Frontier Reit raises $216 million at 2% discount

The Japanese trust issues the fourth-largest domestic follow-on offering this year in an effort to stabilise its debt levels.
Frontier Real Estate Investment Corporation, one of JapanÆs leading retail Reits, issued 35,000 units - followed by an over-allotment of 2,500 units - to raise a total of $216 million on Wednesday last week. The deal priced at the tight end of the discount range of 2% to 4% to the reference price of Ñ638,000 ($6076). The offer price of the new units was Ñ625,240 each, a 3.48% premium to the issue value of Ñ604,186, with the difference going to the underwriting banks instead of fees. Ñ625,240 amounts to a 2% discount to the reference share price.

The total amount of units outstanding increased from 125,000 to 162,500 as a result of the issue. The issue value in yen terms amounted to Ñ21.146 billion before the over-allotment, which amounted to Ñ1.510 billion, for a total of Ñ22.656 billion, or $216 million at an exchange rate of 105 to the dollar.

On Friday, the units were trading at Ñ637,000, down 0.15% from the Wednesday reference price. The counterÆs stock price has dropped dramatically over the past three months, from Ñ870,000 in mid-May, and Ñ1.3 million in early 2007.

ôIn spite of challenging market conditions, Nikki Citigroup, Daiwa Securities SMBC and UBS were successful in completing Frontier's follow-on offering. The completion of this offering demonstrates that, despite elevated investor selectivity, investors remain ready and willing to put capital to work,ö Bruce Wu, co-head of ECM at Nikko Citi in Tokyo, told FinanceAsia.

The deal was 70% allocated to domestic retail investors, and 30% to domestic institutional investors. Demand levels were reportedly æcomfortableÆ.

Nikko Citigroup, Daiwa Securities SMBC and UBS were joint lead managers, as well as another five firms. Nikko Citigroup and Daiwa accounted for 30% each of the underwriting; UBS for 16%; and the other houses for the balance.

The proceeds of the deal are earmarked for repaying part of the borrowings incurred by the acquisition at the beginning of July of four commercial property investment assets both within Tokyo and outside, at a cost of Ñ33.36 billion. Frontier Reit specialises in outlet malls and has high-profile tenants such as AEON, Izumi, Mycal and Ito Yokado. The company has loans outstanding amounting to Ñ46.5 billion as of July 9 and announced net income of Ñ2 billion for the second half of 2007, fractionally down on the first half. The company is aiming for a loan-to-value ratio of around 40%, according to its latest financial report.

As of Friday last week, the companyÆs units were trading at a dividend yield of 5.6%, compared to a 10-year Japanese government bond yield of around 1.5%. One banker said this was an ôacceptable yieldö and adds that that companies trading at much higher yields are focussed on the less profitable residential space, for example Japan Single-Residence Reit which trades at 7.7% dividend yield.

The variance in yields reflects the changing fortunes of the Japanese Reit market. The Reit sector in Japan, after a sharp rise in 2006 on the back of interest by non-Japanese investors, has seen a strong correction. The sector is finding debt re-financing more difficult in the wake of the global credit crunch as well as a Bank of Japan perception that the run up in property prices has been excessive. On April 30, 2008, the Tokyo Stock Exchange Reit index dropped to 1,492, down more than 40% from its historical high of 2,612 on May 31 2007. (The index stood at 1,319 as of Friday.) As a result, the public offering amount in the sector has plunged in the past two years from the almost Ñ1 trillion peak recorded in 2006.

The result is a two-tier market, with around half of the 41 listed Reits showing discounts to NAV and the other showing premiums to NAV. High and low dividend yields respectively are the counterpoint to that. At the marketÆs peak, many Reits were trading at an astonishing 80% to NAV, with correspondingly low dividend yields. However, two rate hikes since then have helped change sentiment in the sector. The common factors of the weaker Reits are higher short-term debt, weak capitalisation, higher LTVs (loan-to-value ratios), exposure to the residential sector, and exposure to Japan outside Tokyo.

One banker says that one of the advantages of the current issue for Frontier is that the company can restructure debt with the proceeds until the time is ripe for further expansion û or to take out more debt if the market worsens. The current winnowing out is likely to be especially hard on companies with stretched balance sheets, he says.

Availability of financing in the public markets has been tightening. The long-term Reit bond market, which expanded significantly in 2007 to Ñ330 billion from less than Ñ50 billion in 2002, has been largely moribund this year. The same is true for the relatively new commercial paper market.

On the bright side, office rents in Tokyo have continued to be strong, with vacancy rates at under 2%. Tokyo continues to benefit from the hollowing out of the rest of the country as businesses and individuals move to the metropolis.

The difficulties in the sector have prompted some Japan-style consolidation, although regulations prevent US-style M&A. Frontier itself saw its management company from Japan Tobacco replaced by a specialist real estate company, Mitsui Fudosan, earlier this year. Whereas FrontierÆs sponsor Japan Tobacco was feeding old factory sites around Japan to the Reit, Mitsui Fudosan Frontier Reit asset management should be able to provide benefit from its real estate expertise and the fact that, being linked to a leading developer, it can more easily source yield-accretive projects. However, one rationale for the change û that having links to a real estate company helps access a shrinking supply of real estate projects û has diminished as the real estate market has cooled. In addition, Mitsui Fudosan sponsors other Reits, such as Nippon Building Fund.

It could be argued that the market needs a return of cash-laden foreign investors as well as an improvement in the macroeconomic outlook before it can improve. On the hand, the woes of Freddie Mac and Fannie Mae in the US are sure to concentrate the minds of the regulators on the prevention of a similar real estate bubble in Japan. It seems as if, in the near future, Reits will appeal to investors more for the security of their bond-like characteristics than for rapid capital gains.
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