Property giants convert to an alternative bonds debt source

Three firms have raised debt via unusual route of convertible bond issues, writes Doug Morrison

Debt diversity was the rallying cry of three of Europe’s largest listed property groups last month when they took advantage of the cheap corporate bond market to raise new debt – and not just any old bonds, but convertibles.

In quick succession, British Land, Unibail and Capital Shopping Centres (CSC) all elected to go for the relatively rare convertible bond as a means of broadening their debt portfolios.

It was a sort of Super September for the convertible. France’s Unibail raised €750m. British Land and CSC raised a further £400m and £300m respectively.

So rare is this instrument in real estate at least in recent years – that British Land and CSC each proclaimed their convertibles to be a “new” source of capital, even though the sector was no stranger to such bonds in the pre-credit crunch era.

The first to launch, British Land, raced out of the blocks on the day after the August Bank Holiday, after it had become apparent that redemptions in some specialist convert-ible bond funds earlier in the summer would create demand for new issues.

“A number of convertible funds have to invest in investment-grade offerings – and we obviously are investment grade,” says Lucinda Bell, British Land’s finance director. “We were told that there would be good appetite for the bonds. It was clear that  quite a few companies would want to issue  and I wanted to be ready to go first.

“We launched on the Tuesday at £300m and had the book covered in an hour. We then tightened the price and increased the amount from £300m to £400m, and we were 2.8 times over-subscribed at the higher amount. Timing is always key.”

British Land’s bonds, announced on 4 September, will have a coupon of just 1.5% a year and will be convertible into ordinary shares at a conversion price of 693.07p – a 31.25% premium to the pre-issue share price.

“When I look at that I say, well, if it doesn’t convert it’s been jolly cheap debt,” says Bell. “To get debt costing 1.5% for five years is very attractive. If it does convert, that’s also pretty attractive.”

She adds: “The way that I look at our debt portfolio is I’m always looking to diversify our sources of finance, stretch our maturi-ties, manage our cost of finance, maintain flexibility, access markets well, opportunistically and maintain good balance sheet metrics. What’s particularly attractive about the convertible bond is that it’s a new source of finance.”

Both British Land and Unibail’s bond issues have been well received in the City. Mike Prew, managing director, European real estate equity research at Jefferies International, says: “These are fixed-income investments, so the timing tends to coincide with the view that long-term interest rates are going towards the bottom and might rise at some point. Because there is an equity kicker, you want to maximise the conversion premium to minimise any dilution.

“As a result, the equity share prices tend to be relatively high – so far this year some of the larger companies have seen their share prices rise 20% or 30%.”

“Opening up another pot of money”

Prew adds: “A convertible should be looked at not just in financing terms, but also in terms of what it does to the overall capital stack of the business. It’s actually opening up another pot of money, another market, so that if the [mainstream] debt, bond and equity markets are closed, the convertible market might be open.

“So we’ve seen a general theme here of debt diversity – the companies talk of broadening their sources of capital – which is exactly the right thing to do.”

Analysts at Deutsche Bank, meanwhile, have published a strongly bullish ‘buy’ note on Unibail, whose bonds pay a coupon of just 0.75% and can be converted into shares at a 35% premium to the share price just before the issue. The bank’s analysts regard Unibail’s “ability to issue debt at a lower cost than its competitors as a sustainable competitive advantage for the group”.

However, the property industry’s real trailblazer was Derwent London, which issued convertible bonds in June 2011 – the sector’s first such issue for four years. Derwent’s issue raised £175m, with the bonds paying a 2.75% coupon – reflecting higher long-term interest rates at the time and converting at a 30% premium after five years.

“At the issue date, the conversion price was roughly 50% above the last published net asset value per share,” recalls Damian Wisniewski, Derwent’s finance director. “So the thinking was that if we did really well in the next five years and the shares convert, everyone will be pretty happy – it’s unlikely there would a large amount of dilution.”

He adds: “We were interested in getting a good cost of debt and wanted to have good dividend protection so that we can increase our dividend without having an impact on the conversion price. We also wanted to make sure we can access other capital markets transactions over the following five years.”

Derwent’s issue was all the more attractive to Wisniewski because it was unsecured. Nor was it subject to corporate or asset-specific covenants. He adds: “It’s very flexible and if it’s properly documented, it gives you very little restriction.”

According to British Land’s Bell, the convertible is not just a bond with a fancy wrapper, but a means of broadening the investor base; investors in such bonds tend to be specialists. Matthew Roberts, CSC’s finance director, agrees. He says: “We have bank debt in place. We have CMBS in place. Having a convertible was another leg and another type of investor for us to talk to.”

Yet after the excitement of Super September… silence. There is a suspicion that the convertible bond window has shut again for the time being. “I’m not sure there is going to be a huge amount of demand [ following the three issues],” says Bell. “That’s quite a focus on real estate, which is not a particularly vast market for the convertibles.”

One possible stumbling block is that the froth has come off property shares, after analysts such as Jefferies International’s Prew urged investors to take profits.

“The equity markets are very tricky at the moment,” notes Prew. “REIT share prices did very well until recently. They started the year very cheap and reached full value on both capital and income grounds in August which is when we took profits with out ‘Topping Out’ downgrade memorandum. “The dividend yields were in line with the equity market and share price discounts to net asset value – still the dominant metric closed to 5%. But they are now back to 10% and the companies still can’t access equity capital substantially, as REITs should be able to.”

There is another niggling doubt about convertible bonds in property. This is a complex investment; no two bond issues are the same. Yet CSC’s bonds, which carry a coupon of 2.5% and a conversion price at a 30% premium, are clearly more expensive than British Land’s and Unibail’s. This is quite a shift in a matter of weeks, which some in the City suggest reflects a waning appetite already.


CSC pursues debt diversity

Like the other two, CSC’s issue was about diversification, as well as refinancing short- term debt and raising money for potential development at some of its shopping centres.

But Prew points out: “Capital Shopping Centres we find to be in the most difficult position. It’s got about £3bn to refinance over the next three to five years and has grandiose development plans, largely shopping centre extensions.

“CSC has only made a minor bite into that refinancing. Diversity was the key here, but the problem with the piece of paper you’re buying is that a lot of CSC’s shopping centres are ring-fenced, with asset-specific financing against them, so the convertible is subordinated.”

It should also be noted that, unlike CSC, British Land and Unibail benefit from formal investment ratings from the rating agencies, so should – in theory – command better terms. They also have a longer track record of issuing bonds.

“We’ve had a good, positive reaction from our shareholders and from the market,” says Roberts. “We’re paying a little bit more than some of our peers, but it is cheap money and it is up to us to make sure we drive a materially higher return on the cash we’ve now got in than we’re paying out through interest rate payments initially or through the cost of the equity. Given the development angles, we’re confident we can do that.”

Roberts believes, too, that the convertible bond market is “bound to reopen during the course of 2013 at the latest”.

Derwent’s Wisniewski concurs. “Some individual investors may have decided that they’ve had their fill of real estate for the time being,” he says. “There’s still sufficient demand for the right issue, but clearly it’s not perhaps as easy to get away as it was six weeks ago. My understanding would be that the market would be open for the right credit, however.”

A handy addition to fund raising toolbox: how convertibles work

A convertible bond is a fixed-income investment in which the noteholders have the discretion to convert the debt to shares at the end of a set term, which is usually five or six years.

Typically, convertible bonds carry a cash coupon that is paid until conversion takes place. Given the option to convert into shares and potentially benefit from a company’s growth, the convertible’s coupon is lower than that of conventional bonds.

The conversion price is invariably set at  a premium to the share price at the time of issue; the property sector’s four bond issues to date were only feasible on the back of strong share performance.

However, no two bonds are alike and the British Land’s bond issue will help fund the purchase of the Clarges Estate in Mayfair outcome is not absolutely certain. For the noteholders, the higher the premium the lower the probability of conversion – and therefore upside participation.

For the companies, meanwhile, there is the possibility that issuing shares down the line will be dilutive to their net asset value per share.

Another key factor is the company’s dividend. With dividend payouts, the share price usually falls, while the conversion price remains constant – effectively increasing the conversion premium.

But the convertible bond is undeniably  a useful tool, especially if the money has a specific purpose. British Land’s bond was well received partly because it used the proceeds to fund its £129.6m acquisition of the Clarges Estate in London’s Mayfair, as well as to repay existing borrowings relating to other acquisitions.