BENEFITS OF DIVIDEND REINVESTMENT PLANS AND SHAREHOLDER INVESTMENT PLANS FOR SHAREHOLDERS, REAL ESTATE INVESTMENT TRUSTS AND THE ECONOMY
Capital formation or the lack of it is a national problem. Americans do not save enough or invest enough of national income. The U.S. savings rate is less than six percent. The Japanese savings rate is 20 percent. It is in the national interest to encourage greater savings and investment.
Real estate investment trusts (“REITs”) are mutual funds for real estate. The REIT industry raises important capital for industry, housing, retail and related industries. REITs traditionally pay out all of their taxable income and, in many cases, 90% of their funds from operations in the form of dividends and distributions to shareholders.
Dividend Reinvestment Plans (“DRIPs”) and Shareholder Investment Plans (“SIPs”) provide a simple means of raising capital from existing shareholders. There are approximately 180 REITs in the U.S. with a market capitalization in excess of $180 billion. The existing shareholder cash contributions together with the existing dividend distributions can provide an important capital formation source.
DRIPs are offered by about 1,000 companies. These are programs which allow current shareholders to purchase stock directly from the company and bypass the broker and brokerage commissions by reinvesting dividends. Many companies also permit investors to make voluntary ash investments directly in the plan to purchase (SIPs).
It is not surprising that many investors have never heard of DRIPs and SIPs and the advantages they provide. It is an unusual stockbroker that will recommend a stock program when no commission is involved. Since no commission is paid on DRIPs and SIPs, the virtues of these plans are often unsung. DRIPs and SIPs are relatively new vehicles. It is only within the last decade that the SEC promulgated Form S-3 for the formation of DRIPs. The S-3 registration statement provides a convenient means for shareholders to invest in their own corporation both dividends received and new shareholder capital. The cost of this simple registration form is minimal to the company. The SEC’s promulgation of Form S-3 is a very progressive innovation important to the American economy and capital formation.
There are substantially different public policy considerations in regulating the investments of shareholders in their own company as distinguished from corporations raising capital from the public at large. Historically, the Board of Directors of a corporation established a dividend policy. This policy could vary from between a zero payout of earnings to a 100% payout of earnings. The Board of Directors has the power to reinvest all income without shareholder decision by not paying dividends. Therefore, when the Board of Directors wants to give shareholders a voice in that decision, it makes little sense to create an elaborate and expensive regulatory process. DRIPs allow corporations to adopt maximum dividend payout policies and still, through shareholder reinvestment, provide capital for corporate growth.
There are two basic types of DRIPs. One type involves purchasing shares in the open market for he accounts of shareholders reinvesting their dividends. This type of plan requires an outside bank trustee. Under that type of plan, the company does not issue any new shares. The shareholders reinvest their cash dividends through the bank trustee who purchases in the open market. Since the shares are purchased in the open market, the shareholder gets his shares at market. In some cases, the company subsidizes the transaction by providing the brokerage cost. In this type of plan, it is not possible to offer shareholders a discount from market.
The type of DRIP and SIP that allows shareholders to purchase new shares directly from the company may provide for a discount. The discount gives a substantial advantage to the subscribing shareholder. It also benefits the corporation since the discount is substantially less than the cost that would be incurred from another capital forming transaction. DRIPs include periodic optional cash investment. Companies have adopted plans providing for shareholders to invest as little as $500 each quarter to as much as $40,000 per month. The emphasis is more on new shareholder investment rather than simply on dividend reinvestment. The middleman is eliminated. Instead of using a broker/dealer’s customers for a capital market, the company uses its own shareholders.
REITs traditionally sell at relatively high yields as compared to industrial shares. At the present time, REITs are selling at yields of approximately 7%. Shareholders participating in a DRIP offering a 5% discount from market have the ability to earn dividend yields of 7% plus the additional 5% discount. Therefore, the total first year return is 12%.
DRIPs and SIPs are important to all of corporate America. They are of particular importance to the REIT industry. In order for a REIT to qualify for the special tax treatment afforded it under Subchapter M of the Internal Revenue Code, a REIT must pay out at least 90% of its income. This makes it difficult for small REITs to grow through the reinvestment of earnings. This also makes it difficult for larger REITs to borrow funds for substantial real estate acquisitions since lenders look to retained earnings as a source of repayment of loans. REITs paying out all earnings cannot provide a scheduled source of repayment of principal. DRIPs and SIPs allow REITs to pay out high yields yet retain earnings and grow.
REITs raising capital in a conventional manner may be faced with paying commissions as high as 10% and expenses running an additional 5%. It is often difficult to provide investors with a satisfactory return if 15% of the investor’s capital is taken off the top. DRIPs and SIPs raise money for the REIT with no commission costs and only minimal other costs. Therefore, a REIT can attract capital with a DRIP and SIP that could not be attracted through a normal underwriting.
The 5% discount provided to subscribing shareholders can be viewed as a “cost” of raising capital. This “cost” is borne by the non-subscribing shareholders who receive a small dilution. The benefit goes to those who do subscribe. A successful equity or hybrid REIT may have a current yield on its investments of 7% plus 3% appreciation on its properties. The shares tend to appreciate over time because the underlying assets are appreciating. The sale of a relatively small number of additional shares at a 5% discount is such a small dilution that there may be no visible effect on the market price of the shares. The individual shareholder earning a 7% cash dividend plus a 5% discount has a very visible 12% return on investment.
The total return a REIT provides to its investors is a combination of cash generated and paid out plus appreciation in property values. DRIPs and SIPs allow REITs to pay out a cash dividend annually which approximates the total return to investors earned over time by the REIT. REITs in the long run can pay out cash flow plus appreciation because appreciation can be realized by sale or refinancing. REITs, without DRIPs and SIPs, might experience a shortage of cash to make annual distributions in excess of cash generated from properties. REITs that have a substantial shareholder participation in DRIPs can pay out non-cash appreciation because it is offset by dividend reinvestment.
There is a market differential between the yield on private real estate and the yield on publicly traded REIT securities. There is also a substantial market differential between the yield on publicly traded REIT securities and the yield on industrial stock. Shareholders investing into a REIT by a DRIP and SIP is the most efficient means of exploiting the market price differential between real estate in the conventional form and real estate in the securitized form.
We can put together a unique and innovative format using only fundamental proven real estate financial concepts. These concepts include the securitization of real estate, the investment in sound, high yielding real estate and the efficient raising of capital through DRIPs and SIPs. At certain times, these concepts will work better than at others. When there is a steep yield curve, yields can be enhanced through yield spread investing. When stock market prices are high, the REIT advantage can be enhanced through equity leverage. This is the process of earning more on the new shares than the return on the older shares, resulting in dividend increases and higher share prices. The DRIP and SIP program allows investors to dollar average investments by participating in the growth in the REIT value and the real estate value through various business cycles and varying market conditions.
There are problems in implementing this business plan. Paradoxically, the weaknesses in the plan are also the strengths. Equity leverage works best with small capital REITs. Equity leverage works best when new capital is raised in small pieces. Wall Street has little interest in capital that is raised in small pieces. DRIPs and SIPs are sold directly to investors, and there are no commissions for investment bankers.
The key, therefore, is to go directly to the investor or to money managers and financial planners who are no dependent on commissions for their compensation. Financial planners should be interested in investments when they can earn for their investors a current return of 7% plus a 5% discount. In addition, there is the possibility of additional share price appreciation. REITs interested in raising capital through this procedure could provide for a $40,000 investment per month per account. There should be a significant group of financial planners willing to dollar average their investment and invest the relatively small amount of $500,000 per year into a well run REIT.
This author has been one of the foremost advocates of DRIPs and SIPs and believes they are a cost efficient means of raising capital. They provide an advantage for both the company and the investors. Unfortunately, the number of companies offering DRIPs and SIPs at a discount is decreasing. The trend is for companies to discontinue the discount. The stated reason for this is because arbitrageurs buy the stock at a discount, depressing the stock price of the issuing company. While this theory is widely accepted, this author believes it is inaccurate.
If SIPs are a cost efficient means of raising capital, they are, in the long run, advantageous to the issuing corporation. In the case of REITs, it can be demonstrated that the return on the new shares, even after the discount, may be higher than the return on the old shares. Thus, issuing more shares in the SIP will result in higher earnings and higher dividends. The REIT industry calls this “equity leverage”.
Managements who discontinue SIPs at a discount are being misled by the short-term effect of resales in the open market. The shares may trade on the AMEX, NYSE or NASDAQ National Market System. Wherever they trade, the markets are reasonably efficient. Over even a modest span of time, any resales of stock should be offset by informed investors being attracted to the market place by the combination of the temporary lower price and the long-term growth through the new capital raised. This is a topic that should be taken up by one of the leading business schools. Some professor interested in game theories should do a research and theoretical article on raising capital through DRIPs and SIPs.
Financial planners should take advantage of DRIPs and SIPs offering shares at a discount. They should be aware that arbitrageurs are putting some pressure on the stock prices of these REITs. Management, at some time in the future, may discontinue the plan. This depends on whether the market pricing of shares is an efficient market or an inefficient market. Only time will tell which of these theoretical views will be supported in practice. Certainly, any investment that currently offers a current return of 7% plus a 5% discount should be attractive both in the short run and long run to investors.
July 24, 2002
Eugene W. Landy
President, Monmouth Real Estate Investment Corporation
President, Monmouth Capital Corporation
Chairman of the Board, United Mobile Homes, Inc.