Many investors like REITs because of their consistent dividend payout which can be 2 or 4 (half-yearly or quarterly) times a year.
While the business model is simple, there are details that investors must be aware of and be careful with their implications. Similar to equities and any businesses, only a handful are high-quality where investors can enjoy good return with rising dividends and rising share prices. It is defintely not a case of simply “buy REITs and income will come”.
REITs’ (oversimplified) business model
The fundamental operation of a REIT is that the manager undertakes loans and issues new equity to buy assets, lease the assets and collect rental from the assets.
REITs’ unique characteristics
REITs’ basic model of generating income from their assets is simple to understand and attracts many investors. However, they do not operate like the usual businesses. It has a few unique characteristics that investors must be aware of:
- Singapore REITs must pay out at least 90% of their income as dividends, making them an attractive dividend investment.
- At least 75% of a REIT must be invested in mature, income-producing properties. This excludes development properties that would be using up cash rather than contributing to cash flow.
- Maximum debt ratio of 45%* of the value of a REIT’s assets.
- Each REIT has a sponsor – a parent or a majority unitholder of the trust. Sponsors usually provide the properties that are transferred into the REIT at the time of its initial public offering (IPO). By structuring a portfolio of properties into a REIT, sponsors have a platform to sell properties to the trust often at fair or lower-than-market average prices. This, in turn, frees up capital for further investments.
The sponsor can also continue to provide a pipeline of assets for future acquisition by the REIT after its IPO. This is why the attractiveness of REITs is also dependent on the strength of its sponsor.
* It was raised to 50% to help REITs cope with operating challenges during the COVID-19; the policies may change. There is a specific formula used with a set of requirements.
What do these mean?
Cash sufficient for status quo
Because REITs pay out at least 90% of their income as dividends, they have just enough cash. It is insufficient for large acquisitions which they need to tap into debt and/or equity for financing. It is enough for daily operations but it can be insufficent to handle the sudden unexpected changes in the operating envionment such as increase in finance costs and unexpected delays in rental payments. It assumes status quo.
Debts
All REITs have debts. Investors have to be aware of the implications of debts: exposure to interest rates, finance costs, ability to service the interest expenses, refinancing risks and the assumptions of stable and steady income (tenants will come and pay and rents can increase).
REITs operate with a balance of cash and leverage, requiring careful asset selection to ensure expected returns. As their assets are less liquid than some investments, proactive management strategies is important to mitigate risks.
REITs > Interest rates
Good REITs > Good assets
REIT is a collection of assets. Finance costs are a major cost item as REITs borrow to buy assets. This make REITs sensitive to changes in interest rates. Investors have to examine not just the cost of debts but the resulting finance costs. Hence, it is important to compare the debts to their assers (i.e. gearing) and interests expenses to earnings (i.e. interest coverage).
Finance costs matter.
The total returns from assets must be (a) capable of generating sustaining and consistent income that more than covers the interest expenses and (b) the assets appreciate over time. Good assets at the right price matter greatly.
REITs’ assets are an essential part of an economy/country as they provide retail outlets, corporate offices, hotels, healthcare, logistics and manufacturing premises. The attractiveness of the REITs’ assets depends on what better and cheaper alternatives the companies and cosumers have.
- Can a retail outlet generate more profits in another malls? Can they do better with e-commerce?
- Are there other office buildings have the location, surrounding amenities and prestige that the companies and employees want? Do they cut their office expansion as more work from home and/or slowing economy?
Also, REITs invest in mature, income-producing properties. They should be able to evaluate the potential return of the assets with high certainty before investing in them. So, what gives?
There are two typical characteristics about REITs’ assets:
- The lifespan of the assets is in years and decades. It is difficult (impossible) to predict what will happen to interest rates and the business environment during the lifespan of the assets.
- The returns from these assets are low-growth at best. They cannot impose hefty rental increases on their tenants (consistently) when times are good. A good asset can increase slightly more than the inflation rate.
If the assets can continue to provide good income and able to increase their yield (cap rate), the impact of the higher interest rates can be cushioned. Distribution per unit (DPU) can increase too. If the REIT manager had been acquiring well, valuations of the underlying asset should steadily increase and show up in the NAV or Book Value. The REIT manager matters. A good REIT is not just about a collection of good assets.
On the other hand, when the assets are not able to deliver as expected and the financial position of the REITs is tight, it can have serious domino effects to the REITs.
- Invested in poor quality assets (whether the assets are good or poor will usually be known later during tough times) — low occupancy rates, unable to raise rents and increase yields, risk of being revalued lower that will affect gearing ratios, risk of refinancing and high interest rates
Example: SoilBuild REIT on 72 Lokyang Way (see below) - Assets turn bad. Competition and macro changes can cause assets to being revalued lower.
Example: Manulife US REIT where its real estate valuation of the portfolio declined by 14.6% within 6 months (see below) - Paid a high price for assets (during good/euphoric times which we will know later when times turn bad) — asset being revalued lower will affect gearing
- Too much debt — high debt ratio (especially when assets being revalued lower) and low interest coverage (when interest rates increase)
- Too much equity fundraising —- REITs raising money through shareholders; issuing more shares that dilute DPU and NAV per share (worse, when REITs need to raise money after a plunge in share price; heavily diluting the existing shareholders)
Depending on the severity of the situation, the REIT can constantly be in a tight spot and its survival can be threatened with unexpected negative situations.
Increase in income ≠ Increase in DPU
Beside debt financing, REITs may need to raise money through placement or rights issue to fund the acquisition. The acquisition will increase the REIT’s distributable income but the latter is divided by more units. Depending on how much the distributable income increase relative to the increase in units, DPU may increase just marginally, stagnate or worse, drop. The acquisition may not enhanced shareholders’ value; it can be a DPU-dilutive acquisition. Number of units matter.
Instead, the acquisition increases the management base fee as it is calculated as a percentage of assets’ value.
The better-performing REITs in the past two decades have been able to exhibit an increasing DPU growth profile, despite capital raising via placements or rights issues.
Making your millions in REITs by Gabriel Yap
Return on investment
The primary test of managerial economic performance is the achievement of a high earnings rate on equity capital employed (without undue leverage, accounting gimmickry, etc.) and not the achievement of consistent gains in earnings per share. In our view, many businesses would be better understood by their shareholder owners, as well as the general public, if managements and financial analysts modified the primary emphasis they place upon earnings per share, and upon yearly changes in that figure.
Warren Buffett, Berkshire Hathaway 1977 Shareholder Letter
Besides knowing the DPU, gearing ratio, interest coverage, net income yield, etc., we need to have a measure of the return from the invested capital (equity and debt). This is to measure how well capital has been deployed to achieve the return over time. It is also a gauge of the value created. It is an important metric in evaluating stocks. Return on Invested Capital is one metric that many use.
A good post on REITs and ROIC by Gabriel Yap: The Good, The Bad and The Ugly in S-REITs – Avoiding Value Traps with ROIC
Other risks
Country risks
Investors may underestimate the country’s risks (home bias). Depending on the economic conditions, it can affect the assets’ ability to generate income and value of the assets which in turn affect its gearing, increase refinancing risks and interest rate.
Currency risks
The currencies that the REITs operate in may weaken against the currency that they are listed and that DPU will be paid in. Their rental income may be okay and increasing in the local currencies but resulting in a lower increase or worse, a drop in DPU.
The REIT Triangle: The interdependence of Assets, Debts, and Equity
REITs’ assets and debt/equity structure must be durable to withstand different unexpected situations.
It is not just about assets. debts and interest expenses. We have to evaluate their assets, debt and equity in totality and their interdependence on whether their assets can consistently generate more net income (after finance costs) to pay more DPUs.
REITs must have good assets at the right price with the right proportion of debts and equity.
- Too much debt due to aggressive asset acquistion and/or buying of assets at high prices can threaten the survival of REITs in unexpected bad times
- Too much equity will dilute shareholders. Due to its gearing and little cash they have, one problem can easily ignite into a perfect storm!
REITs that can consistently make DPU-accretive acquisitions and employ shareholder-friendly financing structures to finance such acquisitions will be winners in the REIT sector.
Finding high-quality REITs
Hence, the hallmarks of high-quality REITs include:
- Invest in good assets at a right price (not a high price); it is easy to find good assets at a high price
- An appropriate use of debt and equity financing that is (a) accretive to shareholders and (b) not over-stretched the financial position of the REIT
- Ability to enhance the assets to stay relevant and competitive
- Grow DPU consistently with the increase in distributable income
Few REIT managers can do the above well consistently to grow DPU and achieve capital gains for shareholders over the long term. It is not as easy as it seems.
The best REITs have 2 characteristics over the long-term: (a) rising DPU and (b) rising share price. These are results. Focus on the the quality of the REIT and its ability to grow and generate good retturns. Do not be overly focused on dividend distribution, dividend per unit and dividend yield.
Conclusion
Dunning-Kruger Effect
Investors may oversimplify REITs and think that they are easy to understand and evaluate; and easy to make money from. However, they may overestimate their ability and knowledge especially when macro developments are not favourable to REITs.
It is time to re-evaluate our REIT investing process and improve.
Do you due diligence
Good assets with debts allow REITs to grow and give good dividends. However, the characteristics of REITs also make them vulnerable during poor economic conditions and rising interest rates. Investors should not be too aggressive and myopic in chasing REITs with high dividend yield.
Not all REITs are the same; only a few will do well over the long term. Investors should be discerning and not be gullible with. Similar to stock investing, good REIT investing skill is required to find high-quality REITs at good prices.
- Buy well and buy low.
- Keep validating to hold long.
- Do not buy and forget.
Professor Aswath Damodaran of NYU explained that all qualitative factors (strengthening moat, improving fundamentals, improving macros, insiders buying) will show up in financial performance over time. The same is equally applicable to REITs. The ability to grow DPU, NAV per share and ROIC over time is the ultimate validation of the quality of the REITs, their assets invested and management.
My notes of great books on REITs; worth reading:
Making your millions in REITs by Gabriel Yap
Building wealth through REITs (3rd edition) by Bobby Jayaraman
