Factors in selection of REITs

4 weeks ago JCprojectfreedom 2

There are many factors to consider when investing in REITs.

1 – REITs that receive income support

Some REITs are sponsored by a property developer. After developing the property, the developer injects this asset into the REIT. The developer may provide income support for the first few years to compensate for the shortfall in rental income which the REIT would otherwise have been able to receive based on prevailing conditions. Income support can support a REIT’s distribution payout which will then be higher than the rental income collected from the tenants.

A potential problem may arise when the income support expires. Unit holders have to ask: Will the REIT be able to sustain the same rental yield from the property’s tenancy?

2 – Interest Rate Sensitivity

Since a REIT is a yield instrument, it may be perceived to have the same behaviour as bonds with regards to interest rate changes. Bond prices fall when interest rates increase. However studies in Singapore and US markets have not conclusively shown this inverse correlation between REIT prices and interest rates.

A rise in interest rates mean higher debt servicing costs for the REIT.

Thus it is more important to consider the ratio of fixed versus floating rate debt. In a rising interest rate environment, a REIT that uses more floating-rate debt will be hurt much more compared with one that uses fixed rate debt.

3 – Dilution Risk

A REIT manager may undertake capital fund raising activities such as rights issues to fund new property purchases or expansion plans. Investors who do not participate in these fund raising activities (they do not subscribe to their rights issue entitlements)

4 – Yield

It is important that investors in REITs should not be solely focusing on the yield but also the capital gains/loss of the REITs. This is a similar risk to investing in stocks. Investors have to understand why a REIT may have a higher yield after IPO or when compared to other REITs.

The price of the REITs may have come down, resulting in higher yield (assuming the same DPU). Has the price come down because of the future earnings outlook due to sectorial performance or some specific problems? Problems may include the loss of an anchor tenant, the inability to refinance loans or even financial distress. As distributions are not guaranteed, a REIT may cut the distribution amount.

Distribution yields are calculated from the historical information. Forecasted distribution yields are available from analyst reports or consensus estimates from some financial databases. However, these are only estimates and not guaranteed. If a lower distribution is declared, unit holders will receive a lower yield even though if the REIT price remains constant.

5 – Alignment of interest of REIT Manager

Often, the REIT Manager is compensated based on the size of the portfolio they managed and a fee for acquisition of new assets. So a REIT Manager may keep increasing its portfolio by issuing new rights issue as discussed above to fund their new purchases, which may not be in the interest of existing REIT holders.

6 – Overseas Properties Risk

REITs that invest in overseas properties will be subject to laws and regulations governing property investments of the overseas country. This may differ significantly from the rules of Singapore.

In particular, REITs that invest in developing countries may be exposed to risks associated with political stability, exchange controls, changes in taxation, foreign investment policies and other restrictions and controls which may be imposed by the relevant authorities in those countries. In addition, the rule of law in these markets may not be as strong, and the properties could become the subject of arbitrary confiscation or retrospective taxation.

7 – Domiciliation of Sponsor and Controllers of the REIT

Some REITs have Sponsors or managers where the key personnel have their primary base of operations overseas. It would be harder for unit-holders to hold such personnel to account under the laws of Singapore should something subsequently go wrong with the REIT.

8 – Other Risks

While some REITs can offer diversity based on the type of properties or region you want to invest in, such diversification could carry other risks such as sector and country regulation risk.

You can read my previous post here on understanding the basic of REITs.

You can read my next post here on selection and valuation of REITs.