TOT - 360 Capital REIT - Can REITs be even worse than LICs and LITs?

Summary: This site is about the hazards of ASX Closed End Funds (CEFs). I intentionally limited this to LICs and LITs, but there is another type of ASX CEF: Real Estate Investment Trusts (REITs). I have no plans to cover REITs generally as they are complicated, very different to assess, and I have no expertise in them.

However, I ended up invested in one REIT (360 Capital REIT - TOT) accidentally via it merging with a LIC called URB. Since 2019, I've followed TOT's travails closely and it would be remiss not to point out the pitfalls of REITs that mirror the ones I've catalogued for LICs and LITs.

Captive capital in closed end structures appears to make it inevitable that fund managers and insiders will prey on shareholders and face no consequences from the ASX, ASIC, the finance industry (e.g. taking products off platforms, research ratings), or even the media. Given my observations on TOT, retail investors should also be very careful about the REIT sector in general. TOT retail investors just looking for the asset exposure should be extremely careful about getting deeper into this hole rather than getting out. (Traders can punt on). As they say: Fool me once, shame on you; fool me twice...?

ASX REITs: Shiny on the outside, rotten on the inside?

Details:

Initially, I plan to brain dump bullet points so I can get a warning out to retail investors in TOT or those who might end up considering it or similar REITs. As time permits, I will illustrate them with evidence.

Also see: > 95 theses on why ASX Closed End Funds should be eliminated

1. REIT shareholder returns depend much more on the fund manager's particular decisions and level of extractiveness than on asset class exposure

- REIT investors might think the returns of the asset class (the type or mix of real estate) will largely determine their returns. My experience has been that key 360 Capital decisions (Irongate property purchases, timing, insistence on increasing scale, extent of leverage, no hedging, continuing dividends rather than paying down debt), and the timing and extent of its extractiveness, have vastly overridden the asset class exposure. This defeats the purpose of wise portfolio construction and a better structure is needed to obtain the asset class exposure without uncompensated risks.

- This concords with the results of my analysis of almost all ASX LICs and LITs - the more active they are, the more this detracts from (and overrides) the passive exposure to the asset class (e.g. adding multiple asset exposures, adding non-asset exposure, leverage decisions, over-trading, cash weighting, factor/strategy changes, etc). Some managers understand that the returns come from the asset class and minimise temptations to fiddle (e.g. Chris Mackay at MFF) while other managers feel like they're at a casino, roaming among different games, to place bets with other people's money (e.g. FPC).

2. Extractive NTA dilution potential is enormous, uncapped and seemingly inevitable

- Based on the TOT capital raising announced 14 Feb 2024, it's clear there is literally no constraint on the dilution of existing shareholders that Australian REITs can get away with. TOT's share price dropped 25% in a day with no change in circumstances; it was mostly due to the sheer level of extraction and dilution in the capital raising. LICs and LITs at least have some restraints on this (though it shouldn't be possible at all).

- Also, given all REITs borrow to fund property exposure, it seems inevitable that they will conduct dilutionary capital raisings as they have a constant excuse ("we can't risk breaching our debt covenants") and dilution (with a growing asset base to charge fees) suits the insiders.

3. REIT Board of Directors can even more easily act against the interests of most shareholders

- LIC Boards are generally not actually independent and often sacrifice shareholder interests, but TOT's Board took this to a whole new level, approving the issue of 117 million shares (to dilute the existing 146 million) at a price of 40 cents when it claims the NTA as of 31 Dec 2023 is 90 cents (a 56% discount!).

- Apparently, REIT Boards don't even have to seek shareholder approval via a vote to conduct such massively dilutionary raisings. Amusingly, TOT's Board claim three out of four directors are independent!

4. CEFs holding only (or mostly) unlisted assets provide much greater opportunities for insiders to extract value from shareholders

If TOT was a CEF holding listed assets, there are some limits on the ways a fund manager or insider can extract value. Mostly, this is via fees. Unless it's feasible and worthwhile to build a Blocking Stake, most fund managers don't want to have "skin in the game" and achieve the shareholder returns of the fund - that's not the pathway to prospective yachts.

It's taken me too long to realise, but CEFs with unlisted assets open up a whole different game. This Feb 2024 TOT capital raising is proof positive of the massive value extraction possible in unlisted assets. 360 Capital doesn't have to worry about the effect on the TOT share price of its extractive actions. They are playing the longer game of cheaply taking ownership and control of the unlisted assets themselves!

If you follow the logic, the bigger the gap between TOT's share price and NTA, the bigger their opportunity. 360 Capital Group has had an incredibly perverse interest in TOT's share price spiralling down to big discounts to capitalise - the exact opposite aims of the majority retail shareholders! Unlike retail shareholders, 360 Capital Group don't have to exit at on-market prices; they can ultimately exit these unlisted assets off-market.

This episode with unlisted assets has been very revealing, and I'll be investigating further.

5. All REITs use leverage. Apparently, some (many?) don't manage it wisely by minimising its risks from overwhelming the asset class returns

- Try and find a bond fund investing overseas not fully hedging its currency risk - you can't, this Investing 101 fail isn't tolerated (the currency variance overwhelms the purpose of the fund: bond exposure). Even if a particular manager thinks it has some currency timing guru onboard, it wouldn't be allowed. Yet, TOT decided to run its property borrowing (35-40% geared) fully unhedged to interest rate risk since 2022!

- Surely, institutional investors don't tolerate such irrationality and conceit. Is TOT unusually dominated by retail investors among REITs? Do institutional investors even invest in most listed REITs? Retail investors should seek investment structures that have at least some safeguards such as minimum standards set by institutional investors. Thus, sub-scale CEFs (including REITs) should be avoided.

6. Many (most?) listed REITs appear to be vehicles for retail investors to be extracted

- Closed End LICs and LITs are almost wholly owned long-term by retail investors. Their IPOs were dominated by retail investor money. The very first of my 95 reasons why CEFs should be eliminated is: No ongoing demand at NTA. Almost all LICs and LITs are sold by their fee beneficiaries (hence the selling commissions), not bought (demanded by investors as the best way of getting the asset exposure).

- If TOT is anything to go by, then the predominance of retail investors in a REIT signals the level of extraction likely.

7. REIT disclosure rules and norms are appalling. TOT is unlikely to be an exception

- For example, TOT kept the ~$16 million in stamp duty it paid to acquire the Irongate properties very quiet. The obvious question would have been: why not return most of the IAP trading profits and continue to take property exposure (debt or equity) that didn't require losing such major chunks of net assets to tax. However, 360 Capital was intent on scaling up a standalone REIT.

- TOT's prior annual report and ASX announcements didn't make clear that operating profits were so constrained, that borrowings had expanded by $11.8 million to pay the Irongate transaction income tax, or that a discounted capital raising to reduce gearing was already on the table. The sustainability of TOT earnings and dividend coverage was the key investor question, but it's taken till 14 Feb 2024 for the reality to be revealed.

- TOT's debt covenants (or growing risks of breach) were never disclosed till the capital raising. The Loan to Value covenant, Interest Coverage Ratio covenant, other key loan terms, and hedging are critical disclosures. While making no disclosures, 360 Capital mismanaged these risks (e.g. paying dividends it wasn't earning), and made a capital raising inevitable unless it sold down assets (which it refuses to do). Given the only beneficiary of the capital raising is 360 Capital (which moves toward 40% ownership and total control), the obvious question is: did 360 Capital do this intentionally?

8. Blocking Stakes are bad enough in equity CEFs, in REITs large insider stakes can be used to literally extract value from other shareholders

- In LICs and LITs, insiders often obtain enough of a holding (25% of shares likely to vote) to block any votes requiring 75% agreement to restructure the CEF (e.g. obtain an exit near NTA). In REITs there is an even more insidious outcome that the Feb 2024 TOT capital raising has exposed: Tony Pitt and 360 Capital are able, without a shareholder vote, to transfer an enormous amount of the value in TOT from retail holders to themselves.

- If 60% of the TOT Feb 2024 Entitlements are taken up by non-360 shareholders (+ 70m shares), NTA will drop from 90c/share to 73c/share and Forecast FY24 EPS will drop to 2.1c/share. 360 Capital Group (TGP) would end up with 35.9% of TOT. And it could be closer to 40% if general shareholder participation is lower. TGP currently has 30% of TOT. So Tony Pitt and 360 Capital are going to considerably expand their ownership and control of TOT without having to buy shares on-market and pay fair value (TOT was trading ~55c prior).

- Of course, 360 Capital could have raised capital prior at higher prices. And it can certainly raise at much smaller discounts than 56%. Indeed, given how disastrous the returns 360 Capital has delivered for TOT investors, they could have just used the millions in cash TGP is sitting on to raise capital at the share price (~55 cents) TOT was trading at before the 14 Feb 2024 announcement. But if insiders with minority stakes can get away with it, well a 56% discount sounds fabulous!

9. Blocking Stakes also make takeovers in underperforming or flawed REITs impossible

- At the 25-40% discounts to NTA it's traded in recent years, TOT would be a takeover candidate hence why 360 Capital quickly acquired a Blocking Stake (almost 25% of shares) as soon as this NTA gap became large.

- Retail investors often stay invested (or buy in) when the NTA discount is large hoping for an eventual takeover to exit nearer NTA. But there is no way anyone else can make an unfriendly takeover for TOT since 360 Capital Group got to 25% of shares (indeed 15-20% is typically enough to ward off others given not everyone votes and 75% majorities are required).

- The most naive retail investors actually think insiders building stakes might provide their exit near NTA by ultimately taking the fund private. As we've seen with the TOT capital raising, insiders aren't aligned with retail shareholders, they make money at other shareholder's expense. Underperformance in funds like TOT don't guilt insiders into finally acting for retail shareholder's interests; indeed they often provide opportunities for more shameless extraction!

- 360 Capital may well take TOT private eventually, but only after they've extracted as much value as feasible. Buying out 20% of holders nearer NTA is very different to buying out 80% (which is when the "20% rule" and takeover provisions are supposedly meant to take effect!). The key purpose of takeover law (ensuring all shareholders share in benefits from changes in control) are undermined by the exceptions: creep provisions and rights issues. 360 Capital has demonstrated just how easy this is to exploit in REITs.

10. In REITs, just like all captive capital CEFs, the majority of shareholders aren't consulted and their interests are readily ignored

- Virtually all TOT retail shareholders would vastly prefer to sell one of the three office properties (or a substantial stake in one) in order to reduce the unhedged debt. 360 Capital Group argue they couldn't get fair value and so are issuing shares at 40c on value as at 31 Dec 2023 of 90c! This 56% discount is so ridiculously inferior to the discount TOT investors would have to take to offload a stake that it's embarrassingly obvious that 360 Capital is only pursuing the capital raising because it stands to benefit the most. The sad aspect is that it seems it will get away with this with little embarrassment and clearly no adverse consequences from the ASX, ASIC or wider industry. That says a lot about the pitfalls of ASX REITs.

11. Could the extraction in TOT happen in an Open End REIT which trades at NAV?

Open End funds can hold lumpy and illiquid assets like real estate but exiting constraints exist or can be implemented as needed (including "gating" the fund for a period), as when investors are rushing for the exits there isn't new money coming in or liquid assets to sell.

While open end funds for real estate have their own pros and cons, the critical open end structure (where shares are only allowed to be created or redeemed at NAV) eliminates the major way investors can have value extracted from them by insiders.

The open end structure also typically necessitates that fund scale be large enough to facilitate greater liquidity. It also places pressure on NAVs (at least when entry and exit occurs) to be accurate and driven by the asset class. Conversely, TOT's NTA is going to drop from 90c/share to as low as 67c/share driven by the capital raising extraction!

Links:

> 360 Capital REIT (TOT): ASX Announcements

> Firstlinks: The biggest loss this year in my SMSF portfolio

> The Mayne Report: Chronological list of 300+ >$20m post Covid-19 capital raisings