In this seniors’ guide to investing in REITs, we explore how interest rate movements may make these financial instruments a worthwhile consideration.
In the article “Happiness for an Investor is an Interest Rate Cut“, real estate investment trusts (REITs) were cited as being among the possible beneficiaries when interest rates are eventually lowered.
This is mainly because REITs are landlords who own and operate properties such as retail malls, office buildings, hospitals and warehouses. In order to buy such large and expensive properties and to also maintain and enhance them, REITs have to borrow, and in so doing incur large interest payments.
However, since REITs are meant to be relatively safe instruments, the authorities here have limited their borrowing to 50% of total assets in order to avoid too much distress when interest rates rise sharply, as they have since 2022.
REITs are thus attractive to many investors, including those new to investing. Because of the need to enjoy tax transparency (explained later), they will distribute most of the income they derive from rentals, which means investors can, in theory at least, enjoy a regular stream of income known as distributions.
On top of this, investors can also benefit from capital gains when prices rise.
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Note the difference between REITs and Business Trusts
Some newbies may be confused by how another category of trusts known as Business Trusts (BTs) operate.
Note that REITs are set up as trusts and governed by the Securities and Futures Act whilst BTs are governed by the Business Trusts Act.
BTs can also own and operate properties but there are important differences. Possibly the most important, as far as investors are concerned, are that REITs have to distribute at least 90% of net income in order to enjoy tax transparency (i.e. if they pay out 90% of their net profits they don’t have to pay tax) whilst BTs are not obliged to pay dividends if they deem it fit not to do so.
Also, whilst borrowings by REITs are capped by the gearing limit, there is no such cap for BTs.
The rest of this article will focus on REITs as their business models tend to be slightly easier to understand.
Given that rates will be lowered sooner or later, thus reducing the interest payments burden and therefore lifting profits, how might an investor go about screening REITs?
1. Ideally, the REIT’s gearing should be as low as possible
Even though a REIT is entitled to borrow up to 50% of total assets, those that are close to this limit would:
a) be incurring significant interest payments which would raise their financial risk;
b) have insufficient debt headroom to borrow for later expansion; and
c) be more likely to have to raise capital from their unitholders through rights issues which are usually unpopular with unitholders because such exercises are dilutive.
In fact, the number one reason given by REITs for reducing their distributions for the 2023 financial year is high interest payments.
One guideline for investors is thus to look for REITs whose gearing is well below the 50% threshold, preferably under 35%, in order to mitigate financial and interest rate risks.
2. Check whether there is income support and if so, for how long it can continue
Income support is an arrangement where the REIT sponsor, usually a large property developer, assists in topping up any difference between the desired rental income and the actual rental income derived for a stipulated period of time. Income support cushions the yield of the REIT by providing short-term boost to support yield.
Income support is usually provided if the REIT has new assets that are still in the process of finding new tenants and is not meant as a long-term solution. In a sense, the money is coming from a related party and is not being generated by the REIT’s operations. When the support is withdrawn, the distribution yield of the REIT could suddenly drop.
Investors should therefore look for REITs that don’t rely on income support to prop up their bottom lines.
3. Check if there are any special arrangements
Some REITs have special arrangements with strategic partners whereby those partners may not necessarily receive distributions for the first few years.
However, the agreements could provide for payment of distributions to those partners that gradually increase after that initial period, in which case this would then adversely affect the distributions to other unitholders.
In other words, although distributions may be attractive in the early years, they could drop later when the strategic partners qualify for payments.
4. Check whether there’s a sponsor and whether there’s a pipeline of properties
Besides understanding the financial ability of a REIT to undertake acquisitions in order to grow its distributions, it is important to assess the REIT’s potential pipeline of properties.
A strong sponsor such as CapitaLand or Keppel Land can give a REIT access to high quality assets through a robust pipeline of asset injections into the REIT.
Divesting properties into the REIT offers benefits to both parties. It allows the sponsor to offload capital-intensive assets, effectively maintaining a lighter balance sheet, and because it still retains a stake in the REIT, it gets to earn income.
In addition, REIT managers are usually subsidiaries of sponsors, which means sponsors get to retain management control of the REITs.
Having a strong sponsor also means probably access to financing at good rates.
5. Check the occupancy figures and lease renewal dates
Occupancy and lease renewal risks arise because there is an uneven distribution of tenant lease expiries, exposing the REIT to the risk of renewing a large proportion of lease contracts at the same time or period.
One useful metric is WALE or weighted average lease expiry, which is a measure of the average time period in which all leases in a property will expire, usually measured in years. It is an indirect measure of the risk of a property becoming vacant. The longer the WALE, the less risk of a property going vacant and the more predictable the income from rents.
Note however, that a short WALE may not always be negative. If the economy is booming and rents are rising, then having shorter WALEs could mean that expiring leases can be quickly renewed at higher rates, thus benefiting unitholders.
6. Check the debt maturity profile
The lifeblood of a REIT is the ability and need to obtain financing at reasonable costs and in the amounts required. However, a well-managed REIT should have a fairly evenly distributed debt maturity profile.
If for instance, the majority of a REIT’s debt matures at the same time, this will put pressure on the REIT, especially if economic conditions are adverse as this could then mean difficulty in obtaining refinancing.
If this happens, a cash-strapped REIT may then have to ask unitholders for money through a rights issue. Then again, if there’s an economic downturn, unitholders themselves may be cash-strapped, further complicating matters.
Whatever the case, rights issues are usually frowned upon by unitholders as it means issuing more units – albeit at a discount to the market price – which is dilutive for everyone.
Investors should therefore look for REITs that have an evenly distributed debt expiry profile, with one possible guideline being that there is no more than 30% of debt being due in an any one year whilst all maturities are spread out over 5 or more years.
7. Check the manager’s track record of value creation
Most REIT investors make the mistake of looking only at yields when evaluating a purchase. However, yields could be elevated because prices are low, in which case you’d have to wonder why this is the case. It could be that the market takes a dim view of a REIT’s prospects, thus depressing the price.
It’s more important to check whether the manager has a track record of buying high-quality assets, and has created value consistently through rising income, distributions and the REIT’s price. Management should also have demonstrated solid business acumen by buying good assets at attractive prices.
8. Tap into GIFT
When screening REITs, ultimately, the major considerations that would determine a REIT’s performance are the quality of its assets and how good the manager is in creating value and its relationship with the sponsor (if there is one).
From this discussion it is thus crucial to consider the quality, integrity and track record of sponsors and REIT managers when deciding which to buy.
In this regard, investors can make use of the Governance Indices for Trusts (GIFTs), which was developed by National University of Singapore Associate Professor Mak Yuen Teen and private investor Chew Yi Hong.
Each year, a GIFT report is released, ranking all REITs and BTs according to how well they score on various categories such as corporate governance, board independence and business risks.
Here is the link to the scoring mechanism.
However, note that the 2024 GIFT report has not been released yet.
