Understanding REITs

4 weeks ago JCprojectfreedom 2

There are many different types of assets class such as bonds, equities, Unit Trusts, Exchange Traded Funds (ETF), Real Estate Investment Trusts (REITs), Options and others. REITs are instruments that offer investors the opportunity to invest in a professionally managed portfolio of real estates through purchase of a publicly traded investment product. Individuals invest by purchase units of the REIT.

The investment objective of REITs is to provide unit holders with distribution income, usually from rental income, and capital gains from appreciation of REIT price and the profitable sale of real estate assets.  Distribution income is similar to dividend income you get from shares.

REITs possess market risks, value of units will fluctuate and investors may receive more or less than the original purchase price. REITs are collective investment schemes that invest in a portfolio of income generating real estate assets such as shopping malls, warehouses, offices, hotels or serviced apartments.

  1. Development limit up to 10% of assets (can be raised to 25% if certain conditions met)
  2. At least 75% of assets should be in income-producing real estate
  3. The REIT must derive at least 90% of its revenue from rentals or interest/ dividends from investment
  4. Limits on gearing up to 45%

Assets in REITs are professionally managed and revenues generated from assets are distributed at regular intervals to investors. Singapore listed REITs offer investors access to a diversity of real estate assets:

  • Industrial – warehouses
  • Healthcare – hospitals, nursing homes
  • Hospitality – hotels
  • Commercial – office space
  • Residential – serviced apartments
  • Retails – shopping malls

Earnings Growth Strategy for REITs

Acquisition/ Property Rebalancing

New property will take time to complete. A faster way to grow is to acquire properties. Commonly known as a yield acquisition, REIT Manager may identify good opportunities where they can get higher rentals through acquiring a property which exceeds the cost of debt/equity deployed.

A REIT Manager can realise better capital management by selling an underperforming property and freed up cash to buy another property which can provide better returns or rental yields. It is important that the REIT manager is astute in getting the timing of this property rebalancing act correct.

Rental Increase

Increasing the rent is one other way to increase the REIT earnings. However the REIT manager has to take into consideration the demand and supply of the market. Tenants may move to another property if they cannot sustain or do not see the value after the increase in rents. By increasing rents, the cost of business may eventually be passed on to the end consumers and there is a risk that the manager or the REIT may develop a bad reputation.

Asset Enhancement and New Property Development Strategy

The better way is to increase earnings is through Asset Enhancement. This method seeks to change the tenancy mix by attracting higher yielding luxury tenants to optimise space usage or to convert low yielding space to higher yielding space.

Sometimes the REIT Manager may decide to refurbish the entire property to give a fresh look or improve its facilities to attract higher yielding tenants. Through capital expenditure to maintain or enhance the property, it provides the basis for the REIT’s share price appreciation. REIT Manager can also undertake new property developments which may command higher rental incomes than older property.

Structure of REITs

Trustee

REITs are structured as trusts and thus the assets of a REIT are held by an independent trustee on behalf of unit holders. The trustee has duties as laid out in the trust deed for the REIT which typically include ensuring compliance with all applicable laws, taking custody of the real estate assets and protect rights of unit holders. Trustees charge a fee for providing this service.

In a typical REIT structure, money is raised from unit holders through an Initial Public Offering (IPO) and used by the company to purchase a pool of real estate properties. These properties are then leased out to tenants and in return the income flows back to the unit holders (investors) as income distributions (which are similar to dividends).

REIT Manager & Property Manager

The underlying real estate properties are managed by a property manager and the REIT itself is managed by a REIT manager in exchange for a fee. The underlying assets are held by a trustee on behalf of investors. Each party receives fees in return for his or her services. Most REITs have annual manager’s fees, property manager’s fees, trustees’ fees and other expenses that will be deducted from their cash yields before distributions are made.

The responsibility of the REIT manager is to manage the REIT, setting and executing the strategic direction of the REIT. For instance, it is responsible for the acquisition and divestment of the underlying properties.

The property manager’s responsibility on the other hand includes renting out the property to achieve the best tenancy mix and rental income, to run marketing events or programs to attract shoppers/ tenants and to upkeep the property.

Sponsor/Major Shareholder

In some cases, a sponsor or a major shareholder is present. For example, a property developer launches a REIT, it may choose to keep X % stake in the REITs itself. Like any other investor, the developer in this instance will receive income distributions, where applicable. In most cases, the sponsor is also the owner of the REIT manager.

Key Considerations Before Investing in REITs

  1. Consider if the REIT’s investment objectives suit your personal risk appetite and investment time horizon.
  2. Always read up on the REITs you are considering. REITs can have different structures, geographical or sector focus, and some REITs may carry more risk such as political and regulatory risk.
  3. Understand the asset quality and resilience of the underlying real estate properties, what is the experience and track record of the REIT manger, property manager and the income distribution policy.
  4. Consider the tenancy mix and occupancy ratio
  5. Assume the gearing ratio and debt maturity
  6. Consider the Net Asset Value for potential profit
  7. Find out more about the sponsors or key personnel of the REIT
  8. Ask yourself what is the avenue to seek legal recourse.
  9. Compare and understand all the fee payable to the respective parties as this will impact the returns of the REIT
  10. Do not invest in a REIT if you do not understand or are not comfortable with its investment objective and strategy
  11. Compare REITs with other yielding generating investments such as bonds and high dividend stocks

 

Benefits of REIT

Diversification

REITs typically own multi-property portfolios with diversified tenant pools. For instance, if you invest in a REIT, you are buying a share of a portfolio of shopping malls, office buildings or industrial buildings with a diversified tenant base. This reduces the risk of relying on a single property and tenant which you face when you directly own a condominium or real estate property.

You can diversify further by selecting REITs based on the type of properties or region you want to invest in. Having REITs as part of your portfolio further helps in your asset allocation and diversification as REITs may have lower correlation with other asset classes. REITs also provide a steady income to investors.

Affordability

The REIT investor enjoys the advantage of being able to invest in properties that he would not be able to afford otherwise. By investing in a REIT, you get to invest in these large assets in bite-size chunks.

Liquidity 

Compared to investing directly in real estate properties, a REIT investment offers the advantage of liquidity – ease of converting assets into cash. It is easier to buy and sell a REIT than to buy and sell properties.

Tax

The REIT vehicle enjoys tax transparency on qualifying income derived from the underlying portfolio, if the REIT distributes at least 90% of its income to units holders. In addition, individual investors are exempted from tax on such distributions.

Transparency and Flexibility

Buying or selling a REIT is transparent and flexible, just like trading stocks listed on the exchange. Investors can access information on the REIT prices and trade REITs throughout the day. There are a lot external controls and monitoring of REITs which increase transparency and corporate governance.

S-REITs are regulated on the amount of borrowing up to 45% of the REIT’s deposited property. This safeguards the interest of unit holders against an excessive burden when interest rates rise or in an economic downturn. However, do note that REITs listed outside of Singapore may not have regulations on gearing.

Distribution Yield

One of the major attraction of REIT is the distribution yield. S-REITs may have yields that can be above 5%. However, bear in mind that yields are not guaranteed.

Risk of REITs

Market Risk

REITs are traded on the stock exchange and the prices are subject to demand and supply conditions, just like other stocks. Investors could receive less than the original investment amount when they sell their unit in REIT. The prices generally reflect the investors’ confidence in the economy, the property market and its returns, the REIT management, interest rates, and many other factors. Investors must be able to tolerate such price movements.

Income Risk

Distributions may not be paid if a REIT reports an operating loss. You should consider whether the REIT has taken any measures such as procuring payment upfront or contractual lock-ins of rental rates and other clauses in tenancy agreements. Similarly, if the underlying properties are financed by debt, there is a refinancing risk which refers to possible changes in the cost of debt (the interest rate the REIT needs to pay on its borrowings). A high cost of debt may also reduce the income distributions to unit holders.

Concentration Risk

If a substantial portion of the value of a REIT’s assets is derived from one or a few properties, you may be exposed to a greater risk of loss if something untoward should happen to one of these properties. Similarly, if a REIT depends on only a few tenants for its lease income, you are exposed to a greater risk of these tenants not being able to fulfill their lease obligations.

Liquidity Risk

Although investors are able to exit their investments easily by selling it on the exchange, the real estate in the REIT may be relatively less liquid compared with financial securities such as stocks and bonds. This is because it is difficult to quickly find buyers and sellers for property, especially if the value of the property is high. As a result, it may be difficult for REITs to vary their investment portfolio or sell their assets on short notice should there be adverse economic conditions or exceptional circumstances.

Leverage Risk

Where a REIT uses debt to finance the acquisition of underlying properties, there is leverage risk. As is the case with other listed companies, in the event of an insolvency of the REIT, the assets of the REIT will be used to pay off debtors first. Any remaining value will be distributed to unit holders.

Refinancing Risk and Interest Rate Risk

As REITs distribute a large amount of their income to unit holders, they may not have the ability to build up cash reserves to repay loans as they fall due. Thus they will typically seek financing by entering into new borrowing agreements, or other capitalization measures such as rights or bond issues.

One potential risk is higher refinancing cost when loans are due for renewal. This could happen if interest rates rise. Another risk is that a REIT which is unable to secure refinancing may be required to sell off some properties if they are mortgaged under the loan. These risks could affect the unit price and income distribution of a REIT.

You can read the next post here to understand factors to consider in selecting a REIT.