📖 Building wealth through REITs (3rd edition) by Bobby Jayaraman

Overview of REITs

Attractiveness of REITs
The biggest attraction about REITs is that it is a very simple business to understand: raise money from investors (equity) and take a loan from banks (debt) to fund and manage properties.

Here are reasons why REITs make good investments:

High-quality and resilient assets. Many Singapore REITs own some of the best and most visible properties in Singapore. The assets have proven earnings power across business cycles. Investors can thus sleep peacefully knowing the assets have a proven ability to generate cash in good times and bad.
Mix of yield and growth. REITs are required to pay out 90%– 100% of their profits as dividends. This gives investors a stable source of income. Their assets also have good capital appreciation potential which may increase the book value of the REIT and lead to increases in its share price.
Easy to understand business. A REIT is a very transparent business with virtually all relevant information available to the lay investor. A REIT investor feels like a true part owner of a business. This is different from investing in specialised industries such as manufacturing and technology where much of the information is only known to industry insiders.
Favourable tax treatment. REITs do not pay taxes at the corporate level and investors do not need to pay taxes on dividends. This means virtually all of the cash a REIT makes ends up in the pockets of its unit holders.
Inflation protection. Over the years, REITs have been successful in increasing rentals in line with inflation, thereby providing a hedge against inflation, unlike bonds.
Liquidity. Unlike physical property, REITs are liquid investments which can be traded on the exchange just like any stock.
Diversification. When an investor buys a REIT, he is buying a share in several properties and leases; this greatly reduces his investment risk. CMT, the largest retail REIT, receives income from more than 2,500 leases across 15 malls.

There are some major differences of the loans a REIT takes:

Tenure is much shorter, usually between two and five years.
The loans are not amortised, meaning only the interest amount is paid. The implication of this is that the loans are never fully paid but have to be rolled over at the maturity date.

How REIT complements the developers?
Developer-sponsored REIT allows the developer to sell their investment properties. This arrangement will allow the developer to retain a stake in the properties (usually 20%–35%) while receiving recurring rental income as dividends. In addition to dividends, the developer-sponsor is also entitled to fees for managing the REIT.

The paradox of the REIT model
A REIT manager may feel that the potential benefits from the acquired property, in the form of increased rentals, will more than offset the cost of debt (interest cost on bank loans or bond interest payment) or equity (dilution through the issuance of new units), thus leading to higher DPUs for the unit holder. This is called a yield-accretive acquisition.

The problem with this method is that genuine yield-accretive acquisitions are hard to come by. During a strong market, when funding is easy to obtain, the properties are richly valued. In contrast, during weak markets, properties may be available at attractive valuations but bank loans may be difficult to procure and equity financing may be expensive due to a low share price.

Quality of growth matters far more than the pace of growth
What is important is the stable income-generating potential of the assets along with a well-planned and prudent growth strategy that can help increase dividends and share prices over time. REIT investors should not be looking for the next Google or Apple among REITs!

A REIT that grows its rental along with inflation, does a couple of asset-enhancing exercises and acquires high-quality property slowly will create more long-term for its unit holders than a REIT that aggressively pursues growth and acquires a string of properties fast.

How were the REITs able to grow so fast?
There were two main reasons for this.

Availability and reasonable pricing of commercial real estate
Example: Singapore’s real estate market from 2002 to 2005 after the prolonged bar market following the Asian crisis in 1998
Low cost of funding.

How REITs had failed?
By late 2006, REITs were starting to be valued as growth stocks. They were trading way above the net asset value and offering low yield compared to the 10-year Singapore Government bond. Investors were expecting the strong growth of prior years to continue and lead to capital gains.

The REIT managers too got carried away by all this euphoria and made three key mistakes.

Steady increase in leverage.
Acquisition of properties at relatively low yields (meaning overpriced) in the hope that future rental increases would increase the yield
Use of short-tenure loans to quickly finance acquisitions with a view to extending the tenure of the loan at a later date.

There were also other mistakes such as not having diversified sources of funding (for example, over-reliance on CMBS) and not spreading out the maturity of their loans.

To cut the story short, both investors and REIT managers expected the good times to keep rolling on.

They are not quite crisis-resilient with double-whammy effects.
The lifeblood of a REIT is the ability to procure financing at a reasonable cost. Hence, any turbulence in the credit market will have a strong impact on the financing ability of REITs and in a worst-case scenario (if the liquidation value of its properties is unable to cover the loan cost) may lead to bankruptcy.

Singapore REITs also made heavy use of CMBS loans during the boom period from 2005 to 2007. This market virtually shut down during the crisis and the REITs had to approach banks to refinance the maturing CMBS loans.

Other than the financing issue, the crisis affects the real economy resulting in tenants having difficulty paying their rentals and high vacancy rates.

A major reason for the severe fall in 2007 was many REITs had simply become too overvalued. Investors have to differentiate between different REITs and the importance of resilient assets, financially strong sponsors and competent REIT managers.

In a crisis, REITs can face a perfect storm. They are confronted with the risk of not being able to refinance their loans on maturity plus the likelihood of slowing revenues from their properties which would put at risk the REITs’ ability to service their debts and pay dividends to unit holders. The REIT managers learned their own lessons about leverage, the excessive use of short-term financing and the need to have diverse sources of funding.

Surviving a crisis
The quality of the assets matters. REITs must have high-quality properties in good locations that have a proven ability to generate cash through good and bad times.

The REITs have to act swiftly to shore up their balance sheets and reduce gearing. This can be done through raising equity via rights issues and bank loans. Many investors will not be happy with the dilutive nature but they will avert the immediate disaster.

Perception versus reality

PERCEPTION #1: Sponsors dump only their weak assets into REITs. Why would they otherwise sell them?

This view is held even by savvy investors, which is surprising not because all assets are necessarily great as some REITs do indeed have poor quality assets but because it is so easy for an investor to check whether an asset is good or bad.

PERCEPTION #2: REITs usually buy assets at high prices from their sponsors who sell when the market is peaking.

It is generally true that REITs are unlikely to get assets on the cheap from their sponsors as the latter are listed companies responsible to their own shareholders. Also, given the relatively strong balance sheets of the major Singapore developers, they can wait out a bad market if need be. This means, in most cases, that the sponsors are the price setters and the REITs can take it or leave it.

Does it imply that REITs end up buying overvalued assets? Maybe, maybe not. Ultimately, each acquisition needs to be considered on its own merits.

Does buying a fully valued asset make sense for the REIT? The objective of REITs is to hold stabilised assets and provide a regular income to the investors, not to re-sell the asset to another party. In this context, what is critical is that the asset has sustainable earnings power to fund dividends. Good REIT managers do thorough due diligence to make sure this is indeed the case.

REITs are unlikely to get bargains from their sponsors but neither are they necessarily purchasing overvalued assets.

PERCEPTION #3: REITs trading at high yields and large discounts to NAV (net asset value) represent a bargain.

This perception can be very dangerous to your net worth! There are broadly two reasons why some REITs trade at higher yields than others.

Deterioration in the fundamentals of a specific REIT, such as the REIT not being able to refinance its loans, the loss of a major tenant or similar issues. The market senses a deterioration in the future earnings power and hammers down the price of the REIT such that the REIT trades at a high yield temporarily.
Structural. Some REITs such as industrial and cross-border REITs generally trade at higher yields than retail REITs to compensate for higher business risks such as income sustainability, weaker asset quality, lower potential for capital gains, foreign currency exchange rate (FX) risk and country risk. This does not mean they are necessarily better investments: their prices merely reflect the risks inherent in the business.

The same approach that we take for yields should be applied to NAVs. The discounts to NAV can also be a reflection of the market’s assessment of the REIT’s management capability and track record. Another possible reason is that the market expects valuations of a certain sector (for example, the office sector) to fall and discounts the fall in asset prices ahead of time. In summary, it is important for the investor to realise that, on its own, a high yield or discount to NAV does not signal a good buy but merely reflects the risk inherent in the REIT.

PERCEPTION #4: REITs will suffer during a rising interest rate environment.

A rising interest rate environment can affect REITs in two major ways.

The first is through rising interest payments which may lead to a higher cost of debt resulting in lower dividend distributions. A moderate rise in interest rates is unlikely to have a strong effect on the cost of debt and distribution profile for most REITs. Investors can easily work out the effects of rising interest rates as all the pertinent information such as the amount of debt, cost of debt, type of loan (floating rate versus fixed rate) and tenures are disclosed by the REITs.
Another effect is on REIT valuations. REITs being primarily yield instruments may behave like bonds and fall in value during a rising interest rate environment as investors demand higher yields resulting in lower unit prices.

Savvy investors will realise that higher interest rates as a result of a stronger economy would be, on balance, beneficial to REITs. They can increase rentals in line with inflation. The tenants will be doing well. However, if interest rates shoot up because of supply-side inflation (for example, the high oil prices in the 70s or the 2008 food price inflation in Asia) or speculative attacks on the currency (as seen during the 1988 Asian crisis), then every asset, including REITs, will suffer.

PERCEPTION #5: REITs are very risky investments as they constantly need to refinance their debts

The real issue is not whether the loans will be paid in full or refinanced. What matters is whether the underlying assets can generate enough cash under various market conditions to service the loans.

PERCEPTION #6: REITs are constantly going to unit holders cap in hand for more funds.

A rights issue, placement or any other method for raising capital is in itself neither good nor bad. What matters more is whether the funds will be used to create value for unit holders. The key question for an investor is—how is the cash going to be used? Is it for buying high-quality assets at good prices that can generate real and sustainable long-term value for unit holders?

Differentiate between cash calls made for genuinely accretive acquisitions and those made for value-destroying acquisitions or for refinancing loans. Yes, a cash call at the wrong time can be an unpleasant surprise, but an investor has to accept the realities of the REIT business model and prepare himself for such cash calls beforehand.

PERCEPTION #7: As REIT managers are paid based on the size of the assets, this makes them act in their own interests rather than create value for unit holders.

Most REITs have behaved responsibly and created value for unit holders through both organic and inorganic growth. Any REIT that abuses the incentive framework and takes its unit holders for a ride will, over time, be left without any long-term investors and have to trade at a high discount to its asset value which will ultimately require it to be liquidated. This will happen more and more as investors learn to discriminate between the good and bad ones rather than tar them all with the same brush.

Investors should instead scrutinise the track record of the different REITs and go only with those that have truly created long-term value for unit holders.

Different types of REITs

Retail REITs
Some characteristics of Retail REITs:

Retail REITs have the leeway to increase base rentals as long as tenant sales also improve. In other words, rentals can go up but not occupancy costs.
Retail REITs have the ability to execute asset enhancement initiatives (AEI) to increase the NPI and value of the property. Retail REITs have the ability to add value to their portfolio through AEIs, and this is a major advantage not available to other types of REITs.
Another unique advantage that malls have over other commercial assets is the “stickiness” of tenants.

There will always be retailers that can easily pay the rentals and still make enough profits. Those are the ones that make up the core tenant base of malls.

Structural factors:

Growth in disposable income
Strong tourist arrivals
Increase in international brands
Modest supply

Retail REITs are a very transparent and easy-to-understand business.

Hospitality REITs
Characteristics of a good hotel REIT

Quality of assets
Quality of master lessee
Lease structure
Prudent REIT management. Hotel acquisitions need to be very prudent with a good margin of safety given the high cyclicality of this sector. What may seem like a great idea during a bull market for hotels may turn out to be a disaster when the environment normalises.
Capital expenditure (capex) levels. Hotel REITs require relatively frequent capex to keep their hotels competitive with newer properties on the market. Unlike retail REITs which can make a high return on asset enhancement initiatives, hotels have to enhance their properties just to stay in the game.
Debt levels. Investors should keep a close eye on the gearing levels and interest coverage of hotel REITs due to the higher volatility in income.
Reasonable valuations Given the cyclicality of the sector, one should be cautious in extrapolating boom market operating incomes.
To leave a good margin of safety, assume a cap rate upwards of 6% on the stabilised NPI.

Office REITs
High-quality office assets do not come on the market often and there is a scarcity premium attached.

While office REITs can make good investments, investors need to proceed with a bit more caution because of their cyclical nature and upward limitations to rental due to competitiveness issues

Timing. This is more important when investing in office REITs as compared to retail or healthcare REITs. Recognise at what stage of the cycle you are investing and do not make the mistake of blindly extrapolating rentals achieved during strong markets.
Quality of assets. Choose REITs with assets in good locations and close to MRT stations. During bad times, these are the ones that get occupied first.
Valuations. Treat official valuations that the REITs report with caution as valuers generally use spot rents to value the asset. This is not always representative of the long-term earnings power of the asset given the cyclical nature of the market.
High volatility. The office REIT investor will need stronger nerves than any other REIT investor (except perhaps hospitality REITs. These REITs are highly susceptible to movements in the general economy and are frequently sold down by REIT investors in a knee-jerk reaction to macro news.
Capital expenditure. Office buildings require capex from time to time to keep up with new buildings. Since most office REITs pay out 100% of their income, additional debt might need to be raised. Factor this in the DPU payouts.
Acquisitions. Given the difference between the cap rates (3%– 4%) at which office assets trade and the distribution yield of office REITs (usually 5.5% plus in normal times), it is very hard for an office REIT to make a truly yield-accretive acquisition. To overcome this, REIT managers use all kinds of creative financial engineering. Make sure you understand this.

Office REITs might seem more risky as compared to other REITs given the cyclical nature and high volatility of such REITs. The flip side is that such volatility offers a smart and prepared investor excellent opportunities to invest in some of Singapore’s best office buildings at attractive prices.

Health care REITs
Healthcare REITs are considered defensive, yield-driven investments due to their long-term master leases. They offer limited organic growth. Unlike retail or office REITs, they do not allow for rental reversion growth during up cycles. Investors should note that given their bond-like characteristics, they are more susceptible to the general interest rate environment compared to other REITs

Just as with all REITs, the quality of the underlying assets is critical. Hospitals are superior to nursing homes as they are much less prone to an oversupply situation. A hospital such as Mount Elizabeth will cost around half a billion dollars to build and require many reputable doctors, specialists and nurses to be recruited and trained over a period of time. It will also take a lot of time and effort to develop a good reputation among the public. All of this poses a strong barrier to entry for new entrants and keeps supply in check. By contrast, an elder care nursing home can be built with a capital outlay of just S$20 million to S$30 million and good location and pricing are more important than branding.

Whether the patient pays out of his own pocket, from private insurance or national insurance plays a major role in determining the risk profile of the health care asset. In the United States in 1999, five of the nation’s seven largest skilled nursing operators filed for bankruptcy as the government cut reimbursements for nursing care. Over-reliance on government insurance programmes will render the REIT vulnerable to any policy changes. Similarly, if the REIT is mostly dependent on wealthy patients paying out of their own pockets, its fortunes may dwindle during a recession if patients move to lower-cost hospitals.

Counterparty risk is much higher for healthcare REITs than for other REITs. A huge percentage of its revenue is dependent on the master lease (more than 60% of PLife REIT’s revenue is from Parkway Holdings and more than 90% of First REIT’s revenue is from Lippo Karawaci).

The master lease agreements are only as safe as the strength of the counterparty. Should things take a turn for the worse, the investors need to be sure that the healthcare operators have the financial wherewithal to honour the agreements. To understand the degree of counterparty risk, an investor should get an understanding of the rental/earnings before interest, taxes, depreciation and amortisation (EBITDA) ratio of the hospital operator. This simply means the rental is to be paid to the REIT as a proportion of the cash that the healthcare business is generating.

Industrial REITs
Some features of industrial REITs to take note of:

Commodity nature of assets. A simple warehouse or flatted factory requires little capital and is easy to build thus offering limited barriers to entry.
Questionable valuations. Industrial assets are on short 30- to 60-year leases and undergo much faster land depreciation than other assets. So the dividend yield actually should be seen as part income and part capital payout. Fundamentally, a simple S$15m warehouse in Tuas on a 30-year lease is unlikely to appreciate in value over time. Investors should take a critical look at published valuations by appraisers.
Limited rental upside. Manufacturing (other than activities on the highest end of the value chain) is under great pressure. Singapore manufacturers offer basic products and services and compete with other low-cost Asian countries mostly on price. Rentals in high-cost Singapore eat heavily into their operating costs and can render many such businesses unviable. It affects not only SMEs but also MNCs.
Acquisition-driven growth. Organic growth through rental increases is not a long-term option for industrial REITs and neither is asset enhancement. A close analysis of industrial REITs from inception will reveal a strong spread between revenue growth and DPU growth due to the constant issuance of new shares.
Client credit quality. Tenants are typically “non-investment grade” and their ability to honour their rental obligations during a prolonged recession is suspect.
Long-term sustainability. Low-end businesses may disappear and move to a low-cost location. This could cause a glut of poorly utilised industrial space.

Cross-border REITs
Some things to take note of:

Yields. The yields of most overseas assets are higher because of the higher borrowing costs and risk-free rates in such countries
Currency risk. Many REIT managers find investing in overseas assets attractive because of the spread between the high yields of overseas assets and the low cost of Singapore dollar funding
Supply and demand dynamics. Malls in Singapore are seen as a defensive asset does not mean they would perform the same way in Indonesia or China. Similarly, competitive dynamics in the office sector are very different in India as compared to Singapore.
We have to avoid stereotyping when evaluating these REITs and assume that they “operate” the same as those assets in Singapore. Here, land is limited and expensive. However, in most countries, land is abundant and there can be oversupply (overbuilding) during upcycles.
If the assets are as good as they claimed to be, why do these foreign sponsors want to list their REITs in Singapore where the investors are less familiar with the potential of these assets? Beware of fool’s gold.

Cross-border REITs do present their own set of challenges but that does not mean they should be avoided. Proper appreciation of risks and good due diligence can sometimes help you uncover good value as the market is more likely to misprice such REITs.

The health of a REIT

REITs, more than any other business, are at the mercy of capital markets and unit holders for their funding needs. Key areas to look at when analysing a REIT’s financial strategy:

Overall leverage. Dividing the total debt (including deferred payment in units or cash) by total assets gives the leverage of the REIT. The REIT’s leverage should, however, be seen in the context of its business. Usually, retail REITs have the highest gearing as strong long-term mall leases and high occupancies offer them more stability compared with a hospitality REIT where the cash flow is more volatile. Banks also are reluctant to finance REITs with overseas properties. Leverage levels also have an impact on valuations as high leverage is likely to lead to capital calls and low leverage indicates more room for acquisitions.
Debt repayment schedule. REITs have to constantly refinance their debt as their loans are not amortised. If a large portion of debt repayments falls due during the same time, there is a refinancing risk due to the volatile nature of capital markets. A prudent REIT will have staggered debt maturity to minimise refinancing risk.
All-in interest cost. REITs with higher credit ratings, a strong portfolio of assets and a blue-chip sponsor have lower financing costs.
Unencumbered assets. When banks give loans, they like to have collateral to fall back on in case the borrower runs into financial difficulties. Having unencumbered properties gives a REIT more financial flexibility during times of weak credit markets. It can quickly pledge the properties to a bank to get a loan or, in a worst-case scenario, even sell the property to service its debt.
Sources of financing. This is a critical area not accorded due importance by investors. A REIT with a variety of funding alternatives will be better placed to thrive in different types of market environments.

In summary, the balance sheet and financing strategy of a REIT is critical to its long-term survival. The good REITs show a disciplined and well-thought-through strategy in managing their financing. They are not unduly leveraged and show the ability to raise financing from a variety of sources at competitive rates. They have their debt maturities well-spaced out to avoid refinancing shocks.

Here is a list of key questions regarding a REIT’s financing strategy an investor should probe into:

What leverage levels and interest coverage ratio has the REIT maintained historically?

What are the different sources of financing used by the REIT?

What percentage of its properties is unencumbered?
Does the REIT frequently rely on short-term (less than three years) bank loans for financing acquisitions?
Does it frequently call on existing unit holders for capital or make private placements to refinance existing debt?
Does the REIT have a meaningful MTN programme? What interest rates has it been able to achieve for the different sizes and tenures of notes issued?
Are its debt maturities well-spaced out?
Does it refinance its obligations early and raise funds during good times rather than wait till the last minute?

An investor also needs to look critically at the occupancy and rental metrics and question if they are sustainable across cycles. For REIT rentals to be sustainable over the long term, their tenants have to be making money be they retail, office or industrial.

How to evaluate acquisitions
Acquisitions are widely used by REITs to grow their asset size and revenue base. There is, however, a big difference between acquiring an asset at market price, which just about anyone can do, and getting a true deal. Most Singapore REITs have unfortunately not proven to be great deal makers.

Virtually every acquisition put forward by a REIT manager is said to be “yield-accretive”. What does this really mean? In simple terms, yield-accretive means that after the acquisition, unitholders will end up with a higher DPU as compared to before the acquisition. In other words, the net income from the acquired property will more than make up for the incremental cost of financing (if the debt is used for acquiring) and dilution from new units issued (if equity is used).

The important point to recognise is that an acquisition needs to be truly yield-accretive (at least a 5% increase in DPU in the author’s view) to offset the likely increase in leverage and uncertainty associated with turning around a property (if applicable). Marginally accretive acquisitions are of no use to the unit holder; they only benefit the REIT manager and the army of bankers, consultants and advisors working on the deal.

A checklist for investors to go through when evaluating acquisitions:

Is the acquisition DPU-accretive from the start or is there a need to turn around the asset? Investors need to be sure that the REIT manager is up to the task and has a track record of successful turnarounds.
What are the risks of the acquisition? Does it lead to a significant increase in leverage?
Is the acquisition accretive only because of low-cost debt? Debt-funded acquisitions are easiest to make accretive given the low interest cost environment of the past years but consider the effect of increased gearing and a change to interest rates.
Is the cost of debt funding and the property cash flow in the same currency?
What is the tenure of debt and is it variable or fixed rate?
Does the acquisition require any financial engineering (such as rental support)? Understand the true earnings power of the asset across business cycles.
Are the valuations “real”? Investors should use the valuer’s report only as a starting point and critically look at the assumptions made.
Is the acquisition being done during times of distress? Beware of acquisitions done during turbulent times at market prices without any discount for the uncertainty.

How much is a REIT worth?

REITs can be valued through a yield-based approach or through an NAV approach.

Yield-based approach
An investor wants to sleep peacefully at night knowing that his REIT has properties that have demonstrated strong earnings power even during a weak economic environment; he wants a REIT that is not over-leveraged and can service its debts easily even if the credit situation worsens; and he wants strong and experienced management that acts in the interest of unit holders and can steer the REIT ably during good times and bad. The safer the REIT, the less the risk premium assigned by the investor.

The second aspect is the growth potential of the REIT. Unlike a bond, an added attraction of a REIT is its ability to increase rental income and the value of its properties. If an investor thinks that there is strong potential for the properties to appreciate in the future, he might settle for a lower initial yield.

The market price or trading yield of a REIT is ultimately a mix of these two factors.

It is useful to compare the trading yield of a REIT historically to see whether the changes in yields are indeed backed by better fundamentals for the specific REIT or if the market has simply re-rated all REITs on general optimism. Similarly tracking the spread between government bonds and REIT yields over time gives an indication of how the markets perceive the riskiness of REITs across business cycles.

Ultimately, it is up to the investor to arrive at an appropriate yield at which the risk-reward of owning a specific REIT becomes compelling.

NAV approach
The NAV is the value of all the assets of a REIT minus the liabilities (mostly the debt taken by the REIT to buy the properties).

The big problem with these valuations from an investing perspective is that they merely reflect the current state of the market and not the true earnings power of the property across business cycles. The appraisers tend to overvalue properties during up cycles, extrapolating peak rentals into the future and undervalue them during down cycles as if recessions go on forever. The investor thus cannot rely entirely on the appraiser’s valuation. He must develop a good understanding of the factors that drive the valuation of a property and how they are likely to shape up in the future

Capitalisation method
A property is only as good as the cash flows it produces so an intuitive and simple way of valuing the property is based on yields or what is known as capitalisation rates (cap rates).

What drives cap rates?

Risk-free interest rates: A return an investor can earn from a risk-free investment which in Singapore can be proxied by the 10-year government bond. The lower this is, the more the appeal of higher-yield assets.
“Real estate risk premium”
Expected income growth of the property: If an investor expects high growth in NPI in the future, he will be willing to pay a low cap rate as the cap rate only capitalists the first year income and not the expected growth in the following years.

Discounted cash flow (DCF) method
DCF method discounts rental income back to present value or today’s dollar using a rate of return required by investors for such properties.

Replacement cost method
It questions what it would cost to build a similar property.

Comparable sales method
While a REIT investor should always keep tabs on commercial property transactions, he should be sceptical and not take these valuations at face value because the whole market can be over- or undervalued at a particular point in time.

Summary

The value of a REIT lies in the value of its underlying properties and the calibre of its management team. REIT yields merely reflect the safety of a REIT and its growth prospects as perceived by the market.
Yields of cross-border REITs should be compared to that country’s risk-free rates.
REIT yields equal to or lower than risk-free rates reflect high growth expectations. Similarly, very high REIT yields may be an indication of financial distress. Investors should proceed with caution in both cases.
A REIT may be re-rated positively because of improving fundamentals for the specific REIT or a general improvement in market sentiments. In both cases, the yields will “compress”.
The property values of cyclical REITs such as offices and hotels swing wildly in response to the changing economic environment, unlike the more stable retail and healthcare REITs.
Property valuations done by appraisers and reported by REITs in their financial reports are subjective and involve several assumptions. The important ones to question are the cap rates used for a particular property and rental growth assumptions.
The valuations of a REIT with overseas properties in particular should be scrutinised thoroughly.
Ultimately, valuation is an art that one acquires through experience and research. It involves a good understanding of a variety of factors that may impact valuations — property specifics, track record of the property’s performance across business cycles, global benchmarks, future supply and demand situations, structural changes in consumption trends, credit environment, etc. — and then “connecting the dots”. To become a savvy REIT investor you need to develop this judgement

Building a strong REIT portfolio

The biggest advantage of REITs is the transparent nature of their business and easy access to information. All the information to become knowledgeable on REITs is easily available.

Characteristics of a strong REIT:

High-quality assets. This does not mean prime assets but assets with strong earnings power.
Genuine and verifiable valuation of assets. Investors should not just rely on the valuation reports of property consultants. They should do their own research by looking at comparables and be particularly sceptical about highly optimistic rental growth assumptions and low cap rates.
Track record of value creation. A strong REIT creates value for its unit holders through increasing the value of its existing properties and acquiring other high-quality assets.
Shareholder-friendly management. Management has a track record of delivering DPU growth increase rather than just increasing the size of its asset base.
Financial prudence. Leverage is kept in line with the cash-generating ability of its assets and the REIT has access to multiple financing sources. The REIT has demonstrated its ability to raise financing during crunch times at a reasonable cost and always acts in a responsible fashion by refinancing debt well ahead of time.
A track record of truly yield-accretive acquisitions. Management has shown business savvy by buying assets at attractive prices rather than at market prices.

Major fundamental risks for REITs:

Prolonged structural oversupply
Weak demand and high interest rates.
Corporate governance debacles.

The good REITs will be highly coveted investments trading at a strong premium to their property values while the poor ones will trade at a big discount to their underlying properties and ultimately disappear as unit holders put pressure on them to liquidate their assets and distribute the proceeds.

REITs in a volatile interest rate environment

REITs are primarily seen as yield instruments by the market, hence the 10-year government bond yield — considered as a proxy for a risk-free rate — is used as a benchmark to price REITs. The rationale is that if the 10-year SGD bond yields x%, then REITs should be priced at x% plus a risk premium.

Even though at times the market can get obsessed with interest rates, it is important to recognise that bond yields are just one factor that influence REIT pricing.

Long-term bonds are not a practical investment alternative for most individual REIT investors. Such bonds are better suited to institutions such as pension funds and insurance companies that need to buy long-duration bonds to match their liabilities. What matters more for the investor is the rate of bank fixed deposits.

Another reason why REITs cannot be valued based on bond yields is that they are not purely yield investments. Most REITs in Singapore have a good track record of increasing their cash flows and dividends to unit holders through both organic and inorganic growth. During periods of high inflation and high-interest rates, high-quality properties are better positioned for growth than most investments.

To sum up, rising bond yields are just one factor in REIT valuations and intelligent investors should put this in perspective. At any point in time, whether the market chooses to value a REIT at yields of 5%, 6% or 7% is hard to predict and a futile exercise. Investors would be better served by focusing on REIT fundamentals and their long-term earning power irrespective of the temporary rises and falls in interest rates.

Some REITs will fare better than others in a rising interest rate environment. Here are key metrics an investor needs to look at to understand the impact of higher interest rates on REIT operations and payouts to unitholders.

All-in cost of debt. Higher interest rates will lead to higher finance costs, impacting the dividends to unit-holders (assuming no change in revenues). Thus an investor should understand the true cost of debt for a REIT and whether this is sustainable going forward once the loans come up for refinancing.
Debt maturity and nature of financing. As interest rates rise, not all of REITs’ debt gets hit with higher rates. The impact would depend on the absolute gearing levels, debt maturity schedule, the amount of debt on the floating rate, and whether financing is raised through bank loans or through the capital markets.
Highly geared REITs are risky even during normal times and become even more so during times of interest rate volatility. Take a critical look at REITs with gearing levels of 40% and above.
Conservative REITs take care to space out their debt to avoid refinancing difficulties. REITs with a big chunk of low-cost debt due for refinancing from the capital markets in the near future will likely see a rise in their financing cost. Similarly, REITs with floating rate debt are more susceptible to higher interest rates but in this case, it is the short-term rates that matter (SIBOR or SOR, swap offer rate) rather than long-term bond yields. Short-term interest rates may well stay low even as long-term rates rise.
REITs dependent on capital market financing in the form of MTNs or bonds are more susceptible to rising rates as such financing is priced using bond yields as a benchmark. Bank loans are based on short-term interest rates but also price in a credit risk premium depending on the market environment.
Growth profile and lease structure. Interest rates usually rise when economic conditions improve which means more spending in malls, higher office and hotel occupancies, and better utilisation in manufacturing factories and warehouses. All this is obviously good for REITs that own properties which can ride on an improving economic environment.
It is important for an investor to determine whether a REIT is able to monetise an improving macro environment and reward investors with increasing dividends despite rising rates.
What ultimately drives REIT valuations irrespective of the interest rate environment is the ability to maintain stable growth at least above inflation without taking undue risk.
Capital value
Capital value increases have the most credibility when they are backed by increasing rentals, not when the cap rates are lowered. Investors can easily compare capital values of various properties REITs own over the years and judge whether they are indeed backed by rising rentals and earning power or are increased valuations simply the result of appraisers lowering cap rates “in line with market transactions”.
Investors that derive their own NAV (net asset value) based on sustainable cap rates across business cycles for the specific property sector will avoid devaluation surprises as interest rates normalise and/or demand-supply dynamics worsen.

Below is a quick checklist to choosing REITs in a volatile interest rate environment:

Avoid REITs with gearing over 40%.
Assume a 3.5%–4.5% financing cost for any debt maturing over the next couple of years irrespective of the current cost of debt.
Pick REITs where you can see some growth in rentals over the coming years or REITs where current dividends are well protected.
Take a critical look at capital values, especially for REITs with foreign assets and industrial REITs. Recalculate NAVs based on conservative property cap rates.
Focus on quality rather than reaching for yield. Stick with REITs where the source of cash flow is clear. There is a world of difference between a REIT which pays out dividends based on genuine cash flows received by its tenants and one where cash flows are pumped up by the sponsor or a third-party vendor (known as income support) in the hope that, at some point, the tenant will start paying these rentals.

Spotting dubious REITs/Business Trusts

The magic hook common to all these “investments” has always been a high and guaranteed yield. The results has been a huge capital loss (examples: Rickmers Maritime Trust, Asian Pay Television Trust, Eagle Hospitality Trust).

Why do these REITs/Business Trusts come all the way to Singapore to sell their assets located in places unfamiliar to Singapore investors? Why don’t they list in their own countries or markets where their assets can be better appreciated?

It is not a “tick the box” comprehensive analysis of the REITs/Business Trusts. There is a need to understand the nature of assets, quality of sponsor and sponsor motivation in selling the assets and more importantly, the valuations of the assets.

Using Eagle Hospitality Trust to illustrate:

Nature of assets: Suburban hotels can at times perform better than luxury hotels but they do have lower barrier to entry, leading to frequent overbuilding; hence, valuation assume even greater importance.
The portfolio is focused on single-country hotel sector; a risk during recessionary times as theu can be long and painful.
Sponsor. The EHT sponsor (Urban Commons) was founded in 2008 and had a relatively short track record. There is no information on the financials of the sponsor on prospectus and website.
The sponsor is also the master lessee for all the hotels.
Two major risks:
- Ability to get debt refinanced during credit crises, which now seem to occur periodically. REITs and business trusts operate with high leverage levels of close to 40%, which means they are at the mercy of the banks and capital markets to roll over debt.
  The single biggest reason Singapore REITs stayed afloat during the 2008–09 crisis was the financial strength of the REIT sponsors.
- Counterparty risk. The master lessee must have the wherewithal to make fixed rental payments year after year regardless of whether the hotel is operating profitably or not.
Valuations. The main motivation for sponsors to sell their properties to a REIT is of course attractive prices. Investors thus have to be extra vigilant on the valuations they pay for the properties.
The author was only able to find information for 12 out of 18 hotels.
2018 yield or cap rate for the 12 hotels was only 4.9%. The valuers “projected” 2020 earnings to determine valuations and the cap rates jumped to 6.6% (for the whole portfolio of 18 properties which is still way below the 8.5% cap rates such hotels should trade at.
The author prefer to see demonstrated earnings power without any artifical support, not hypothetical projections.
As per the prospectus, the 2020 NPIs are expected to grow 35% (for 12 out of 18 hotels). The sponsor makes a number of assumptions to justify the profit forecast.
He found it puzzling that SGX allows valuations based on projections for a sector as volatile as hotels. It is also not clear why one-third of the hotel portfolio does not have any historical NPI information.

Published by Lifenotes