However, the first mandate was only granted in FY2011, and the REIT cycle has been fairly benign. In 2008 and 2009, S-REITs were volatile, and their yield spreads rose sharply towards the 8% to 10% range, which is far above the 4% range they usually trade at. If S-REITs turn more volatile, some of them now have a tool to stabilise their unit prices.
