As the Commonwealth REIT (NYSE:EQC) drama unfolds, the notion of "dilution" has been weighing on the minds of investors, as a coalition of stockholders sue the REIT over a secondary share offering they claim would overly dilute stockholders' value.
Hot on the heels of this kerfuffle comes the announcement that American Capital Agency (NASDAQ:AGNC) is offering a secondary stock issuance of 50 million shares, as well as 7.5 million that underwriters may opt to purchase. With concerns over dilution front and center at the moment, it's no wondersome are wary about whether this new issuance of stock is a good idea.
After taking a look at this issue, however, I've come to the conclusion that investors needn't fear any injury from American Capital Agency's stock offering. In fact, history shows that this could actually be a boon to investors' portfolios.
Key differences between the two REITs
While both companies are offering secondaries, the situations are like night and day. The biggest difference is the actual dilution factor. For Commonwealth, a stock issuance of 30 million shares, plus an additional 4.5 million set aside as an underwriters' option represents a huge dilution factor when you consider that only 90 million shares were outstanding. American Capital Agency, on the other hand, has more than 340 million outstanding shares, so the offering won't shock the system like the Commonwealth secondary would.
Another issue is the destination of the funds raised. Commonwealth plans to pay down debt, and the activist shareholders are obviously upset with the way the company is being run, as evidenced by a presentation filed with the Securities and Exchange Commission, titled, "Restoring the Health to Commonwealth."
American Capital Agency, however, plans to purchase some nice, juicy agency-backed mortgage-backed securities, which CIO Gary Kain has very recently noted is on the mREIT's shopping list now that they have stabilized in price.
Secondary offerings are the nature of the REIT beast
As fellow Fool Dan Caplinger has explained, secondary offerings are fairly common with mREITs, and are not necessarily a bad thing. As devotees of the sector well know, REITs are required by law to pay out 90% of their profits to their shareholders, lest they lose that sweet tax position they currently enjoy.
This state of affairs doesn't allow for a rainy-day fund into which mREITs can sock away funds with which to make purchases of more MBSes, and that's where the secondaries come in. Since these new shares are offered at a price that is a smidge lower than the current price, however, the stock price usually declines.
How long will the price dip persist? It varies, but, by looking back in time, we can see that it isn't onerous.
Shares rebound, and then some
For 2012, for instance, American Capital Agency announced a public offering of 62 million shares, with an additional 9.15 million for underwriters' options, on March 7. On that date, the closing price was $30.27, which promptly fell to $29.35 the very next day, on unusually heavy trading. By April 18, however, the stock price had rebounded to $30.52, and it was pretty much uphill from there.
Again, another offering on July 17 for 32 million shares with a 4.8 million underwriters' option saw shares close on the day at $35.29, which fell to $33.92 on July 18, having seen heavy trading that day. The rebound began almost immediately after that, though, and the closing price of $35.38 was attained on July 27.
Similarly, Annaly Capital Management's (NYSE:NLY) most recent public offering of 120 million shares of common stock announced on July 11, 2011 caused a drop in the share price from $18.32 on the day to $18.05 on July 12, after extremely heavy trading. The price bounced around the $17 zone for a while, even dipping down to $16 and some change on occasion, until it registered $18.35 on August 15, 2011. Annaly had previously issued 75 million shares in February of that year, with an attendant $17.30 price tag.
In addition, it is important to remember that issuing stock helps these companies grow, which should eventually increase book value. While most analysts agree that secondaries are best offered when the stock is trading above book value, American Capital was trading at book value at the time of the announcement. Similarly, at the time of Annaly's February, 2011 issue, shares were trading at 1.1 times book. Why would a mortgage REIT do this?
Will Annaly join in?
As Fool Analyst Ilan Moscovitz explains, the move could be in expectation of change, such as a rise in short-term interest rates, or the anticipation of a bigger interest rate spread.
Indeed, though Fed chief Ben Bernanke recently reiterated that bank's commitment to QE3 until the economy gets up a head of steam, which will keep short-term rates low, he also spoke about plans to wind down that money-easing program, which would result in a rise in the same rates. Additionally, mortgage interest rates have been edging away from their 52-week low, which is good news for mREITs, particularly if short-term rates stay put.
I would suggest that having a shopping spree in mind might also prompt a secondary offering. For American Capital Agency, there are those attractive agency MBSes to load up on. Annaly also has a big purchase in mind: The remainder of commercial paper from mREIT CreXus Investment (UNKNOWN:CXS.DL.DL), which Annaly has agreed to buy at the end of the 45-day period (which expires March 16) during which CreXus can entertain better offers. Is there a secondary in Annaly's future, as well?
For investors, knowing that there will be a dip can create the perfect opportunity to initiate a position or add to a present one. So far, at least, American Capital Agency's stock price didn't suffer much after the announcement, despite heavier-than-usual trading. This week may be different, but I think investors have faith in the trust's management. And that, of course, is the main ingredient in any mortgage REIT's success.